The BHP DVD interview explained
Following an exclusive interview with BHP Billiton chairman Don Argus and CEO Marius Kloppers, Robert Gottliebsen explains why he believes BHP is preparing to go hostile in its Rio bid.
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Ten lessons about BHP from the Argus/Kloppers interview with Robert Gottliebsen
1) The most important lesson from my Argus-Kloppers interview is that BHP Billiton is convinced that the recent fall in commodity prices is a correction and does not reflect a fundamental change in direction.
When the interview took place on July 30, the prices of oil copper and other minerals were still strong. Both Kloppers and his predecessor Chip Goodyear have based their strategies on the belief that the extended bull market for commodities would be interrupted by a series of major corrections.
That view is set out clearly in the interview transcript, and so what happened in the weeks that followed did not surprise either Argus or Kloppers. And in the final week of September when the transcript was filed with the stock exchange copper and oil had regained some of their lost ground but then prices fell again as part of the US banking crisis and the slow down in China.
Rio Tinto has a very similar view to BHP on the long-term outlook for commodities. However, on July 30 when the interview was conducted none of us anticipated the huge fluctuations in global share markets that would follow the deepening of the US banking crisis and the measures taken to overcome it.
The effect of that slump on BHP (and Rio Tinto) share prices was fascinating. Even though the Australian dollar was falling, the local market for shares in BHP and Rio Tinto (in Australian dollars) slumped despite the fact the vast bulk of their income was in the rising US dollar. Accordingly, the recent fall in the Australian dollar against the American currency will insulate the company against some of the metal price declines. But in the wildly fluctuating market those trends could be reversed. BHP’s share price is, in practice, set by the overall global market. When the interview was being conducted on July 30 the BHP share price was $39.26. On September 23, as the transcript was being prepared for filing with the ASX, BHP shares closed in Australia at $37.90, slightly below the July 30 level. The night before they were higher than July 30. Any long-term BHP shareholders who had been on an extended holiday might have said: "What was all the fuss?” But more recently the BHP share price has fallen sharply in line with commodities.
2) Although we did not discuss it in the interview, the subsequent fall in minerals markets caused Kloppers to state that if the mineral price setback extended into 2009 it might actually make it easier for BHP to acquire Rio Tinto, assuming the European Commission blows the 'all clear' whistle. I think Kloppers is probably right. If mineral prices are still down in 2009 (and no one is making this prediction) then institutions will have experienced a hard time in mineral shares and will be looking for profits.
3) Let me explain why I think BHP is preparing to go hostile in its Rio bid. At the end of this calendar year or early next year the European Commission is going to decide whether BHP can proceed with its bid on terms that are acceptable to BHP.
If the conditions are too tough, Kloppers made it clear in the interview that "we’ll have to think again”. Without forecasting the European Commission decision , for this exercise, let's assume that the Commission approves the BHP Billiton bid.
In those circumstances, and in the absence of some cataclysmic event, I believe that BHP Billiton is bound to then proceed with its bid. When I asked: "Let’s assume the European Commission gives a decision that you can accept, would you make a hostile bid?”, Don Argus gave an answer in two parts. The first part talked about possible Rio discussions (see lesson four, below) and in the second part he indicated that BHP would go ahead with a bid, but his remarks could have been interpreted as meaning that there was wriggle room. International takeover lawyers are a pedantic lot and the remarks raised their ire, given the interview was to become a stock exchange document. So in accordance with my agreement with BHP (Behind the scenes with BHP, September 24), both the question and answer were eliminated from the DVD.
4) Unfortunately, for production reasons, the views of Don Argus on possible 'engagement’ with Rio Tinto which were contained in the answer also had to be eliminated.
In my view these words were too important to be put in the dustbin so you will see that in the 'cuts' (Out-takes from the BHP interview, September 24) Argus made it clear that if the European Commission approved the bid then his first move would be to engage the Rio Tinto board. But then he adds a rider directed squarely at the Rio Tinto directors: "Shareholders are the decision makers, boards are only stewards of someone else’s money.
Here we see the basis of one of BHP's arguments that may be put direct to Rio Tinto shareholders if Rio Tinto does not recommend the bid. BHP will press strongly on the premium contained in its offer. Rio Tinto’s counter to date has been that the sum of the Rio Tinto parts is worth more than what BHP is offering – that is, Rio believes that its shareholders are entitled to a greater share of the combined pie. I have the greatest respect for the talents of Rio Tinto chairman Paul Skinner and his CEO Tom Albanese. Apart from some badly chosen remarks about BHP oil, they have put their case very well and there is no certainty BHP will win a fight for the hearts and minds of Rio shareholders, although clearly Argus and Kloppers are very confident.
Recently the ACCC has approved the merger. That decision improves BHP's chance of gaining a favourable outcome before the European Commission, although there is no security (BHP's iron clad case, October 1).
If the European Commission sets conditions acceptable to BHP, then Rio Tinto directors will need to decide whether to engage in talks with Argus and Kloppers and recommend any higher bid, or whether to fight on. A Rio Tinto problem in the "sum of the parts is worth more than the BHP bid” argument, will be valuing its Australian iron ore assets – clearly they would be worth a great deal more if the Australian Government were to allow them to be sold to China. Of course, if the European Commission sets conditions that effectively block the bid there will be no such debate.
5) In the interview cuts it is clear that BHP does not think the original WMC plan to process all its uranium and copper metal in South Australia will work. While copper metal will still be produced in South Australia, Kloppers wants much of the advanced processing to take place elsewhere. Olympic Dam’s reserves are monumental but it is clear from the Kloppers remarks that the big Olympic Dam growth will not come until China greatly increases its nuclear power capacity. This is a project that will probably not deliver the forecast huge rewards until well into the next decade. But the rewards will be massive and will transform the South Australian economy.
6) BHP believes that one key reason for the bid is the better allocation of expansion capital. Rio Tinto has never disputed this. Rio’s arguments are about relative value. If BHP and Rio Tinto both undertake massive expansion programs along with all the other projects being considered around the world, then China will have to be still growing at a very fast rate in the second half of the next decade to handle the material being produced.
7) The traditional BHP view is that each CEO must hand to their successor greater resources or projects than they were given when they arrived in the job. Kloppers has embraced this tradition and you see it emerging when I asked him about the BHP dividend. In 2007-08 BHP earned $US2.75 but paid out only 70 US cents. It is clear that BHP’s first priority remains using most of its massive operating cash flow – $US18 billion in 2007-08 – on capital spending. And it is this capital spending that tells you where the big longer term drivers of BHP’s profit are gong to be.
8) Around one third of BHP’s capex is in oil. The company is really driving its oil, an opportunity which is an enormous difference to Rio Tinto which stays clear of oil believing that the cultures of an oil company and a mining company are very different. Oil operators must replace or increase their reserves each year to offset production which means that the cash flow sums are very different. While in theory BHP may have an advantage over Rio Tinto if mineral prices fall, what BHP really wants is for oil prices to rise strongly which will enable its new oil projects to be experiencing spectacular profit growth as the bid is put before Rio shareholders.
9) BHP believes that it must have an aluminium business to be an integrated minerals company. This will be an important point in the European Commission hearings. The combination of Rio Tinto and BHP Billiton aluminium operations would be superb. If the European Commission’s aluminium requirements are tough, then it could be a deal breaker. On the other side, BHP believes that the fact that it will be looking to base its iron ore pricing on market levels rather than fixed contracts will be help its case before the Commission.
10) Most analysts don’t agree with Kloppers and Argus (or Skinner and Albanese) on the minerals outlook. The analysts believe that mineral prices are going to suffer an extended setback in coming years. Most assume an extended price setback in calculating the value of both stocks. Leaving aside 2008-09 profit forecasts, BHP earned $US2.75 in the 2007-08 year which converts to $A3.43 on the basis of an US80c Australian dollar. BHP shares are fluctuating wildly but on those simple sums the price-to-earnings ratio has fallen below 10, with big profit rises likely in 2008-09 and beyond. Yet it does not have a growth rating.