The BHP split

The market did not immediately support BHP's demerger ... but history suggests demergers work.

Summary: In announcing a surge in full-year profit this week to $US13.83 billion, BHP Billiton also unveiled its plans to spin off a number of its minerals and metals operations. They will be housed in NewCo and will include operations in nickel, aluminium, manganese, zinc, silver and other areas.
Key take-out: The stripped-down BHP Billiton should, in theory, deliver a steadier profit performance and pay broadly predictable dividends across the commodity-price cycle. NewCo, on the other hand, will likely outperform BHP at times because of upswings in different commodity prices.
Key beneficiaries: General investors. Category: Shares.

Never judge a spin-off by first impressions: Earlier today (Wednesday, August 14) global markets gave a cold shoulder to news of a demerger at our biggest company and the world's biggest miner BHP. The 'big Australian' fell a full 4% on the ASX following the demerger announcement.

But if you understand the parable of the tortoise and the hare, then you also understand what’s likely to happen in the future investment performance of BHP Billiton and its NewCo spin-off.

Over time BHP Billiton, with its super long-life assets in mainly bulk commodities such as iron ore, coal, oil, copper and potash, will outperform the new company being cobbled together with its discards.

But, at certain times in the commodity-price cycle, NewCo is likely to outperform its parent with highly cyclical metals such as nickel, aluminium, manganese, zinc and silver subject to occasional upward price spikes, followed by equally sharp falls.

In a way BHP Billiton is being reshaped into two businesses which appeal to different categories of investors, with the spin-off process likely to trigger a sustained period of uncertainty about how to value the old and the new – and even whether some international investors will be allowed or willing to hold shares in NewCo, which will be listed on both the ASX and South African stock exchange.

As the dust settles, the lumbering giant, which is the parent, will remain a lumbering giant, producing large volumes of material at close to the world’s lowest prices.

The stripped-down BHP Billiton should, in theory, deliver a steadier profit performance than today’s BHP Billiton, appeal to investors with a lower tolerance for risk, and be less likely to repeat the disastrous mistakes such as trying to enter the high-risk platinum, titanium, gold and diamond businesses, which destroyed shareholder wealth in the past.

BHP Billiton will still carry risks but it will also have the financial appearance of a semi-annuity, generating broadly predictable profits and paying broadly predictable dividends across the commodity-price cycle.

NewCo will be the more exciting company, with all the risks and theoretical rewards that come from exposure to metals such as nickel, which in the past 10 years has moved between a stratospheric $US25 a pound down to $US6/lb, and now back up to $US8.37/lb.

Managing NewCo will be a much tougher job than managing the stripped-down BHP Billiton because its major commodities, while also subject to price swings (iron ore has been up to $US170 a tonne, down to $US80/t and now at $US93/t), are more likely to be steady performers.

There is also the potential for BHP Billiton, as one of the world’s lowest-cost producers of its major products, to enforce its role as a price setter by switching production off in times of glut, and back on when demand rises, using its market power to dictate prices.

NewCo will not be anywhere near the lowest-cost producer of any of its minerals and metals, nor will it be the biggest. It will be a classic price-taker, unable to influence the global markets in which it participates.

What BHP Billiton is doing with its unwanted business units that form the starting point for NewCo is in effect what it did more than a decade ago when it spun off its steel business with the creation of BlueScope Steel and OneSteel, which later became Arrium.

In their early days both BlueScope and OneSteel struggled for investor support, but then enjoyed a strong following in the years before the 2008 global financial crisis, before sliding away as demand for steel in Australia slowed and imports captured a bigger share of the local market.

Investors will almost certainly treat the latest NewCo spin-off by BHP Billiton with the same level of caution because of the risks associated with highly cyclical minerals and because so much of NewCo has its roots in politically and economically unstable South Africa, home of the Billiton part of the parent.

But set against the understandable caution there are two points for investors to consider as the spin-off makes its way through the legal and shareholder approvals process.

Firstly, that management at BHP Billiton has not simply dumped their rubbish into NewCo. The addition of the NSW metallurgical coal business is a positive sign, as is the exclusion of the troubled NickelWest business, which requires a period of intense investment if it is to survive.

Secondly, there is plenty of evidence to demonstrate that carefully-planned spin-offs can perform strongly when liberated, as shown in the case of two successful spin-offs last year: Orora and Recall.

Orora contains the packaging operations which were once a key part of Amcor. Recall is a physical and digital information management business that was once part of Brambles.

From a first day price of $1.16 when it listed on December 18 last year, Orora has risen to trade around $1.46 and has a strong following of leading stockbrokers.

Recall opened at $4.15 on December 10 last year and is now trading at $5.16, and while it has performed well on the market it has a less enthusiastic following.

The point about spin-offs performing well was taken up by Eureka Report contributor Karl Siegling earlier this year (Spin-offs beat IPOs, February 7) when he pointed out that established businesses, when sold by their parent companies, can deliver impressive returns that often are better than those achieved by initial public offerings.

Another way of looking at the BHP Billiton split is through the prospective performance of its major commodities.

According to the latest “commodities matrix” compiled by Macquarie Wealth Management (see tables) the short-term outlook (three-to-six months) for iron ore, the major profit generator for BHP Billiton, is classified as OK, in a colour-coded system of green for good, yellow for OK and red for poor.

Over longer terms of 12 months and three-to-five years, iron ore is rated as either neutral, or poor with BHP Billiton’s iron ore operations likely to perform well because of their low costs and marketing power.

Copper, another business sticking with BHP Billiton, also has a less-than-buoyant outlook in the short term (red), but gets a green over a three-to-five year time period.

Aluminium, a major business going into NewCo, has a poor outlook in the short term, getting better over the medium term. Nickel, another business being transferred, has a good outlook in the short and medium terms.

J.P. Morgan, in its latest set of commodity forecasts, reckons nickel is heading for $US10.89/lb next year, up by more than $US2/lb on its current price, while aluminium and thermal coal, two of the biggest parts of NewCo, will remain depressed at US86c/lb and $US78/t respectively in 2015.

Like a number of brokers, J.P. Morgan is lukewarm about the NewCo spin-off, as it has been explained so far, with the primary concern being that it will not free up capital and that some shareholders will have to sell immediately on listing.

“Certain shareholders (on the London share register of BHP Billiton) will be unable to hold ASX listed shares, which is likely to result in technical selling of NewCo upon listing,” J.P. Morgan said.

Citi says there is logic in the demerger but the deal offers little scope to re-rating, while Deutsche Bank notes that the assets going into NewCo generated $US1.8 billion in pre-tax earnings last financial year, leading to an estimated net present value for the spin-off of $US19.5 billion.

Underwhelming is the consensus view of the demerger proposal, perhaps because of annoyance at the failure of BHP Billiton to announce an immediate share buyback.

But there is also the possibility that brokers dislike the future growth potential of the parent with its more predictable cash flow businesses, the uncertainty over NewCo with its exposure to highly cyclical commodities, and the uncertainties of South African coal and aluminium.

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