The delicate balancing act beneath BHP's simplification strategy

BHP Billiton remains committed to generating volume growth despite its push for increased operational productivity and capital efficiency. It won't be an easy task.

Andrew Mackenzie’s ever-increasing targets for operational and capital productivity improvements within BHP Billiton might appear to be a relatively simple strategy. However, that understates the complexity of the balancing act he is trying to manage.

The drive for simplification, operational productivity and capital efficiency is by itself straightforward in concept, if not quite as straightforward in execution, and in tune with what the big end of the resources sector is pursuing.

Since Mackenzie became chief executive, that relentless focus on cutting costs and reducing investment has produced very substantial gains and changes to BHP’s financial profile.

In the two years to June 30, BHP has delivered $US6.6 billion of what it terms "productivity" gains, which are a combination of cost reductions and volume increases. Over the same period it cut capital investment from $US21.7bn to $US15.2bn.

At today’s investor briefing, Mackenzie outlined his new goals. He is now targeting another $US4bn of productivity improvements, including a reduction in cash costs of at least $US2.6bn, by the end of the 2017 financial year (following last year’s $US1.9bn reduction) and plans to cut its capital investment from $US14.8bn last financial to $US14.2bn this year and to $US13 billion in 2015-16.

The planned de-merger will help, given that the spinning off of those non-core assets will leave BHP will a smaller portfolio of high-quality assets and enable a far simpler operational structure. With Mackenzie saying that the group today spends about $US3bn a year on what he describes as ‘’functional’’ costs, there are potentially substantial savings there.

Despite the planned further major cuts to operational spending and capital investment, BHP still expects to generate volume growth.

Its production volumes from its core operations (excluding the assets to be demerged) increased 15 per cent last financial year. Mackenzie expects volume growth from those assets to reach 23 per cent over the two years to the end of this financial year.

Coupled with the planned demerger of its non-core assets (which is on track for the first half of 2015), the simplification of BHP could be regarded as the shrinking of BHP and the focus on reducing costs and investment as a strategy focused on increasing near-term returns at the expense of longer-term growth.

Complicating assessment of the strategy are BHP’s commitment to maintaining its progressive dividend policy and its ambition of returning capital to shareholders while preserving its investment-grade credit rating.

Those goals are, of course, being pursued against the backdrop of steep falls in the prices of BHP’s key commodities.

The balancing item within the strategy -- the one that Mackenzie believes/hopes will enable him to be able to deliver strong returns to shareholders while maintaining BHP’s balance sheet strength without compromising its longer term growth -- is its increased productivity.

He believes BHP can generate a lot more value with less capital intensity and therefore that its future investment, while at a much-reduced rate compared to its recent past, will give BHP a lot more bang for its buck. BHP targets internal rates of return on new investment of more than 20 per cent.

BHP is committed to at least maintaining but preferably growing its base dividends under its progressive dividend policy while returning excess capital to shareholders.

While the market had focused on net debt and its reduction to $US25bn as the trigger event for capital management, Mackenzie made it clear today that it isn’t a particular level of net debt but rather maintenance of the group’s credit rating that is the key to whether or not capital is returned to shareholders.

He also made it clear that BHP won’t distribute excess cash until it has actually accumulated it on its balance sheet. It isn’t going to risk its balance sheet strength by borrowing to undertake capital management in anticipation of generating the cash to restore its financial position. That’s a more conservative and prudent position than the market previously appreciated.