In early April, in response to media speculation, BHP confirmed its intention to simplify its business, probably by divesting non-core business units. The non-core assets include aluminium, nickel, bauxite and potentially Cannington which mines lead, silver and zinc.
Simplification should allow greater focus on the productivity and performance of the core operations. The divested assets could be worth more outside the company with new management focusing more time than BHP’s current leadership to maximise value from the non-core mines.
A divestment would allow BHP to focus on its core assets of iron ore, petroleum, coal and copper. In first half fiscal 2014, iron ore contributed 50 per cent of earnings, with Petroleum & Potash, Copper and Coal accounting for 19, 26 and 4 per cent respectively.
This compares with the non-core Aluminium, Nickel and Bauxite assets, which together contributed 12 per cent of revenue but only 1 per cent of operating earnings. A demerger of these non-core assets would markedly reduce revenue, however there would only be a small reduction in earnings given the assets to be demerged have a very low margin relative to the core assets.
The difference in operating margins is seen below (compare the circled core assets with the low margin non-core Aluminium, Nickel and Manganese assets in green).
Figure 1 – BHP EBIT margins, by division
Focusing on the four key pillars would retain the assets that deliver stronger returns while still providing diversification. Post-divestment, BHP will still provide greater earnings diversification than Rio Tinto, whose earnings are 85 per cent iron ore. BHP is much lower at around 50 per cent. Over time, energy and potash should contribute a greater proportion to BHP’s earnings and reduce earnings sensitivity to iron ore.
It is understood a number of options are being considered for the divestment of assets. BHP might pursue a demerger, establishing a new listed company containing its non-core assets and distributing shares in the new company to its existing shareholders. It could also float the assets in a separate company or sell the unwanted individual assets for cash or share consideration, but it faces the challenge of getting the right price for these assets.
In what form and whether a restructure takes place is speculation at this stage. As investors, we would only want a restructure to occur if it will improve value. More details are required before we can assess the impact on shareholders.
BHP can improve shareholder value if it can divest its low-returning assets while concurrently improving its balance sheet. If the deal can generate cash and improve the balance sheet, gearing will be reduced and interest savings will be achieved. The balance sheet will benefit and BHP’s financial health will improve.
BHP’s gearing has increased significantly over the last five years, rising from 7 per cent in 2010 and reaching over 40 per cent in 2013. Management is working hard on reducing debt. We would like to see gearing come down further.
Realised commodities prices are key risks to profitability with key sensitivities being iron ore, the currency and the oil price. BHP’s profitability and value depends heavily on the iron ore price (as iron ore contributes around half of its operating earnings). BHP holds a strong position on the cost curve, but we are cautious on the iron ore price outlook in the near term.
We currently adopt a forecast Return on Equity of 22.5 per cent (green) and a Required Return of 12.5 per cent (red), reflecting the strong financial health rating due to sound fundamentals, large market capitalisation and premier access to both debt and equity markets.
Figure 2 – BHP Future Valuation
We derive a fiscal 2014 valuation of $39.62. In the absence of currency depreciation or a transformational deal like the mooted demerger, we see little near term upside to the valuation.
With volatile earnings and profitability, investors should require a margin of safety of 15 per cent before considering investment.
Written by Brian Soh, associate analyst, with insights from John Abernethy and George Whitehouse of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation-free, FREE trial please visit StocksInValue.com.au or call 1300 136 225.
Disclosure: Clime Asset Management owns shares in BHP Billiton Ltd