Why glum on BHP, Blighty?

The probable explanation for BHP Billiton’s London sell-off is disappointment with the lack of capital return. Given the nature of the miner's demerger, that reaction is hard to understand.

The London-ignited sell-off of BHP Billiton today, after the announcement of its spin-out of second-tier assets on Tuesday, appears to have been driven by investor disappointment about the absence of conventional capital management rather than in response to the detail of the assets to be demerged.

The near 4 per cent decline in BHP’s share price would imply that the UK investors thought that BHP, in announcing a 10 per cent increase in earnings to $US13.45 billion and a reduction in net debt to $US25.8 billion, might have been willing to give them a greater return. But it may also have been partly due to the fact that the demerger, having been leaked extensively, had already been factored into BHP’s share price.

That, however, can’t be regarded as the major influence in the sell-off because the nature of what BHP proposes to demerge, the surprisingly attractive quality of the assets being spun off and the positive impact of the demerger on the continuing BHP entity hadn’t been entirely recognised before Tuesday’s announcement.

Thus the probable explanation for the selling is the lack of capital management.

BHP had said previously that if it could get net debt down to $US25 billion it would consider buy-backs or returns. While it didn’t quite get there, the $US8 billion increase in its free cash flows probably means that in the absence of the demerger some kind of capital management program was on the cards.

The UK investors, knowing that a corporate transaction involving the second-tier assets (they are second tier only in relation to BHP’s core iron ore, petroleum, copper and prime coal businesses) was on the cards and having read the speculation that the entity would be listed in Australia with a secondary listing in South Africa, may have expected a different form of transaction.

They may have anticipated that shares in the new company would be given to BHP Billiton Ltd shareholders and that shareholders in the London-listed BHP Billiton Plc entity would be compensated via either a return of capital or bonus shares in the larger entity.

No doubt BHP looked at various options, given that it had concluded that there was little point in listing the spin-out in London, where it wouldn’t be big enough to make it into the FTSE 100 index.

Distributing the shares in the new entity to all its shareholders -- including those who hold their exposure through the UK portal into the dual-listed entity -- is, however, the simplest and fairest way to treat both sets of shareholders. It also avoids potentially messy tax issues.

In fact, while it might take up to nine months for the demerger to be executed and BHP shareholders to get their hands on the scrip, the transaction could be regarded as a giant capital management exercise. The UK shareholders will, of course, have the capacity to turn that scrip into cash at that point if they wish.

It’s not that different from BHP selling the assets that will be held within Spin Co and distributing the cash to shareholders via a capital return, except that the shareholders themselves will determine if, how and when they want to cash out their interests.

The nature of the portfolio BHP is hiving off made it impracticable for BHP to do both the demerger and conventional capital management at the same time.

It wanted to make sure that the new entity wasn’t simply a dump for unwanted assets. The portfolio of aluminium, nickel, manganese, base metals and metallurgical coal assets, with EBITDA (earnings before interest, tax, depreciation and amortisation) margins that have averaged 34 per cent over the last decade and averaged 21 per cent in the most recent financial year, is only unattractive when compared to BHP’s core basin assets, which have margins twice that size.

The desire to give its shareholders an exposure to a BHP-quality portfolio meant some problematic assets, like Nickel West, were excluded. It also meant that, given that the commodities the new entity is exposed to are more volatile than iron ore or petroleum, BHP wasn’t going to put much financial leverage next to it.

The spun-out vehicle will have net debt of only about $US1 billion against an asset base of something around the $US14 billion to $US15 billion level. It will be quite a large, ASX top 20, company with the capacity to cope with commodity price cycles – and to invest in growth projects that wouldn’t be able to compete for capital with the returns from BHP’s basin assets.

Having determined that it wouldn’t load the new entity up with debt, and reduce its own borrowings in the process, BHP didn’t have the excess balance sheet capacity of its own to undertake a separate capital management initiative.

With up to nine months to go and a lot of exposure to market risk before the transaction is effected, it may also have been conscious of the volatility within its own environment. In the midst of such a large corporate transaction it makes sense to maintain a conservative balance sheet.

It is hard to understand why the UK investors should be unhappy about BHP planning to give them the option of cashing out $US5 billion or $US6 billion of value (about 40 per cent of BHP is owned via the London-listed entity) while still retaining their interests in the world’s still most diversified resources group.

As they gain a better understanding of the proposal, the assets involved and what it might mean for the slimmed down BHP, whose returns will be super-charged once it sheds its lower-returning assets and which has already promised to at least maintain its current dividends per share (an effective increase), it will be interesting to see whether their attitude changes.