BHP Billiton: Result 2014 and spinoff

When BHP Billiton announced that it would spin off a collection of mines into a new business to be listed on the ASX, some said it was throwing out the rubbish. Others suggested the new company would be the dregs of BHP – parts of the business the miner couldn’t sell. The consensus agrees that, because the new business will house mines that aren’t good enough for BHP, it won't be good enough to invest in.

The consensus is wrong. It’s true that the new company, should it be approved, won't share the quality of its parent. That doesn’t mean it isn’t worth a look.

BHP will split into two businesses: BHP will retain iron ore, petroleum, copper and most of its coal mines. Into the new company will go unfashionable aluminium, alumina, silver, manganese and some coal mines. The dregs of BHP still make a formidable business: the new miner will likely be worth about $US12bn. It will house assets worth about US$11bn that generate average revenue of US$10bn and net profit of US$2bn.

Ours is a lonely opinion but here it is: we’re excited by the spinoff. Shares in the new business will be distributed to BHP shareholders in Australia, the UK and South Africa but the new company won’t be listed in London, giving plenty of investors reasons to sell regardless of price.

The mines themselves, although disparaged, are better than average. They include the world’s largest silver mine, Carrington, the largest manganese business, a sprawling aluminium and alumina business and an attractive nickel business in Colombia. These mines have been neglected within BHP for years and offer enormous potential for improvement. South African coal assets, however, blight the asset suite.

BHP will offer investors a vote on the idea. It is likely to pass and the new company could be unleashed by mid next year. So far, price and financing are unknown but we will be looking at the offer closely.

Make mine smaller

Today, BHP is a sprawling empire of 41 mines producing almost every major commodity. Yet, last year, BHP generated 97% of earnings before interest, tax, depreciation and amortisation from a dozen mines. With more than 50% of its assets generating just 3% of profit, a break up makes sense to allow the pursuit of productivity gains. BHP says it has saved over US$6bn over the past two years chasing efficiency gains and the split will allow it to save a further US$3.5bn over the next two years. There is little doubt that, over the past decade, the company has grown inefficient.

The slimmer BHP will boast stunning operating margins of almost 50% and can still deploy large amounts of capital at attractive rates of return. Following the split, BHP should produce more stable cash flow with less capital intensity to allow regular dividends to be paid. The new BHP will be an attractive business but this is already widely understood and reflected in the price.

Less attention goes to the merits of the spinoff where lower costs and productivity gains should be far greater. The new company’s assets are out of favour and cyclically depressed; EBITDA margins are less than half of the (admittedly exuberant) 10 year average. There could be more opportunity in the new business than the old.

Why did the share price fall?

Investors cheered the breakup but they were disappointed by an absence of share buybacks. BHP’s result (see Table 1) was good enough but debt, at US$26bn, is a tad high to fund buybacks. We’re glad management refused to comply. Even though full year dividends were raised 4%, the share price tumbled.

Management has pledged higher dividends following the split, signaling a dramatic shift in the business. Miners are being forced to seek returns first and expansions second. A maturing of the industry is long overdue and welcome. Despite the share price fall, BHP remains fairly priced. We would be enthusiastic buyers at lower prices but with the share price down marginally since BHP: Interim result 2014 (Hold - $39.28), for now, HOLD.