BHP Billiton (NYSE: BHP), the world’s largest miner, is pruning its conglomerate and lopping off a few of its less productive branches. When the spin-off is complete, the $188 billion mega cap will be smaller by about $16 billion, shedding off some 9% of its company.
Management believes the trimming down will improve its performance going forward. “A demerger is a logical next step for other high quality assets also in our portfolio that don’t have a scale of those in our major business,” CEO Andrew Mackenzie explained the reasoning behind the plan. The company would rather focus on its larger scale core businesses and sell-off those divisions that aren’t keeping pace.
But investors did not receive Tuesday’s news happily, dumping shares and driving the company’s stock down by more than 4%, though gaining back 1% the next day.
Why the sell off? Did management get it wrong? Should you take this as a nice buying opportunity, or stay clear in case of further declines?
The Company’s Intentions
A number of years back during that miraculous commodity bull market that ran through two financial crises in 2001 and 2008 and which ultimately culminated in multi-year highs in 2011, miners all over the world embarked on a buying spree. The focus then was to keep adding more and more mineral reserves to their portfolios and grow their companies through acquisition, adding as many small producers as they could find, often overpaying dearly.
Everything changed when the commodity bubble burst in 2011. Some commodities burst a little sooner, others a little later, but the overall trend was undeniably down, turning companies’ strategies on their heads. Suddenly mining conglomerates who were previously buying everything they could get their hands on were forced to write-off billions of dollars’ worth of unproductive acquisitions, often divesting such operations all together.
BHP is now doing a similar house-cleaning of its own. Most of the operations to be spun-off were acquired in 2001 when BHP in the U.K. merged with BHP in Australia. The result was a fusing together of two of the world’s top iron ore, aluminum, coal, copper, nickel and oil producers, with plenty of savings through synergy making the whole worth more than the sum of its parts.
“The spin-off company… will bundle BHP’s aluminum, manganese, Cerro Matoso nickel in Colombia, South African energy coal, some Australian metallurgical coal assets, and the Cannington silver, lead and zinc mine,” Reuters breaks down the throw-aways whose performance haven’t been measuring-up to the company’s core businesses.
The core operations the company will be focussing on – collectively known as the “four pillars” that BHP is built upon – are iron ore, copper, coal and petroleum, though potash may also be incorporated into the core structure as the fifth pillar.
These five divisions accounted for 96% of BHP’s core profit in fiscal year 2014. We can understand the spin-off, then, as the company would rather optimize its investment costs by focussing on those operations that produce the hardiest returns.
Why So Uptight?
“It’s probably a better asset mix than we thought it would be beforehand,” David Radclyffe, an analyst with CLSA in Sydney gave his approval of the trimming plan.
So why are shareholders none so pleased, punishing the company with a 4% plunge on Tuesday?
“Some people may be disappointed because nothing was announced on a special dividend or [share] buyback,” answers analyst Albert Minassian at London-based Investec.
Shareholders had been expecting an announcement of a stock buyback which would have returned some $5 billion to them. But the company wants to continue cost cutting, having already cut $2.9 billion from 2014’s budget, with another $3.5 billion of savings projected over the next three years.
Management also wants to reduce the company’s debt from the current $38 billion in total to around $25 billion net before returning capital to shareholders. Yet even then, the company stressed it would consider returning capital only if it can be done in a “predictable and sustainable way”.
“We are planning ahead prudently, but we will not be excessively conservative. We will continue to look at ways of shifting excess cash in a timely way to our shareholders,” CEO Mackenzie kept the share buyback promise alive.
Opt In, or Stay Out?
So should investors pick up some BHP stock now that we know there won’t be a share buyback? There seem to be more than one perk to look forward to.
There may be no share buyback yet, but we know it’s coming at some point, which should drive BHP’s stock higher on the news. Plus there are the ongoing cost reductions totalling some $6.4 billion, nearly half of which have already been booked. And of course, there would be an infusion of cash were the spun-off companies to be bought-out by a rival.
Add these together and we just may have a strong case for a buy here – especially since BHP’s stock is still down some 3% since the news came out earlier this week, giving us a little 3% bonus.
Christopher Moore, portfolio manager of Fidelity Global Industrials Fund, believes the spun-off entities would perform better on account of “more focused management and investment”.
As for their potential buyout by a rival, Moore expects that “shareholders could benefit from a potential acquisition of all of them by a larger mining company, or part of them to crystallize value.” Already a BHP shareholder, Moore plans on holding his shares in the new company once it is formed, on the expectation of just such a buyout which would send the new company’s shares soaring.
So buying into BHP shares now would grants us shares in the new company once the conglomerate splits, with those new shares potentially worth a whole lot more in a few years’ time, if not sooner.
Investors should be aware, however, that the new company’s shares could experience an initial sell-off as soon as they are split from BHP, on account of the effect such a split would have on investment funds and their allocations. If investment funds currently holding BHP shares decide the new spun-off company does not fit their investment objectives or perhaps messes-up their sector allocation, some funds may be forced to sell the new company’s shares as soon as they are allocated.
Were that to happen, investors might find it nothing less than another bonus buying opportunity. Estimated to be worth between $15 billion and $17 billion, the new company’s components are already generating “more than $1.4 billion in operating cash flow and had achieved an underlying core profit margin of 21 percent in the 2014 financial year,” BHP informed. The new company “would carry ‘minimal debt’… targeting an investment grade credit rating”.
“It looks like quite an interesting company,” Brenton Saunders, a Sydney-based portfolio manager at BT Investment Management which owns shares in BHP, expressed his optimism. “Given the size and diversification, it’ll be pretty well received.”
Of five analysts posting their recommendations last month, 2 recommend BHP as a strong buy, 1 recommends it as a buy, while 2 suggest it should be held.
It must be noted, however, that BHP has lagged behind the S&P 500 broader index, as well as the SPDR Select Sector Materials ETF (NYSE: XLB) which tracks miners along with other materials producers.
As per the graph below, after posting a strong come-back in the early part of the 2009 recovery until the commodity peak in 2011, BHP (black) has since then moved mostly sideways, while the S&P 500 (beige) and the XLB (blue) have more than doubled BHP’s performance.
Perhaps by dropping its heaviest loads, the spinning-off may give BHP the lift it needs to mount a comeback.
Source: BigCharts.com
Joseph Cafariello
