The proposed spin-off of South32 received near-unanimous assent at BHP Billiton’s (BLT) recent annual meeting, so the group will cease trading with an entitlement to South32 shares from the end of 15 May 2015. The demerged mining entity will begin trading on the London Stock Exchange on a ‘when-issued’ basis from this coming Monday. (This describes a transaction that is made conditionally because a security has been authorised but not yet issued).
The residual operations of BHP Billiton will amount to roughly a dozen or so large-scale mining and petroleum projects, while South32 will draw its output predominantly from the parent group’s non-core aluminium, silver, zinc, nickel, and metallurgical coal operations. This is slightly ironic given that these assets were largely those brought to the table by Billiton Plc during the 2001 merger deal. Now it appears as if economies of scale have given way to rationalisation, while cost synergies have all but evaporated.
Presumably the institutional advisers that convinced management about the benefits of the original consolidation weren’t extolling the virtues of a more focused asset portfolio this time around, but you can never be sure. It’s thought that City advisers will pocket around $30m on the back of the deal, but with the vote in the affirmative there’s little point in musing on skewed incentives. The bottom line, however, is that the contribution of the former Billiton assets to group earnings has contracted by 63 per cent since the Anglo-Australian resource giant came into being.
South32 will draw its output predominantly from the parent group's non-core operations
So in retrospect, it is clear that the original all-share deal didn’t deliver much in the way of value to BHP Ltd’s shareholders. The fall-away in segmental asset values has been reflected in a number of hefty writedowns over the years - a process that might not necessarily have run its course. But the group’s new(ish) chief executive, Andrew Mackenzie, can no more be blamed for plummeting commodity prices than he can for over-exuberance (some may say profligacy) on the part of some his predecessors - in fact, Mr Mackenzie’s immediate predecessor, Marius Kloppers, received no end of flak for a seeming inability to close-out deals. The problem is that marquee deals of this kind have hardly been synonymous with value creation, so shareholders would be justified in casting doubt over this latest wheeze.
Hopefully, BHP Billiton shareholders will fare better this time. Under the terms of the demerger, shareholders will receive one South32 share for each group share currently held, although holders of 10,000 shares or fewer will be entitled to sell their South32 shares through BHP Billiton and receive cash proceeds following completion. But if you were to opt for the scrip alternative, what would you be getting? Well, at the December half year, South32 effectively had gross assets of $26.7bn, which delivered $738m – or around 16 per cent – of net earnings. Admittedly, some analysts have revised their initial valuations on lower commodity price assumptions. Last September, for instance, Investec had indicated a blended NPV/PE valuation of $18.6bn, but that estimate has subsequently been cut by 35 per cent on reduced expectations for commodity prices and foreign exchange translations. That might seem rather steep, but it’s actually broadly analogous to the fall-away in BHP Billiton’s share price over the same period.
Quality assets, though short-dated
Although there have been some curiously dismissive assessments of South32’s portfolio in the financial press, it would hardly be in the best interests of BHP Billiton’s management to unload a wholly underperforming or marginal group of assets. But the fact remains that less than 12 per cent of BHP Billiton’s full-year capital expenditure was devoted to the segments that are being spun-off – an indication that they’re either fast-maturing assets or simply surplus-to-requirements, or perhaps both. Peak capital expenditure on the assets took place through 2009-2013, so the timing of the spin-off is certainly advantageous on that score.
It may be true that the relative performance of the South32 assets has had a diminishing impact on the share price of the existing group, where investor focus has progressively been drawn towards the iron ore, energy and Bowen Basin coal segments. And it is true that some of the South32 mines are nearer to the end of their productive lifespans than the beginning.
Nonetheless, we still think the miner boasts some very attractive assets. The demerged entity will be one of the world’s biggest nickel suppliers, partly through the Cerro Matoso deposit in Colombia. And it will lay claim to being the preeminent producer of manganese, important as nickel and manganese are used extensively in advanced steelmaking processes. The Worsley alumina refinery in Western Australia is one of the biggest and lowest-cost complexes in the world. South32 will also have the world's largest silver mine on its books – Cannington, located in north-west Queensland. No doubt BHP Billiton’s management would have considered the possibility of hiving-off these assets piecemeal, but the general pullback in commodity prices would have put paid to that notion. It’s also worth pointing out that because of its resource mix, South32 will not be as reliant on Chinese demand as its parent group; China will account for just 11 per cent of South32’s sales.
South32 will be headed by Graham Kerr, who served as BHP Billiton’s chief financial officer for three years, so he will doubtless be au fait with the operations in question. Mr Kerr has already made it plain that he will initially be focused on establishing a platform for organic growth. The good news is that the BHP Billiton’s board have ensured that South32 will start life with a solid balance sheet on which to expand the business – through acquisition, if needs be. South32 will commence trading with an estimated net debt of $674m, which is equivalent to just 2.7 per cent of the parent group's net borrowings at the end of 2014. The miner will also have to take on around $1.5bn in provisions that must be put aside for mine closures and remedial costs, which is pretty much standard fare. Overall, the borrowing commitments appear relatively modest compared to the peer average. South32 will also begin life with a $1.5bn syndicated credit facility to ensure that it has adequate liquidity. The facility affords a degree of flexibility in the event that suitable acquisition targets eventually come to light. Indeed, analysts at Deutsche Bank have already suggested that Mr Kerr and his team could buyout Anglo American’s (AAL) 40 per cent stake in the Samancor manganese asset, which is valued at around $1.4bn.
Although South32 won’t be overly burdened with interest repayments or capital commitments, the effect of recent commodity price falls on margins suggests that free cash-flow yield will still be under pressure. It should fare better than BHP Billiton, itself, which could struggle to meet its dividend obligations through internal cash flows. But no one is pretending that the demerged entity is an income option. Management has already confirmed that South32 will pay out a minimum of 40 per cent of underlying earnings in dividends. That is a more conservative policy than that of BHP Billiton, which has a payout ratio of 62 per cent.
