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BHP too quick to dismiss break-up proposal

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By Paul Rickard

It is somewhat ironic that BHP has reacted so quickly to dismiss the break-up proposal from shareholder activist Elliott Associates.This is the same company that has destroyed billions of dollars of shareholder wealth through its misjudged merger with Billiton, paying top dollar for US oil shale assets and offshore petroleum (now largely written off), and the maintenance of a flawed progressive dividend policy.

To name but a few examples.

Chairman Jac Nasser will soon be riding off into the sunset. Maybe that will crystalise a change in the Board’s approach to considering ways to increase shareholder value, but in the meantime, the normal “BHP knows best” view prevails.

That’s unfortunate (and potentially costly) for shareholders, because the Elliott proposal deserves the Board’s full attention. Judge for yourself.

And in case you think Elliott isn’t serious, visit their special “value unlock plan for BHP” website here

The Proposal

The Elliott proposal has three steps:

  • Step 1: Unifying BHP’s dual-listed company structure into a single Australian-headquartered and Australian tax resident listed company;
  • Step 2: Demerging and separately listing BHP’s US petroleum business on the NYSE; and
  • Step 3: Adopting a consistent and value-optimised capital return policy – an opportunity to monetise the substantial franking credit balance through discounted off-market buybacks.

By way of background, New York based activist investor Elliott manages two funds, Elliott Associates, L.P. and Elliott International, L.P., with assets under management totaling more than US$32.7 billion. The Elliott Funds, together with certain of their affiliates, hold an economic interest in respect of approximately 4.1% of the issued share capital of BHP’s UK-listed entity (Plc). This represents just under 40% of the aggregate BHP shares on issue, which means that Elliott speaks for about 1.6% of BHPs shares.

In relation to the first step, Elliot argues that a price distortion frequently occurs between the shares of the UK listed entity (Plc) and the shares of the Australian listed entity (Ltd). Since the merger of BHP and Biliton in 2001, and the implementation of the dual-listed company structure, Elliott says that the Plc shares have traded at an average 12.7% discount to the Ltd shares.

The demerger of South32, which saw many of the ex-Biliton assets spun off into the new company, has further exacerbated the economic asymmetry within the BHP group. According to Elliott, approximately 8.9% of BHP’s EBITDA is generated by Plc assets, whereas Plc’s shareholders hold c.39.7% of the aggregate number of issued BHP shares.

They propose a unified BHP, which would own 100% of both the Ltd shares and Plc shares. While this unified company would be an Australian tax resident, it would be listed in the UK, with Australian shareholders owning Chess Depositary Interests (CDIs). Elliott argues that unifying BHP’s current dual-listed structure would remove a number of clear inefficiencies and create a platform for BHP to deliver optimal value to shareholders. They say that BHP has a surplus franking credit balance of US $9.7bn which is largely “stranded”, and this would be easier to unlock in a unified structure. They argue that this is a remarkable “value unlock” opportunity, and that if BHP retains its current dividend payout ratio of 50% using the current structure, the balance of surplus franking credits could hit US $17.0bn by 2022! 

BHP says that it has not yet identified sufficient benefits to outweigh the significant costs which would be incurred in unifying the dual-listed company, and that the proposal would require approval by the Australian Foreign Investment Review Board. It maintains that there are some benefits of the structure, and estimates the costs of unification to be US $1.3bn or US $0.24 per share.

The second step is to demerge BHP’s US petroleum business, which comprises BHP’s US onshore and Gulf of Mexico petroleum assets. Elliott says that these businesses have not contributed to BHP shareholder value.

Elliott argues that:

  • they provide no meaningful diversification benefits to BHP as a whole;
  • there is a lack of synergies between BHP’s US petroleum assets and its mining assets;
  • the intrinsic value of the assets is being obscured by bundling it with BHP’s other assets; and
  • a demerger would allow a clear value re-rating for both BHP’s US petroleum business and the remaining core BHP business.

BHP’s US petroleum business could significantly re-rate as an independently listed business. Elliott says that it might be worth up to US $22.0bn, well in excess of the current analyst valuations.

BHP dismisses this claim out of hand, saying that there is no obvious discount in BHP Biliton’s trading multiples relative to the weighted average of relevant mining and oil and gas peers. It argues that a demerger has significant downside risk, and only limited upside potential. And of course, “BHP Billiton has disclosed the information the market needs to fully value the Petroleum businesses.”

The third step is the adoption of a capital return policy. Elliott says that BHP should use the excess cash it is generating, and return this to shareholders via discounted off-market share buybacks.

It estimates that BHP could generate US $31bn of excess cashflow in the next five years, assuming the current 50% payout ratio of net income. Rather than use this cash to make “value-destructive large-scale acquisitions, such as Petrohawk and certain Fayetteville assets”, it could via off-market buybacks pitched at a 14% discount to the market price, effectively buy BHP’s own first-class core assets at a meaningful discount.

Over the last few years, BHP has conducted two very successful off-market buybacks pitched at a discount of 14% to the current market price. Both were heavily oversubscribed, as the buyback is very tax effective to low-rate taxpayers such as superfunds. With BHP’s huge reserve of franking credits, it is well positioned to offer these programs to Australian resident shareholders.

BHP doesn’t like Elliott’s third step, because its “formulaic” approach doesn’t take into account the cyclical nature of the resources industry or the other uses of cash. It says that now is not the right time to conduct a US$6 billion buyback. Of course, BHP already has a “rigorous capital allocation framework, which balances value creation, cash returns to shareholders and through the cycle balance sheet strength in a transparent and consistent manner.”

Bottom line

In summary, Elliott says that implementation of its value unlock plan could provide BHP shareholders with an increase in the value attributable to their shareholdings of up to 48.6% for Ltd shareholders and 51.0% for Plc shareholders.

Even if this claim is true to say only 10% or 20%, it is still not insignificant and shouldn’t be sneezed at. It is probably why the shares rallied by around 5% when news of the proposal emerged. Time for the BHP Board to pause and consider its abysmal track record in managing capital, eat some humble pie and actively seek feedback from the market on the proposal. 

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Published: Thursday, April 13, 2017


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