BHP Billiton (LSE: BLT) (NYSE: BBL.US) shares rose by up to 3% this morning, after the company confirmed that it is aiming to spin-off assets worth up to $12bn, in order to focus on five core commodities: iron ore, coal, copper, petroleum and, potentially, potash.
This plan is essentially a reversal of BHP’s $11.6bn merger with Billiton, but we need to look ahead — is this likely to be a good deal for BHP shareholders, and will it improve longer-term returns for the miner?
In both cases, I think the answer is yes.
Concentrated performance
The assets BHP wants to dispose of are expected to be its aluminium, manganese and nickel operations, plus selected coal mines.
A look at BHP’s first-half results makes it obvious why: these assets are not pulling their weight. BHP’s aluminium, manganese and nickel assets generated just $148m of operating profit from revenues of $4.1bn — an operating margin of only 3.6%.
In contrast, BHP’s petroleum, copper and iron ore operations generated operating margins of between 35% and 50% during the same period, on combined sales of over $25bn.
Disposing of the laggards in BHP’s portfolio should improve shareholder returns and growth over the medium term, as the firm’s return on capital and free cash flow should rise.
What will BHP do with the cash?
The planned spin-off is expected to take the form of a listed company in Australia. I suspect that BHP would initially retain a stake in the company, so the cash proceeds would be less than the full $12bn analysts have estimated the newly-demerged assets could be worth.
However, BHP would receive a multi-billion dollar cash payout, most of which I expect would be returned to shareholders, through some combination of special dividends and share buybacks.
Although the demerger would reduce BHP’s revenue by around 15%, the effect on profits might be as little as 2%, so I don’t think the demerger would have a significant effect on BHP’s valuation or share price.
Is BHP a buy?
BHP intends to confirm its plans when it publishes its full-year results, on 19 August.
However, I rate BHP shares as an income buy regardless of next week’s decision: the firm’s diversified business provides shareholders with a rare opportunity to earn a reliable income directly from commodities.
Of course, commodity prices can be volatile. Iron ore — for example — has fallen by around 30% so far this year.