Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Is breaking up hard to do?

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On Tuesday night BHP's management confirmed that they are looking at simplifying their portfolio and investigating a demerger of the company's smaller minerals businesses. This proved to be unpopular with shareholders who were expecting a capital return, especially the company's London-domiciled BHP plc shareholders. In this week's piece we are going to look at the rationale behind this move, together with some divisional spin-offs conducted by BHP over the years.

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The unloved child gets a new lease of life

The most common reason cited for a company demerging or "spinning off" a division into a separately listed vehicle is that the previously unloved division will now be run by management totally focused on it. The theory goes that as a result of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper. Furthermore management at the parent company benefit, as the more attractive "core" business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole.

Recent examples of this can be seen in Orica's 2010 spin off of their paint division Dulux and Woolworth's spin-off in 2012 of a portfolio of shopping centres into Shopping Centres Australasia Property Group. Indeed this morning we met with the management team of a business recently spun out of one of Australia's largest companies to discuss their profit results. The senior management clearly exhibited more care and ownership over the results of their own smaller company, than I imagine they would have as relatively unimportant cogs in a very large business.

BHP's spin-off strategy

BHP is planning on creating a new company listed on the ASX (with a secondary listing in Johannesburg) from the company's aluminium, Columbian nickel, manganese, silver, and Illawarra and South African coal assets. These assets comprise the bulk of what Billiton Plc originally brought to the table in its 2001 merger with Australia's BHP Limited. A deal that subsequently proved to be significantly weighted in favour of Billiton's shareholders.

BHP is planning to list the new company in the middle of 2015 with minimal debt and distribute shares to its Australian and London shareholders through a pro-rata in-specie distribution to ensure the equal treatment of all shareholders. This move did not please BHP's London-based fund managers, as they will be left with ASX-listed shares. When Fox delisted from the ASX and moved solely to the NASDAQ, the majority of Australian fund managers (including us) were forced to sell their FOX holdings due to mandate restrictions.

What remains with BHP will be the core assets in iron ore, petroleum, copper and metallurgical coal, which are generating the vast bulk of BHP's profits and have received the most capital expenditure in recent years. Based in the 2014 profit results, the core BHP delivered 97% of the company's underlying profit and the separation would raise the Core BHP's profit margin from 47% to 55%. BHP's management expects that in time, the more focused core BHP will be re-rated higher.

Not the first time around the block

BHP has previously spun-off divisions in the past that they viewed as less desirable. In 2000 BHP demerged their long steel division (Arrium née Onesteel) and in 2002 their flat steel division BlueScope. This was motivated by the view that greater returns could be made from digging ore out of the ground, rather than producing commodity steel. From the below table both spin-offs performed very well in the years post the spin-off, with Onesteel's market capitalisation rising from $400 million to $6 billion and BlueScope from $2 billion to $9 billion. Indeed the two co-operated in 2007 to takeover Smorgon steel for $2.5 billion.

During those heady years, BHP was criticised for letting go of their steel manufacturing businesses, however often the genius behind this course of action does not become apparent for several years. In the period up until 2007, the newly separated steel companies enjoyed the benefits of a low AUD and more importantly supernormal profits from being able to fix their material costs (iron ore and metallurgical coal) for a year at time in a period of steadily rising steel prices. The breakdown of the annual iron ore contract system that had been in place since the 1960s in 2010 and the move to short-term prices has permanently removed this source of profits for the steel mills. Further, as a result of massive dilutionary share issues in the period between 2009 and 2012, BlueScope is now -47% below its initial 2002 issue price and Arrium -2.5% below its 2000 issue price in nominal terms. Ultimately investors would have been better off putting the money in term deposits!

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Whilst the above suggests that spin-offs can be marvellous means for management to unlock value for shareholders, there are downsides. Two separately listed companies results in the additional costs of maintaining two separate listings on the ASX, including two separate boards and management teams. In the case of previous BHP spin-offs, the new companies started in good shape with low debt, however after a number of years, BHP's rationale for spinning them off became apparent. We will keep this in mind when we receive shares in the "new BHP" in August 2015.

Disclaimer
This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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