BHP, Rio And The Capital Management Countdown

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

– Cash generation rising
– Debt falling quickly
– Surplus capital anticipated soon
– BHP will move first

By Greg Peel

In the past two years, Australia’s Big Two diversified commodities producers have abandoned expensive additional tier one aspirations, sold off non-core assets and reduced their capital expenditure as existing expansion projects approach maturity. They have also tightened their belts and improved production efficiencies as the emerging market-driven commodity demand boom eases back to a slower pace of growth. They are lean, mean, mining machines.

BHP Billiton ((BHP)) and Rio Tinto ((RIO)) both reported half-yearly earnings last month, the first half in BHP’s fiscal year and the second in Rio’s. Both companies reported solid production numbers but the market’s focus was less on P&L and more on cash generation and balance sheets. With cash flow rising and capital and operating expenses falling, both companies are paying down debt even faster than analysts had earlier anticipated. New growth projects are not off the agenda, but after years in the wilderness it appears BHP and Rio shareholders can now look forward to some long awaited capital distribution in the not too distant future.

BHP was still reporting negative cash flow in its first half profit report last year, but this year cash flow turned positive in the half thanks to capex and opex reductions. Shareholders held their breath but the Big Australian made no change to its standing dividend payout policy. Management is targeting debt reduction to a level below 30% gearing, or US$25bn net debt, and suggested at the result release that debt would “approach” the target by end FY14 (June). Deutsche Bank assumes this would represent the trigger for capital management.

Capital management will likely include a share buyback outside of any special dividend or payout ratio increase. Share buybacks do not result directly in additional cash paid to shareholders but they reduce the share count, hence a fixed payout quantum indirectly means a greater payout amount (and hence yield) per share held. Fresh growth options cannot be ruled out as an alternative, but Deutsche believes BHP could pursue both growth and capital management.

UBS believes a buyback announcement is possible as soon as BHP’s full-year result is released in August. The analysts suggest some US$5bn worth of shares could be bought back over a two year period. In FY15 UBS forecasts a US$5bn cash surplus after debt repayment and regular dividend payment that could be used for further capital management.

Macquarie notes that relative to Rio, BHP appears to be offering a higher dividend payout ratio, earlier buyback potential and greater investment in unsanctioned growth projects given a higher credit rating and a more impressive set of growth opportunities. Management is looking to supplement its “base” dividend, which suggests to Macquarie the door is clearly opening for capital management in August. The broker is pencilling in US$7bn.

While BHP maintained its base dividend payout level at its result, Rio increased its dividend quantum to 192cps, representing a 15% increase on 2012 and exceeding consensus forecasts of 181cps. The primary driver of a positive earnings surprise in Rio’s second half was not increased production but reduced opex and lower than expected capex. The implied payout ratio was 35% of earnings and at the current rate of increase, Macquarie suggests Rio could be paying out 80% by 2020.

Rio did not, however, announce any further capital management in the form of a share buyback or special dividend. Management reiterated its intention to focus on debt repayment in 2014 and as such Morgan Stanley does not expect capital management before next year. Citi forecasts a US$6bn reduction in net debt to US$12bn in 2014 and US$7bn in cash flow in 2015, suggesting a “big” share buyback from February next year.

Credit Suisse notes Rio’s net debt in December was US$18bn against a US$15bn target and BHP’s was US$27bn against a US$25bn target but the broker’s forecasts suggests Rio can “de-gear” at a faster rate, to the point December 2014 would see Rio at US$13bn and BHP at $24.7bn. The difference reflects BHP’s ongoing hefty spend on US shale operations, and a head start available to Rio from the sale of Clermont for US$1bn and US$1.2bn from the Turquoise Hill Resources capital raising.

Rio is thus best placed for higher returns on Credit Suisse’s numbers, with the broker forecasting US$14.6bn available to Rio for additional distribution by December 2016 and US$12.5bn available to BHP by June 2017.

In terms of just what form capital management might take, Rio has several options, notes CS. Other than raising its regular dividend payout the company could pay special dividends or buy back either the locally-listed (Ltd) or UK-listed (Plc) shares. A local buyback is more valuable for local shareholders given franking credits, but Rio’s local share count represents only 24% of capital to BHP’s 60%. Both companies derive the bulk of their income from Australian iron ore so local share buybacks are not going to get ahead of the rate of building franking credits anyway, the broker notes.

Credit Suisse believes Rio will buy back Plc shares and thus increase the Ltd share ratio to 27% of capital. Special dividend payments could then begin in 2017 and be 15% larger to Ltd shareholders than they would have been if Plc shares were not bought back.

JP Morgan concedes that BHP will likely move first on capital management and Rio will wait until February next year, but suggests Rio offers the more compelling capital return story.

JPM suggests BHP will announce the commencement of capital management at its August result. The broker suggests a Ltd share buyback would be more cost effective than a Plc buyback and could provide earnings accretion of 1.4%, or a 5% yield on a special dividend alternative. Rio can offer 4% accretion with a buyback or a 7-8% yield via a special dividend, JP Morgan calculates.

Given Rio’s smaller local share count, JP Morgan suggests Rio offers the stronger chance of a special dividend.

What we do know is that neither company has yet made a decision on just what form any capital management might take, emphasising they are in “listening mode” with regards to any preferred mechanism.

The FNArena database currently shows five Buy ratings (or equivalent) from brokers to two Hold ratings and a consensus target price of $42.07 for BHP. Rio attracts six Buys to one Hold and a target of $81.68.
 

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