BHP Heads South

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

– South32 offers yield and growth options
– BHP rump leaner and more efficient
– Cost-outs will exceed demerger cost
– Twin 6% yields
 

By Greg Peel

Macquarie today further downgraded its iron ore price forecasts by 20% in 2015 and 11% in 2016. The broker believes the iron ore price will bottom at US$48/t in the September quarter. The earnings impact on the iron ore majors is offset by accompanying material cuts to currency forecasts, and the broker does expect the iron ore price to recover back to over US$70/t by 2017.

But no one is much fussed at the moment. The story for BHP Billiton ((BHP)) is one of the impending demerger of ten non-core assets into a vehicle called South32. The board has now approved the demerger and shareholders get to vote on May 6. Assuming shareholder approval, South32 could initially list on a deferred basis as early as May 18. BHP shareholders will receive one South32 share for each BHP share held.

Macquarie retains its Outperform rating on BHP, having suggested last week that pending details of the South32 demerger would be a key catalyst for the stock. Those details were released yesterday, and brokers are pleased with what they see.

The process of demerging the new entity will cost money. But BHP assures the cost reductions achieved by streamlining its business will well exceed this amount. South32 itself will incur new costs as a standalone entity, but management is confident a “regional business model” will also see cost savings in excess of the amount.

South32 will kick off with low gearing of around 5% and access to $1.5bn bank facility. This combination of low initial gearing and liquidity access suggest the company will be in a good position to exploit growth options, JP Morgan notes. A major feature of the detail provided yesterday is that South32 will pay dividends based on a 40% payout of underlying earnings.

This dividend model differs from parent BHP, which maintains a progressive dividend policy rather than a fixed ratio. But management justified the difference by noting South32’s underlying assets will be subject to greater underlying variability of cash flow (a mixed bag of commodity prices) and as such a percentage payout makes more sense. Brokers agree.

The first dividend will be paid in early 2016 rather than this year given South32 will have only been trading for a month when it posts its debut “full year” result. UBS suggests this is six months later than expected but other brokers are not surprised. The only downer is that South32 will start life with zero franking credits, which will all be kept by the new BHP.

With South32 gone, the leaner BHP remainder will see its gearing rise to 27% from 23.8% but this is not expected to impact on the company’s A credit rating, nor on the exiting progressive dividend policy. BHP will not be rebasing its dividend as a result of the spin-off, which is good news. Management had originally suggested the demerger exercise would ultimately deliver US$4bn in efficiency gains but now believes this figure will be exceeded, albeit they did not suggest by how much.

The BHP board recommends shareholders vote in favour of the demerger and Citi agrees. The only question is one of whether one buys BHP shares now in order to score South32 shares or just to wait and buy South32 on listing. Citi notes BHP’s own dividend yield will lift to above 6% from its current level above 5% post demerger and as a result has upgraded its recommendation on BHP, pre-demerger, to Buy.

In a report unrelated to yesterday’s provision of South32 detail, Morgans’ analysts included BHP as a stock to watch among potential M&A targets, as offshore resource companies enjoying US dollar strength go stalking. Not BHP itself, but South32. Morgans notes BHP has a long track record of spinning off assets that ultimately become significant companies in their own right.

With regard South32’s dividend yield, it’s difficult to forecast at this stage given no price point for share valuation, but Citi suggests that were the stock to trade on listing at the analysts’ calculated net present value, applying the 40% payout would provide a yield of around 6%.

Citi, JP Morgan, UBS and Deutsche Bank have all provided updated views on the demerger post yesterday’s release of details. Citi joins UBS and Deutsche on Buy with its upgrade, while JP Morgan retains Neutral on its sector-relative basis, preferring Rio Tinto ((RIO)). Having downgraded its iron ore price forecasts, Macquarie retains a Buy on BHP and a preference over Rio given Rio’s greater exposure to iron ore.

Morgan Stanley, Morgans and Credit Suisse are all sitting on Hold or equivalent ratings for BHP but have yet to respond to yesterday’s announcement.

So that leaves four Buys, four Holds on BHP in the FNArena database (Rio is 6/2). The consensus target price sits at $35.70, suggesting 18.5% upside from the current trading price.
 

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