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Summary

  • As the commodity boom has ended, miners have been forced to reassess their strategy.
  • This week BHP Billiton announced spin-off of its non-core assets into a new independent company.
  • BHP Billiton’s shares fell sharply after the announcement of the spin-off; however, the drop in shares was due to the fact that the company did not announce a share buyback.
  • Weaker iron ore prices have resulted in BHP Billiton not announcing a buyback.
  • The company’s strategy to simplify its portfolio and focus on core assets will eventually create value for shareholders.

The end of the commodity boom has forced mining companies to rethink their strategies. If the focus was on increasing size and diversifying in the previous decade, it is now on improving productivity. As China grew rapidly in the previous decade, its demand for industrial commodities also rose sharply. In this period, major mining companies such as BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) focused on increasing their size through acquisitions. However, as the Chinese economy slowed down and is now rebalancing, demand for industrial commodities is expected to be not as strong as that seen in the previous decade.

Over the past two years, major mining companies have been trying to adjust to the new environment. The likes of BHP Billiton and Rio Tinto have already announced several divestitures. Both companies plan to focus on a few core assets instead of diversification. Their strategy is to improve productivity, bring down capital expenditure, reduce debt and increase free cash flows. This strategy will ultimately reward shareholders in the form of increased distribution. This week, BHP Billiton took a major step towards achieving its goal by announcing the spin-off of several non-core assets.

BHP Billiton Simplifies Portfolio

BHP Billiton was formed in 2001 following the merger of two mining giants, BHP and Billiton. Around same time, the commodities market saw a boom as China registered double-digit growth. Miners' strategy of expanding through acquisitions made sense during this period. In fact, BHP Billiton even tried to merge with rival Rio Tinto and unsuccessfully bid for Potash Corp. (NYSE:POT).

In the last two years, though, the Chinese economy has seen a slowdown. Over the years, the Chinese GDP growth relied heavily on investments and exports. However, it is now trying to rebalance. The shift to consumption-led growth from investment and export-led growth means that China's demand for industrial commodities is slowing down. This has forced mining giants such as BHP Billiton to reassess their strategy.

BHP Billiton and other mining giants have already divested several non-core assets over the last two years as they look to focus on a few core assets and improve productivity. Recently, BHP Billiton said that it will focus on just four main areas; iron ore, petroleum, coal and copper. The Anglo-Australian company may enter the potash market in the future.

With the new strategy in mind, BHP Billiton this week made a major announcement. The company announced a plan to spin-off a selection of its high-quality aluminum, coal, manganese, nickel and silver assets into an independent global metals and mining company. The spun-off company will be listed on the Australian and South African exchanges. The spin-off will allow BHP to focus on its iron ore, copper, coal and petroleum assets. More information on the planned spin-off can be read here.

The Right Strategy In The New Environment

In my opinion, BHP Billiton has implemented the right strategy that is in-line with the new environment in the commodities market. We are never likely to see the kind of boom seen in commodities market in the previous decade. Therefore, it makes sense for miners to focus on a few core operations instead of maintaining a diversified portfolio. This will help in reducing costs and improving productivity.

For instance, BHP Billiton has 41 assets globally. However, only 19 of the company's core iron ore, copper, coal, petroleum and potash assets generated 96% of its underlying EBIT in the 2014 fiscal year.

BHP Billiton has one of the lowest costs among iron ore miners. This means that even prices were to weaken further to around $80 per ton, BHP Billiton can generate profit. When it comes to copper, the company is one of the top four exporters of copper concentrate. As I had discussed in an article earlier this month, the outlook for copper is solid amid an improvement in the U.S. and Chinese economy. The company is also likely to enter the potash market in the future. While the breakup of one of the cartels in the potash market had a negative impact on prices last year, the long-term outlook for potash remains robust given the rising food demand. BHP with its potash resource in Saskatchewan is well-positioned to take advantage of this demand.

Andrew Mackenzie, CEO of BHP Billiton, said this week, "As we move towards a simpler portfolio, comprised of our pillars of Iron Ore, Copper, Coal, Petroleum and potentially Potash, we will become a higher-margin, higher-return business."

If BHP Billiton's strategy delivers, it will result in improved productivity, which in-turn will boost the company's cash flow. Given that the company is reducing its capex, this means more rewards for shareholders. The only risk of course is the weakness in commodity prices, especially iron ore. In fact, BHP Billiton's shares fell sharply after the company announced the spin-off plan. However, the negative reaction was not to the planned spin-off. It was due to the fact that investors were expecting BHP Billiton to announce a share buyback.

Indeed, last year, BHP Billiton had hinted at a buyback. As mining companies transform themselves, shareholders expect them to return more money in the form of dividends and buybacks. BHP Billiton certainly seemed to be on track; however, a sharp decline in iron ore prices this year has forced the company to change its plan.

China, which consumes 40% of the world's seaborne iron ore, is rebalancing its economy. As a result, the country's demand for the bulk commodity will weaken going forward. At the same time, the likes of BHP Billiton, Rio Tinto, Vale SA (NYSE:VALE) and Fortescue (OTCQX:FSUGY) have been increasing production. The iron ore market is expected to go into a surplus this year. As a result, iron ore prices have fallen sharply.

Weaker iron ore prices have also hurt BHP Billiton's cash flow, which in-turn have meant that the company has not been able to bring down its debt to the levels it planned. Not surprisingly, BHP Billiton decided to not announce a share buyback this week when it released its fiscal 2014 results. But that does not mean that the company will not introduce a share buyback program in the future.

BHP Billiton and the other major iron ore miners have a simple strategy at the moment. They are trying to win market share. Many of the miners in Australia and China have significantly higher costs when compared to majors such as BHP and Rio. At the current price of iron ore, most of these miners will find it difficult to sustain. In addition, iron ore prices are expected to fall to around $80 per ton. If that happens, most of the high-cost miners will be shut down, enabling the likes of BHP, Rio and Vale to increase their market share. All three companies will remain profitable even if iron ore prices stay at $80 per ton for a prolonged period. At the same time, though, they will be able to increase their market share. This is why the likes of BHP Billiton have been increasing production even though the seaborne iron ore market is expected to go into a surplus. The cost of increasing market share, however, will be reduced cash flows. As a result, BHP Billiton's plan to reduce net debt and increase shareholder distribution through buybacks will be delayed. But eventually, I expect the company to be in a strong position to reward shareholders as its focus on core assets will likely payoff. Investors, however, will have to keep a long-term horizon.

Source: BHP Billiton Will Create Value For Shareholders In The Long Term