Sent: 27-02-2013 13:12:02
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Why BHP Needs to Shrink to Succeed
BHP Billiton remains the most fortunate company on the Australian stock market: no growth, a board that has failed to satisfactorily implement a corporate strategy in two decades, chief executives habitually leaving with clouds over their heads and, yet, it remains a compulsory investment for all Australians because superannuation funds are compelled to buy size.
The two resources sector market leaders highlighted their common strategic difficulties as they reported their financial results this month. Neither had performed well enough to secure the continuing position of their chief executives and investors remained unclear about how either would source future growth.
BHP reported an EBIT reduction from $15.9 billion to $9.8 billion for the latest half year. The overwhelmingly largest contributor to the fall in profit was lower commodity prices which cut $5.7 billion in their own right.
Despite the penchant of BHP Billiton executives to highlight a vast array of new projects to which the company has access, extra volumes only contributed the equivalent of $0.4 billion to earnings in the six months to December 2012 compared with the six months to December 2011.
However meagre, the impact of growth on the December half results was much greater than had been the case through most of the recent cycle. Between 2004/05 and 2011/12, investors saw a $17.3 billion increase in the BHP EBIT. Organic growth accounted for none of this increase. In fact, BHP’s output contraction reduced the earnings of the company by some $700 million.
Asset purchases such as the takeover of WMC contributed more substantially but only by around $3 billion. Over this time, BHP benefited by $33 billion from higher commodity prices.
BHP Billiton is too big for its pipeline of new projects to make a meaningful contribution to the overall financial performance of the company. Rio Tinto has the stronger growth trajectory of the two companies.
In 2012, the year for which Rio Tinto reported its results this month, its profit dropped from $15.5 billion to $9.3 billion. As with BHP, this was due overwhelmingly to lower commodity prices which accounted for $5.3 billion of the profit decline. Volume contraction accounted for the equivalent of $309 million.
Over the seven years since 2005, Rio Tinto profit has increased from $5.0 billion to $9.3 billion having peaked at $15.5 billion in 2011. Better commodity prices added $10.3 billion and higher volumes added $1.4 billion.
In both cases, the two market leaders would be sitting on lower profits today without the benefit of higher commodity prices. Their own contributions to shareholder value have been non existent.
The achilles heal for both companies has been rising costs. Since 2004/05, BHP’s cost base has risen $12.0 billion. Rio’s cost base went up $6.2 billion.
The inference from these results is that growth is too hard to achieve for these two giants although it has been easier for the smaller of the two. Therein lies an important trade-off: size versus growth. Seeking either might be a legitimate goal but getting both from the same investment might be a forlorn hope.
Both BHP Billiton and Rio Tinto have spent much of the recent cycle in pursuit of growth by acquisition. In reality, the commodity price cycle is probably too short for large scale acquisitions to be easily accommodated.
The lead time for a major acquisition is so long there is a high likelihood that conditions will be greatly changed by the time a deal is completed. In an age when investors are looking for an immediate earnings increment, the large resource company is placed in an almost impossible position.
Since they are usually bidding for listed entities, it is also difficult to get a bargain unless they wait for the bottom of a prolonged cycle when stressed directors of target companies become willing sellers. WMC and MIM Holdings both fell to acquisitive majors in this way after their directors lost their nerve and threw in the towel.
Today, the number of companies of that size has been greatly reduced and, in any case, they were opportunities that arose only after unusually lengthy tough times for the industry. Picking over similar carcasses today is likely to offer an insufficient diet.
Of course, the greatest value for a mining company comes from successful exploration. BHP does not have an especially strong track record for finding mineral resources. Some of its key assets today such as Escondida, Australian coal, Olympic Dam and iron ore were bought. Its overall size is the product of a corporate deal with Billiton.
So, the number of value creation levers available to the incoming executive teams at BHP Billiton (and, not coincidentally, Rio Tinto, Anglo American and Xstrata) is very limited. The cost lever might be all they have to work with.
Only two of eight business groups within BHP Billiton have had an EBIT margin consistently above the average of the company since 2002-03. The two were petroleum and iron ore. The company’s overall EBIT margin would be higher (and would have been higher) if it quit all its other business lines. They are all generally uncompetitive as internal investment options.
The most appropriate strategy for BHP going forward might be a brutal focus on costs and ways to rationalise the business to take advantage of where it can get acceptably high rates of return on capital.
This strategy would involve scaling back the size of the company. BHP Billiton probably needs to become smaller over the next 3-5 years to succeed.
This might not suit those investors who like size. A scaled back BHP could become a smaller part of the market indexes. Those investors who enjoy the comfort of being able to hug an index through a single investment might have to learn how to choose between more like-sized alternatives.
Some time later, say 2018-2020, BHP could start rebuilding. By then, it will have a higher rate of return on its capital. By coming off a smaller base it might actually be able to create a more dynamic growth profile for investors rather than simply talk about projects that are consistently making a negligible contribution because they are not big enough to make a difference.
A high return on capital with strong growth: now, that would be a good investment.
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