BHP shows how to leverage modest rises into massive gains

Andrew Mackenzie and his team have baked operational discipline into the BHP business model.

It isn’t just the massive rebound in profitability reflected in the BHP Billiton half-yearly result that is impressive but the way in which the improved commodity price environment flowed through to its bottom line.

The underlying attributable profit of $US3.24 billion ($4.22bn) BHP reported for the half is a dramatic improvement on the $US412m it generated in the same half of 2015-16, when BHP abandoned its progressive dividend policy after a statutory loss of $US5.7bn.

What it appears to reflect is the leverage the group has built into its model after four years of focusing on reducing costs, improving productivity, simplifying its portfolio and being disciplined on how it deploys capital.

With $US1.2bn of further productivity gains in the December half to build on the $US11bn of annualised gains BHP says it has extracted from its operations over the past four years, the group generated free cash flows of $US5.8bn. Cost gains across most of its portfolio and stronger commodity prices fell straight through to cash flows.

While the stronger commodity prices added $US3.5bn to earnings before interest, tax, depreciation and amortisation and the reduction in unit costs added $US1.1bn, there was little leakage from the impact of the swollen margins.

That is testimony to the operational discipline and leverage ­Andrew Mackenzie and his team have baked into the BHP business model.

The rebound in cash flows has enabled BHP (with a $US2bn benefit from fair value adjustments generated by interest rate and currency movements) to reduce net debt by $US6bn within the six months, to $US20.1bn, strengthening an already solid balance sheet.

It has also enabled the group to top up the payout ratio-based formula it adopted when it ditched its progressive policy last year. It has declared a US40c a share dividend for a payout ratio of 66 per cent.

What is impressive about the result is that the average prices it received for two of its key commodities, iron ore and oil, were only modestly above those experienced in the previous corresponding period.

The average oil price was $US45 a barrel against the $US42 of the previous period (and $US39 a barrel for the full 2016 financial year) and the average iron ore price achieved was $US55 a tonne against the $US43 realised in the first half of last financial year.

Oil prices have been steady around $US55 a barrel since the start of this year and iron ore prices have risen above $US90 a tonne.

It was iron ore that drove a large proportion of the gains — generating just over 40 per cent of EBITDA and about $US1.3bn of the increase in underlying earnings — but BHP’s petroleum business also made a significant contribution. A loss of $US199m last time has been transformed into a $US360m profit.

Metallurgical coal prices, which more than doubled relative to the same half of last financial year, drove a similar transformation in the contribution of coal to BHP’s EBIT. Where it incurred a loss of $US342m last year, it generated $US1.6bn of EBIT in the latest half.

Copper went from a modest contributor ($US101m) to a significant one ($US914m).

What would please Mackenzie is that, for the first time since commodity prices crashed, all of the commodity groups are in positive territory. While iron ore did produce just over 40 per cent of the group’s earnings, each of the other three key commodities contributed close to 20 per cent.

With the end of OPEC’s ill-fated attempt to drive US shale production from the market, the outlook for the petroleum business has improved significantly. In the latest half, even BHP’s much-maligned onshore US business was cash flow positive.

With a question over the sustainability of the iron ore price, a rebound in the cash flows and earnings of petroleum would restore the benefits of BHP’s diversified model that disappeared over the past couple of years.

While Mackenzie is starting to dial up capital expenditures, largely in petroleum, BHP remains in capital conservation mode. Capital and exploration expenditure was down 38 per cent at $US2.7bn for the half.

It will be similar in the second half and will rise to about $US6.3bn in the full 2018 financial year, largely because of BHP’s successful tender for the Trion discovery in the Gulf of Mexico and the recent go ahead for its $US2.2bn share of the Mad Dog Phase 2 project in the Gulf, but it is clear the group is determined not to lose discipline on capital allocation in an environment where there is volatility and uncertainty.

Mackenzie does have latent growth options. The improved oil price could enable BHP to ramp up US onshore activity and production. While there is industrial action at Escondida, BHP is within sight of a massive infrastructure investment program at the Chilean project. A the third concentrator is to be reintegrated by the middle of this year, allowing a surge in copper production.

Mackenzie has said previously that for modest amounts of capital he can extract large volume gains from his portfolio of large high-quality assets. He doesn’t need to embark on acquisitions or greenfields projects to generate gains in volume and value.

With the increased dividend, a share price that has risen more than 55 per cent since this time last year, a stellar result and a maiden dividend from South32, the demerged ex-BHP collection of ­assets to which many BHP shareholders still are exposed, shareholders ought to be pleased with the results of both companies.

Their performances this half do tend to support the view that well-constructed demergers create value through the increased focus and the more ­efficient allocation of capital they enable.

For BHP, it has meant a more efficient portfolio operating model and, as the latest result and its predecessors have demonstrated, the ability to maximise the leverage to any improvement in its key commodity prices while remaining resilient through commodity price troughs.