Elliott needs board seat at BHP to push its agenda

If Elliott had its way BHP wouldn’t contemplate big investments in the Canadian potash project.

Elliott says BHP’s Jansen potash project in Canada could be the “next US shale”.

The increasingly slick campaign being mounted by US activist shareholder Elliott Management for a radical restructuring of BHP Billiton has so far been prosecuted with aggressive rhetoric rather than any real action. That may have to, and almost certainly will, change.

If Elliott wants to try to impose its agenda on BHP, and uses a similar game plan to those it has implemented in the US, it has a window of probably less than two months to nominate a candidate or candidates to the BHP board. The first of BHP’s two annual meetings is in London on October 19.

It is obvious that, whatever traction Elliott may or may not be gaining with BHP’s institutional shareholders with its arguments for change, it hasn’t yet — perhaps with one significant exception — managed to convince BHP’s board and management of their validity.

To force the board to adopt its proposals, it would need to demonstrate that it has substantial support from a sufficient proportion of the group’s shareholder base. And it would need to exercise influence from within the boardroom. The most effective way to achieve that would be to get nominees voted on to the board.

With the retirement of Jac Nasser as chairman and the internal appointment of Ken Mac­Kenzie as his successor, BHP will have only 10 directors despite having shareholder authority to appoint as many as 20. Elliott could nominate candidates without having to try to displace existing directors, which would be a tough task in the face of opposition from the incumbents.

The proposals themselves have changed somewhat since they were first unveiled in April. The original plan to unify the entities, within the dual-listed entity structure, envisaged shifting BHP’s incorporation and primary listing to Britain. That demonstrated a complete lack of understanding of the political context in which BHP operates — and was quickly shut down by the federal government.

The revised plan still revolves around unification, but the primary place of incorporation and primary listing would be Australia.

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Another key element of the original proposal has evolved. Elliott originally wanted to impose a formula-driven (BHP described it as “mechanistic”) approach to share buybacks, based on a net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) target of 1.3 times.

After BHP said that had it adopted that formula in the past, it would have conducted $US20 billion ($25bn) of buybacks in 2012 and ended up with $US51.5bn of debt and a net-debt-to-EBITDA ratio of 4.2 times, Elliott backed away from its original presentation of the plan, saying the formula was a “yardstick” against which BHP could measure potential uses for surplus capital. That presupposes that BHP doesn’t already — like almost all major listed companies — do that.

The biggest argument Elliott has put forward for collapsing the dual-listed structure is that because BHP has to top up reserves in the Plc structure (after the demerger of South32 stripped it of most of the operations and earnings held within it) there is a wastage of franking credits. Since 2015, Elliott says, $US853 million of franking credits have been wasted.

There is no doubt that there is some wastage of franking credits within the current structure. The problem with Elliott’s proposal, however, is that it would lead to a far greater leakage of franking credits to those who can’t use them. About 60 per cent of the combined BHP investor base is foreign. Even if that fell slightly, as a unified BHP became a larger part of the Australian indices, a majority of the dividends BHP paid in future would flow to foreign shareholders for whom they have no value.

While it’s not something that either BHP or Rio Tinto highlight, their dual-listed entity structures effectively enable them to stream their franking credits to Australian shareholders. They pay franked dividends within their Ltd entities and unfranked dividends within their British vehicles.

Unification would mean they would burn far more credits in future than they do today. It would also remove, at considerable cost — BHP, which has looked at unwinding the structure continuously over the years, says it would cost between $US1.3bn and $US3bn, a number Elliott disputes — the option, twin currencies and discrete shareholder bases the structure provides.

One doubts whether the concept of tearing up the value of the majority of BHP’s franking credits is going to be attractive to BHP’s local shareholders or, in particular, the retail shareholders Elliott plans to target with social media campaigns.

Underpinning its assault on BHP is Elliott’s core themes that BHP’s current board and management have destroyed value, the group’s shares have underperformed those of its rivals and the company needs to be refreshed. The biggest contributor to that underperformance has been BHP’s US onshore oil and gas business.

The OPEC-inspired collapse in the oil price and the fact that BHP is, in the mining sector, uniquely exposed to it, explains why its sharemarket performance has lagged that of, say, Rio’s in recent years. The collapse of the Samarco tailings dam and the loss of production and the significant costs and liabilities flowing from the joint venture with Vale hasn’t helped.

BHP has issued mea culpas for the timing of its plunge into US shale. The oil price was high and so were the prices BHP paid. The writedowns have been heavy.

While BHP has dramatically improved the economics of its US onshore operations, to the point where they are now cashflow-breakeven, it appears to have recognised that the shale assets are the one element of the Elliott campaign where it has gained real traction with BHP shareholders. They’ve given up on shale. While it might not be the most sensible thing to sell oil and gas assets with oil trading below $US50 a barrel, a trade sale (rather than the demerger and US listing Elliott appears to favour) might salvage some of the value of a business not well reflected the current BHP share price.

Thus the Elliott campaign may force, or encourage, BHP to do something it might have preferred to contemplate in a different oil price environment. While there is no argument from BHP that the foray into shale has been anything but a large-scale mistake, it is worth noting that BHP first entered that market in mid-2011.

With Nasser’s retirement, only five of BHP’s directors were on the board when that decision was taken and two of them — Lindsay Maxsted and Shriti Vadera — had joined only months earlier.

One of the interesting aspects of the BHP board is that the longest-serving director, Wayne Murdy, joined in 2009. Two more (Malcolm Broomhead and Carolyn Hewson) were appointed in 2010, another two (Maxsted and Vadera) in 2011 and the rest (Malcolm Brinded, Anita Frew, Grant King and Ken MacKenzie) joined within the past three years.

BHP chief executive Andrew Mackenzie was appointed to that role in 2013, long after the plunge into shale.

There’s been continuing change within the boardroom — Ken MacKenzie only joined last year and King this year — and therefore a platform based on a need to renew a tired slate of discredited incumbents can be countered. The (Andrew) Mackenzie era at BHP has been anything but profligate, marked by an intense focus on minimising capital intensity, simplifying the business, lower costs and boosting productivity.

If BHP can deliver on its forecast of a 7 per cent increase in copper-equivalent production volumes this financial year and the commodity price matrix doesn’t implode again, it should be able to build on the expected resurgence in profitability it will report for the financial year recently ended. That report is due on August 23, which may represent the opening of the window between then and the annual meeting within which Elliott will act, assuming it is going to ratchet up the aggression by nominating candidates for the board. It would be out of character for Elliott to simply criticise without some more concrete actions.

BHP has, after its original analysis and rebuttal of Elliott’s initial proposals, generally refrained from responding directly to its stalker’s campaign.

Andrew Mackenzie’s more recent presentations have addressed some of the issues Elliott has raised without ever referring to the group, while a more subtle response might have been the publishing of a blog entry extolling the virtues of potash and the rationale for continuing to invest in the shafts for BHP’s Jansen potash project in Canada.

If Elliott had its way — it queried whether potash could be the “next US shale” — BHP wouldn’t contemplate large investments (Jansen could be a $US12bn to $US14bn project) in resources whose returns, if any, might be nearly a decade down the track.

There is a collision of interests and timeframes between an opportunistic investor (Elliott claims an interest in about 4 per cent of the Plc entity) that essentially wants BHP to distribute all of its excess cash to current shareholders, and a board and management whose primary responsibility (and legal responsibility) is to the corporate entities within the dual-listed structure.

The incumbents would inevitably want to continue to invest in BHP’s future, and for the benefit of future shareholders. If they don’t, of course, the continually depleting nature of a resource company’s asset base means that at some point BHP would have no future.

Whether or not Mackenzie takes the Jansen project to his board next year, as he has suggested he might, and whether or not the board ever approves the project, it provides a useful focal point for an illustration of the different motives and perspectives of the key protagonists within a debate about BHP’s structure and strategy — and purpose — that appears destined to intensify.