Equities

BHP has delivered for shareholders in the 12 months since we laid out our bullish thesis on Livewire which you can see here. Collectively Andrew Mackenzie as CEO and the recently installed Chairman Ken MacKenzie have done a good job in managing the business and the balance sheet.

Nothing exemplifies this more than the successful exit from the shale industry announced in July this year. The shale business was a perennial destroyer of value so the realisation of more than USD$10bn in cash from the sale to BP is an excellent outcome.

The shale industry fails to provide shareholders with sustainable cash returns and the asset was not tier one, like the remainder of the BHP portfolio. We applaud BHP’s decision to exit the industry and return the sale proceeds to shareholders in the most tax efficient means possible.

"The shale business was a perennial destroyer of value so the realisation of more than USD$10bn in cash from the sale to BP is an excellent outcome." 

Commodity markets have also played a part in BHP’s revival. Oil markets have tightened significantly over the past twelve months with oil inventories declining by approximately 700kboe per day.

In the year ahead we expect oil inventories to continue to decline supporting oil prices as well as BHP’s decision to retain their conventional oil business. Rising global trade tensions do present a risk to commodities demand over the medium term though and so need to be carefully monitored.

Whether these risks can derail the current strong levels of global demand for commodities remains to be seen. The Chinese have responded to anticipated trade disruption by improving liquidity and lending to the banking sector whilst also redoubling their investment efforts in fixed asset investments like property and infrastructure.

This will be a positive for the Chinese steel industry and in turn iron ore and met coal, two important products for BHP. Overall we think the outlook for global growth, and therefore commodity markets, remains sound although with slightly elevated risks versus 12 months ago.

"In the year ahead we expect oil inventories to continue to decline supporting oil prices as well as BHP’s decision to retain their conventional oil business."

The combination of strong commodity markets and the shale sale means BHP’s balance sheet is now in great shape. The CEO and Chairman of BHP have also refined the capital allocation process at BHP over the last couple of years so shareholders can have much more confidence that excess capital will be reinvested at above cost of capital returns or returned to shareholders.

BHP capital allocation decisions are first compared to the value accretion from a share buy back – typically the easiest and least risky capital management option for any company. The focus is then on optimising the value of the existing assets and deploying capital in brownfield expansions or other accretive investments.

New projects or acquisitions are then compared to all of BHP’s other investment opportunities which are ordered on the basis of risk and return. If the company’s capital requirements are less than the free cash being generated then the excess capital will be returned to shareholders. BHP have proven their commitment to improved capital allocations is more than just lip service by selling shale and committing to return the proceeds to shareholders expeditiously. They have also clearly articulated their capital allocation framework so investors can assess the likelihood of excess cash being generated and what the company may then do with it.

"BHP have proven their commitment to improved capital allocations is more than just lip service by selling shale and committing to return the proceeds to shareholders expeditiously." 

As investors, we believe that the management of a company’s balance sheet is THE key priority for company management. The balance sheet provides a solid foundation for the whole business so investors need to be confident that capital will be deployed efficiently at returns above cost of capital and not squandered on dilutive acquisitions or poor investments.

BHP is providing that confidence and getting capital management right at a crucial time when commodity markets remain supportive and the company is generating significant free cash.

The BHP turnaround is well on track.

Paradice Investment Management



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