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Does bhp deserve a place in your portfolio?

BHP's newly announced chief executive inherits an excellent business but there are three lingering problems he must address.

As the China-led resources boom got underway, BHP's board positioned to take advantage of commodity prices that would be 'stronger for longer'.

To capture the Chinese market, BHP wanted to get bigger. It merged with Billiton, bought more than US$20bn worth of shale asset, bought Western Mining, initiated an entry into potash, approached Rio for a merger and considered buying Woodside.

The audacity of BHP was grounded in a single, unwavering belief: that China would change everything. 


Key Points

  • New CEO announced
  • We suggest three priorities
  • Business performing splendidly

The man to drive that ambition was Marius Kloppers, who believed in China's rise so completely that his own children were learning Mandarin alongside their native tongues.

Under his watch, BHP morphed from a conventional mining business into an idea; an all-in bet on Chinese industrialisation. 

The idea worked. China has come of age and everything is different. Yet the boom didn't have the expected outcome for BHP, which spent lots of money for little return. The greatest commodities boom in a generation came and went with little notice.

Kloppers was replaced by Andrew Mackenzie with another mission from the board; a restoration of glory. 


Back to the future

The Billiton merger was unwound resulting in the spinoff of South32; shale was expunged; capital expenditure collapsed and Mackenzie brought a laser focus on returns. His reign has been equally as momentous as Kloppers but far more successful.

Dividends and free cash flows have swelled under Mackenzie's watch and BHP has become a smaller but better business. The Mackenzie era, however, is about to end. 

BHP announced that Mike Henry will take over as chief executive at the end of the year. Henry ran BHP's Australian business and has been with BHP for 16 years.

Both Kloppers and Mackenzie have defined and redefined BHP under their watch. The business has changed from a giant desperate to get larger to a smaller business focused on cost, efficiency and shareholder returns. BHP today is the business it should have always been. 

What will happen under its new boss? How will Mike Henry make his mark?

It is an important period for BHP. Growth is harder to find and easy productivity gains have already been made. We think there are three areas that might occupy the new chief.

The first is the oil dilemma. 


The oil dilemma

BHP holds over 1 billion barrels of oil equivalent (boe) in its portfolio and a further 2 billion boe in contingent resources. No other major miner runs a significant oil business alongside a conventional mining one. For BHP, that quirk has paid off. 

The petroleum business, which includes conventional oil, gas and LNG assets, averages return on capital employed of 15% and boasts the highest operating margins in the portfolio. 

Petroleum is at once a hedge against higher energy costs and a source of significant cash flow, contributing about 20% of BHP's operating profits.

Yet the petroleum business probably accounts for only 10% of BHP's valuation. The business generates excellent cash flow now but a period of unusually high profitability will soon end as large projects deplete and demand more cash. 

Petroleum is likely to account for over 40% of group capital expenditure over the next few years and there is a growing gap between those who expect lower demand for petroleum and those who expect low growth. Everyone agrees the days of soaring oil demand are over. In time, BHP's oil business could morph from a sail to an anchor.

It's time for management to consider the place of petroleum within the group. A sale or spin-off of the petroleum business should be a key consideration of the new chief.


Olympic Dam is damn hard

Olympic Dam, located in an isolated region of South Australia, is among the most remarkable orebodies in the world. 

It contains the single largest deposit of uranium - as much as 25% of the world's known supply is locked inside. 

It is also the fourth largest copper deposit in the world and produces significant volumes of silver and gold. It vies with Russia's Norlisk mine as arguably the most valuable orebody on the planet.

Yet BHP currently makes no money from the mine. In fact, it has barely eeked out a return since it bought the mine (for almost $10bn) 15 years ago. 

That the world's biggest miner can't turn a profit from the world's most valuable orebody isn't just a problem for shareholders, it is a corporate embarrassment.

To be fair to BHP, this is a complex mine. Multiple metals tinged with radioactivity make processing and metallurgy rather complicated and BHP has never invested in enough volume to make the economics work. Olympic Dam needs to get bigger before it gets more profitable.

BHP has spent more than a decade trying to solve the mine's profit problem. It never has. Few single orebodies can move the dial at BHP. This one can. It carries enormous latent potential and should be prioritised.


Nickel returns

The other sleeper in the portfolio is nickel. Like many of its previous successes, BHP owes a lot to luck with this asset. 

BHP's nickel business has long been a mess. In fact, BHP has spent the last five years trying to sell the business, a combination of mines and processing facilities, to anyone it can find. For five years, no buyers emerged. 

Earlier this year, however, BHP announced it would keep it. What changed?

It turns out that the electrification of cars requires substantial nickel volumes. Specifically, the kind of nickel BHP happens to have - the same stuff it has spent half a decade trying to sell - is now in hot demand.   

As it stands now, the nickel business is of modest quality compared to the other assets in the BHP portfolio. This is one part of the portfolio that could benefit from acquisitions or development to improve quality.

The integration of mining, processing and logistics could make the nickel business a strong returning one; BHP, after all, knows a thing or two about running integrated logistics. Curated carefully, nickel could be a new leg of growth for years. 

The new chief will inherent BHP in the best state it has ever been in. The balance sheet is rock solid, costs remain low and a new capital allocation model is working. Free cash flows have been consistently high despite volatile commodity prices.


Your turn

BHP is arguably the best miner in the world but it's not perfect. The oil question must be asked and answered under Mike Henry's watch; Olympic Dam carries too much potential to ignore and the bourgeoning nickel business may need an injection of aggression to raise it to the same standard as the rest of the portfolio. 

Andrew Mackenzie has left a fine legacy. Your turn, Mike.

Note: The Intelligent Investor Model Income portfolios own shares in BHP.

The Intelligent Investor Equity Income fund owns shares in BHP.

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