Mining │ Australia April 23, 2015 BHP Billiton BHP AU / BHP.AX Market Cap Avg Daily Turnover Free Float Current A$30.27 Target A$34.90 US$122,011m US$206.9m 100.0% Prev. Target A$157,129m A$266.6m 5,346 m shares Up/Downside NA 15.3% Conviction| | (61) 3 9947 4134 Head south for winter Adrian PRENDERGAST T (61) 3 9947 4134 E [email protected] Share price info Share price perf. (%) 1M 3M 12M Relative 1.0 -2.8 -26.9 Absolute -1.3 4.9 Major shareholders -20.4 % held Colonial First State Asset Management (Australia) Ltd. 1.4 The Vanguard Group, Inc. 1.2 BlackRock Fund Advisors 1.0 BHP150423 We believe investors should be adding to their BHP positions ahead of the planned demerger. We value South32 at A$2.98 per share. Although we expect an initial “washing out” period of share price volatility for South32, we believe the sum of the two individual companies will quickly exceed BHP’s current market capitalisation once the ‘dust settles’. We re-initiate coverage with an Add recommendation. Worth more separated Sum of the parts. We re-initiate coverage on BHP with a high conviction Add recommendation and A$34.90 DCF-based price target ahead of the planned demerger. We hold the view that the sum of the two individual companies (BHP ex-demerger A$32.66 + South32 A$2.98) will equal more than BHP’s current market capitalisation (A$30.27). In fact BHP is already trading at a discount to our post-demerger valuation of its core business before the spinoff even occurs, highlighting the value proposition on offer through the demerger. Not their responsibility Competitive landscape. While it is popular to blame the ‘Big 3’ (BHP, RIO, and Vale) for the current supply surplus in iron ore, it remains our view that the supply wave they (and FMG) developed did not appear overnight. In fact it was years in the making with the industry well aware it was coming. Despite this, smaller players rushed to develop high-cost production in an attempt to capitalise on peak-cycle pricing. We therefore do not blame the majors for now completing their planned expansions at the expense of their less-competitive peers (who appear to have failed to plan accordingly for the eventuality of lower iron ore prices). Excessive uncertainty remains around the iron ore price outlook, which has resulted in increased volatility. Ultimately we believe an improvement in the Chinese steel market is required to sustain an iron ore price recovery. Superior commodity mix Better outlook for energy. Despite the weak commodity price environment, we expect a medium-term recovery in oil prices will benefit BHP’s large energy interests. We maintain a positive view on BHP’s commodity-focused strategy approach, which we expect will see it exposed to a superior basket of commodities post the South32 demerger. Price Close Financial Summary (pre-demerger) Relative to S&P/ASX 200 (RHS) 40.0 102.5 35.0 90.0 30.0 77.5 25.0 40 65.0 30 Vol m 20 10 Apr-14 Jul-14 Oct-14 Jan-15 Source: Bloomberg 52-week share price range 30.27 39.68 26.90 34.90 Current Target Revenue (US$m) Operating EBITDA (US$m) Net Profit (US$m) Normalised EPS (US$) Normalised EPS Growth FD Normalised P/E (x) DPS (US$) Dividend Yield (A$ %) EV/EBITDA (x) P/FCFE (x) Net Gearing P/BV (x) ROE Normalised EPS/consensus EPS (x) Jun-13A 69,900 30,297 13,755 227 -21.8% 10.4 116 4.9% 5.1 6.3 26.8% 1.77 16.1% Jun-14A 68,730 32,359 14,844 252 10.6% 9.4 121 5.1% 4.7 5.0 23.2% 1.58 15.7% Jun-15F 63,761 24,769 9,439 150 -40.5% 15.8 126 5.3% 6.3 7.4 25.9% 1.65 9.6% 0.96 Jun-16F 61,676 24,644 8,965 146 -2.2% 16.1 130 5.5% 6.3 6.7 24.6% 1.59 9.0% 1.08 Jun-17F 65,021 26,196 9,551 160 9.4% 14.7 133 5.7% 5.8 6.5 22.3% 1.51 9.6% 0.96 SOURCE: MORGANS, COMPANY REPORTS IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN 49 010 669 726) AFSL 235410 - A PARTICIPANT OF ASX GROUP Mining │ Australia April 23, 2015 BHP Billiton - Financial summary (pre-demerger) Capital profile Number of shares (m) Market capitalisation (A$m) Enterprise value (A$m) 5,346 161,823 197,093 Valuation Petroleum - conventional Petroleum - onshore Potash Petroleum + Potash Iron Ore Copper Coal Al, Mn, Ni Total Operations Net Debt Corporate costs Exploration Total Valuation Target Price P/NPV (BHP.AX) US$m 23,048 21,000 8,533 52,581 73,470 34,224 24,629 12,907 197,811 (25,837) (3,904) 1,978 170,049 126,222 US$m 153,732 US$m A$m 25,896 23,596 9,588 59,080 82,551 38,454 27,673 14,503 222,260 (33,360) (4,386) 2,223 186,736 A$ps 4.84 4.41 1.79 11.05 15.44 7.19 5.18 2.71 41.58 (6.24) (0.82) 0.42 34.93 34.90 0.87 £m 14,869 13,549 5,505 33,923 47,400 22,080 15,890 8,327 127,620 (17,186) (2,519) 1,276 109,192 £ps 2.78 2.53 1.03 6.35 8.87 4.13 2.97 1.56 23.87 (3.21) (0.47) 0.24 20.43 BHP operational split Petroleum conventional 12% Petroleum onshore 11% Potash 4% Copper 17% Iron Ore 37% BHP iron ore production - equity share (Mt) Valuation inputs Rf rate MRP Equity beta Ke Kd Gearing Tax rate WACC 267 270 260 253 250 240 240 4.3% 5.3% 1.19 10.5% 5.3% 30.0% 30.0% 8.5% 232 230 June year end NPAT Reported (US$m) NPAT Underlying (US$m) EBITDA Underlying (US$m) EBIT Underlying (US$m) EPS (US¢) CFPS (US¢) DPS (US¢) P/E (x) P/CF (x) EV/EBITDA (x) EPS Growth Yield (%) 2014A 13,832 13,447 32,359 22,861 252 474 121 9.4 5.0 4.7 10.6% 5.1% 2015F 9,455 7,996 24,769 16,640 150 321 126 15.8 7.4 6.3 -40.5% 5.3% 2016F 7,822 7,822 24,644 15,893 146 353 130 16.1 6.7 6.3 -2.2% 5.5% 2017F 8,560 8,560 26,196 16,907 160 363 133 14.7 6.5 5.8 9.4% 5.7% Divisional EBIT (US$m) Petroleum - conventional Petroleum - onshore Potash Petroleum + Potash Iron Ore Coal Copper Al, Mn, Ni Group & unallocated Total EBIT 2014A 5,726 (156) (285) 5,285 12,102 386 5,080 307 (299) 22,861 2015F 4,000 700 (300) 4,401 5,143 1,367 5,531 739 (540) 16,640 2016F 3,065 194 248 3,507 5,033 693 5,033 2,037 (410) 15,893 2017F 3,408 633 682 4,724 4,952 963 4,617 1,833 (183) 16,907 2014A 67,206 1,524 68,730 (36,371) 32,359 (9,498) 22,861 97 (1,273) (1,176) 21,685 (6,841) 14,844 1,397 13,447 385 13,832 2015F 63,211 550 63,761 (38,991) 24,769 (8,130) 16,640 221 (1,729) (1,509) 15,131 (5,692) 9,439 1,443 7,996 1,459 9,455 2016F 61,126 550 61,676 (37,032) 24,644 (8,751) 15,893 162 (1,729) (1,567) 14,326 (5,361) 8,965 1,143 7,822 0 7,822 2017F 64,471 550 65,021 (38,825) 26,196 (9,290) 16,907 217 (1,729) (1,512) 15,395 (5,843) 9,551 991 8,560 0 8,560 2014A 33.3% 47.1% 31.5% 16.0% 15.7% 2015F 26.1% 38.8% 37.6% 11.5% 9.6% 2016F 25.8% 40.0% 37.4% 10.8% 9.0% 2017F 26.0% 40.3% 38.0% 11.5% 9.6% Cash flow (US$m) Operating cash flow Capex and exploration Free cash flow Other investing cashflows Financing cash flow Net Change in cash 2014A 25,364 (16,287) 9,077 453 (6,445) 3,085 2015F 17,140 (13,798) 3,342 0 (6,629) (3,287) 2016F 18,882 (11,186) 7,697 0 (6,843) 854 2017F 19,423 (9,642) 9,781 0 (7,057) 2,724 Balance Sheet (US$m) Debt Equity Assets Cash Net debt Gearing - ND/ (ND + equity) Net debt / EBITDA EBITDA / net interest 2014A 34,589 85,382 151,362 8,752 25,837 23% 0.8 28 2015F 34,589 83,241 149,641 5,465 29,124 26% 1.2 16 2016F 34,589 86,610 153,020 6,319 28,270 25% 1.1 16 2017F 34,589 88,912 155,926 9,043 25,546 22% 1.0 17 Profit & Loss (US$m) Revenue Other income Total Revenue Cost of sales EBITDA Depreciation & amortisation EBIT Financial Income Financial expense Net finance costs Profit before taxation Taxation expense NPAT Equity minorities Underlying NPAT Exceptional gain (loss) Reported NPAT Profitability Analysis (%) EBIT margin EBITDA margin Effective tax rate ROA - EBIT / (Assets - cash) ROE - NPAT / equity 220 210 2015F 2016F 2017F 2018F Sensitivities (US$ - Underlying NPAT) Oil +US$10/bbl Aluminium +US$0.10/lb Copper +US$0.10/lb Nickel +US$1/lb Iron ore fines +US$10.00/t CFR Hard coking coal +US$10/t Thermal coal +US$10/t AUD/USD +1¢ USD/ZAR +1 rand Attributable production Petroleum products (Mboe) Aluminium (Mt) Alumina (Mt) Copper (kt) Gold (koz) Uranium (Mlb) Diamonds (Mcts) Nickel (kt) Iron ore (Mt) Manganese ore (Mt) Coal - hard coking (Mt) Coal - thermal (Mt) 2013A 236 1.2 4.9 1,209 177 9.0 1.0 154 170 8.5 38 73 2014A 246 1.2 5.2 1,727 243 8.8 0.0 143 202 8.3 45 73 2015F 265 1.0 5.2 1,663 192 8.0 0.0 140 232 8.6 50 75 2015F 762 192 166 189 1,431 261 324 (109) 1 2016F 590 195 172 248 1,246 208 287 (97) 1 2016F 286 1.1 5.3 1,611 162 9.4 0.0 166 240 7.9 46 74 2017F 308 1.1 5.3 1,584 162 9.4 0.0 166 253 7.9 46 74 Assumptions AUD/USD WTI Crude Oil (US$/bbl) Nat Gas (US$/Mbtu) Aluminium (US$/lb) Copper (US$/lb) Nickel (US$/lb) Iron ore fines (USc/dmtu) Hard coking coal (US$/t) Thermal coal (US$/t) 2014A 0.92 100 4.13 0.81 3.18 6.92 184 133 79 2015F 2016F 2017F 0.85 0.77 0.79 73 64 70 4.00 3.59 4.20 0.87 0.82 0.86 3.12 3.18 3.22 7.43 8.62 8.50 93 82 80 131 107 113 64 60 65 SOURCE: MORGANS, COMPANY REPORTS BHP Billiton April 23, 2015 MARCH QUARTER HIGHLIGHTS BHP continues productivity and efficiency drive The quarter was driven by strength in iron ore output, with lower production recorded across the majority of other business segments. Key highlights from the quarter: Slowing growth to 290mtpa. BHP announced it is slowing its planned expansion to 290mtpa of installed iron ore capacity (saving on the capex required for the Inner Harbour Debottlenecking project and focusing on achieving the target through productivity gains). C1 costs cut to US$20/t. BHP has effectively (and sustainably) reduced its unit cash costs across its Pilbara iron ore operations to US$20/t (excluding royalties and freight). Resolve maintained. 3Q15 iron ore output increased 6% Q-o-Q to 59mt. As a result BHP lifted FY15 iron ore guidance to 230mt (from 225mt). We view expansion to 270mtpa as a firm target given the meagre capex required to ramp up mine production (capital intensity of US$30/t versus recent industry average of ~US$150/t). Copper guidance lowered. FY15 copper guidance was lowered by 100kt to 1.8mt, after heavy rainfall in March impacted Escondida (50kt) while an electrical failure at the mill has taken Olympic Dam offline for ~6 months (60-70kt). Less upside to iron ore. We expect a significant supply response in iron ore will take time to build. However, a long-term issue has been the aggressive flattening of the global cost curve as high-cost iron ore miners implement extreme measures to sustain output. This could see the downturn become more protracted and upside potential reduced in a recovery scenario as the marginal cost of production declines. Figure 1: BHP production summary - March quarter (3Q FY15 attributable) Calendar year quarters Crude oil and condensate ('000 bbl) Natural gas (bcf) Natural gas liquids ('000 bbl) Petroleum products (Mboe) Alumina (kt) Aluminium (kt) Copper (kt) Nickel (kt) Iron ore (kt) Manganese ores (kt) Manganese alloys (kt) Metallurgical coal (kt) Thermal coal (kt) 4Q13 19,202 203 4,771 58 1,352 302 440 38 48,433 2,200 166 11,540 17,767 1Q14 21,752 202 5,492 61 1,250 286 414 34 49,280 1,801 162 11,467 17,723 2Q14 22,686 215 6,191 65 1,325 276 470 31 56,643 2,255 181 11,886 17,723 3Q14 24,126 219 6,819 67 1,235 261 389 36 57,091 2,259 171 12,769 17,837 4Q14 24,754 194 6,409 64 1,398 256 424 34 56,352 2,296 201 13,538 18,622 1Q15 25,376 182 5,922 62 1,248 245 460 33 58,979 2,049 182 11,458 19,714 QoQ 3% -7% -8% -3% -11% -4% 9% -5% 5% -11% -9% -15% 6% YoY 17% -10% 8% 1% 0% -14% 11% -5% 20% 14% 12% 0% 11% SOURCES: COMPANY REPORTS Earnings set back a decade We estimate the recent collapse in commodity prices will set BHP’s gross earnings back to the lowest level seen in the last 10 years. The strongest blow will come from iron ore, where we estimate the EBIT contribution has declined from 53% in FY14 to just 32% of depressed earnings in FY15. In the short term the ongoing weakness in iron ore represents one of the largest risks to our investment thesis. Despite the decline in forecast earnings, we expect BHP will remain in a comfortable position to continue its progressive dividend policy. Albeit we expect the payout ratio will increase to approximately 80%, we expect this will be manageable in the short term. BHP Billiton April 23, 2015 Figure 2: EBIT by commodity (US$m) 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F 2020F -5,000 Iron ore Petroleum - conventional Petroleum - on-shore Copper Potash Coking coal Thermal coal Aluminium Nickel Manganese Group, unallocated, reallocated SOURCES: MORGANS, COMPANY REPORTS INVESTMENT VIEW Add recommendation maintained We re-initiate coverage on BHP with an Add recommendation and A$34.90 price target ahead of the planned demerger. We hold the view that the sum of the two individual companies (BHP ex-demerger A$32.66 + South32 A$2.98) will equal more than BHP’s current market capitalisation (A$30.27). In fact BHP is already trading at a discount to our post-demerger valuation of its business before the spinoff even occurs, highlighting the value proposition on offer through the demerger. What to do with South32 We recommend investors remain patient and retain their South32 holdings. There will likely be an initial “washing out” period for South32, with an initial wave of selling from risk-averse BHP holders looking for a quick exit when it first lists. This may create an opportunity for the sell-off to be overdone, which could present a chance to invest in South32 if it trades below our A$2.98 valuation. KEY RISKS Commodity risk We expect the weak commodity price environment poses the largest risk to our investment thesis for BHP. A continued slide in commodity prices is likely to further undermine investor and impact near-term earnings beyond our conservative forecasts. South32 selling pressure We anticipate a substantial “washing out” period for South32 upon listing, as un-natural holders (risk averse, blue-chip focused) seek to exit and are replaced with natural holders (risk tolerant, resource orientated, index huggers, and contrarians). This transition is unlikely to occur smoothly, and we expect the sellers to outweigh buyers shortly after listing. BHP Billiton April 23, 2015 VALUATION SUMMARY BHP combined valuation We value BHP on a 50-year DCF valuation of US$170,042m or A$34.93ps, based on a WACC of 8.5%. The breakdown of BHP’s valuation has changed significantly in the last 12 months, with the collapse in commodity prices directly impacting the company’s two largest business segments, iron ore and petroleum. We view BHP as highly competitive in both segments and well positioned to defend profitability in what has become a difficult operating environment. Interestingly, the valuation of BHP’s long-life business remains sensitive to the discount rate applied. Increasing our assumed WACC to 10% would see our valuation drop to A$28.91. Figure 3: BHP Billiton combined valuation Valuation Petroleum - conventional Petroleum - onshore Potash Iron Ore Copper Coal Aluminium/Mang/Nickel Total Operations Net Debt Corporate costs Exploration Total Valuation US$m 23,048 20,999 8,532 73,468 34,223 24,627 12,907 197,805 -25,837 -3,904 1,978 170,042 US$ps 4.31 3.93 1.60 13.74 6.40 4.61 2.41 37.00 -4.83 -0.73 0.37 31.81 A$m 25,897 23,594 9,587 82,548 38,453 27,671 14,503 222,253 -33,360 -4,386 2,223 186,729 A$ps 4.84 4.41 1.79 15.44 7.19 5.18 2.71 41.57 -6.24 -0.82 0.42 34.93 £m 14,870 13,548 5,505 47,399 22,079 15,889 8,327 127,616 -17,186 -2,519 1,276 109,188 £ps 2.78 2.53 1.03 8.87 4.13 2.97 1.56 23.87 -3.21 -0.47 0.24 20.42 SOURCES: MORGANS, COMPANY REPORTS BHP ex-demerger valuation Post the planned demerger, we expect BHP will boast an enviable EBITDA margin across its business of 47%, a forward PE ratio of 13x, a fully franked dividend yield of ~5.5% and valuation of A$32.66ps. We view these metrics as robust, with the view that BHP will quickly start to fill the gap in its market capitalisation left by the demerger. We value BHP’s diversified petroleum business at A$9.26, almost a third of the company’s total ex-demerger valuation. In our view this division is likely to grow in proportion to the rest of BHP’s business supported by a medium-term recovery in oil prices. South32 valuation We agree with the rationale for the spin off, and the view that a separate/focused management team will be able to squeeze considerable value out of the non-core assets that will be spun into South32. On a DCF valuation with a 10% WACC we arrive at a valuation of US$13,194m (or A$2.98 per share) for South32. At a discount to BHP’s attributed valuation on the spin-off of ~US$15bn, but we attribute much of the difference to the fact that our valuation is more recent, which would account for more of the additional commodity price weakness that has since unfolded. Key value drivers for South32’s business, based on our preliminary analysis and modelling, will be its high-quality manganese and aluminium/alumina businesses that combined account for 58% of the value we attribute South32’s operations. These competitive long-life operations in mid-cycle commodities represent an important market exposure for South32, which would see it leveraged to a broader recovery in resources. BHP Billiton April 23, 2015 Figure 4: BHP ex-demerger valuation Petroleum US Onshore Bass Strait North West Shelf Atlantis Shenzi Algeria UK Stybarrow Pyrenees Macedon Minerva Trinidad Pakistan Mad Dog Neptune/other Total Petroleum Copper Escondida Spence Cerro Colorado Antamina Olympic Dam Resolution Total Copper Diamonds & Specialty Diamonds & Specialty Total Diamonds & Specialty Nickel Nickel West Total Nickel Iron Ore West Australia iron ore Samarco Total Iron Ore Coal BHP Mitsubishi Alliance BHP Mitsui Coal Marawai Total Coking Coal New Mexico, USA Hunter Valley, Australia CDC & CZN, Colombia Total Thermal Coal Total Coal Total BHP Post-Demerger Ops Net Debt Corporate Total BHP Post-Demerger US$m 20,999 4,306 5,813 5,671 1,593 428 36 38 292 2,132 1,315 402 47 558 416 44,047 US$ps 3.93 0.81 1.09 1.06 0.30 0.08 0.01 0.01 0.05 0.40 0.25 0.08 0.01 0.10 0.08 8.24 A$m 23,594 4,838 6,531 6,372 1,790 481 40 43 328 2,395 1,478 452 53 627 468 49,491 A$ps 4.41 0.91 1.22 1.19 0.33 0.09 0.01 0.01 0.06 0.45 0.28 0.08 0.01 0.12 0.09 9.26 14,823 3,742 838 6,079 6,906 300 32,687 2.77 0.70 0.16 1.14 1.29 0.06 6.11 16,655 4,204 941 6,830 7,760 337 36,727 3.12 0.79 0.18 1.28 1.45 0.06 6.87 8,532 8,532 1.60 1.60 9,587 9,587 1.79 1.79 2,287 2,287 0.43 0.43 2,570 2,570 0.48 0.48 71,434 2,034 73,468 13.36 0.38 13.74 80,263 2,285 82,548 15.01 0.43 15.44 12,169 1,949 250 14,368 865 3,598 2,956 8,755 23,123 184,145 -25,163 -3,604 155,379 2.28 0.36 0.05 2.69 0.16 0.67 0.55 1.64 4.33 34.45 -4.71 -0.67 29.06 13,673 2,190 281 16,144 971 4,043 3,321 9,837 25,981 206,905 -28,273 -4,049 174,583 2.56 0.41 0.05 3.02 0.18 0.76 0.62 1.84 4.86 38.70 -5.29 -0.76 32.66 SOURCES: MORGANS, COMPANY REPORTS Figure 5: South32 valuation South32 Operations South Africa - Mn ore South Africa - Alloys GEMCO TEMCO Manganese Alumar smelter/refinery Worsley refinery Hillside smelter Mozal smelter Aluminium Cannington, Queensland Silver Cerro Matoso, Colombia Nickel Illawarra, Australia Metallurgical Coal Ingwe, South Africa Thermal Coal Total South32 Operations Net Debt Corporate Total South32 US$m 719 1,633 376 818 3,546 546 3,126 671 829 5,173 1,536 1,536 1,901 1,901 1,504 1,504 1,336 1,336 14,996 -674 -1,128 13,194 US$ps 0.13 0.31 0.07 0.15 0.66 0.10 0.58 0.13 0.16 0.97 0.29 0.29 0.36 0.36 0.28 0.28 0.25 0.25 2.81 -0.13 -0.03 2.65 A$m 807 1,835 422 919 3,984 642 3,512 754 932 5,812 1,726 1,726 2,136 2,136 1,690 1,690 1,501 1,501 16,849 -757 -1,267 14,825 A$ps 0.15 0.34 0.08 0.17 0.75 0.12 0.66 0.14 0.17 1.09 0.32 0.32 0.40 0.40 0.32 0.32 0.28 0.28 3.15 -0.14 -0.03 2.98 SOURCES: MORGANS, COMPANY REPORTS BHP Billiton April 23, 2015 DEMERGER OF SOUTH32 South32 overview With commodity prices in decline, BHP has moved to simplify its business and maximise profitability by demerging the majority of its non-core assets into a new entity (South32). South32 will hold a diversified portfolio of mature assets producing a range of mid-cycle commodities including aluminium, alumina, manganese, coal, nickel silver, lead and zinc. Figure 6: Map of South32 assets SOURCES: COMPANY REPORTS Geographically diversified, South32’s business will be headquartered in Perth, with operations across five countries. On our estimates just over half of South32’s gross earnings will be generated outside of Australia. Figure 7: South32 EBITDA by country Mozambique, 4% Colombia, 14% Brazil, 7% Australia, 49% South Africa, 25% SOURCES: MORGANS, COMPANY REPORTS Key details BHP shareholders as at 15 May will be issued shares in South32 on a 1-for-1 basis at no cost, with normal trading set to start on 2 June. South32 has promised a “minimum” dividend payout ratio of 40%, which on pro-forma EPS estimates implies a possible yield of ~3% unfranked based on our South32 valuation. BHP Billiton April 23, 2015 Higher leverage / risk It is important to note that the risk profile for South32 will vary from that of BHP, given the difference in scale of its business, profitability and commodity/country exposures. This may result in a portion of BHP shareholders not being natural holders of South32. South32’s assets are concentrated toward a narrower collection of mid-cycle commodities dominated by base metals. They are less profitable than those of its parent, generating an FY14 EBITDA margin of 20% (versus ~47% for BHP ex-demerger) and declining revenues due to weakening commodity prices. Strong balance sheet To counter this, BHP is spinning off the company with a strong balance sheet, with initial net debt of US$0.67bn (including US$350m cash). South32 will also have a US$1.5bn five-year debt facility that could conceptually be used to fund acquisitions or internal growth. Value under pressure At the time of proposing the demerger, BHP attributed a book value of ~US$15bn to the South32 assets (about A$3.50ps). Although since that time we expect the market value has come under significant negative pressure from falling commodity prices. On our price deck, we now value South32 at a reduced US$13.19bn (or A$2.98ps). It appears to be the argument of value that divides the market’s view on South32. Former BHP spin-offs encouraging Former BHP spin-offs have performed well in the past. The founding assets of Newcrest included assets spun out via BHP Gold in the late 1980s. OneSteel and BlueScope were both spun out in the early 2000s, with all companies subsequently evolving into larger and more successful businesses when independently managed. Well capitalised assets put into the hands of more focussed management is also likely to attract the attention of contrarian investors. SENSITIVITIES Earnings sensitivities BHP’s earnings remain highly sensitive to fluctuations in iron ore, where the price outlook remains uncertain given the ongoing market surplus. To demonstrate this leverage, a US$10/t shift in iron ore price would impact FY15 underlying NPAT by US$1.43bn on an annualised basis. This remains a major hurdle for the business as a substantial portion of the global iron ore supply chain has demonstrated it is willing to slash costs rather than curb production. In our view the cost curve shifting lower is starting to reduce the upside potential for the iron ore price in a recovery scenario. Figure 8: Sensitivities (US$m - Underlying NPAT) NPAT Impact Oil +US$10/bbl Aluminium +US$0.10/lb Copper +US$0.10/lb Nickel +US$1/lb Iron ore fines +US$10.00/t CFR Hard coking coal +US$10/t Thermal coal +US$10/t AUD/USD +1¢ USD/ZAR +1 rand 2015F 762 192 166 189 1,431 261 324 -109 1 2016F 590 195 172 248 1,246 208 287 -97 1 SOURCES: MORGANS, COMPANY REPORTS BHP Billiton April 23, 2015 QUEENSLAND BRISBANE - HEAD OFFICE BRISBANE - EDWARD STREET BRISBANE - TYNAN PARTNERS BUNDABERG CAIRNS CALOUNDRA EMERALD GLADSTONE GOLD COAST IPSWICH/SPRINGFIELD KEDRON MACKAY MILTON MT GRAVATT/CAPALABA NOOSA REDCLIFFE ROCKHAMPTON SPRING HILL SUNSHINE COAST TOOWOOMBA TOWNSVILLE YEPPOON (07) 3334 4888 (07) 3121 5677 (07) 3152 0600 (07) 4153 1050 (07) 4222 0555 (07) 5491 5422 (07) 4988 2777 (07) 4972 8000 (07) 5581 5777 (07) 3202 3995 (07) 3350 9000 (07) 4957 3033 (07) 3114 8600 (07) 3245 5466 (07) 5449 9511 (07) 3897 3999 (07) 4922 5855 (07) 3833 9333 (07) 5479 2757 (07) 4639 1277 (07) 4725 5787 (07) 4939 3021 NEW SOUTH WALES SYDNEY ARMIDALE BALLINA BALMAIN BOWRAL CHATSWOOD COFFS HARBOUR GOSFORD HURSTVILLE MERIMBULA NEUTRAL BAY NEWCASTLE NEWPORT (02) 8215 5055 (02) 6770 3300 (02) 6686 4144 (02) 8755 3333 (02) 4851 5515 (02) 8116 1700 (02) 6651 5700 (02) 4325 0884 (02) 9570 5755 (02) 6495 2869 (02) 8969 7500 (02) 4926 4044 (02) 9998 4200 PORT MACQUARIE SCONE SYDNEY – LEVEL 7 CURRENCY HOUSE SYDNEY – LEVEL 9 SYDNEY – HUNTER STREET SYDNEY – REYNOLDS EQUITIES WOLLONGONG (02) 6583 1735 (02) 6544 3144 (02) 8216 5111 (02) 8215 5000 (02) 9125 1788 (02) 9615 4500 (02) 9373 4452 (02) 4227 3022 ACT CANBERRA (02) 6232 4999 VICTORIA MELBOURNE BRIGHTON CAMBERWELL CARLTON FARRER HOUSE GEELONG RICHMOND SOUTH YARRA SOUTHBANK TRARALGON WARRNAMBOOL (03) 9947 4111 (03) 9519 3555 (03) 9813 2945 (03) 9066 3200 (03) 8644 5488 (03) 5222 5128 (03) 9916 4000 (03) 8762 1400 (03) 9037 9444 (03) 5176 6055 (03) 5559 1500 WESTERN AUSTRALIA PERTH WEST PERTH (08) 6462 1999 (08) 6160 8700 SOUTH AUSTRALIA ADELAIDE NORWOOD (08) 8464 5000 (08) 8461 2800 NORTHERN TERRITORY DARWIN (08) 8981 9555 TASMANIA HOBART (03) 6236 9000 DISCLAIMER The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual’s relevant personal circumstances. 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