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Morningstar | BHP’s Capital Allocation Approach Shows Learnings from Past Mistakes

BHP updated the market on its capital allocation framework. Overall the update is pleasing, particularly the detail BHP went into around its process and approach, how it has changed based on learnings from past mistakes and how it fits with the overall business strategy. Pleasing too is the honesty BHP showed around the track record for the industry, which has been mixed and at times materially value destructive. Investing procyclically in large projects raises the risk of value destruction.

For BHP, the investment in shale oil and gas was a material mis-step. The company was also lucky to miss out on the proposed 2010 acquisition of Potash Corp and Rio Tinto at the top of the market in late 2007. We think BHP has learned significant lessons from these capital allocation mis-steps. However, we think the changes for now most directly influence our thinking towards stewardship, rather than valuation. The capital allocation update supports our current standard stewardship rating. Our unchanged AUD 25 per share fair value estimate assumed BHP would not repeat the mistakes of the past by investing in value destructive projects. Our confidence in that assumption increases with the latest update, particularly in the near- to medium term, but that in itself does not directly impact the fair value estimate.

Longer-term the challenge for BHP will be to remain disciplined, particularly when commodity prices and cash flows are high, other mining firms are growing faster and the pressure from investors to expand is close to a peak. The cyclicality of commodity prices, asset prices and cash flows makes for a difficult environment for capital allocation. This is particularly true as even the largest miners still have relatively small market shares. Capital discipline will need to be spread throughout and sustained across the industry in the long-term for investor outcomes to be substantially different. In the long-run, we think this level of discipline will be difficult.

We’re comfortable with management’s approach towards the balance sheet and have been since BHP explicitly targeted debt of USD 10 to USD 15 billion through the cycle. We forecast total debt/EBITDA of less than 1.0 for our five-year forecast period. Deleveraging is now complete and net debt at the bottom of the range, appropriate given the maturity of the current cycle. BHP intends to stay towards the bottom of the range at this point in the cycle, but importantly has the flexibility to increase debt to invest countercyclically when conditions worsen. Given the balance sheet is in good shape, and medium-term capital expenditure commitments are relatively modest, we continue to expect any excess cash beyond the guided 50% payout ratio to returned to shareholders, either via dividends or buybacks.

We’re also comfortable with BHP’s unchanged strategy to focus on large, long-life, expandable mining assets diversified by commodity, geography and market. Capital allocation is key to delivering future Tier 1 operations at the right price. But it’s here where the firm's track record is more mixed. We expect BHP to retain firm control of capital allocation in the near- to medium-term, but the challenge will be to embed discipline through the cycle and have it sustain long after the initial architects are gone.

The difficulty in buying or developing the right assets, at the right price and at the right point in the cycle is the key reason we think a Standard stewardship rating, rather than exemplary, is still appropriate. Also important to shareholder returns will be the decisions that other mining firms will make through the cycle. We don’t see better BHP capital allocation decisions materially changing this dynamic. It still seems likely the industry will continue to allocate capital procyclically in future, given equity and debt markets are biased to invest when backward looking returns are good, and risk appears low. Cash from operations is also more readily available around cyclical highs. Also, we expect some miners to retain a growth-orientated stance, particularly the smaller and mid-tier miners looking to rise in importance, and this encourages procyclical investment.