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Morningstar | Onshore Shale Sale Ends Painful Chapter for BHP

We maintain our AUD 24.50 per share fair value estimate for no-moat-rated BHP following the sale of its shale assets for USD 10.8 billion. The company expects net aftertax cash proceeds of USD 10.7 billion with only a small cash tax payment associated with the sale. This is in line with our estimate of the value of the assets. The proceeds equate to USD 2.00 per share, equivalent to 11% of our fair value estimate. With the balance sheet in excellent shape and net debt towards the lower end of the USD 10.0 to USD 15.0 billion target range, BHP intends to return the proceeds to shareholders.

We have mixed feelings about the sale but on balance feel the price is fair. BHP overpaid when it purchased the U.S. onshore assets for approximately USD 20 billion. This high installed capital base mean BHP generated poor returns and EBIT losses on shale. However, we think there has been meaningful improvements in technology and the efficiency of developing new wells. Retention of the shale assets would offer BHP an alternative investment option, and in general we think greater investment choices bring a mild benefit. Shale investments are also different in that the time between drilling a well and capital payback is much faster than the conventional mining or petroleum assets.

BHP is yet to determine exactly what form the shareholder return will take. We have not made a judgment on how BHP will return the cash and will adjust our forecasts once a decision is made. There are several options but each has pros and cons for different shareholders. BHP could pay a special dividend. This would be beneficial to Australian shareholders as the company has ample credits to fully frank the dividend. However, a dividend is unlikely to be tax effective for foreign shareholders ineligible to benefit from franking. A capital return may be preferred by foreign shareholders, but in that case, BHP would not be using its franking credits to benefit Australian shareholders.

An off-market buyback of Australian listed shares would allow the franking credits to be distributed to the shareholders in Australia who benefit most from them while allowing the company to buy back shares below the prevailing price. This could be coupled with a proportional buyback of U.K. listed shares, which trade at a discount to the Australian listed shares, to maintain the current 60:40 ratio between Australian and U.K. listed shares. The downside to buy backs is we think it would be procyclical and the shares are relatively expensive. Current economic conditions are favourable and those are reflected in the level of earnings and BHP’s share price.

From an accounting perspective, the sale will be effective from July 2018 and we have removed the shale operations from our forecasts from fiscal 2019. BHP will take a further USD 2.8 billion after-tax impairment on its onshore U.S. assets in the financial 2018 result. Adjusted earnings will be higher in the near term, given the shale operations were saddled with a large installed capital base and associated depreciation charge. While free cash flow positive, the shale assets were making EBIT losses. Our fiscal 2019 and 2020 adjusted earnings forecasts increase by 5% and 6% to USD 1.69 and USD 1.40 per share respectively. Our longer-term earnings forecasts are unchanged as we expected improvement in the shale operations over time.

BHP's management is participating at the Management Behind the Moat conference held at Morningstar’s Chicago office on Nov. 7-8, 2018. If you are interested in attending the conference, please reach out to your sales representative for registration information.