Elliot shaking things up at BHP
Elliot Management has been in the press and out on the hustings in relation to BHP.
Argentina defaulted on a number of its bonds during their debt crisis which started in 2001. Elliot is perhaps most famously known as one of the bondholders that subsequently held out and sued the Argentinean government for non-payment (and won). [It is actually quite an interesting story, including seized ships, huge court cases, and a follow-on crisis. Read more here.] Elliot is known as an activist investor.
What is an activist investor?
Well, it is exactly as the name suggests. It usually seeks to change the management, structure, culture, efficiency and / or other characteristics of a company with the view that such change would increase shareholder value. It normally needs to own a meaningful number of shares (>5% of a company's register) and / or take a Board position to exert influence. Publicity, as Elliot is currently achieving in relation to BHP, can also be used.
What is Elliot seeking?
Elliot is (as we interpret) seeking three things. Firstly, the divestment of the company’s oil and gas assets. Secondly, a change of corporate structure such that BHP is no longer a dual Australia/UK listed company. This now appears to be off the table, after backlash including from Australian Treasurer Scott Morrison. And finally, increased returns (including dividends) for shareholders.
We consider BHP to be a company that has, over time, been generally good at running its business from an operational perspective. This includes running its mines and fields well, i.e. efficiently, and usually safely (but not always).
But what it has been (in our view) is a terrible allocator and manager of capital. Thus we are somewhat sympathetic to Elliot's activism (not in relation to ending the dual listing though).
A few instances of BHP’s poor capital allocation include:
1. the purchase of Petrohawk (US onshore energy business) at a ridiculous price and with poor timing (at the top of the cycle in Aug-11)
2. iron ore expansion expenditure (expansion of production capacity even as prices rapidly declined, demand outlook was uncertain and other players were adding significant volumes), and
3. enacting a share buyback at an elevated share price (please refer to our recent article on South32’s buyback – click here).
Very significant destruction of shareholder value has resulted from this poor capital allocation. For instance, shareholders would be billions and billions better off now if BHP had not purchased Petrohawk and instead repaid debt and / or paid a special dividend at the top of the recent commodities cycle. Instead billions have been written off the value of these assets.
And PS., we really shouldn’t forget what a writedown is (management often tries to make us forget by focusing on underlying earnings). A writedown is essentially management telling shareholders future earnings from the acquired asset aren’t going to live up to their expectations (expectations which formed the financial underpinning to initially acquiring the asset), that they essentially stuffed up in making the acquisition and either should not have acquired the asset or should have paid less.
Not the only ones
BHP is not the only company guilty of being, in our view, a poor capital allocator. Other companies have poor track records, or have made significant poor one-off decisions.
Two examples that come to mind are Rio Tinto, with the Alcan acquisition in 2007 after a bidding war and at the top of the aluminium cycle. Widespread commentary at the time questioned this purchase. And this commentary has proven correct.
Another example is Wesfarmers with the purchase of Coles, also in 2007. Yes management deserves a tick for successfully turning Coles around (although it has taken quite some time). But Wesfarmers paid a quite generous price (generous for Coles shareholders). Then in Jan-09 it needed to enact a highly dilutive capital raising to repay debt associated with the Coles purchase.
As a general comment, we don’t believe enough attention is given to the value destruction that poor capital allocation can cause. It probably occurs because it often doesn’t become apparent until a few years after the acquisition (or buyback etc), and thus attributing accountability is difficult - particularly when the Board and management have moved on.
Why do we invest in BHP given this?
Clients of First Samuel have had a quite complicated ownership of BHP during the period of the general recovery in commodity prices. This includes a significant ‘top-up’ purchase at the Jan-16 lows, and the South32 spin off.
Some may rightly question why we have invested in a company with such a poor record of capital allocation. Firstly, the timing of our investment was post many of the acquisitions and subsequent writedowns in question (or at least when coming writedowns were factored into the share price). Secondly, investing in BHP when we did provided a commodities exposure at the right time, i.e. on a favourable valuation.
Nevertheless, we are mindful of their history, and that we do not have evidence of any change in relation to culture / process of capital allocation. We would sceptically review any proposed major asset purchase (including consideration of price paid). And we would also carefully review whether we would participate in an associated capital raising.
And finally (back to Elliot) activist shareholders aren’t always a positive or stabilising influence on a company. But should Elliot’s actions end up changing BHP to make it more a more disciplined capital allocator, then bring it on!