Questor share tip: Buy BHP Billiton's dividend income

BHP Billiton
£20.67+17p
Questor says BUY

BHP Billiton [LON:BHP], the world’s largest mining group, is tomorrow detailing plans to demerge assets and increase returns to shareholders.

The Anglo-Australian miner, which was formed through the merger of BHP and Billiton, is now planning to unpick part of that 2001 deal. Out goes a lot of the Billiton parts, including aluminium, nickel and manganese mining assets, with the company keeping its iron ore, copper, coal, petroleum and potash businesses.

The preferred route is a separate listing of these demerged assets, giving BHP Billiton shareholders shares in a new company.

The impact of the demerger on the group is easily manageable. The mining giant’s market capitalisation is currently £118bn, while the value of the demerged assets is estimated at around $14bn (£8.4bn), or 7pc of the whole group.

The assets most likely to be demerged are those with low profits. According to analysts from broker Investec, these are businesses focusing on aluminium, nickel, manganese and South African coal, and a silver and lead mine at Cannington in Australia. Combined, these contribute 6.6pc of the group’s total operating profits.

Following the demerger, BHP Billiton will become a more focused group, generating about 48pc of profits from iron ore, 28pc from petroleum, 22pc from copper and 2pc from coal, based on Questor’s estimates.

Embarking on such a course of action suggests that there were not many buyers when the assets were offered for sale privately.

Success in mining is about scale and size, so, when the assets are demerged and the shares granted, Questor would sell them.

Whether investors should hold on to shares in a demerged BHP is an easier question to answer.

The company is reliant on the value of iron ore for profits and China, the world’s largest user, is the largest driver of that price. China’s economic growth slowed to 7.4pc in the first six months of the year, while the price of iron ore has fallen from $140 per tonne to $93 per tonne.

Andrew Mackenzie, BHP chief executive, has focused on cost-cutting to protect profits, achieving savings of $5.5bn so far this year, with more to come.

The mining company has also increased production. This is helping to protect profits, as more iron is being sold despite the price falling.

This is part of a strategy across the industry. BHP Billiton and Rio Tinto have the lowest production costs in the world due to the size of their mines and can make profits at much lower prices than their rivals. They hope that this scorched earth tactic will push many smaller iron mines around the world out of business.

BHP is also making more cash, which has reduced debt levels, leaving the company free to increase shareholder returns.

For investors, the mining sector could move from a growth play to an income play, with JP Morgan Cazenove analysts estimating BHP share buybacks could total $3bn, while UBS analysts believe they could reach $5bn.

The miner launched its last buyback programme, which totalled $10bn, in 2011. Over the past decade, BHP has paid out $62bn in buybacks and dividends to shareholders - about half the company’s underlying earnings.

The sale of assets could boost these returns further. JP Morgan analysts think BHP could fund a special dividend of about $2.6bn by June 2015, increasing the effective dividend yield to 5.5pc.

Questor said on April 2 (Buy, £18.82) that BHP would increase cash returns to shareholders. The shares have risen 10pc since then, easily beating the wider FTSE 100, which has remained largely flat.

The fundamental reasons behind the investment still stand. So, the shares, trading on 13 times forecast earnings, retain their recommendation.

Buy.