BHP Billiton mining equipment works at a trial pit mine at Ravensthorpe Nickel in Western Australia in this undated company photo. BHP Billiton Ltd. and Minara Resources Ltd., Australia's two largest nickel producers, halted output at mines after heavy rain, which may add to supply shortages that have driven prices to a 19-year high. Source: BHP Billiton via Bloomberg News

BHP Billiton has put its planned spin-off of unwanted assets at the heart of its cost-cutting strategy, telling investors that the restructuring is needed to make further productivity improvements and to fight a commodities downturn.

Shares in BHP, the world’s largest miner by market capitalisation, rose more than 5 per cent after its interim results showed cost-cutting helped the company weather falling prices while increasing free cash flow and reducing net debt.

As the commodities cycle has deteriorated, BHP and its peers have ratcheted down operating costs and ditched expensive projects.

While BHP reported a 31 per cent fall in underlying net income for the six months to December 31, its earnings and cash flow generation were better than expected.

Peter Beaven, BHP chief financial officer, said the interim results were “the sort of numbers a company in this sector needs to produce at the moment” but added: “It gets harder. We have to be realistic . . . we have to find every lever . . . to be able to offset the pressure from lower prices.”

BHP’s productivity gains have helped it maintain healthy profit margins even amid slumping prices. For example, even though the average price of iron ore fell 38 per cent during its reporting period, BHP cut unit production costs by 29 per cent. It still earns a 50 per cent operating margin on iron ore, and 32 per cent across its business.

But with relevant spot commodity prices lower than their average last year, the Anglo-Australian group is further paring back its capital spending plans by 20 per cent, taking $5.4bn out of an intended $27.2bn of investment this year and next.

The greatest cuts are in its US oil and gasfields, where BHP is reducing the number of drilling rigs from 26 to 16.

Now BHP’s productivity strategy is entering a new phase. Its interim results are set to be the last before BHP in effect unwinds one of the key commodities deals of this century, spinning off many of the assets that it acquired when merging with Billiton in 2001.

On Tuesday, BHP made clear that the demerger of South 32— the chosen name for the now unwanted mines and smelters, scattered across Australia, southern Africa and Latin America — would be intrinsic to delivering the further cost cuts that the darkening commodities environment requires.

Earnings significantly improved at most of South 32’s assets because prices for its main commodities — including aluminium and nickel — held up relatively well last year. This is in stark contrast to prices for the commodities that BHP does consider core — iron ore, copper, coal and petroleum.

But with shareholders expected to have to vote on the demerger in May, BHP is giving no hint that it might reconsider the spin-off.

Rather, BHP sees the demerger as essential to pushing down costs in the remaining business, partly because it simplifies operations. South 32 is a “catalyst for further progress”, said Andrew Mackenzie, BHP’s chief executive.

BHP did not quantify how much it could save annually by spinning off South 32, but Morgan Stanley analysts said it could be about $500m before tax.

Tuesday’s stock price rises in Australia and the UK are a stark contrast to BHP’s badly received results last August, when the company failed to produce an expected share buy-back.

Nor did BHP produce an additional capital return on Tuesday, in contrast to rival Rio Tinto, which this month announced a $2bn buy-back. Glencore announced a $1bn buy-back last August.

With South 32 set to be given to BHP’s investors, the company’s view is that it represents a capital return of sorts to shareholders. The assets to be included in the new company have a book value of $12bn.

But Morgan Stanley analysts highlighted how the assets due to be held by South 32 generate about $1bn of free cash flow for BHP. The spin-off “increases the gap between dividend and [free cash flow] at the parent company which we think will only be partly (around 35 per cent to 40 per cent) offset by additional savings,” they said.

BHP made clear that its policy of steadily increasingly dividends was close to sacrosanct. It proposed a 5 per cent rise in the interim dividend and stressed that increases would continue as far as possible — using debt if the payout is not covered by operating cash flow.

“We have a commitment to the progressive dividend. We do not have a commitment to cover our dividend every year with free cash flow,” said Mr Beaven.

The question of how far BHP may have to be flexible with its balance sheet – it still has an A+ credit rating, better than its long-term target – is one that he and colleagues will continue to grapple with if the commodities downturn persists.

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