S&P Affirms Ratings, Comments on BHP Billiton Ltd. (BHP) Following Spinoff News

Standard & Poor's Ratings Services said that it had affirmed its 'A+/A-1' corporate credit and issue ratings on global mining company BHP Billiton Ltd. (NYSE: BHP) and the company's associated senior unsecured debt. The outlook remains stable.

The rating affirmation follows BHP Billiton's announcement that it proposes to spin off some of its noncore assets to a newly created entity, NewCo. Following the demerger, BHP Billiton will focus on its core assets of iron ore, copper, petroleum, coal (mainly metallurgical coal in Queensland and thermal coal in New South Wales), and potash. NewCo will hold the aluminum and manganese businesses; nickel in Cerro Matoso; energy coal in South Africa; metallurgical coal in Illawara, Australia; and silver-lead-zinc mines in Cannington. NewCo will list both in Australia (primary listing) and South
Africa (secondary listing). The proposal is subject to final board approval and shareholder votes.

"We consider BHP Billiton's business risk profile will remain "strong" should the demerger proceed. The core assets generated much higher profit margins and returns on capital for the past 10 years, compared with the demerged assets under the proposal," said Standard & Poor's credit analyst May Zhong. "More importantly from a credit perspective, we expect the new, leaner BHP Billiton will experience cash flow volatility that will not be materially different from the current portfolio, notwithstanding the moderate reduction in commodity and asset diversity."

If the demerger is successful, in our view the new BHP Billiton's product mix would still compare favorably with its mining peers', due to its superior profit margin (measured by both EBITDA margin and return on capital) and the presence of sizable petroleum assets in its portfolio. Petroleum provides good product diversity to the group as it is less correlated to movements in steel demand, compared to iron ore, coking coal, and manganese. However, if petroleum revenue were to decline significantly, or the company further narrowed its product mix, it could weaken our view of its strong business risk profile.

In our view, the proposed demerger should have minimal impact on BHP Billiton's "modest" financial risk profile, given the fact that the core assets generate the majority of the group's earnings and cash flows. Nevertheless, the spin-off will modestly reduce BHP Billiton's earnings or cash flows, which would be offset by the transfer of associated liabilities (debt including finance leases, operating leases, and asset retirement obligations) to NewCo. More importantly, we expect the company's financial policy and commitment to a solid 'A' rating to remain unchanged. In addition, we consider the company will continue to have significant financial flexibility.

Our view of BHP Billiton's "strong" business risk profile reflects company's excellent competitive position and superior profitability, which is tempered by the volatile and cyclical nature of the mining industry. With its large scale and long-life assets, it is the largest mining company in the world with revenues of US$66 billion in the year ended June 30, 2014--a position that it will still hold post a successful demerger. We believe BHP Billiton's major mining operations (in particular iron ore) are well-positioned at the first half of the global industry cost curve. This, together with better commodity mix than its peers, has enabled the company to consistently generate superior margins in the past decade. The company's continued productivity gains through lower production costs and increased production volumes should improve its cost position, in particular in the coal sector.

In addition, the company's petroleum assets compare favorably with most of its petroleum peers in terms of country risk exposure, as the majority of the assets are located in Australia (about one-third of reserves) and the U.S. (about two-thirds of reserves). The scale of BHP Billiton's exploration and production (E&P) assets is smaller, though, than that of its multinational peers' like Chevron, Conoco Philips, Royal Dutch Shell PLC, and Total S.A. But the assets compare favorably with independents' such as Apache, Occidental Petroleum Corp, or Marathon Oil. About half of BHP Billiton's proved reserves are in conventional assets, and half are in unconventional assets.

Notwithstanding the weaker commodity prices from iron ore and coal, BHP Billiton's credit metrics in fiscal 2014 are in line with our expectation for the "modest" financial risk profile. Based on its preliminary results, we estimate that its adjusted FFO to net debt was about 65% and lease-adjusted debt to EBITDA was about 1x in fiscal 2014. More importantly, the group generated higher free operating cash flows, which improved from a deficit of US$3 billion in fiscal 2013 to a surplus in fiscal 2014. Supporting the improvement in cash flows are the company's initiatives to reduce capital expenditure significantly and improve productivity through lower costs and increased production volumes.

Our base-case scenario forecasts that BHP Billiton will generate flat or slightly declining cash flows in fiscal 2015 and its adjusted FFO to debt will be about 65%. In our view, notwithstanding the improvement in costs and volume, the ongoing weakness in commodity prices in the mining sector has reduced the buffer in the 'A+' rating that the company used to enjoy during previous peak commodity prices. If commodity prices are much lower than our base case--in particular iron ore prices sustaining at less than US$90 per ton--there is a risk that its credit metrics could drop below our rating expectation. In our view, a key strength is BHP Billion's ability to use financial levers such as flexibility to further cut its capital expenditure given the portfolio's diversity, including its shale gas operations. Unlike a conventional resources project, the relatively short lead time of the shale capital expenditure provides BHP Billiton with flexibility not enjoyed by other mining companies.

Ms. Zhong added: "The stable outlook reflects our expectation that BHP Billiton can maintain a free operating cash flow and adjusted funds from operations (FFO) to net debt at more than 60% in the near-to-medium term. We believe the company's continued productivity gains through lower costs and increased production volumes, and a cut in capital expenditure should partly offset the impact of the recent decline in commodity prices (i.e. iron ore and coking coal). In addition, given the group's significant financial flexibility and commitment to a solid 'A' rating, we expect the company to pull more financial levers if the operating environments are weaker than expected. If the demerger proceeds, we expect minimal execution risk."

We could lower the rating if the company's credit metrics fall below our expectations for the rating or if its free operating cash flow remains negative for a prolonged period. This scenario could occur if the company fails to offset a significant decline in commodity prices to a level below our base-case assumptions, in particular for iron ore. All other things being equal, if benchmark iron ore sustains at less than US$90 per ton, it could exert downward rating pressure.

An upgrade is less likely in the short term, given the volatile nature of the mining industry, but could occur if the company achieves a much more conservative financial profile.

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