BHP Billiton is still a darling of investors

Group aims to stay lean and efficient

As commodities prices tanked this week, the world's biggest mining group, BHP Billiton, barely noticed, rejigging its management and releasing a surprisingly upbeat production report for last year.

BHP, listed on the Australian, London and Johannesburg stock exchanges, said it achieved record production for the nine months to March at its iron ore division, its largest.

Of all mining shares listed in South Africa, BHP Billiton has been perhaps the most highly rated for its management team.

But the top brass is set to change next month when Andrew Mackenzie takes over Marius Kloppers's old seat.

Mackenzie takes the job with metals prices lurching. In one week, BHP's share price fell 5.6%, while other mining companies had an even rockier ride.

With commodities prices in flux, BHP is expected to focus sharply on containing costs to improve its profitability. On Thursday it sent a highly visible signal to the market that it intended to remain lean and efficient. It said Mackenzie would be paid a base salary of $1.7-million when he starts next month - notably less than the $2.2-million paid to Kloppers.

One of Mackenzie's immediate tasks will be to deal with calls by the South African government to renegotiate bargain-basement electricity prices that Eskom guaranteed to BHP.

Although BHP Billiton has negligible operations in South Africa - its local aluminium operations contribute only 2.5% to earnings - the company is under fire as these operations guzzle electricity desperately needed in other sectors. Some critics do not believe BHP's smelters should be based in a country short of power.

To make it worse, BHP pays less for electricity than it costs Eskom to produce it. According to a report by electrical engineering journal EE Publishers, tariffs Eskom charges BHP are proportional to the current aluminium price measured in dollars a ton, and the rand-dollar exchange rate. So, for its Hillside smelter, BHP pays 20.1c/kWh.

Eskom has been charging BHP 24.5c/kWh for its Mozambican smelter Mozal since 2010, rising only 1% a year, with residential consumers facing 16% hikes.

Overall, Eskom supplies electricity to BHP at an average of 27.2c/kWh, yet it costs Eskom 41c/kWh to produce that power.

The National Energy Regulator (Nersa) will review the legality of BHP's contract with Eskom.

But analysts say if the group is forced to pay a renegotiated electricity price it will probably shut the smelters, costing hundreds of local jobs but freeing up thousands of megawatts of much-needed electricity.

BHP chairman Xolani Mkhwanazi said the group signed a contract with Eskom and expects it to be upheld. Low power rates helped BHP's profitability and margins will take a hit if the deal is altered.

Clinton Duncan, equity analyst at Avior Research, said that if the contract was renegotiated BHP could shut the Hillside smelter.

"In the last financial year, BHP only achieved an earnings margin of 1%, compared to 13% in 2011, from its aluminium operations globally. It is safe to say that if Eskom reneges on the contract, BHP will more than likely shut down these operations as they will no longer be profitable from a cashflow perspective," he said.

Vestact analyst Sasha Naryshkine agreed, saying the local aluminium operations were not very important to BHP.

"Iron ore represents 52% of BHP's earnings before interest and tax, while petroleum represents 23% and base metals another 15%. This is 90% of BHP's earnings. The rest make up only 10%. So if the company's South African smelters close it will have a negligible effect on either the top or bottom line," he said.

While aluminium is a relatively small part of BHP's portfolio, Hillside is a key element. Its production report this week showed 55% of group aluminium production for the nine months to March was at Hillside. The rest was at Bayside, Alumar and Mozal smelters.

Another resource sector analyst, who did not want to be named, said it was too soon to calculate the effect of loss of revenue from Hillside smelter.

Yet, despite the management changes and tussle over the Eskom prices, BHP Billiton remains a darling for investors, trading at a significant premium to its competitors' shares.

Rio Tinto trades at a price:earnings ratio of 7.7 on the London Stock Exchange, while homegrown Anglo American trades on a price:earnings of 10.6 and pricier BHP on 10.7 in London.

This premium reflects how BHP is prized for its management prowess and ability to execute even the most difficult projects.

But with the sharp downturn in the commodities supercyle - which this week's yo-yo share prices aptly illustrate - BHP had to write off large amounts, especially on shale gas acquisitions, as metals prices fell.

This was cited as one of the main reasons for Kloppers being replaced. With the recovery in US gas prices, Kloppers's bet may still be proved right.

Vestact's Naryshkine said in a research note that the gas assets overpaid for would be "absolutely huge" within a decade.

The premium attached to BHP's business comes into sharper focus when you glance at investor returns in the past year.

On the JSE, BHP's share price climbed 8% over the past 12 months - outdoing the other major diversified miner, Anglo American, which saw its share price fall 22.4%.