Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

Does Elliott Management Corp. founder Paul Singer understand the tax system?

As a major donor to the Club for Growth, the U.S. lobby group dedicated to lowering or eliminating taxes, you'd certainly think so. But looking at Elliott's case for creating more value for shareholders from the world's biggest miner, you have to wonder.

Its plan for BHP Billiton Ltd. has three parts, with the first the most radical and the one that makes least sense. The proposal is to collapse BHP's dual Australian and U.K. listings into a single entity, headquartered and tax resident in Melbourne but with a primary listing on the London Stock Exchange. Australian shareholders would maintain their exposure via local depositary receipts, analogous to ADRs.

Where The Hell Are You?
Australians make up a bare majority of shareholders in BHP's main listings
Source: BHP annual report 2016
Note: ADR totals have been deducted from the common stock numbers of the Australia and U.K. listings. Australian shareholders are probably over-represented because of use of nominees to disguise true beneficial ownership.

The purpose relates to franking, the system by which Australia's government gives a tax credit to shareholders receiving dividends, as compensation for the corporate taxes that the company has already paid. Collapsing the dual-listed structure, according to Elliott, would:

allow BHP to access the value represented by its existing massive US$9.7bn franking credit balance, plus future franking credits generated by the business, for the benefit of all BHP shareholders

The language chosen doesn't give a good picture of how the system actually works. The key thing to know is that only Australian taxpayers are entitled to franking credits. So the big shareholders that Elliott needs to convince (BlackRock Inc. and Aberdeen Asset Management Plc together have about 15 percent of voting rights) will get no direct benefit from the restructuring.

Australian Rules
BHP Billiton's Australian shares tend to trade at a premium of $2 or more to the U.K. stock
Source: Bloomberg, Gadfly calculations

Perhaps a BHP that's paying out more franking credits will be more richly valued by holders of the Australian depositaries, dragging up the value of the primary shares? Perhaps, but the argument is based on some highly questionable assumptions. One is that there's efficient arbitrage between the two listings, although Elliott argues elsewhere for an inefficient relationship in pointing out BHP Billiton Plc's persistent discount to the price of BHP Billiton Ltd. shares.

It also assumes that BHP's share price is driven by Australian investors, who'll be most responsive to changes in franking payouts. A look at the performance suggests that's not the case: About $12.8 billion of shares in Ltd. have changed hands since the start of the year, $11.1 billion in Plc and $7.8 billion in U.S. ADRs. With 60 percent of trading activity happening in offshore securities, the marginal buyer of BHP shares is probably outside Australia.

Global Markets
Australia rarely makes up more than half of the daily turnover in BHP Billiton's main three listings
Source: Bloomberg, Gadfly calculations

On the face of it, it's a better deal for mom-and-pop shareholders down under, who have about a third of the shares in Ltd. and tend to be fans of the franking credit system.

That's until you reflect on the fact that the restructuring is essentially a way of transferring value from investors in Ltd. to those, like Elliott, who hold mainly Plc stock. Unifying the two businesses, according to Elliott's presentation, will add about $1.50 a share to the value of the U.K. company, and take about $1 a share away from the Australian one.

All the improvement for Australian shareholders depends on the uncertain valuation of spun-off U.S. petroleum assets and money coming from enhanced buybacks and franking credits. That sort of financial engineering with money that already belongs to the company's owners might appeal to Singer, but is likely to be less appealing to conservative retail shareholders who regard BHP stock as a way of funding their retirement.

The proposal isn't all bad. The suggestion to spin off some of the company's U.S. petroleum assets seems quite sensible: Gadfly has previously argued that reducing exposure to that cash-hungry, weakly profitable business may have merits. 

And the third prong of the attack -- an argument for a more aggressive return of capital through buybacks -- is reasonable, if surprisingly routine. BHP has been dealing with such demands, and doling out some $19 billion of buybacks in return, since the merger that created it in 2001.

Driving Uphill
BHP's dividends have suffered less than capex from attempts to rein in debt
Source: Bloomberg, company reports
Note: Represents balance sheet date (franking balance, net debt) and fiscal year figures (other items).

The underlying problem appears to be that Elliott hasn't thought through the way BHP operates. The company has a large number of franking credits not because of strange features of the corporate structure but because it's been trying to conserve cash, in common with all mining companies in recent years.

The credits are handed out only when dividends are paid, and payments haven't been a priority while management has been trying to rebuild BHP's balance sheet. The next wave of capital spending may be coming around the corner, and BHP's shareholders will be best served if the company has the flexibility to either strengthen its finances or surf the next boom. Elliott's plan provides neither.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net