Fitch Rates BHPB's Hybrid Notes 'A-'; Assigns 50% Equity Credit
The notes' rating and assignment of equity credit are based on Fitch's hybrid methodology ("Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis" dated 25 November 2014 on www.fitchratings.com)
KEY RATING DRIVERS OF THE NOTES
Ratings Reflect Deep Subordination
Fitch has notched the notes down by two notches from BHPB's Long-term Issuer Default Rating of 'A+'/Negative given their deep subordination and consequently, the lower recovery prospects in a liquidation or bankruptcy scenario relative to the senior obligations of the issuer and guarantor.
Equity Treatment Reflects Equity-like Features
The issues qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, remaining effective maturity of at least five years (including coupon step ups under 1.0% and replacement language) and deferrable interest coupon payments at the option of the issuer. Fitch regards these characteristics as key requirements for assigning equity credit to hybrid issues, as they offer issuers the financial flexibility required to protect its capital structure.
Cumulative Coupon Deferrals Limit Equity Credit
The interest coupon deferrals are cumulative, which results in 50% equity treatment and 50% debt treatment of the hybrid notes by Fitch. Despite the 50% equity treatment, Fitch treats coupon payments as 100% interest. In addition, the company will be obliged to settle interest arrears under certain circumstances, including following the resumption of dividend payments as well as on redemption dates. These are debt-like features, which reduce the company's flexibility under the instruments and accordingly limit the equity treatment to 50%, in line with Fitch's methodology.
KEY RATING DRIVERS
Negative Outlook
Fitch revised BHPB's Outlook to Negative from Stable in June 2015. The Negative Outlook reflects BHPB's elevated financial metrics for the rating given the negative pressure in the industry resulting in declining commodity prices. As a result, funds from operations (FFO) adjusted leverage increased to around 2x in FY15 (30 June 2015) which is not commensurate with its rating. Fitch expects credit metrics to weaken further in FY16 before starting to gradually improve in FY17 and progress towards a level more in line with its rating of 1.5x by end-2018. However, to achieve this, Fitch expects BHPB to implement further cash preservation measures than the already announced cost and capex cutting measures. We note that the recent hybrid facilities will provide the group with some much needed flexibility. However, this has been partly offset by the current pressure on commodity prices and as a result we would need to see further measures taken by BHPB to maintain a 'A+' rating.
Strongest Operational Profile
BHPB's operational profile has superior product diversification compared with the broad industry with exposure to the high margin oil business. This places it at the higher end of the 'A' rating category. Low cost position of the company's key business areas such as iron ore, oil/petroleum, copper and coal provide higher profitability and hence resilience to the weak price environment. Operational improvement and AUD depreciation vs USD resulted in Western Australia Iron Ore unit cost decline by around 30% YoY to USD19/tonne in 2015. This compares favourably with the average realised price of iron ore of USD61/tonne for the year ended 30 June 2015. The company has made good progress in cash cost reductions in other business segments, e.g. drilling costs per well at Black Hawk onshore oil field declined by 19% YoY in 2015 to USD3.4m with another 26% YoY decline expected in 2016.
Demerger of South32 to Improve Margins
In May 2015 BHPB completed the demerging of South32, a mining company involved in coal, aluminium, manganese, silver and nickel production. Fitch assesses the effect of South32's spin-off on BHPB's credit profile as positive as discontinued business is less profitable, 26% of EBITDA margin vs 52% for continued business of BHP. BHPB will benefit from a streamlined business structure and a better average position on the commodity cost curve, which will help the company navigate the depressed commodity prices environment. The demerger will also allow BHPB to save around USD0.5bn on capex spending previously channelled to divested assets.
Elevated Leverage
The company's FFO gross leverage was 1.96x at 30 June 2015 vs 1.54x at 30 June 2014. Fitch views this leverage level as high for the rating, which is reflected in the Negative Outlook. At the same time, Fitch expects leverage to decline towards 1.5x by the end of 2018, which is based on gradual improvement on commodity prices (see Key Assumptions) and higher volumes in some segments. Fitch notes decline in total adjusted debt with equity credit to USD36bn at 30 June 2015 from almost USD40bn at 30 June 2014 and expects further absolute debt reduction to USD33.6bn by 30 June 2016 partly due to equity treatment of new notes, which will help the company to refinance short-term debt and improve maturity profile of its debt portfolio.
Positive FCF Expected
Despite the expected weak price environment in the medium term, Fitch expects the company to retain a strong profit margin during the forecast period (2016-2019) with the EBITDA margin staying above 45%. Moderate capital spending versus previous years should add to the company's ability to remain free cash positive through the cycle. However, lower capex may compromise longer-term cash flows and reserve replacement. This is expected under Fitch's assumption that the company will continue to stick to progressive dividend policy, as BHBP has committed to. In Fitch's view, the progressive dividend policy decreases BHPB's financial flexibility given the current challenging market environment BHPB is operating in.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuers include:
- Slower pace of infrastructure capacity increase at Pilbara iron ore mines with lower capex incurred
- Stabilisation of annual capital spending at approximately USD9bn
- Negative effect on profitability in 2015/2016 caused by the weak price environment on major commodities, especially iron ore, should be partly compensated by operational efficiency improvements and local currency devaluation versus USD
- Price assumptions for selected commodities: iron ore (USD50/t in 2015- 2016, USD55/t in 2017-2018 and USD60/t long term), aluminium (USD1,700/t in 2015-2017, USD1,800/t in 2018 and USD2,000 long term), copper (USD5,250/t in 2015, USD5,500/t in 2016, USD6,000/t in 2017-2018 and USD6,500/t long term), nickel (USD13,000/t in 2015, USD13,500/t in 2016, USD15,000/t in 2017-2018 and USD17,500 long term), WTI crude oil (USD50/t in 2015, USD60/t in 2016, USD75/t in 2017 and long term).
RATING SENSITIVITIES
- Sustained FFO adjusted gross leverage at or below 1.5x (FYE14: 1.47x)
- Sustained FCF margin above 3% supported by lower shareholder distributions or capex payments
Negative: Future developments that could lead to negative rating action include:
- Inability to maintain FFO adjusted gross leverage less than 1.5x by end-2018
- Inability to maintain EBITDAR margin above 40% on a recurring basis (FY15: 46.8%)
LIQUIDITY
Liquidity and capital market access remain strong for BHPB. The company had USD6.7bn of cash on its balance as of 30 June 2015 while its short-term debt amounted to USD3.5bn. The company also had USD6bn of undrawn committed facilities.
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