Is This Giant Miner or the Company it's Spinning Off a Better Investment?

By Markets Fool.com

BHP Billiton Ltd. is a massive natural resource company with a focus on iron ore, copper, coal, and oil. It's looking to make this focus more meaningful by shedding its smaller businesses via a spinoff. What should you make of that decision?

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Giants unite
BHP Billiton was created by the merger of BHP and Billiton in 2001. The logic was that pairing two already large miners into one massive miner would result in business synergies and help create a more reliable revenue stream.

With most major commodities floundering of late, it's hard to argue that BHP Billiton isn't living up to that expectation. In fact, despite top-line weakness, BHP has remained profitable over the last few years and has raised its dividend annually for a decade. But BHP is now looking to reverse course on the big merger by spinning off its smaller operations as South32.

Core business
BHP Billiton hasn't been shy about its emphasis in recent years. Iron ore, metallurgical coal, copper, oil, and a potash mine still being built have been the main focus. The rest of the company, which consists of its thermal coal, noncore metallurgical coal, silver, lead, zinc, manganese, and aluminum businesses, is heading out to shareholders as South32.

The is intended to enable BHP to focus on what it sees as its best opportunities without the distraction of dealing with smaller and disparate operations. And the benefits should be notable, with BHP predicting it can reduce costs by $100 million annuallyvia streamlining and that margins should improve. Although the savings will take time to materialize, history suggests margins should get an instant boost.

The core portfolio has an earnings before interest and taxes, or EBIT, margin of 48% versus the entire BHP portfolio's EBIT margin of 41%. The core has also grown at a faster clip in recent years, posting annualized EBIT growth of 21% versus 15% for the entire portfolio. Production growth has been similarly more robust in the core, at an annualized 7% compared to 4% for the entire portfolio.

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Source: BHP Billiton.

In fact, BHP is so confident the core portfolio's prospects that it plans to maintain the current distribution after the spinoff. A big part of this is because the core portfolio provided roughly 95% of the company's EBIT in fiscal 2014. BHP shareholders, then, should like the idea of this spinoff for BHP. But what about South32?

A collection of cast-offs?
If the spinoff goes through as planned sometime in the first half of 2015, BHP stockholders will wind up with shares in South32 whether they want to or not. At some level that means they will be holding a company full of small and relatively low-margin businesses that used to be hidden within BHP. But that doesn't mean they are bad businesses.

For example, size is relative. South32 will be small in comparison to BHP, but it won't be small on an absolute basis -- these businesses earned $8.3 billion worth of revenue in fiscal 2014. And roughly 85% of South32's EBITDA is expected to come from assets that rank in the top two quartiles for cost in their industries. Some of these assets are leaders in their respective spaces, too. For example,Worsley Alumina is one of the largestalumina refineries and is in the top quartile of its industry for costs. South32 will have similarly situated businesses in manganese and silver, too.

(Source: BHP Billiton)

While South32's marginslikely will be lower than BHP's, the new company is still expected to throw off a lot of cash. For example, in fiscal 2014 the South32 businesses had $1.4 billion in cash flow before financing activities and taxes but after capital expenditures. Also, investors are in line to benefit, with the dividend expected to be set at 40% of earnings from day one.

One, the other, or both
At the end of the day, BHP Billiton looks likely to be a much stronger company after this spinoff. If you like it now, you should like it more once South32 has been created. That said, the assets that will make up South32, though notable in their own right, aren't as desirable from a growth perspective. So growth-oriented investors should probably stay away. Those interested in income, however, might wish to hold on since the dividends South32 pays will augment the payouts from its former parent. While growth will be slower, South32 will still be an important global miner.

The article Is This Giant Miner or the Company it's Spinning Off a Better Investment? originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.