BHP Billiton (BLT) reported a 10% increase in underlying fiscal 2014 earnings of $13.5 billion, in line with expectations. The final dividend of £1.46 per share was similarly as expected. This result is very clean, with little in the way of exceptional items, just a $530 million profit from the sale of Pinto Valley copper. Improvement was driven primarily via cost cutting and increased volumes, with commodity prices generally lower. Productivity-led volume and cost efficiencies saved $2.9 billion and a one-third decline in capital expenditure drove a $8.1 billion increase in free cash flow.
We have yet to incorporate the latest result into our valuation model, but don't expect material changes to earnings or the fair value estimate given the lack of surprises. Net debt to equity is just 30%, net debt is conservative at $25.8 billion.
BHP has confirmed it will spin out noncore assets via an in-specie distribution of shares in a new company to be listed on both the ASX and Johannesburg exchanges. ADRs are also proposed for the over-the-counter market in the U.S. BHP will spin out its aluminium and manganese businesses, but only components of others. Cerro Matoso nickel in Columbia will go, but Nickel West in Western Australia stays for now. South African energy coal goes but New South Wales energy coal stays. Illawarra coking coal goes but Queensland coal stays. The Cannington silver-lead-nickel mine also goes. The board's go-ahead is subject to government, taxation, regulatory, and other approvals, including from shareholders.
BHP's narrow economic moat is intact. Fair value uncertainty is medium, compelling in the generally higher-risk resources segment. On balance, we're ambivalent about the proposed spin-off. A risk is that shareholders see the new company as noncore, as we would, and any mass exodus upon issue would make it difficult to achieve a reasonable price, especially in the short term.
Offsetting this nickel and aluminium prices are showing signs of a turnaround, which may assist the process. Further, it's only a small portion of BHP so materiality is limited. On the other side of the ledger, some diversification is lost in BHP. While spin-off assets are not contributing much now, spikes in value can occur and BHP is foregoing earnings diversity and the potential opportunity to offload the assets in future at a high price when commodity markets are more favourable. Again here, materiality is somewhat limited, and the benefits of portfolio streamlining probably overshadow.
BHP will be left with four pillars in iron ore, petroleum, copper and coal. A potential fifth may materialize if potash gets off the ground. The company expects to reduce costs and improve productivity via the portfolio simplification with gains of $3.5 billion flagged by end 2017. We think that has merit, but the new company will bring a new set of costs, including new management to be headed by current BHP CFO Graham Kerr.
The operations are predictably not BHP's best, and in a stand-alone entity may not enjoy the security of cash flows that would encourage BHP's famed countercyclical investment approach. Collectively they generated just 4% of group EBIT (earnings before tax) in 2014 but account for around 6.5% of our BHP fair value estimate overall, predominantly via aluminium. We see the aluminium component as one of the more attractive elements in the proposed new company, in line with our outlook for improving alumina fundamentals.
At the current £19.75 price, the shares are somewhat undervalued. In the long run, BHP is well placed to continue to invest in its high quality businesses and take market share. We forecast BHP's returns on invested capital to progressively head back towards 15% by 2018 as the reins tighten on expenditure, cost pressures ease, and volumes improve.
