Broken Hill Proprietary (BHP)

In mid 1999 Don Argus, Chairman of BHP announced a loss attributable to shareholders of A$2,312 million. This followed a A$l,474 million loss the previous year. The world mining companies were in deep trouble because of the prolonged trough in commodity prices. The figures were also a reflection of the companys decision to exit some poorly performing operations and take Balance Sheet writedowns on others. Nevertheless, the performance was unacceptable and the

challenge will be to correct the current trend, he told shareholders. (See exhibits 1 and 2 for BHP financials to 31 May 1999)

BHP had a long and. proud history. It was formed in the 1880s in Western New South Wales.

Growth was dramatic so that by the 1950s BHP was Australias largest industrial company, a position that it still held by 1999. Its interests spanned 50 countries with sales of A$21,921 million.

(US$ 10,536 million.) The companys principal businesses were in

Minerals exploration, production and processing

Oil and gas exploration and development

Steel production and merchandising

A services division was also part of the group although most of this was responsible for intragroup activity. The four activities were (i) Transport and Logistics, which owned and operated a fleet of ships to transport BHP products, (ii) Information technology which provides consulting and systems services, (iii) Engineering and (iv) Insurance. Acquisitions in the middle 1990s had meant that the company ventured into Power Generation and amber nectar via a 37% stake in Australias most famous company: Fosters Brewing Company.

The problems of the last years of the 1990s led to management changes and the adoption of turnaround strategies. Paul Anderson was appointed CEO in late 1998. He had an engineering background and had held key positions in Power and Steel companies. He had a reputation of being tough but likeable, an engaging individual, keen to involve, but a man with balls! Divestments were part of his strategy so that the Power Generation Company was sold to Duke Energy International Inc. and in l998 the stake in Fosters Brewing was disposed of.

Financial Management

The difficult financial position of BHP weighed heavily on the minds of all the directors and employees. As well as cost reduction strategies and divestments, BHP had to look carefully at managing both the absolute level of debt and financial hedging which could add degrees of certainty to the companys financial costs. They had long had a policy of hedging commercial price risks but in the volatile situation of the late 1990s were willing to extend hedging to fix some financial costs as well. The commodity hedges included forward contracts and swaps on oil sales, which were showing a mark to market unrealised loss of US$4 million, and hedges which fixed the costs of aluminium, zinc and electricity. Partial hedges were company policy.

In late 1999 the company had $50 million of fixed rate debt maturing in the U.S., and Chief Financial Officer Chip Goodyear felt it would be necessary to roll this over. Given the companys situation there was not much doubt that the Board would agree but he had to advise his fellow Directors at the next meeting on whether the borrowing should be fixed rate or floating and how cost-effective financing could be achieved. He rang his lifelong friend Kerry Castlemaine at ANZ Capital Markets in Sydney and they agreed to meet to discuss the alternative financing packages which BHP might adopt. Chip Goodyear explained that BHP wanted to take out US$50 million funding because they already had plenty of A$ borrowing. They were relatively well known as a US$ borrower, both in domestic U.S. markets and in the Eurodollar market. Their significant U.S. mining interests (Utah International had been acquired in 1984) plus the fact that most of the groups revenue was US$ denominated meant that BHP had often worked with a number of American Banks, as well as Australian, on innovative financial packages.

Mr Goodyear estimated that BHP needed to refinance US$50m. In theory, they could have merely borrowed more from their existing bank lines, at a borrowing cost slightly above the prime rate^[1]. But they were reluctant to use part of their remaining short-term credit lines, or to compromise their future flexibility by borrowing in the 2-5 year range. They wanted longer term funds, in either the 7 to 10 year range or perhaps in the 20 year range. Recent history also persuaded Mr Goodyear that they should raise fixed rate funds, although the rates on 20 year money seemed high. He had therefore considered the possibility of raising medium term floating rate money and swapping this to achieve fixed rate. ANZ had advised that this could probably be arranged. BHP could borrow in the U. S. public debt market at a spread over LIBOR, and then swap interest payments with a swap dealer.

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After a long discussion, Mr Goodyear asked Mr Castlemaine to look at four financing possibilities. 7 year floating rate, 7 year straight fixed rate, 7 year fixed rate via the swap and 20 year fixed rate. Mr Castlemaine went away and the next day worked out details of each package. (See Exhibits 5 and 6 for swap dealer quotes and Exhibit 7 for US$ market interest rates) After a mornings work he rang Mr Goodyear and recommended 7 year fixed rate synthetic finance achieved by a simultaneous issue of a seven year floating rate note in US$ and a swap. The transactions and fees were as follows:

1. The issue of a 7 year semiannual US$50m Eurodollar FRN linked to LIBOR
2. The payment of semiannual fixed rate cash flows to the swap dealer
3. The receipt of semiannual LIBOR floating rate cash flows from the swap dealer
4. Payment of an upfront fee of $625,000 to ANZ for arranging the FRN
5. Payment of an upfront fee of $125,000 to ANZ for arranging the swap

Mr Goodyear indicated that he was happy. The FRN was issued on May 7th 1999 and the swap agreements signed.

EXHIBIT I

Income statement for BHP as of May 31

EXHIBIT 2: Consolidated Balance Sheet for BHP 1996-1999

EXHIBIT 3: Financing arrangements for BHP 1997-1999. A$

EXHIBIT 4: Credit rating information for mining companies in 1996-1999 (average of all mining companies).

EXHIBIT 5: Dealers required spreads over Treasuries for AAA swaps

EXHIBIT 6: Dealers required Credit spreads for 7 year swaps

All of these rates are quoted here on a semi-annual equivalent yield basis, the conventional yield to maturity basis used in the domestic U.S. bond markets. In the Eurobond markets, bonds typically pay interest annually, not semi-annually as in the U. S. An 11 % Eurobond (with annual coupons) would have a semi-annual equivalent yield to maturity of 10.70%, not 11 %.

Questions:

2. Show diagramatically the appropriate swap between BHP and the swap dealer and BHPs capital raising transaction.