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Don’t transfer $5 billion of Australian money to Billiton

Your action? I recommend that you use your important franchise and VOTE NO.

As an engineer (yes I have made the odd ‘No Engineers as clients” exemption) client critically said, “BHP won’t give me the information I need. Advisers don’t have the complete picture so I can’t even seek professional advice.”

By voting “NO” he is feeding back to the CEO & director Don Argus that they should resign from what, after a “No” vote, will be an untenable situation.

If the takeover succeeds, the calculated net loss of present BHP shareholders’ value is a substantial $4.6 billion. The broker who calculated this was presaged by the London Stock Exchange where, as soon as the details were announced, Billitons price shot up 20% to 3.50 pounds,where it still is today.

BHP is carrying on as if this Billiton deal is the only way it can grow. What rubbish.

Sadly whilst all Financial analysts are critical of BHP & Billiton for holding back important information, those same “advisers” are condoning this sham by, in their own words,”reluctantly” voting for it.

Today’s AFR carried an article that appraised sharebroker advice & some institutional voting comments. It is included here further down.

It would be cynical to point to the massive financial fees, directly & indirectly, being earned by many of, mainly overseas-owned, said “experts” as a factor in their blind acceptance.

Two of the most consistently succesful “Australian Shares”managed funds groups, Perpetual Trustees &, Colonial First State, have opposed the loss to BHP shareholders that the deal would instigate.

Such is the publicity they both created that Don Argus has found it necessary to make a personal extra effort to head them off.

Shareholders are now having their own money used to pay for a telephone campaign as a “Last ditch effort to convince wavering shareholders to back BHP” (today’s Financial Review).

One of the clearest criticisms of this “Let’s help make Australia a Back-Water Office” deal comes from the independent Ian Huntley Newsletter.

Today’s reviews are included here. His powerful first assessment made back in March is available from me if you wish.

The other report, an extract, here, is an 11th May 2001 analysis from a Melbourne Broking house, Auzeq Securities. The calculated net loss of present BHP shareholders’ value is a substantial $4.6 billion.

You will note it refers to BHP’s recent business plan “Value Creation” strategy as a far better option for BHP shareholders than the merger proposal.

Billiton shareholders also must approve the merger but with the claimed 20% bonus they are getting why wouldn’t they?

There is a lot of information here if you have time to read it.

AUSEQ – BHP Ltd. – Billiton Merger Reject First 2 pages of a 6-page report.

BHPMarket Cap. (m) : $39.0bn NAV: $19.84 NPV: $20.44

3 Month View: REJECT 1 Year View: HOLD David Walker +61 3 9607 4940

11th May 2001 Diversified Resources BHP Ltd. – Billiton Merger Reject

Recommendation – Reject the Merger Terms

Key Questions For Shareholders

We continue to believe the BHP Billiton merger is a compelling case which will deliver shareholders the benefits of global size, operating synergies, significant cost reductions, and more cycle-stable returns from the combined group.

We remain concerned, however that the merger ratio will transfer A$4.6b of value to Billiton, which undermines future merger benefits for BHP. We recommend BHP shareholders REJECT the current proposal, and instead seek to adjust the merger ratio to 70:30 to more fairly reflect relative company values.

In our report of 30th April 2001, we concluded that the (Dual Listed Co) DLC Merger proposal was earnings dilutive until FY04, and value negative for BHP shareholders. On this basis, and given the significant value being transferred to Billiton Plc, we advised shareholders to Reject the proposal.

Since that time BHP has released further commentary and data relating to their valuation methodology. This release is welcomed, but is a long way short of the information required by investors to make a fully informed decision on the DLC Merger proposal.

In this report we examine some of the recent statements made by BHP Directors.

In particular, we focus on the assertion that no viable alternative to the DLC Merger proposal for BHP exists, a statement we believe ignores BHP’s own internal “valuation creation strategy” announced to investors last August, and well underway prior to the DLC Merger announcement.

We conclude that BHP’s value creation strategy provides significantly higher earnings growth and value creation, and is lower risk than the DLC Merger proposal, but may not deliver global diversification or access to global markets.

This shortcoming could be overcome by simply listing a significant portion of BHP equity in either the London or New York markets.

We believe it is incumbent on BHP to fully disclose the alternate growth option to shareholders, and also to explain why the DLC Merger option is so attractive, given the viable and more financially beneficial alternative.

What is the Value Equation?

The value equation for both BHP and Billiton shareholders is:

Value added = Merger ratio + Merger Benefits

The merger ratio is any value transferred to either BHP or Billiton above the fair value of each company at the time of the merger. We have estimated that the proposed merger ratio is value negative for BHP shareholders, with the transfer A$4.6b ($2.55per BHP share) to Billiton.

BHP have stated the merger benefits are likely to be 5% over 3-4 years time frame, or $1.05 per BHP share and $0.82 per BLT share.

Therefore for BHP the total is negative $1.50 per BHP share, for BLT positive $2.79 per BLT share.

BHP Value added ($ps) = -$2.55 + $1.05 = -$1.50 Negative for BHP

BLT Value added ($ps) = +$1.97 + $0.82 = +$2.79 Positive for Billiton

Does BHP Accept they are Paying a Premium Through the Merger Ratio?

Yes. BHP stated on page 14 of the Explanatory Memorandum that they are paying between 9-13% premium to Billiton through the merger ratio. 5% of value to be added

We estimate this premium at 20% to Billiton. In our view this equates to A$4.57b or A$2.55 per BHP share transferred to Billiton through the merger ratio.

Does BHP Identify Value Added by the DLC Merger?

Yes. BHP state in their letter of 4 May 2001 that the DLC Merger is likely to create value for BHP shareholders of about 5%. On the pre-bid BHP share price of $20.96, this equates to $1.05 per BHP share.

In addition, BHP state the DLC Merger is likely to lead to a positive re-rating of BHP shares. We point out that this re-rating applies to both BHP and Billiton shares, and is probably due to the increased size and strength of the merged group, and listing in a major northern hemisphere market. For BHP, part of this re-rating could be achieved simply by listing a significant proportion of equity in either London or New York.

Principle Driver is Shareholder Value BHP state the principle driver for the DLC merger is shareholder value. BHP have stated that the DLC Merger will add 5% to the BHP value in BHP Billiton or $1.05 per BHP share.

We accept this estimate of creation of value, but in addition we identify the transfer of $2.55per BHP share of value to Billiton through the merger ratio.

Thus we conclude the net value to BHP shareholders is negative.

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Why the Billi/BHP deal does not pass the smell test!

Ian Huntley’s YMW – Special Report 14/5/2001 –

Part 1 – How much should it cost to feed an inferiority complex:

Because it is so important, we will bring you our final special report on the BHP/Billiton affair. We can speak our mind because we are highly independent, and feel that the issue is very, very important. We do not believe Australian shareholders are being treated properly as owners of BHP, and feel that there a number of issues which indicate that the deal is NOT in BHP’s interests. So we would recommend voting NO. The lack of a clearly reasoned Independent Assessment is critical. Management’s recommendations are couched in very broad rah rah terms, with little or no attention to key detail or valuation issues.

The questions we raise, and our comment follows:

Are the special payments to top echelon BHP and Billiton Management – triggered by the merger proposal – a proper reason for even deeper questioning of the affair? – Yes. Management is ever human, and when there are special benefits alongside any deal, it means the deal has to be explained even more strongly. These details were hardly highlighted by the companies involved, and came out some time after the initial announcements.

Where are the synergies in the deal to make the combined group a stronger player, where is the compelling logic for BHP shareholders? BHP has a very strong position in copper, coal, iron ore, and petroleum. These assets are certainly world class, with strong cash flows. By contrast it is difficult to very difficult to tie the same world class description to Billiton assets other than its aluminium/alumina operations – Worsley in WA, Mozal in Mozambique, and major operations in South Africa.

Surely with a sense of timing, BHP is on the cusp of very powerful earnings – petroleum, coal, and iron ore must all be going extraordinarily well. Billiton, as we have commented previously has a lot of fibre but few calories. Yes, the aluminium/alumina operations have BHP style super returns, but not the rest.

Has the country risk nature of important Billiton assets in Africa and South America been factored in? This is a complex issue, and we have absolutely no guidance from an independent assessment. Behind closed doors, it would appear from press reports that Chairman Don Argus has given “trust me” style answers. However we have a wary view on Southern African and Colombian risk issues. The countries in which BHP’s great assets are situated, show the contrast very, very sharply. Australia mostly. Then Chile, one of the best South American countries. Sixty per cent of Billiton’s turnover and 58 per cent of its profit is from Southern Africa! (See Page 10 for more detail).

Do these valuation question marks mean that BHP shareholders are giving away the value of BHP’s great asset base – one of Australia’s great cash flow machines – too cheaply? The valuations set the terms for the “dual” approach where BHP has admitted to paying the premium in a valuation sense for the deal to be accomplished. That Billiton takes management control of the group shows all the hallmarks of the classic reverse takeover by a smaller company. Taking into consideration relative country risk, and the quality of the assets and earnings, we strongly favour the argument that the ratio of value of Billiton to BHP should be more 30:70 than 40:60.

It thus follows that BHP shareholders are being “diluted” and “sold out too cheaply”. And that the BHP Board, if that is the goal, is paying a hell of a price for management succession. There has to be a first class man just downstairs in the BHP ranks, and there should be as part of Anderson’s job to date. Otherwise, with that cheque book, they have a global choice!

Does this deal really stack up with the well-crafted nature of the CRA/RTZ “dual listing” merger a number of years ago? In one sense it does. Shortly after that merger the CRA head office functions rapidly went to London, a huge loss to the legal, accounting, and investment advice service industries in Melbourne. That will rapidly follow in this case, too, despite Gilbertson’s weekender in Melbourne.

On the other hand – NO. RTZ already owned 49 per cent of CRA, they had a common culture and roots and world class assets. Both companies had similar quality assets so there was not the case where one could argue disadvantage to either shareholder base.

In this case it is a clear win to Billiton, its management and its shareholders, and a clear loss to BHP and its shareholders. The merged group, as is evident from our comments above, dilutes the value of BHP’s shareholders’ assets on two grounds:

(1) BHP has admitted to paying a 12 to 20 per cent premium in a valuation sense.

(2) we feel the Billiton assets as a group are distinctly inferior. Thus BHP should trade at a better price alone, than in conjunction with Billiton.

The need for an independent assessment I think is now rather obvious, and is even more a question of corporate integrity in the sense of the Caesar’s wife dictum: Justice must be seen to have been done. BHP is a dearly loved investment of many mums, dads, widows and orphans. Surely they deserve better treatment!

Why are Australian companies the only ones seeking such “globalisation” deals? You don’t hear this from Finland’s Nokia, Sweden’s Ericsson or Canada’s Nortel. Or any other national icons the world over.

Is it only we who have an inferiority complex?

How much does it take to feed an inferiority complex? Answer: quite a few billion dollars in shareholder value, arguably!

For we do not believe the “global benefit” arguments mounted by the BHP board. BHP plus Billiton will make very little difference to BHP’s cost of capital, or presence in that market. Bigness for bigness’ sake is hogwash, as BHP’s track record when it styled itself “the Big Australian” proved. Remember Magma, Beenup, the Australian and Venezuelan HBI plants?

How can a $US100 million deal break up fee and a $A140 million Billiton executive bonus be justified? Answer: With huge difficulty. Why weren’t these arrangements announced right up front, and not let to be dragged out during proceedings? If Messrs Anderson and Gilbertson are such good chief executives you’d reckon there would be plenty of change from that $US100 million.

The Billiton reputation in London. It seems best enshrined in the strong reaction to the stitching of the $A140 million executive bonuses to approval of the BHP deal, a very tricky bit of work, that does not in any shape lift one’s respect for the executives responsible for the “stitching.” It implies that the architect believed the BHP deal was so obviously good as to drag a questionable proposition along with it willy nilly. The UK blast of protest is typical of the backwash to “too tricky… too clever by half ” manoeuvres such as this. I’ve read that Billiton has been voted the least popular company in The City of London. The risk here is quite real. If Billiton, now Billiton/BHP takes a wrong step, then the sharemarket punishment will be doubly leveraged by the corporate reputation.

In glancing through this report there is a sufficient number of real and valid question marks to strongly justify the proposition that the BHP/Billiton merger does not pass the smell test. Billiton is the clear winner, and its shareholders should vote yes.

But for BHP, it’s a NO!

Part 2 – Sharemarket strategy:

We would hold at current prices over $21.00, in the hope that the merger will be scrapped. Even with Brian Gilbertson’s very evident ferocious abilities as a manager, we are not keen in the short term and would need a lot of convincing to say more than “hold” if the merger does go through. Should the merger be scrapped, as we hope, and the BHP share price falls sharply – we would be buyers. For then the company will be forced to pursue its obvious independent growth organically and by judicious acquisition.

Diversified Resources Recommendation: Hold Mkt Cap: $38.6bn Last Review 22/3/01 (YMW 10)

52 Week High: $22.53 Low: $15.81

BHP’s EGM to vote on the proposed DLC with Billiton is scheduled for May 18. Shareholders need to consider their vote very carefully – this decision could fundamentally alter BHP’s business and risk profile.

We have little argument with BHP trying to diversify risk. This will be achieved by adding new commodities such as nickel and aluminium to the company’s asset base, however we are not so sure that this should be accomplished at the expense of a higher political risk profile. Shareholders need to make their decision on the DLC depending on their perceptions of country risk, and the price they wish to pay for that risk.

Billiton’s assets are predominantly located in lesser-developed nations. Just over 60% of assets, by book value, are located in Southern Africa (Mozambique and South Africa). Approximately 17% of the asset base is in Latin America, mainly Peru and Colombia with smaller exposures to Brazil and Suriname.

There are a large number of semi-government and private sector political risk insurers and risk analysis agencies. Analysis of risk is far from subjective. In the context of mining companies, risk analysis will include an assessment of issues as varied as regulatory interference, kidnapping of expatriates, prevalence of disease and independence of the judiciary. Some of these factors will change only slowly, others can alter very quickly.

The Moody’s ratings agency looks at investment risk, however its simple rating system is probably as good a guide to overall business and political risk as any other measure. Moody’s ratings start at AAA, and progress through AA1, AA2, AA3, A1, A2, A3, BAA1 etc down to C. Moody’s has rated Colombia as BA2, South Africa as BAA3 and Peru as BA3. Mozambique is unrated while Australia is AA2.

The World Bank makes the following comments about Colombia:

“Colombia has developed rapidly despite a fifty year, simmering, civil war. In the past decade, however, the scale and intensity of violence has changed from marginal conflict to generalised violence that now dominates the daily lives of most citizens. Today, the government and civil society alike recognise that violence is a key constraint on development, as it affects the country’s macro and micro-economic growth and productivity, and weakens the government’s capacity to tackle the poverty, inequality and exclusion experienced by the majority of its urban and rural population.

The Colombian economy’s performance has deteriorated significantly over the past four years, with a particularly sharp recession affecting the country in 1999. GDP fell by about 4.5% in 1999, while the fiscal accounts of the non-financial public sector, roughly balanced in the early 1990s, showed a deficit of 5.5% of GDP.

Combined with the deterioration of public sector and external accounts, this led in 1999 to the downgrading of the country’s investment grade status by three major credit rating companies.”

Every BHP shareholder needs to form an opinion about the risk profile of Billiton and the price discount that should be applied for that risk. We believe the current pricing of the DLC does not include any discount for geographical risk.

Shareholders now need to consider whether they want the higher risk Billiton assets and whether they are prepared to pay full price for them. This is the only question of importance for the EGM.

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Some sources have pointed to potential conflicts of interest among those institutions that are primarily based overseas but also operate in Australia, given their operations in the UK and the US are likely to hold more shares in Billiton than their Australian offices hold in BHP and they would probably want to see the merger proceed.

ABN Amro expects Billiton shareholders will vote “overwhelmingly” in favour of the deal at that company’s extraordinary general meeting in London on Tuesday. It expects BHP shareholders also will vote positively on Friday. Proxy votes from BHP shareholders have to be received by 9am on Wednesday. “Again, despite media speculation to the contrary, we expect no major hurdles here,” the note says.

ABN retains its overall positive view of the deal. “We are of the view that currently in the resources sector, ‘size does matter’,” it says, adding that BHP Billiton is likely to become its preferred holding in the sector. ABN has placed a 3-6 month target of $25 on the stock.

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Big end to say yes, grudgingly

2001, May 14

AFR by Brett Clegg

BHP’s institutional investors might not like transferring substantial value to their Billiton counterparts, but they are set to approve the landmark merger if only because of the negative consequences of a “no” vote.

A fund manager with one of the top 10 institutions on the BHP share register summed up the sentiment like this: “In the end we will vote ‘yes’, but that doesn’t mean we want to.”

The fund manager, who declined to be named, said institutional investors were “stuck between the devil and the deep blue sea” on the $58 billion merger vote – to be held on Friday at a special BHP meeting.

“Voting ‘yes’ means giving up value to Billiton shareholders, but the alternative is worse,” he said.

“The BHP executive is tied to this deal and if it’s voted down, they will go and what is left is a directionless company.”

Many view the fact that the executive ranks and board of BHP have staked their reputations – and, implicitly, their futures with BHP – on the deal as a “smoking gun” against the temples of those who have qualms about the deal’s terms.

These are the commodity pricing assumptions used in valuations, the $140 million in bonuses to be paid to top Billiton executives, and the 58/42 split in ownership of the new dual-listed company that some consider to be like a reverse takeover.

Morgan Stanley analyst Mr Paul McTaggert said the deal was valuation neutral for BHP shareholders, but “the 58/42 split sees the Billiton valuation increase at 17 per cent. On our modelling, a fair split would have been 62/38”.

“Every way we cut the pie – which we’ve done a lot – it doesn’t look fair,” said another fund manager, who declined to be named.

“You have to view that as short term and think about the big picture benefits accruing from the tie-up of their complementary asset bases.”

JB Were & Son quantified this value transference at $US2.8 billion ($5.4 billion), so it’s not surprising that many fund managers say it’s one of the toughest investment decisions of their careers.

The largest investor on the share register is giant US money manager Capital Group with an 8.2 per cent stake. It has indicated it will vote in favour of the resolutions.

Then comes Colonial First State, AMP Henderson Global Investors and Perpetual Investment Management. Other significant shareholders include Deustche Australia Asset Management and Credit Suisse Asset Management.

It is understood that at least three of those five fund managers have decided internally to vote in favour of the deal, despite reservations.

This followed high-level meetings with BHP’s chairman, Mr Don Argus. One attendee at the meetings said they had addressed many concerns but that investors remained unimpressed at the bonuses to Billiton executives and still described the 58/42 split as “generous”.

“Strategically, this deal is undeniably attractive but we feel a touch done over by the detail – or lack thereof,” he said. “It seems a high price to pay for BHP to take the next evolutionary jump.”

The tangible hope for investors who are opposed to the deal is for a motion to be put to shareholders on Friday to defer the meeting on the grounds that more information needs to be provided to investors. Otherwise, it appears the big end of town is putting its weight behind Mr Argus and managing director Mr Paul Anderson, even if they resent doing so.

Peter Fray

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