This deal-hungry miner is heading north

Even if majors buy in at a discount, such actions are the dream of the small-cap mining investor. South32 has also opted for the sainted full-scale buyout several times in recent years, and more consistently than other major miners.

For its own shareholders, the company has been more of a transition play. Not in the energy sense – although South32 would certainly argue it will help supply electric vehicles and the like – but more in relation to its consistent spending on base metal projects as it looks to supplant aluminium and metallurgical coal as the majority source of its sales and earnings. Given the two commodities provided two-thirds of underlying revenue in the six months to December 2022, this is still very much a work in progress.

The reason for a shift is clear when looking at the operating margins across the metals divisions – at peak times, aluminium and alumina sit on a margin of around 33 per cent, but nickel and copper are above 50 per cent. Zinc, lead and silver, which are mined together, have had inconsistent margins, ranging from 33 per cent in 2020 to 43 per cent in the most recent half-year results.

Dealmaking is not limited to smaller plays. Larger acquisitions include $1.55bn (£1.2bn) on a 45 per cent stake in a Chilean copper mine last year, following on from its $1.3bn acquisition of Arizona Mining in 2018, which gave it the Hermosa base metals that include several deposits grouped together.

Other recent deals include increasing its stake in a Brazilian bauxite mine, and raising its ownership in an Argentinian copper project to 50.1 per cent through an earn-in arrangement. Added to this, overall greenfield investment spending in the year to 30 June came to $42mn.

This acquisition strategy marks a break from the early days after its spin-out from BHP (BHP) in 2015, when South32 tried to buy a Peabody Energy coal operation in Australia. The separation from BHP also came at a very tough time for the industry, with weak metals prices and heavy debt loads resulting in slashed dividends, decade-low share prices and uncertainty over which commodities would be in demand when the next cycle began.

South32 was at an advantage at the time, given BHP had left it low on debt. Despite recent acquisitions, its balance sheet has remained trim – net debt edged up to $439mn at the end of 2022, after sitting in a net cash position for some years.

Lower returns

Still, the stock’s performance has been patchy. On a five-year view, a total return of 23 per cent puts it just ahead of the FTSE All-Share, but behind the big four of Rio Tinto (RIO), Glencore (GLEN), Anglo American (AAL) and former owner BHP, which has returned 134 per cent to shareholders once dividends are factored in.

But the investment case for South32 lies in its portfolio’s differentiation. If at least a few of its development projects reach production, the company’s valuation should move into the ranks of the base-metals-focused operators such as Antofagasta (ANTO), whose enterprise value sits at seven times Ebitda – double South32’s own multiple. By comparison, Rio and BHP trade largely on the back of their iron ore earnings, with some points for copper, and so sit lower than Antofagasta. On other valuation metrics, South32 stacks up well. Its free cash flow yield is well ahead of Anglo and both companies (alongside Rio) boast an operating profit margin of around 30 per cent.

Beyond the future portfolio envisioned by long-serving chief executive Graham Kerr and the board, South32 also provides immediate diversification away from iron ore, given many investors stick to the majors. There is still some exposure there, because manganese prices are partly driven by the steel market, but base metals have a better spread of key markets.

Like others in the industry, South32 has pared back its dividend largesse since last year, when investors took home 25.7¢ a share (including a 3¢ special). The half-year dividend was down 44 per cent when announced in February, and the final is forecast to drop when the company reports next week.

But beyond those ever-fluctuating distributions, the ongoing portfolio shift and a good operating baseline provide two bigger reasons to take the long-term investment case seriously. Following a nasty surprise in the second-quarter production update, this could be a compelling moment for would-be buyers.

Last month, the group halved the balance sheet valuation of the critical Hermosa project in Arizona. This was due to higher costs and a $365mn expense for de-watering, which also delayed first production at the zinc-lead-silver Taylor deposit. Cleary, pre-feasibility study estimates were overly optimistic. A final investment in Taylor is still imminent, while a pilot plant for the Clark deposit (manganese, zinc and silver) will be online soon.

There is some good news on the project. Following the designation of zinc and manganese as “critical minerals” by the US Geological Survey, the US government has put it on a list of fast-track permitting, known as the FAST-41 process. Manganese is used in lithium-ion batteries and is also covered by a law that allows the US Department of Defense to “increase domestic mining and processing necessary for the large-capacity battery supply chain”.

While this does not guarantee the project will receive the green light, it provides some insulation against the difficulties around permitting, which has stymied Rio Tinto and others recently in the US. What’s more, Hermosa is on private land, which cuts some of the risk around approvals from local and federal regulators. Still, the project is likely to cost many billions of dollars – it will entail one huge underground operation that accesses three different deposits containing several metals in significant quantities, meaning multiple processing plants as well. The current US focus on domestic supply should help the feasibility calculations, however, although political priorities may of course shift in time.

Near-term cash

While South32 is coming off a record year for aluminium, copper and manganese production, a combination of lower prices and higher costs mean next week’s full-year numbers won’t reveal record profits. Like other miners, a drop from last year is on the way – the consensus forecast for the cash profit for the 12 months to 30 June is $2.4bn, half that of last year but almost $1bn ahead of 2021 and 2020.

The outlook for the current year is similar before an expected uptick in FY2025. Analysts say the aluminium market remains distorted due to a boycott of Russian metal, although stocks are low – they sit at just 10 per cent of the 25-year average, according to Liberum, so a surge in demand could send prices up quickly as buyers look for supply.

A previous driver of higher prices was low water levels in China as constrained power (due to lower hydro production) knocked production from smelters. The hike in European power prices had a similar impact last year, although this catalyst has lessened in recent months.

The outlook for zinc is stronger. Investment bank Bernstein argued this week that the metal could be close to a price “inflection point”, especially if a pick-up in Chinese demand continues.

Indeed, a rapid return to strength in metals markets would be a nice surprise for this year or 2024. But it needn’t be investors’ base case. South32 is on a positive path to upping its base metals output and has the potential to re-rate should its development projects de-risk ahead of current expectations. Mix all of this with a consistent income case, and its shares start to look less like a leftfield sector pick than an obvious one.