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South32: cash-rich and conservative

With one of the strongest balance sheets of the large miners, South32 is well placed to focus on shareholder returns
November 16, 2017

At this stage in the resources cycle, a bullish call on a stock such as South32 (S32) might seem at best contrarian and at worst overoptimistic. After all, investors buy mining shares to get exposure to commodity prices, and there are now distinct signals that the excellent rally in many of the metals seen in 2017 may soften next year. But in taking an agnostic view on the direction for commodity prices, we re-flag this particular investment case for three reasons. First, South32 has proved itself to be a consistently cash-generative business, while its success at improving efficiency was underscored by a healthy 11.4 per cent return on invested capital in the year to June 2017. Second, we believe the group’s conservative investment discipline will keep the focus on asset development rather than new projects, in turn maintaining one of the strongest balance sheets in the sector, and providing a strong backstop to any downturn in prices. Third, we think the group’s appetite for dividends and share buybacks has increased, which should be good news for income seekers.

IC TIP: Buy at 192p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points

Excellent yield

Diversified assets

Strong balance sheet

Less acquisitive

Bear points

Questions over growth

Commodity volatility

As South32’s limelight is perpetually stolen by larger peers, it’s worth offering a brief primer. Forged in the nadir of the commodities cycle when it was spun out of BHP Billiton (BLT) in 2015, its mines cover a wide spread of the more niche commodities involved in steelmaking, including coking coal, nickel and manganese. Because it floated with net debt of $674m (£542m) and several lossmaking operations, the board's mindset has been trained on cash generation and sensible planning. This meant big new projects have continually been overlooked in favour of cost management and cash generation. As a result, free cash flow bucked the industry trend when it hit $597m in the year to June 2016, and then tripled to $1.9bn on the back of solid commodity price increases in 2017.

Wherever it has been able, the miner has made big strides on cost-cutting. Other than the South African mines, where inflation is beyond the group’s control, each of the major divisions – the alumina, manganese and zinc operations in Australia, and the Cerro Matoso nickel project in Colombia – are projected to record a fall in unit costs this year, on top of reductions since 2015.

Despite its track record since float, the company has its doubters. The bear case against South32 hinges on its supposedly limited growth options, and the life of its mines. To the first charge, we point to Macquarie’s base case projections that copper equivalent volumes will grow at an average of 1.5 per cent a year until 2021, as operations recover at the Illawarra coking coal and Cannington zinc-lead-silver mines in Australia. This base case also includes sanction of an extension to the Klipspruit colliery. Approval for this $265m project is expected soon, and on Macquarie’s numbers should deliver an internal rate of return of 26 per cent.

Klipspruit is part of the four-mine South Africa energy coal division, a major feeder to South Africa’s dominant electricity utility, Eskom. While South32 expects local inflation to add 10 per cent to unit costs this financial year, the business is still highly cash-generative. The export-focused Klipspruit extension also sits in the lowest quarter of the global cost curve, as do development projects for an open-cut mine at Cannington, and the Hermosa Taylor polymetallic mine in which South32 owns a stake through its 15 per cent holding in Arizona Mining (Ca:AZ).

So there are growth options that should both extend the lives of three of its mines and generate good cash flows. Even if we assume costs flatline over the next four years, there is still a strong income case for owning South32 shares. As capital expenditure remains relatively lean, HSBC expects the cash pile to rise to $2.62bn by June, and $3.32bn by summer 2019. For its part, Macquarie believes the current $750m share buyback programme could be extended by another $2bn between now and 2021, without denting net cash too badly. Doing so would add another four percentage points to the annual return on invested capital, Macquarie argues.

SOUTH32 (S32)   
ORD PRICE:192pMARKET VALUE:£10.0bn
TOUCH:192-192.3p12-MONTH HIGH:213pLOW: 143p
FORWARD DIVIDEND YIELD:6.8%FORWARD PE RATIO:12
NET ASSET VALUE:197¢NET CASH:$1.67bn
Year to 30 JunTurnover ($bn)Pre-tax profit ($bn)*Earnings per share (¢)*Dividend per share (¢)
20157.740.460.5nil
20165.810.112.61.0
20176.951.4821.610.0
2018*7.191.6121.414.0
2019*7.491.6121.517.2
% change+4+0.4+0.5+23
NMS:15,000   
Matched Bargain Trading    
BETA:1.09   
£1=$1.31.  *HSBC forecasts, adjusted PTP and EPS figures