Should you buy South32?

After beginning trading at $2.13, South32 closed at $2.05 on its first day as a listed company.

This was at the lower end of expectations and meant a market capitalisation of $10.8bn for Australia’s newest listed miner. But it still makes South32 the third-largest miner on the ASX and a Top 50 business.

The media may have already dubbed it a failure but, make no mistake, a giant has been born. Investors now want to know just one thing: should they buy South32?

At its current price, the stock trades at a 4% discount to its net asset value. In my view, it’s a Buy, although a little more complicated than most.

As a highly cyclical business, we can’t simply look at an earnings multiple and decide whether it is cheap or not. Investors need to make a judgment about the returns this business might be able to earn across the cycle.

Sadly, that kind of asset level history isn’t available for the new company.

But with commodity prices currently striking new lows, we're probably closer to the bottom of the price cycle than the top, so there's little risk of paying for inflated earnings. In fact, we would argue quite the opposite. There is a good chance this business is under-earning.

South32 contributed about 3% of BHP’s profit last year. The money lavished on the giant's storied iron ore, petroleum and copper assets wasn’t spent on the small and maligned collection of mines that constitute South32. These are assets that have been neglected for a decade.

So there’s every reason to expect a focused management team with a clean balance delivering far higher returns.

BHP and Rio have shown the remarkable extent to which costs can be stripped from high-quality assets: both businesses have more than halved their iron ore production costs, for example. We expect similar levels of efficiency gains to come from South32.

Last year, South32 reported return on assets of just under 5%. The business can generate operating cash flow of about $1bn a year in a low price environment but, if prices rise, earnings and cash flow could potentially explode.

Over the course of the cycle, South32 should comfortably generate a return on assets above 10%.

A business that generates returns of this ilk should trade at around book value or perhaps a smidge higher. With net asset value of around $2.40 a share, any price substantially under this figure is a good deal for investors, delivering terrific option value for higher commodity prices in the future.

The miner has pledged to pay around 40% of after tax profits in dividends, a potential yield of around 1.8%. This is sensible and ensures dividends will rise in boom years and fall in lean years. If only BHP adopted such a pragmatic dividend policy.

South32 doesn’t carry the famous assets of its parent but it does carry less debt, is more diversified and boasts a far more favourable valuation. Far from being the poor relation to BHP, right now it’s a better buy.