South32: CrapCo no more

Quality assets and sensible management should deliver South32's first dividend.

Some call them dreamers; others, fools. It takes a special individual to decide to strip unseen minerals beneath the earth, a task that demands copious upfront capital and promises uncertain and volatile returns. Yet the one trait that unites all miners is sunny optimism. Their job is to conquer nothing less than the earth itself.

Not so South32. The youngest major miner in the world started life not among hope and optimism but with scorn and condescension. CrapCo, they called it.

That moniker was earned because BHP, from which South32 was torn, had bundled together a random collection of assets it could not sell following the greatest commodities boom in history. A silver mine in Queensland; coal in South Africa; nickel in Colombia; manganese in northern Australia.

Key Points

  • Costs continue to fall

  • Dividend likely to be paid 

  • No longer a bargain

Unwanted, unloved and underappreciated, South32’s share price has sagged and still sits below its debut. Advocates of the business have been few.

Yet, a year after listing, South32 has made its mark. It has been the best performing major miner in the world with the strongest balance sheet in the industry, the most sensible capital management plans and, alone among miners, it will lift dividends rather than rebase them. Yes, South32 has confounded its critics.

There are two sources of South32’s resilience: the quality of its mines and management’s focus on cash flow above production.

Quality is mine

South32’s collection of mines may not be coherent – there is no specific logic to owning a nickel mine in Colombia and a coal mine in South Africa, for example. But 90% of profits are generated from the lowest quartile of industry costs. Among its assets lie some genuine gems.

The Cannington mine in Queensland remains its best asset. Simultaneously the world’s largest producer of silver and a significant zinc and lead mine, it generated a return on assets of over 100% even as prices plunged.

Currently an underground operation attached to an efficient transport and processing facility, declining grades and reserves shouldn't trouble investors too much. The mine has consumed barely any capital in 20 years and a major expansion to create a large open cut mine should provide decades of additional production.

The Worsley alumina expansion was chronically delayed and over budget when BHP completed it in 2011. BHP sunk over US$3bn into the refinery to create the third lowest cost alumina facility in the world. Burdensome capital costs will always constrain return on assets but high sunk costs were BHP’s problem. South32 should enjoy decades of cash flow from one of the most efficient refineries in the world.

Geological advantages have been strengthened by management which has slashed costs beyond expectations. Table 1 shows the extent to which management has wielded the axe. A relatively low-cost asset base has been made even better.

Table 1: Cost reductions, 2015 vs 2017
Asset All in cost 2015 All in cost 2017 Saving (%)
Worsley (US$/t) 266 200 25
Illawarra Coal (US$/t) 104 66 37
SA Mn (US$/dmtu) 2.5 1.9 25
Aus Mn (US$/dmtu) 2.74 1.56 43
Cerro Matoso (US$/lb) 5.54 3.9 30

Cash rules

Perhaps the most impressive trait has been the focus on cash flow above any other metric. When South32 was bleeding cash from South African refineries, it closed them; when nickel prices fell, so did mine output. A focus on financial metrics rather than mining volumes is refreshingly rational and management has optimised its mines for cash generation. Every other miner should take notice.

Management remain, as ever, dour about the future. Chief executive Graham Kerr has said he expects the industry to get worse and has committed to minimum debt across the cycle. A cyclical business, he says, should not risk excessive debt even in a boom. We couldn’t agree more.

With net cash on the balance sheet and modest capital expenditure requirements, South32 should start to generate generous free cash flow. When it reports full-year results in August, we expect earnings before interest and tax (EBIT) of about US$600m.

Dividends are coming

We expect depreciation to exceed capital expenditure, a reflection of lower industry costs and better asset utilisation, so operating profit will be, after taxes are paid, a decent proxy for free cash flow.

Strong cash flow should mean that South32 pays a maiden dividend this year. Assuming a 40% payout ratio, dividends could be around 4cps for a yield of about 2%. It might not sound like much but, for a miner in grim conditions, it is an excellent outcome.

Over the cycle, we expect South32 to generate a return on assets of between 10-12%, which should support a premium to book value, currently about $2.30 per share.

Swelling optimism about the miner’s prospects is reflected in a higher share price, which has more than doubled this year. South32 remains a better than average miner but it is no longer a bargain. We're downgrading to HOLD.   

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in South32. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in South32.