South32: cuts too deep?

Several problems at a key asset raise an ominous question: has South32 cut costs too far?

After a stellar 12 months that have seen the share price rise, profits grow and debt dwindle, South32 has finally stumbled.

Mining has been suspended at the Appin metallurgical coalmine after high gas readings were measured. This is the fourth disruption at Appin since late last year after problems on the longwall were found.

The financial impact of the stoppage should be minor (get it?). Appin generated a loss last year although its interim result was better as prices rose and an upgrade was completed.

Key Points

  • Now fair value

  • Lower portfolio limit

  • Has capex been cut too far?

But the string of incidents has us wondering about the efficacy and, perhaps, the wisdom of deep cost cuts to many of South32’s operations.

The razor gang

Cost cuts were part of our original investment case for the business. The assets that constituted South32 made up just 3% of parent BHP’s profits and we argued they were neglected and over capitalised inside the portfolio of a giant.

A smaller business with focused management could identify savings that were beneath the notice of a goliath like BHP. That is exactly what happened.

South32's management has been a ruthless cost cutter, slashing 30–50% of unit operating costs across the asset base. This has been reflected in financial results with strong cash flows building the best balance sheet in global mining.  

Has that financial strength come at the expense of operating prudence? It's impossible to tell but it is a new risk that we are watching. Any further faults in operations can't be dismissed lightly.

How much is enough?

Last year South32 reported depreciation and amortisation of $775m yet spend just over $300m on capital expenditure. That itself isn’t incriminating.

Big miners are carrying assets on balance sheet that reflect boom time costs but are maintaining those assets in a completely different cost environment. Hence we expect the likes of BHP, Rio Tinto, and South32 – which spent billions on developments over the long boom – to spend less on capital expenditure than the depreciation charge.

That expectation, however, makes it difficult to gauge how much the business should be spending on capital expenditure against how much it actually is.

We have been ardent supporters of South32's management to date. It was this unloved mining orphan that first announced it would pursue profits, return on capital and cash flow targets above production and output; it ran a sensible dividend policy while peers were mad for ‘progressive dividends’; it recognised early that miners have been awful stewards of capital and pledged to do better. So far, South32 has allocated cash sensibly.

So perhaps the series of incidents at Appin is simply a bit of bad luck. We raise the risk now because, with a buoyant share price, members are likely sitting on gains and a relatively large position size.

High conviction, high allocation

Since recommending South32, we’ve suggested a maximum portfolio weighting of 7% – a high number that may make South32 one of the larger holdings in member portfolios. BHP has a recommended limit of 8% and, Rio Tinto, 6%.

Both of these companies are larger and have better quality assets than South32, but our strong conviction in the original idea meant we were comfortable with an elevated position size.

That is no longer the case. South32 now trades at around 1.2 times book value, which we think is fairly priced. The balance sheet is also far stronger and profits have beaten our own expectations.

This is not the time to sell everything but it is sensible to lighten your weighting, especially for members with higher portfolio allocations.

Having risen handsomely, this is no longer the unloved business it once was and we are lowering our portfolio limit from 7% to 5%. We recommend adjusting your own position sizes accordingly even though South32 remains a 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.

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