South32: Interim result 2016

Lower prices have knocked half-year profits by 94% at South32 and forced writedowns of US$1.7bn, but its latest result showed the miner making great strides on the matters within its control.

Despite the profit fall, for example, net debt has fallen to just US$36m making South32 the unlikely custodian of the finest balance sheet in the industry.

Falling debt levels suggest the miner is still generating strong cash flow and the accounts confirm this; free cash flow came in at a healthy US$192m for the half-year, aided by falling capital expenditure which should be just US$550m for the full year, below the US$700m originally forecast.

Most impressively, management presented detailed plans of savage cost cuts. The US$350m of savings initially promised will easily be surpassed and the miner's cost base will fall dramatically to better position itself for when the cycle turns.

Falling costs

Metallurgical coal unit costs are expected to fall almost 40% over two years and manganese costs – already the lowest in the industry – will fall another 40%. Costs at Worsley will fall by a quarter and at Cerro Matoso by a third by 2017. Across all assets, sustaining capital expenditure costs will decline as South32 unwinds the gold plating of assets under BHP.

Operationally, South32's assets are performing splendidly and will spin out more cash as costs are lowered. That's important because, cost improvements not withstanding, low prices are taking a toll.

Falling commodity prices wiped more than US$1bn from EBIT and lower volumes cut a further US$230m. Unlike the majors, South32 is cutting output to maximize cash flow, a rare instinct in this industry that we applaud. Favourable currency moves added over US$400m and cost cuts a further US$180m. Clearly, there is no perfect offset for lower prices.

No divs yet

Cannington was again the standout asset, generating 100% of underlying EBIT and absorbing losses of about US$150m from Cerro Matoso, South African manganese and metallurgical coal.

No dividend was declared and management hinted they would consider acquisitions if distressed assets were available. An obvious target is Anglo American's share of the manganese joint venture, an asset that is well understood by South32 and is being relinquished by a badly injured Anglo.

Balance sheet strength is a hard-fought advantage and we would be cautious about supporting acquisitions but concede that now is a good time to be looking.

The strength of this result wasn't reflected in the bottom line but, rather, in the way that South32 is transforming. A decent miner is slowly morphing into an excellent one and, although South32 has been among the best-performing stocks this year, cheapness prevails: South32 still trades at half its tangible asset value and remains a compelling option in a maligned sector. BUY.

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.