South32: Result 2015
Recommendation
Poor South32. Not only was it granted the smallest, least valuable bits of the BHP empire, it also reported its maiden result on one of the worst trading days in half a decade. The share price plummeted and reaction ranged from disinterest to disappointment but we find such pessimism baffling. This was an excellent result.
Underlying earnings before interest and tax (EBIT) rose 56% to US$1bn, a stunning outcome considering weaker commodity prices.
Those weaker prices stripped US$270m from EBIT although currency gains and cost cuts more than offset that fall, contributing US$700m in EBIT. South32 is surely the only miner in the world to report higher EBIT margins, rising to 14% from 8.6% last year.
Key Points
Strong result
Margins up, debt down
Improving returns on capital
Tellingly, returns on capital featured prominently and management vowed to target that figure over production or resource growth. Every miner should be forced to make the same pledge.
Returns on invested capital rose from last year's 4% to just over 6%. Management outlined realistic plans to cut US$350m of costs over the next three years so that number should rise as attention is lavished on assets.
FY2015 | FY2014 | Change % | |
---|---|---|---|
Revenue | 7,743 | 8,344 | -7 |
U'lying EBIT | 1,001 | 642 | 56 |
U'lying NPAT | 575 | 407 | 41 |
Operating cash flow | 1,838 | 1,358 | 35 |
Drill down
At an asset level, the aluminium business in Australia and South Africa generated stronger than expected profits, contributing about 50% of underlying earnings while the Illawarra coal business reported a small loss. The Worsely Alumina business, the largest asset by value, continues to underperform and will need attention or will attract a write down. Cannington was again the best asset in the business, alone accounting for almost 30% of earnings and generating return on assets of over 100%.
South32 generated operating cash flow of US$1.8bn and spent US$768m on capital expenditure while carrying little debt so interest charges are small. Management said capital expenditure can be reduced to $650m, suggesting the business is capable of generating strong pre-tax cash flows. A dividend wasn't paid this year but investors should expect one next year.
Despite an additional US$600m in impairments relating to its weakest assets, net tangible assets still stand at US$2.02. At current exchange rates, that equates to about $2.80 per share which means South32 – with its fine balance sheet, strong cash flows, promising dividends and increasing returns on capital – is trading at half its net tangible asset backing.
We aren't particularly bullish about commodities or about mining. Industry profitability is clearly declining and will be doing so for many years, but universal neglect is creating bargains. South32 is perhaps the best example of this. The share price has fallen 30% since our initial upgrade in What to do with South32? (Buy - $2.20) but these results confirm that the investment case remains on track. BUY.
Note: The Growth portfolio owns shares in South32.