South32: Result 2016

The headline numbers didn’t show it but this was a cracking result.

An enormous loss of US$1.6bn doesn’t sound like much to celebrate but there was mild jubilation from South32 chief executive Graham Kerr as the newly listed miner delivered its maiden full-year results.

That big loss was the result of asset impairments announced in the first half. On an underlying basis, net profit fell 76% to US$138m, above even the most bullish forecasts. For a business worth almost $11bn, that sounds like a pittance but it does reflect cyclically low commodity prices and ignores phenomenal cash generation.

Consider that South32 started life with US$688m in net debt and now carries over US$300m in net cash, a turnaround made possible because of copious cash flows and sensible management.

Key Points

  • Strong cash performance

  • Maiden dividend 

  • Low commodity prices still hurt

Operating cash flow actually rose more than 50% to over US$1bn, largely a result of working capital improvements and lower interest costs. Note that a full tax bill has not yet been paid by South32 and it will affect cash flows in future. Yet free cash flow of US$597m over the full year is still a stunning achievement.

Lots of miners make decent cash; South32 has been exceptional in its allocation of capital, with high investment hurdle rates and disciplined spending.

Table 1: S32 result 2016 (pro-forma)
Year to June (US$m) 2016 2015 /(–)
(%)
Revenue 5,812 7,743 (25)
U'lying EBITDA 1,131 1,849 (39)
U'lying EBIT  356 1,001 (64)
U'lying NPAT 138 575 (76)
U'lying EPS (US cents) 2.6 10.8 (76)
DPS (US cents) 1 nil n/a
Capex 462 765 (40)
Net cash/(debt) 312 (402) n/a

There is plenty of speculation about acquisitions and a sensible purchase at a decent price does make sense – perhaps buying assets from troubled Anglo American – but South32’s wallet has remained shut.

Management has committed to a strong balance sheet across the cycle and, so far, has met that pledge. The rest of the industry should take note.

Like its peers, South32 has mercilessly cut costs. On average, production costs are half what they were under BHP and headcount has fallen 20%. Capital expenditures have been slashed 40% to just US$460m and the company declared its first dividend at US$0.01 per share. That dividend, although small, is a product of a well reasoned dividend policy that will generate high payouts in boom years and small dividends in lean years. 

Cost out

At an asset level, results were grim reading with lower commodity prices savaging profits. In aggregate, commodity prices wiped about US$1.6bn from operating profit but were offset by currency gains, lower costs and productivity gains. The standout, again, was Cannington which contributed earnings before interest and tax (EBIT) of US$274m, three quarters of the group total.

South African thermal coal contributed US$95m in EBIT, slightly higher than last year, a reflection of favourable power contracts and a mildly higher thermal coal prices.

Losses from nickel, metallurgical coal and South African manganese are being addressed by cost cuts, output changes and alterations to mining plans. At the Illawarra metallurgical coal mine, for example, an US$800m expansion will reduce unit costs and should restore profitability.

We maintain our view that, over the course of the cycle, South32 should comfortably generate a return on assets of 10–15%.

Lessons

Reporting season is a scorecard of performance and a test of the investment case but it is also rich in lessons.

Here is one all investors should consider: buying cheap necessarily means buying a business that is on the nose. A stock cannot be simultaneously cheap and popular.

The single easiest way to improve investment returns is to buy positions in tranches. Any other strategy is a gamble that you have picked the best time to buy and, as South32 shows, cheap stocks can get cheaper and no-one can pick to bottom.

This was a strong result in a weak environment but it was largely anticipated. South32’s share price has more than doubled since touching lows below $1 a share earlier this year and a buying opportunity no longer exists. 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.