South32: Result 2019

South32 reminds us what the big miners have almost had us forget: mining remains a deeply cyclical business. 

A strong operating performance delivered decent profit but South32 couldn't shake off the impact of lower commodity prices over the year.

Lower prices for most of its commodities, led by the sinking aluminium price, tore US$333m from earnings before interest and tax (EBIT). Higher costs have become a theme of the sector, and here they impacted EBIT by over US$350m. The result itself was saved by favourable currency movements which added over US$320m to EBIT.

Worse, the outlook for key commodities - especially aluminium and alumina - appears bleak in the face of global oversupply. It's easy to imagine profits falling further along with prices.

In aggregate, EBIT fell 19% to US$1.4bn and earnings per share fell 23% to just under US$0.20. Yet this was a decent result, especially when we consider how management is positioning the miner.

The new and the old

South32 will soon sell its South African coal business and is investigating the sale of its manganese processing assets. It has shown a refreshing willingness to adapt the asset base to circumstance.

The miner recently made two significant purchases; Hermosa and Eagle Downs. Hermosa is a multi-metal deposit in which, geologically, looks similar to South32's own Cannington mine. Cannington has been an outstanding asset for almost two decades but is now running short of ore. 

There are hopes that South32 can utilise the expertise gained at Cannington - separating different metals from a single ore source does require technical nous - and apply it to Hermosa. There is plenty of work to do yet but, so far, this appears an excellent acquisition. 

Eagle Downs, a metallurgical coal deposit in the Bowen Basin, will require plenty of investment before it is production ready, but the mine has already benefited from past expenditure from Bao Steel, its previous owner. Bao Steel has built water, power and dams infrastructure for the site but it's too early to declare the purchase a success. The economics of the mine are unproven.

Payback

We do, however, rate management as arguably the best of any large miner. Since the day it was spun from BHP, South32 has allocated capital sensibly and preserved the best balance sheet in global mining, with over US$500m in net cash. 

Dividends and buybacks have been more common than acquisitions. Last year, the business paid US$0.096 in dividends (including a special dividend) and completed a US$1.25bn buyback. The business may be more volatile than other large miners, but management are convincingly conservative. 

At an asset level, it's clear that the heyday of Cannington is over. EBIT from the mine fell by 43% and it generated $104m in EBIT; just two years ago it made over US$300m. 

Commodity prices have played a part but mine profitability is now permanently lower as the orebody depletes. At some stage, South32 must decide whether to expand output to restore production levels.

It's also notable that aluminium assets all made losses as the metal faces a global glut. The long underperforming Worsley alumina is, at least, finally generating acceptable returns, last year generating EBIT of US$541m and South32's manganese assets remain world class.

It's not me, it's you

South32 is now just below our Buy price but a lot has changed within the business: Cannington is clearly worth less than it was; the aluminium business faces industry hurdles; and new assets will need cash. 

The miner doesn't look expensive on multiples, trading on an EV/EBITDA multiple of under four times. Yet this is a more cyclical miner than peers and asset quality is no match for the major miners. It deserves a discount. Free cash flow has probably already peaked so the low multiple is a warning more than an opportunity.

We've done well from South32 in the past and there will be a time to buy it again. Now is not that moment. 

We're lowering our Buy price from $2.50 to $2 and our Sell price from $4 to $3.50 to reflect a lower valuation for Cannington, the loss of coal earnings and lower returns from developing assets. South32 is now fairly priced. HOLD.