What to do with South32?

One of the largest demergers in Australian corporate history was completed somewhat anticlimactically yesterday as South32 began life as a listed business trading at $2.13, before closing at $2.05.

That closing price suggests a market capitalisation of $10.8bn for Australia's newest listed miner. That might be at the lower end of expectations, but it still makes South32 the third-largest miner on the ASX and a Top 50 business. The media may have already dubbed it a failure but, make no mistake, a giant has been born.

Investors now want to know just one thing: what to do with South32?

At its current price, the stock trades at a 10% discount to its net asset value, and we're upgrading it to Buy.

Having already written about the company's assets and the rationale for the split in BHP approves South32 float, we won't cover the same ground again. It is worth, however, making some points about the company's valuation.

How much?

As a highly cyclical business, we can't simply look at an earnings multiple and decide whether it is cheap or not. Investors need to make a judgement about the returns this business might be able to earn across the cycle. Sadly, that kind of asset level history isn't available for the new company which makes valuation tricky.

With commodity prices currently striking new lows, it looks like we're closer to the bottom of the price cycle than the top, so there's little risk of paying for inflated earnings. In fact, we would argue quite the opposite. There is a good chance this business is under-earning.

South32 contributed about 3% of BHP's profit last year. The money lavished on the giant's storied iron ore, petroleum and copper assets wasn't spent on the small and maligned collection of mines that constitute South32. These are assets that have been neglected for a decade.

As such, there is every reason to expect a focussed management team with a clean balance sheet to generate far higher returns. BHP and Rio have shown the remarkable extent to which costs can be stripped from high-quality assets: both businesses have more than halved their iron ore production costs, for example.

We expect similar levels of efficiency gains to come from South32.

Higher returns

Last year, South32 reported return on assets of just under 5%. The business can generate operating cash flow of about $1bn a year in a low price environment but, if prices rise, earnings and cash flow could potentially explode. Over the course of the cycle, South32 should comfortably generate a return on assets above 10%.

A business that generates such returns should trade at around book value or perhaps a smidge higher. With net asset value of around $2.40 a share, today's price is a good deal for investors and provides terrific option value for higher commodity prices in the future.

The miner has pledged to pay around 40% of after tax profits in dividends, a potential yield of around 1.8% at current profitability. This is sensible and ensures dividends will rise in boom years and fall in lean years. If only BHP adopted such a pragmatic dividend policy.

It's a buy

BHP fell sharply as South32 floated, a rational reaction as assets are stripped from that business into a new one. We've adjusted our buy price slightly for BHP to reflect the demerger and would likely upgrade again at around $28. For now, HOLD.

South32 doesn't carry the famous assets of its parent but it does carry less debt, is more diversified and boasts a far more favourable valuation. Far from being the poor relation, this is the better buy today and we recommend South32 with a portfolio limit of up to 7%.

Keep in mind, however, that commodity prices tend to move together, so we'd recommend limiting your overall mining exposure to a maximum of about 15% of your portfolio. With that caveat, we're upgrading South32. BUY.

Note: Our Growth Portfolio is buying 7,200 shares in South32 at $2.20 for a total consideration of $15,840.

Disclosure: Staff members own shares in BHP Billiton and South32, but they don't include the author.