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Mid-Cap

South32 Ltd: Is it worth another look?

August 26, 2015 | Team Kalkine
South32 Ltd: Is it worth another look?

  • Impairment charges offset earnings growth: South32 Ltd (ASX: S32) reported a pro forma underlying earnings before interest and tax growth by 56% on a year over year basis to US$1.0 billion for the fiscal year of 2015. The pro forma underlying earnings rose by 41% to US$575 million, against pcp. However, S32 incurred an impairment charge of $416 million during the period, with $391 million impairment coming from South Africa Energy Coal and $25 million incurred from Cerro Matoso. Meanwhile, the group’s pro forma profit after tax reached US$28 million. The firm comprises high quality alumina, aluminum, coal, manganese, nickel, silver, lead and zinc.  The group’s core four assets reported record production levels during the year, after demerging from BHP Billiton. On the other hand, revenues plunged 7% on a year over year basis to US$7.74 billion impacted by the falling commodity prices.

       
  • Improving operating efficiency to offset falling prices: South32 intends to control its costs by at least US$350 million per annum by the end of fiscal year of 2018. South32 is also focusing on decreasing its capital expenditure, and estimates a 9% decrease for the next fiscal year to US$650 million. The group has already achieved a pro forma productivity led cost efficiency of over US$282 million in the fiscal year of 2015.

       
       S32 Daily Chart (Source - Thomson Reuters)
  • Maintaining conservative balance sheet: The Company got a credit quality rating of BBB+/Baa1 credit ratings from Standards & Poor’s and Moody’s and has a net debt of US$402 million as at June 2015. The group had also improved its pro forma fiscal year of 2015 free cash flow before interest and tax to US$ 1.68 billion, as compared to the US$974 million in fiscal year of 2014. As a result, the group intends to pay a minimum of 40% of the underlying earnings as dividends to shareholders for each six month reporting period. Accordingly, the group intends to protect the balance sheet when margins are compressed during tough market conditions through this payout ratio policy and generate returns to shareholders as and when the financial performance improves. 
  • Profit booking by investors led to the stock correction: The shares of South32 began trading on ASX from May 18th, after demerging from BHP Billiton Limited (ASX: BHP) and touched a high of $2.45 on May. On the other hand, the shares of South32 have been under pressure since then and fell more than 28.3% since its listing till date (as of August 27). BHP Billiton shares also corrected by over 20% over the last three months. However, during the demerger of South32, each eligible BHP Billiton shareholder got a share in South32 during the demerger. Therefore, we view that the recent sell off was mainly due to profit booking by these investors in South32 Ltd.
  • Regional wide optimization to drive further growth: On the other hand, South32 has demerged from BHP Billiton to enhance focus on its core assets and intends to further decrease its costs as well as achieve operating efficiencies. Management intends to drive value by optimizing the performance of its core existing assets, convert high value brownfield resources into reserves, as well as capture new opportunities to maximize return on invested capital and deliver sector-leading total shareholder returns. Management has adopted a regional operating model, to decrease layers of management, combine functional support at the regional head offices, develop stronger relationships with stakeholders and improve procurement function.

      
  • Attractive valuation: South32 Ltd is trading at a cheaper P/E of 11.39x as compared to its industry peers. The group improved its pro forma return on invested capital to 6.2% during 2015 financial year, as compared to 4% in earlier corresponding year. Meanwhile, investors need to bear the risks associated with the commodity price fluctuations, to derive good returns from the stock. Moreover, the recent correction also raised some rumors around the stock on its potential takeover by global mining giants, as current price levels of the stock offers an attractive entry opportunity for a potential takeover target. Based on the foregoing, we reiterate our “BUY” recommendation on the company at the current price levels of $1.47

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