Impairments Next For South32?

This story features SOUTH32 LIMITED. For more info SHARE ANALYSIS: S32

-Net debt reduction a key positive
-MS takes relative Underweight stance
-Impairments a substantial risk

 

By Eva Brocklehurst

Is the glass half full or half empty at South32 ((S32))? The company reported a decline in copper equivalent production in the December quarter, with weakness mostly derived from Illawarra coal and South African manganese.

Other assets were stronger performers and one of the highlights of the quarter was a substantial reduction in net debt. This indicates to Deutsche Bank that the cost cutting program is well on track. The broker believes the company is still positive on cash flow at current commodity prices and has compelling potential to cut costs further and improve the balance sheet. Deutsche Bank retains a Buy rating.

Credit Suisse, too, with an Outperform rating, notes the strong balance sheet is a key point of differentiation versus the company's peers and believes the stock is resilient at spot prices, with FY16 operating cash flow expected to show only a modest decrease of 0.9%.

On the other hand, with hindsight, Morgan Stanley believes it should have been more decisive when highlighting the spot commodity risk last year. The broker decides to downgrade to Underweight from Equal-weight, believing further downside risk exists if prices don't recover.

Morgan Stanley now has a contrarian stance but believes the trend has been implying a ratings downgrade over the past three months. The equity is trading close to the broker's price target (90c) so the move to Underweight is made more in relation to relative preferences for other mining exposures.

FY16 guidance was maintained, with the exception of Illawarra coal, where production was down 31% in the December quarter after a record September quarter. A further two longwall moves are planned for the current quarter at Illawarra. The company has noted challenging geological conditions have been encountered at both the Appin and Dendrobium mines.

South African manganese operations at Wessels and Mamatwan were suspended during the period and remain under review. UBS does not expect the company to exit South African manganese but rather look to consolidate and minimise operating costs. The broker was impressed by the cash flow in the quarter as it was amid a substantial fall in commodity prices, net of one-off tax gains, FX translation and despite some likely unwinding of working capital.

Looking ahead, JP Morgan expects lower capex guidance at the first half result and more progress on cost savings as well as details of the strategic reviews. The broker believes the reduction in the net debt position bodes well for the upcoming financials and South32 can ride out the downturn, although oversupply in key markets needs to be addressed before any recovery.

Macquarie has made some material cuts to earnings forecasts based on the production results and expects an earnings loss in FY16 with only modest profit in FY17. The broker also suspects cash flow will come under pressure now commodity prices have declined further, despite the benefit from favourable FX movements.

With a book value of US$11bn Macquarie considers South32 at risk of taking significant impairments at the first half result, should it start to factor in a sustained period of weakness in commodities or an outlook more broadly in line with forecasts.In the absence of an acquisition or recovery in commodity prices the stock lacks a positive catalyst for the near term, in the broker's opinion.

At most risk of impairment are Illawarra metallurgical coal and South African manganese, both of which are carrying negative valuation. The decision to exit the power sales contract in Brazil is also expected to require a revision to the carrying value of Alumar.

A risk, albeit much less, also exists for impairments to the company's larger profit contributors, particularly Worsley alumina. Macquarie highlights the fact Worsley is carrying a book value nearly US$2.5bn higher than the broker's valuation. Only the Cannington silver mine appears to be immune to a write-down risk.

FNArena's database has two Buy ratings, four Hold and one Sell (Morgan Stanley). The consensus target is $1.18, suggesting 23.4% upside to the last share price. Targets range from $1.45 (UBS) to 90c (Morgan Stanley).

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