South32 Expands Base Metal Options

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South32 has taken control of Arizona Mining, which provides a base metal opportunity and expands its geographic base.

-Deal considered fair to fully priced and providing another growth option
-Commitment to capital management reiterated
-Potential upside from an increase in reserves at the Taylor deposit
 

By Eva Brocklehurst

South32 ((S32)) has dug into its substantial war chest and opened up another option, this time taking over a Canadian-listed miner. The company will buy the remaining 83% of Arizona Mining for US$1.3bn.

The deal gives South32 control of the Hermosa project, a zinc/lead/silver resource in Santa Cruz, Arizona. The acquisition comes one month after the acquisition of 50% of the Eagle Downs coking coal project, Queensland. The third recent option is the joint venture with, and stake in, Trilogy Metals, also Canadian listed.

There is no issue with funding the all-in cash consideration as the company had US$2.8bn in cash at the end of March. Brokers suggest it also brings a US asset to the fore to help dilute the South African exposure.

Nonetheless, Credit Suisse believes the remaining shares were obtained at a lofty price, representing a 50% premium to the closing share price on June 15. In addition, South32 will provide a working capital facility of CAD70m upon signing and subsequent tranches up to a total of CAD30m, subject to South32 consent.

Citi was not surprised by the deal because South32 already owned 17% and it answers a question about the company's cash pile, although at the same time raises another question as to how much value South32 can add to justify a 50% premium.

The acquisition is not large enough to change Ord Minnett's investment thesis either, but does provide another growth option and the price paid is considered fair.

Management has reiterated a commitment to its US$1bn capital management program, intending to deliver the remaining US$400m to shareholders by April 2019. A rival bid is considered unlikely, as the company has two years of association with the Hermosa asset.

Hermosa

Hermosa is in a first-class jurisdiction and adjacent to infrastructure. Some permits are still required, although it is seven years before federal approval is needed. The project is made up of the Taylor deposit, the development target, and the adjoining Central deposit, the subject of further feasibility studies.

Based on preliminary assessments, the Taylor deposit has an after-tax return of 48%. Mine life is forecast to 29 years and production is expected to start in late 2020. Arizona Mining has published a preliminary US$2bn net present value in its modelling for Hermosa with a 1.6-year pay-back period.

The deal values the project at US$1.6bn, Citi calculates, pointing out there is little margin for error. The broker awaits the bankable feasibility study to obtain more confidence in project economics. However, South 32's balance sheet and strong management profile de-risks the project significantly, given its experience with Cannington, Queensland.

UBS considers the acquisition sound, with further potential upside from an increase in reserves, as the Taylor deposit is open at depth and laterally. The broker agrees the next step is a bankable feasibility study, development of the exploration decline and further surface exploration.

While recent drilling intercepts have indicated potential upside, and any success would theoretically add to valuation, Credit Suisse assesses further work is required to demonstrate this opportunity.

Macquarie acknowledges this will be a strong replacement for the Cannington silver mine but does not yet include the transaction in forecasts. Forecast production rates and mining methods are similar to Cannington for extracting the Taylor deposit and this should provide some insight into the costs and production assumptions.

The broker observes a lack of growth options was a consistent source of negative sentiment for the stock. Now, along with Eagle Downs and the Trilogy Metals Arctic/Bornite project, South32 has three clear medium-term growth options.

There are six Hold ratings on FNArena's database and one Buy (Macquarie). The consensus target is $3.77, signalling -2.2% downside to the last share price. Targets range from $3.40 (Deutsche Bank, yet to comment on the transaction) to $4.00 (Ord Minnett, Macquarie). The dividend yield on present FX values is 5.1% for FY18 and 4.6% for FY19.

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