South32 Arrives With Focus On Yield

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-Leverage to economic growth
-And commodity rebound
-Potential for acquisitions
-But also simplification
 

By Eva Brocklehurst

It's arrived. BHP Billiton's ((BHP)) new baby South32 ((S32)) has been christened, having commenced trading on the Australian Securities Exchange. With the much heralded listing several brokers step up to initiate coverage of the stock. At this stage, there are three Buy ratings on the FNArena database with a consensus target of $2.62, suggesting 15.0% upside to the last share price.

South32 is a diversified miner, primarily exposed to aluminium and alumina, but spread across geographies, mainly Australia, Brazil and South Africa. Other commodity exposures include manganese, nickel, thermal & coking coal, silver, lead and zinc.

Three attributes stand out for JP Morgan: valuation, management and gearing. More than half of the broker's earnings estimates are driven by aluminium and alumina, with the remainder split between manganese, coal and other base metals. Six assets derive around 75% of the broker's valuation. These are Cannington, Illawarra, Alumar, Worsley, Hillside and Groote Eylandt (GEMCO). JP Morgan considers these businesses well placed on the cost curve with cost-saving opportunities and incremental production growth. Low gearing sets the base for growth and shareholder returns. The broker expects the pay-out ratio will climb to 50% in FY16.

Moreover, the company is underweight in copper and this may be an area where growth can be targeted through acquisitions at a cyclical low point. That said, with seven of the company's 13 assets achieving less than 25% of the broker's valuation, portfolio simplification is also considered likely in the medium term. JP Morgan initiates with an Overweight rating and $2.95 target.

Citi, meanwhile, considers the story one of cost cutting, yield and limited growth options, initiating with a Buy rating. The options to buy growth lie with the strong balance sheet and cash flow. Earnings are likely to be volatile but then this makes South32 leveraged to any improvement in global economic activity. Yield is the main focus at present and this is attractive, at around 5.0% on the broker's FY16 estimates based on a 40% pay-out ratio.

Citi forecasts FY16 earnings of US$2.1bn, which generates an earnings-based valuation of $2.60 a share – the initiation target. In contrast, if spot prices are maintained earnings in FY16 would fall to US$1.4bn, which implies a value of $1.75-2.00 a share. The broker is also mindful that, at spot prices, the dividend yield would fall to 2.0% in FY16, without any increase in the payout. Markets are cyclical and the focus is expected to turn to growth eventually. In this case, the company would be hard pressed to deliver on expectations without acquisitions, Citi suspects.

At least five of the commodities to which South32 is exposed are trading at trough levels, in Macquarie's belief. Importantly, the company is the only large cap ASX resources stock that has no material debt or exposure to iron ore. While Macquarie agrees there are only modest growth opportunities from the existing asset base, this is more than offset by potential for cost cutting and capital management. The broker believes returns to shareholders could be closer to 70% in the first year, as the company rewards patient investors. The increased returns are likely to come via a buy-back but this could lift the effective yield in FY16 to 8-10%, in Macquarie's view.

On the subject of acquisitions Macquarie does not expect any in the next 12 months. Management is likely to focus on extending mine life at existing assets and reducing costs. Nevertheless, should Anglo American look to sell its share of the manganese assets, then this may be the most logical expansion for South32, given it already operates these projects. Macquarie estimates the cost of consolidating the manganese assets could cost more than US$1.0bn.

The company operates from a head office in Perth, Western Australia, while South African assets are run from an office in Johannesburg. South32 has secondary listings on the Johannesburg and London stock exchanges.
 

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