South32 Facing Difficult Choices

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

-Questions over future of three assets
-Still generating cash, lowering debt
-Few near-term catalysts
 

By Eva Brocklehurst

South32 ((S32)) is facing up to realities. Brokers attending the company's recent briefing obtained this impression, noting the CEO expects two more years of weak commodities with the possibility the market may deteriorate further before it improves.

The choice is stark. With no immediate bounce in prices the company needs to make its best assets work as best they can, while making hard decisions on those that are loss making.

Brokers highlights the exposure to good assets such as Worsley aluminium, Groote Eylandt Mining Co (GEMCO) manganese and Cannington silver/lead/zinc, as well as a strong balance sheet.

The upside, too, is that the company is generating cash and lowering its debt. Two thirds of the 30% reduction in functional positions in Australia is complete. Procurement savings are yet to flow through and asset reviews are being undertaken to establish the value of growth options.

Several brokers are also optimistic there is upside to cost savings. JP Morgan expects the target of $350m per annum is likely to be increased at the next financial results.

The main issues at Cannington and GEMCO are around mine life. The company envisages options for extending the life of Cannington, noting closing the Townsville office has made savings and provided more flexibility. South 32 is progressing its negotiations at GEMCO and believes access to the portion of the deposit that lies in the southern leases could double the life of operations.

Meanwhile, resource-to-reserve upgrades remain on the cards at Worsley, and the company highlights the significant potential at this asset, something it believes the market is discounting. The aluminium business in South Africa, brokers observe, is at least not loss making while its power availability issues are improving.

The main problems lie with Illawarra coal, South African manganese and Cerro Matoso nickel. All three areas need a plan by year end to return to profitability, brokers note.

At Illawarra coal the company is looking at a change in operations to ensure its survival. Cerro Matoso personnel are being reduced by around 26% and bringing on the mine at Esmeralda is considered key to viability as this should lift the nickel grade. South African manganese mining has been halted until a strategic review is completed and three of the four alloy furnaces are on care & maintenance.

South32 is cheap and unloved in Credit Suisse's view, not priced for an eventual recovery in commodity prices. The broker observes the company's priorities are unchanged. In order they are – invest in the businesses, protect the credit rating, pay out 40% of earnings in dividends and, then, look to a buy-back.

In the current environment the broker highlights a meaningful buy-back is not possible. Minor adjustments to Credit Suisse's modelling involve suspension of mining South African manganese which is offset by drawing down inventory and the suspension of the three alloy smelters.

There are limited near-term catalysts and buy-backs are unlikely, UBS, too, asserts. Instead management is intent on maintaining a safe balance sheet, the broker notes. Moreover, progressing the life extension at Cannington could drain cash in coming years.

UBS contends the main risks are in the product mix as aluminium, manganese ore and coal are all depressed, and in the regional mix, with 45% of revenue generated in South Africa. While attracted to the strong balance sheet, well-funded assets and the minimal capex commitment in the near term, the broker remains concerned that the self help and any FX support will not be enough to offset weak commodity prices.

Costs of closure for problem assets is most severe for South African manganese. UBS highlights an estimated figure of US$160m. Management has signalled that de-classification of the manganese slag is a possibility. The most likely scenario, in the broker's view, is placing the assets on care & maintenance rather than closure. There is also the possibility of selling Metalloys.

At Cerro Matoso management has highlighted a risk of losing access to the CMSA resource if it were to close the mine and care & maintenance may be a preferable option.

Macquarie suspects the closure of loss-making assets is possible by early next year. At spot prices the broker estimates Illawarra coal is losing around US$50m per annum. With three longwall moves scheduled for the remainder of FY16, Macquarie believes the company has a key opportunity to make a major reduction in its cost base.

Macquarie also notes that Colombian legislation makes closing Cerro Matoso difficult but in the absence of a material recovery in nickel prices, a temporary closure next year appears inevitable. Most of the South Africa manganese smelter business has been off line since August and the broker expects the Metalloys smelter will be closed permanently as part of the review, with mining of the Mamatwan open pit likely to resume next year after suspension following a fatality on November 2.

FNArena's database has five Buy ratings and two Hold. The consensus target is $1.74, signalling 44% upside to the last share price. Targets range from $1.45 (UBS) to $2.00 (JP Morgan).
 

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