South32 Outlook Uncertain Despite Cost Cuts

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

-Hard to ignore cost achievement
-Net cash, balance sheet strength
-Dependent on outlook for key resources
-And supply response to low prices may falter
 

By Eva Brocklehurst

Two broker readings on diversified miner South32 ((S32)) have converged recently. Morgan Stanley has upgraded to Equal-weight from Underweight and Deutsche Bank has downgraded to Hold from Buy.

In sum, the stock now carries three Buy ratings, four Hold and one Sell (Macquarie) on the FNArena database. Targets range from $1.20 (Macquarie) to $1.70 (Ord Minnett, UBS and Deutsche Bank) and the consensus target is $1.52, which signals 0.4% downside to the last share price.

Morgan Stanley's previous contrarian stance was based on a lack of evident catalysts but the company's accelerated cost reductions have changed that view. Last year the company announced a target of US$350m in cost savings over three years. It is now more than half way to US$300m inside of a year.

Further reductions to production costs remain in focus and the broker has taken these expectations into its base case, albeit applying some caution in its view on their realisation. The company is near a net cash position and this is its competitive strength, with Morgan Stanley envisaging US$1bn in free cash flow from FY17.

The broker suspects the company will be prudent with its cash, as it has maintained it will not undertake acquisitions at the expense of balance sheet strength and financial liquidity.

While the production profile is flat and further acceleration of cost reductions is unlikely, Morgan Stanley concurs commodity prices are now the primary driver of sentiment. Cuts by manganese and alumina producers have allowed these two commodities to rally in recent weeks but the broker is aware that they may not move up through the second half of 2016, as some idle capacity could re-start.

So, what has prompted Deutsche Bank to pull back its stance? The broker perceives the rally in commodity prices since mid January has been driven by some positive signals out of China, mostly related to the property sector, as well as the weakness in the US dollar.

Although some supply reductions are occurring there is the prospect that the recent rally in prices delays further efforts to cut back, just when more low-cost supply is entering the market. As most of Australia's mining stocks have rallied hard and the recent strength in the Australian dollar is now a headwind, the broker has downgraded several, including South32.

Deutsche Bank has reduced both nickel and alumina price forecasts and increases FX estimates, partly offset by an increase in zinc price forecasts and an increase to depreciation estimates for South32. The broker acknowledges the company's strong free cash flow, structural cost cutting and lower capital expenditure.

Last week, Macquarie downgraded its rating on the stock to Underperform from Neutral, suspecting that resource equities were running ahead of reality. Equities enjoyed a strong start to 2016, with a modest recovery in commodity prices and a lift in sentiment. Nevertheless, the share prices are well ahead of underlying demand assumptions, in the broker’s view.

Macquarie continues to prefer iron ore and gold exposures and remains negative on coal, alumina and mineral sands. The broker expects earnings improvement in the near term, with South32 estimates upgraded because of higher lead price forecasts.

Earlier this month UBS chose to upgrade to Buy, given the rebound in key commodity exposures, manganese and alumina. Alumina prices have rebounded 22% and manganese 58% from the lows of late 2015. Incorporating the revised outlook for cost and capex meant the broker’s earnings forecasts are raised substantially for FY16-18, amid an increased valuation.

UBS observes management is a good at allocating capital and is intent on unlocking the full potential of the company’s assets. On the subject of acquisitions UBS also notes the company is in no hurry, yet, to find really compelling opportunities. Consolidation of the manganese joint venture by buying out its partner is possible but the broker observes, as South32 has first right of refusal, there is no reason to rush the process.

The company's exposure to Africa in terms of earnings is around 19%, UBS calculates, and this poses proportionately less risk than in the past. Load shedding is less of an issue in South Africa since September 2015, as demand has declined from reduced economic activity.

The company believes it has an advantage over other major miners in the region because it operates long term, lower risk assets with lower rate of injury. Still, management remains cautious about investing further capital in South Africa, which the broker acknowledges brings into question projects such as the life extension to the Klipspruit thermal coal mine.
 

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