Strong Balance Sheet Underpins South32

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This story features SOUTH32 LIMITED, and other companies.
For more info SHARE ANALYSIS: S32
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

South32 missed expectations on several fronts in its June quarter but continues to screen well for brokers on current multiples, underpinned by a strong balance sheet.

-Downgrades to production guidance considered likely in FY18
-Main challenges at Illawarra and Cannington
-Free cash flow remains healthy and prospects exist for further returns
 

By Eva Brocklehurst

South32 ((S32)) missed expectations on several fronts in its June quarter but continues to screen well for most brokers on current multiples, underpinned by a strong balance sheet.

Only two assets out of seven hit full year guidance. Full year production misses occurred versus Credit Suisse estimates at Worsley, South African thermal coal, Illawarra, Australian manganese and Cannington. Meanwhile, the Cerro Matoso and Brazil alumina beat expectations.

The broker suspects there is a risk to current FY18 guidance for both South African thermal coal and Cannington, but awaits the August results for more visibility.

Cannington, GEMCO (manganese), South African coal and Worsley missed Deutsche Bank's expectations and further downgrades to guidance are considered likely in FY18, as Illawarra, Cannington and South African coal are still experiencing problems with operations.

Production Challenges

The most challenged operation is considered to be Illawarra metallurgical coal where a longwall move has been extended by four days and ramp up is slower because of challenging roof conditions.

Deutsche Bank notes the company has a tendency to guide towards stretch targets and expects that production will still fall short of revised guidance at Appin (Illawarra coal).

The broker expects the current outage at Appin will continue for at least another six weeks. Revised FY18 guidance is expected at the August results.

Macquarie was disappointed by the production miss at Cannington and downgrades silver, lead and zinc production forecasts for FY18 by -20-35% to account for the lost crusher availability.

The broker notes FY18 has become an increasingly important year of transition for Cannington, which represents around 25% of group net present value.

Earnings Outlook

Meanwhile, realised pricing for manganese and metallurgical (coking) coal was better-than-expected and this leads Deutsche Bank to upgrade FY17 earnings estimates by 7%, despite the weaker production.

FY18 earnings estimates are reduced by -16% on the expected lower production and higher costs emanating from Cannington and Illawarra.

Citi downgrades to Neutral from Buy, driven by downgrades to FY18 earnings forecasts, given lower production and revisions to its commodity and FX estimates.

The broker observes the operational challenges that affected the company in FY17 have continued into FY18. Coupled with a bearish outlook for coal, this means Citi prefers Rio Tinto ((RIO)) as its diversified miner pick.

Citi has downgraded coal, nickel and silver prices but upgraded aluminium prices and incorporates a stronger Australian dollar and South African rand in its forecasts. Nevertheless, the broker still envisages the company will generate healthy free cash flow.

Credit Suisse retains an Outperform rating but concedes it difficult to find a near-term positive catalyst. In lieu of material M&A there is more capacity to return capital to shareholders and the broker understands there may be a reasonable floor under the share price.

UBS also notes, with a targeted net cash ceiling of US$500m, further returns could be contemplated. UBS forecasts a final dividend of US5.3c per share based on a 40% pay-out ratio. There is a possibility this could be partly franked but the broker would prefer to see franking returned as it is generated.

Macquarie estimates the company has ample balance-sheet capacity to either double the size of the current share buy-back or upgrade its dividend. The broker estimates net cash increased by around US$65m in the quarter. During the quarter the company completed US$211m of its US$500m buy-back.

In the absence of in FY18 guidance up date, Ord Minnett believes Illawarra and Cannington asset to have a difficult year and, as a result, lowers earnings forecasts. The broker acknowledges the concerns regarding operations that overhang the stock but continues to believe these are non-structural.

Ord Minnett maintains a Buy rating and $3.00 target based on solid valuation metrics, a strong balance sheet and the exposure to Chinese aluminium supply reforms.

There are five Buy ratings on FNArena's database and three Hold. The consensus target is $2.98, suggesting 9.0% upside to the last share price. Targets range from $2.60 (Deutsche Bank) to $3.40 (Morgan Stanley, yet to comment on the update).

See also, Appin To Drag On South32 on July 11 2017.
 

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