South32 Redoubles Efforts To Protect Cash Flow

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South32 is making a considerable effort to protect its balance sheet as its commodity spectrum comes under pressure from virus-related restrictions.

-Initiates review to lower costs even further by FY21
-Sentiment centres on aspects outside of the company's control
-Competitive advantage, yet risk lies with a deeper slowdown
 

By Eva Brocklehurst

Weakness across coal and base metals in the March quarter as well as virus-related production restrictions have put pressure on South32 ((S32)), which has undertaken a string of measures to preserve its balance sheet.

The company has pulled back expenditure on several assets amid efforts to reduce costs, and initiated a review to lower costs even further by FY21. Sustaining expenditure has been reduced by -14% in FY20. Expenditure on growth projects will slow as mobility restrictions affect operations, even as South Africa eases restrictions and South32 recommences manganese operations, albeit at a reduced rate.

Although, as Ord Minnett notes, capacity and sales will hinge on the performance of the South African rail provider, Transnet. Capital expenditure of US$22.8m at the Ambler Metals joint venture (Alaska) will be deferred, while greenfield exploration will be reduced by -US$10m.

Guidance had already been withdrawn for energy coal and manganese in South Africa as well as Cerro Matoso (Colombia) and now Australian manganese (GEMCO) guidance is reduced by -5%. Even so, Morgan Stanley still suspect strong increases in production are required at Illawarra and Worsley to meet guidance.

Metallurgical coal and manganese production were weaker during the March quarter, while nickel was the notable positive exception among base metals. Moreover, port delays have affected shipments for Worsley (Western Australia) and GEMCO (Northern Territory).

UBS points out the company relies on third parties for much of its logistics and supply, which could be a problem. The broker's expected recovery in earnings into FY21 also relies on production returning to normal and a recovery in prices from current levels, particularly for alumina, aluminium and coal.

Meanwhile, the divestment of South Africa Energy Coal is progressing and there is an interim pricing agreement on coal to the Duvha power station, as the asset undergoes a divestment process.

Sentiment

The company is one of the better placed, in Ord Minnett's view, in the event commodity prices fall further, given its stronger margins. Still the broker is becoming increasingly cautious about base metals, amid thinning global demand. Moreover, it is hard to isolate short-term re-rating catalysts.

Credit Suisse believes sentiment centres on dynamics that are out of the company's control, despite South32 being net cash and making a big effort to ensure the balance sheet is not compromised. The company's commodity exposures are under pressure and earnings will be soft but Credit Suisse assesses the stock is attractive enough to retain an Outperform rating.

However, Macquarie finds free cash flow is marginal under spot pricing and downgrades to Neutral from Outperform. Production of coal in the March quarter was more than -10% below its forecasts in the range of other metals were also weaker than expected.

This has intensified the pressure on earnings, with Macquarie calculating a spot price scenario generates -35% lower earnings in FY21 and FY22 versus its base case forecasts.

This comes despite tailwinds from currency delivering lower costs for Australia's Worsley, Illawarra and Cannington, countered by higher costs for South Africa and Colombia (Cerro Matoso) as these operations are affected more by the pandemic.

Yet Morgans expects the cash burn will reverse in the June quarter as the company preserves capital. Lower expenditure, savings and reduced dividends should also combine to provide a competitive advantage. Morgans acknowledges there is a risk of a deeper synchronised global slowdown that could stretch the duration of the down cycle to more than 2-3 years and that may not suit all investors.

While retaining an Add rating, the broker recommends most investors should wait for better signs of macro stability before adding to positions. FNArena's database has five Buy ratings and two Hold. The consensus target is $2.65, suggesting 36.7% upside to the last share price.

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