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Morningstar | Higher Thermal Coal Forecasts Offset Rising Costs for South32; AUD 2.70 FVE Maintained

South32 delivered a solid fiscal 2018 result. Adjusted net profit after tax increased 13% to USD 1.3 billion compared with fiscal 2017. Adjusted earnings rose by over 18% to USD 0.26, partially due to South32 buying back 98 million shares. Higher commodity prices were the key growth driver and boosted EBIT by USD 1.5 billion. However, inflation, higher royalties and operating costs, and adverse foreign exchange movements lowered EBIT by USD 0.7 billion. Further, weaker volumes from Illawarra coking coal operations and Cannington also detracted from EBIT to the tune of USD 0.6 billion.

Fiscal 2018 earnings were somewhat below our forecast, due to higher costs in aluminium and lower realised prices in South Africa coal. However, fiscal 2019 guidance is in line with our expectations. Cost inflation is detracting from future margins, but our higher near- and midcycle thermal coal forecasts mean our profit forecasts for the five years ending fiscal 2023 are little changed overall. The lower Australian dollar is also a modest benefit to our fair value estimate, which we maintain at AUD 2.70 per share. South32 shares remain overvalued due to our expectation for weaker demand and lower prices for steel making materials.

South32 expects to increase volumes overall by about 5% in fiscal 2019, with a partial recovery in volumes at Illawarra coal and incremental expansions in aluminium and alumina the main drivers. The key medium-term growth projects--the Eagle Downs coking coal project and the Hermosa zinc deposit--stem from recent acquisition activity. Both are in evaluation. At Hermosa, South32 is exploring a potential processing throughput expansion from Arizona Mining’s 3.3 million tonnes of ore a year to as much as 6.0 million tonnes. Arizona Mining’s aggressive ramp-up schedule is likely to lengthen under South32 ownership, but management sees the potential to extend the resource and for shallow ore to facilitate a faster capital payback.

South32’s financial position is very strong, with net cash at end June 2018 of USD 2.0 billion. Payment of USD 1.4 billion for the Eagle Downs and Hermosa acquisitions falls due in fiscal 2019 and will draw down most of the excess cash. The company also has USD 380 million earmarked for further share repurchases in fiscal 2019. Despite these large outflows, in the absence of a large acquisition, South32’s balance sheet should remain strong for the foreseeable future. We think a conservative balance sheet is appropriate, given the cyclical nature of commodity prices and the relatively high capital intensity of the business.

The strong cash position sees South32 financially well placed to develop both the Hermosa and Eagle Downs deposits from operating cash flow. South32 is also rebuilding its growth pipeline with 18 active exploration projects. However, these represent longer-dated options, and the probability of success on an individual exploration project is relatively low.

The final dividend of USD 0.0625 per share (fully franked) brought the full-year payout to USD 0.135 per share, up 35% from fiscal 2017. The payout ratio increased modestly from 46% to 52%. We expect the payout ratio to increase further due to the firm’s strong financial position. Alternatively, South32 could decide to add to share repurchases; however, at the current stock price, we think dividend growth is the better option.

We see a large acquisition as unlikely in the near to medium term. We’re encouraged by management saying it’s difficult to add meaningful value through acquisitions in the current price environment. However, market pressure to undertake large resource developments or acquisitions is cyclical, and we expect that capital allocation risks will rise over time.