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Morningstar | Share Price Decline Sees South32 Close to Fairly Valued, FVE Lowered to AUD 3.00 per Share

After peaking at around AUD 4.25 per share in October 2018, no-moat South32 shares have sold off by almost one fourth. The price pullback means the shares are now close to fairly valued. This is despite reducing our fair value estimate slightly to AUD 3.00 per share from AUD 3.10 previously. The reduction primarily reflects declines in the spot prices for nickel and zinc. The lower AUD/USD exchange rate, below 0.70, is a partial offset. The base metals and manganese price sell-off is the key reason the shares are no longer meaningfully overvalued. The manganese ore price is down about 30% from its peak a little over a year ago. A more reasonable outlook for prices is now baked into the share price but we still don’t think South32 is cheap.

With a market cap of more than AUD 16 billion, South32 sits alongside Anglo American, Fortescue, Newcrest, and Teck Resources as a mid-cap global miner. The field of global mid-cap miners is relatively small and leaves South32 interestingly placed. Rio Tinto, BHP, and Vale are all vastly bigger, with market caps in the AUD 100 billion to AUD 200 billion range, while Glencore is roughly three times larger. The larger firms are generally seeking to simplify their portfolios, sell off noncore assets. The aim is focus on fewer, larger, higher-quality and expandable operations. This could provide acquisition opportunities for South32.

However, patience will be required. Mining is capital-intensive and key to generating acceptable returns is the cost to bring a mine to production. Being countercyclical is helpful in this regard, but as a group, the industry tends to invest procyclically. By definition, few firms can buck the trend of tending to invest when it’s popular. A sell-off in global metals markets wouldn’t necessarily be negative for South32. It’s also looking to simplify its own portfolio, by reducing exposure to energy coal and focusing on higher-quality assets, such as the recently acquired Hermosa project.

We expect South32’s rate of investment expenditure to be elevated for the next few years. We forecast a spend of around USD 700 million annually, roughly double the rate of the past few years. Though the investment cash outflow is higher, it’s still very comfortable given the operating cash inflow is roughly double this rate.

Development of the low-cost Hermosa project in Arizona is the key driver of the additional forecast expenditure. Hermosa is important to South32. It will change the make-up of the company’s earnings, tilting towards low-cost zinc production. When spun out from BHP in 2015, South32 generally had few development options and was constrained by reserve life. Developing Hermosa adds a low-cost, long life zinc, lead and silver mine and boosts the overall quality of the firm’s assets. High grades support cash costs in the lowest quartile of the zinc cost curve. In isolation, the Hermosa project may be worthy of a narrow moat rating, based on its long life, low operating costs and reasonable acquisition price.
Based on current prices for lead and zinc, we expect Hermosa to add about USD 820 million to EBITDA by 2023 and become South32’s most important contributor. We forecast returns on invested capital to average around 13% for the first 10 years of the mine’s life, higher in the first five years when grades are better, and just above the company’s cost of capital on average. Hermosa will help to offset expected earnings declines elsewhere, notably coking coal and manganese, given we expect the prices to decline from fiscal 2019 levels. We forecast earnings to decline from AUD 0.47 per share in fiscal 2019 to AUD 0.27 per share by 2023.

In the absence of additional growth investment opportunities, most likely acquisitions, we expect South32 to continue to return excess cash to shareholders through dividends and potentially further on-market buybacks. This approach to capital allocation is appropriate given it’s no good investing when prices are high. The opportunities to invest wisely in resources tend to come when commodity prices and asset prices are low, and acquisitions or developments are seen by investors as risky. It’s important South32 retains a strong balance sheet to be in a position to take advantage of those opportunities. For the right option, we could entertain modest debt for a short period to fund an investment. South32 could borrow at least USD 2 billion while retaining net debt/EBITDA at a relatively comfortable 1.0 or less for the five-year forecast period.

Despite the strong balance sheet, we’ve reviewed our near-term cash flow forecasts in light of the lower base metals prices and reduce our fiscal 2019 dividend forecast to USD 0.20 from USD 0.26 previously. At the current stock prices, the USD 0.20 dividend represents an attractive 8.8% fully franked. But we don’t think this level of yield is sustainable. For starters, we think future prices and earnings are likely to decline. The company may also make further acquisitions or capital expenditure to drive growth. There may also be more cash directed to buy backs in future. Our dividend forecasts assume no further buy backs and no investment in growth, beyond what is already known. If those two factors change, so too will our dividend forecasts. We consider the dividends an important contributor to total shareholder returns but don’t think South32 should be considered a sustainable yield play. The key driver of shareholder returns will remain commodity prices, followed by South32’s investment decisions and execution.

The company has a strong balance sheet and financial position. Net cash at end December 2018 was USD 680 million. This equates to AUD 0.19 per share, or 6% of our fair value estimate. We estimate a further USD 650 million in annual free cash flow to be generated to end fiscal 2023, equivalent to AUD 0.18 per share annually. Free cash flow will be slower than fiscal 2017 and 2018, when South32 generated about USD 1.6 billion a year. Despite this, South32 is still well placed to invest if opportunities arise.