A significant catalyst is looming for South32 ((S32)), as it considers offers for its business South Africa Energy Coal (SAEC). SAEC is the main under-performer for the company, with export coal production -7% below guidance. Otherwise, most operations finished the June quarter broadly in line with guidance.
UBS is encouraged by the quarterly performance, given the operating issues that have occurred over the last few years. The company expects unit costs over FY19 will be slightly higher than guided at Worsley, because of caustic consumption, and at South African manganese, because of higher volumes and trucking. Extra rehabilitation costs have also occurred at SAEC. Hillside and Mozal are expected to be loss-making because of the price versus cost squeeze.
SAEC and capital management are the focus going forward, Credit Suisse suggests, and capital management calculations should take into account the Trilogy option which has not yet been exercised. The broker believes the stock is becoming quite attractive on a 12-month view. UBS expects South32 will exercise the option to retain 50% of Trilogy Metals, for $150m, by January 2020.
The Hermosa project pre-feasibility study is expected to conclude before the end of FY20, while Eagle Downs final investment decision (FID) is still expected by December 2020. Hence, UBS agrees the stock offers an attractive mix of cash returns, restructuring and growth initiatives.
Macquarie reiterates an Underperform rating, suspecting any capital management will be modest and declining alumina, coal and manganese prices continue to put pressure on the outlook.
Morgans, on the other hand, upgrades to Add from Hold, believing the market is extremely biased towards short-term earnings momentum in resources and the stock has been sold off just at a time when the company is approaching a major catalyst.
SAEC
Macquarie had expected the sale of SAEC to be completed by the end of August, which indicates the timing may have slipped. Credit Suisse, too, suspects those expecting a close on this sale by the August 22 results will have to wait a little longer.
Bids were received during the quarter for the divestment of this division and offers are being finalised. The company has promised a further update in the second half of 2019. The book value is around US$75m but the company has noted the carrying value will be reviewed in relation to the bids.
Ord Minnett points out it is possible the business will be reported as a discontinued asset. The broker carries the asset for zero value but suspects the market will react favourably to a sale being completed even at zero, given the likely improvement in the company’s environmental, social and governance (ESG) credentials and a lower capital expenditure requirement going forward.
Morgans also values SAEC at close to zero, assuming the company does not recover material proceeds from the sale. The main benefit in the sale, the broker asserts, will be how much the company’s competitiveness in terms of margin, cash flow and sovereign risk improve.
Meanwhile, there was a strong quarter at Illawarra Coal, with metallurgical production up 29% and ahead of many estimates. Both the Dendrobium and Appin mines performed well, despite two longwall moves.
Manganese
The main disappointment for brokers was Australian manganese, where an extended wet season caused output to fall -4% short of guidance. This was slightly offset by much stronger volumes from South Africa, where manganese production shipments were 11-12% of Macquarie’s expectations. The company is now reviewing the options for its manganese smelters.
Morgans assesses, with the US/China trade war impacting on the stock choices, consensus estimates for both South32 and metal price forecasts have been cut aggressively.
This signals to the broker that the market is being overly conservative, leading to South32 trading on a 4.0x enterprise value/operating earnings (EBITDA) basis for FY20. In addition to divesting SAEC, Morgans envisages an opportunity to divest both the manganese alloy assets and Australian aluminium business.
The latter is considered another difficult energy-intensive business that is not supported by a healthy price environment. The company’s management team has been candid about long-term plans to exit some areas and re-orient the business towards base metals, having inherited its original portfolio from parent BHP Group ((BHP)).
FNArena’s database has five Buy ratings, one Hold (Ord Minnett) and one Sell (Macquarie). The consensus target is $3.41, signalling 10.9% upside to the last share price. The dividend yield on FY19 and FY20 forecasts is 5.1% and 4.5% respectively.
