The investment attraction in South32 (ASX:S32) is twofold. Firstly, the Company has an ongoing capital management program which has historically been accretive to earnings. This has helped to smooth earnings swings in recent years. Secondly, S32 has a commodity/portfolio mix that is becoming increasingly skewed towards base metals and critical minerals. These are likely to benefit from the trend towards de-carbonisation and electrification.
Despite these attractions, the shares have continued to weaken. This is mainly due to a higher cost profile alluded to in the recent results. With this in mind, we consider whether the shares are now oversold, or starting to look attractive.
About South32
South32 is a diversified mining company with principal exposure to aluminium/alumina, coal and manganese operations largely in Australia, Brazil and South Africa. The asset quality of S32’s portfolio is high, with the majority of assets in the bottom half of their respective cost curves. The Company has a primary listing on the ASX with secondary listings on the Johannesburg Stock Exchange and the London Stock Exchange.
Key Fundamental Drivers
Upgrade to Production Guidance Negated by Higher Operating Costs
The Company’s production guidance for 12 months to 30 June 2024 (FY24) highlighted volumes growth expectations for alumina, aluminium, copper, and zinc operations. On the other hand, nickel and metallurgical coal volumes are guided to be lower. Also, FY25 production guidance has been increased modestly.
Offsetting the guidance for higher production, operating expenditure in FY24 is expected to be modestly higher. Any volume increases are expected to largely offset underlying cost inflation. When adjusting for currency movements, the majority of assets continue to face inflationary pressures. Operating margin in FY23 was lower for all commodities.
S32’s operations generally fall in the middle or lower half of their respective industry cost curves. As such, many operations are well placed to withstand higher raw material and energy costs. However, this advantage is negated by the high capital-intensive nature of the majority of the asset base.
Strong Balance Sheet Position Despite Higher Debt Levels
The Company reported a net debt balance of US$483m as at 30 June 2023. The balance sheet having swung from a net cash position of US$538m as at 30 June 2022. This was due to lower-than-expected free cashflow, reflecting mostly higher expenditure growth projects. Nonetheless, the balance sheet is also supported by a strong liquidity position. There is US$1.3b cash on hand and an undrawn US$1.4b revolving credit facility. This provides scope for S32 to continue its ongoing share buyback program.
Higher CAPEX Requirements Lower Yield Appeal
The Company has provided guidance for higher capital expenditure (CAPEX) requirements in FY24. This is likely to impact free cashflow (FCF) in FY24. The additional CAPEX requirements have reduced the FY24 yield (on a FCF basis) to ~2%. Excluding the CAPEX on the growth projects, the FCF yield for FY24 is ~5%. In context, the latter remains below the FCF yield in recent years. The FCF yield has varied between 7% and 9% over FY21-23 when excluding CAPEX on growth projects.
Fundamental View
Potential news flow on two key projects may provide a catalyst for the shares over the short term. These comprise:
i. A 4th grinding line expansion at Sierra Gorda, with a Final Investment Decision due in 2H24.
ii. Further progress at the Hermosa project, which includes the zinc-lead-silver Taylor sulphide deposit (Taylor Deposit). A Final Investment Decision for Taylor is expected by December 2023.
Notwithstanding the above short-term catalysts, rising (and elevated) operating expenditure is not being offset by commodity prices. Commodity price forecasts are yet to fully reflect rapidly shifting cost curves. In turn, this creates earnings pressure for S32 over the short-to-medium term. This is because S32’s financial results have a high degree of operating leverage to commodity prices. With higher operating leverage given lower margins, S32 is impacted more than its diversified peers.
Further, the negative operating leverage is creating limited earnings visibility over the short-to-medium term. This is evident in the wide band of EPS forecasts for FY24. These factor in a decline (vs FY23) ranging from -15% to -65%.
Charting View
S32 has been trending lower since the start of the year. However, after briefly falling under the 2022 low, it then bounced higher on strong volume. It is now threatening to push beyond that old support line. If it can do so, then the recent break under support could be viewed as a “false break”. That would mean that a low could be in a place and the shares would be able to head higher again. A daily close above $3.40 would therefore be the buy trigger.
Michael Gable is managing director of Fairmont Equities.
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