The Global Investor has written recently about his bullish outlook for commodities, driven by China’s increases in industrial production. The S&P GSCI Industrial Metals Index is up about 50% since March of this year. Metals markets have a tendency to trend as when supply and demand are out of sync the balance doesn’t correct quickly. One way to play the ongoing bull market is through the mining sector. The Global Investor is bullish on the world’s largest miner BHP Group (NYSE:BBL), but for investors who might not like BHP’s exposure to iron ore or petroleum, South32 Limited (OTCPK:SOUHY) is another diversified mining group with bullish fundamentals worthy of consideration.

The company has strong exposure to the low carbon economy megatrend through its attractive portfolio of aluminum and alumina, nickel, and zinc/lead/silver groups making up 54% of its full year 2020 underlying EBITDA. The other 46% of 2020’s underlying EBITDA comes from the steel raw materials metallurgical coal and manganese ore. The reason for using “underlying EBITDA” is because South32 is undergoing ongoing rationalization of its portfolio, with low-returning assets in the process of being sold, freeing up cash for shareholder returns and value enhancing M&A. So, not only does South32 benefit from a commodity bull market tailwind, especially in its low-carbon economy metals, but the self-help program and shareholder returns are non-macro compelling reasons to believe in a multiple re-rating over the medium term.

Company background

South32 Limited is listed on the Australian Stock Exchange, London Stock Exchange, and Johannesburg Stock Exchange with an American Depositary Receipt traded over the counter.

The company was born from the demerger of noncore assets from BHP in 2015. As with many demergers, South32’s stock price initially fell as investors who owned BHP and got South32 stock they didn’t want sold. At one point, the stock was down 32%, bringing about the unfortunate joke that the company’s name was rather appropriate. However, once the technical selling abated and management had had the chance to show the focus they were putting towards BHP’s unwanted assets, the stock performed very well over the 2016-2018 period. Macro considerations played on the stock price in 2019, and in 2020, the stock has rebounded in line with industrial metals.

South32 is made up of BHP’s former aluminum and manganese businesses and the South African energy coal and New South Wales metallurgical coal businesses. It also owns the Cannington silver/lead/zinc and manganese mine in northwest Queensland and the Cerro Matoso nickel mine in Colombia. The company acquired Arizona Mining in 2018, which brings with it the high-grade low-cost Hermosa deposit in the U.S. The South African thermal coal assets are being disposed of with completion by year-end hoped for. South32’s operations are generally in the lowest half of their industry cost curves. South32’s group weighted average reserve life and resource life are 15 years and 40 years, respectively.

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Review of assets

South32’s aluminum operations are in Australia, South Africa, Mozambique, and Brazil. The aluminum smelting and alumina refining assets are generally in the bottom half of their respective industry operating cost curves. South32’s Cerro Matoso nickel mine is in the second cost quartile of the cost curve. New South Wales metallurgical coal has suffered from production issues but is returning to a more competitive position on the cost curve as operations recover.

The highest-quality operations are probably the Australian manganese and Cannington silver/lead/zinc, both of which are in the lowest-cost quartile of the cost curve and have historically generated solid returns. Cannington is a capital-light mine and the highest-returning asset, with adjusted returns on invested capital base averaging about 100% for the five years ended fiscal 2019 due to exceptional silver grades and a largely depreciated capital base.

The Global Investor expects strong returns to continue, thanks to a bullish, emerging market demand-driven view on silver prices. However, Cannington has a reserve life of less than 10 years. There may be some benefit from the conversion of resources to reserve, but grades are lower. Lower grades will result in lower profits if reserve life does get extended.

The addition of the Hermosa Project with the acquisition of Arizona Mining in 2018 brings a low-cost zinc/lead/silver asset, similar in quality and output to Cannington once developed. High grades support cash costs in the lowest quartile of the zinc cost curve, and resource life is long, sufficient for about 30 years of production. Acquisition of Hermosa boosts the overall quality of South32’s assets, and in isolation, the mine once developed may be worthy of a narrow moat. However, once developed, Hermosa will account for less than 20% of the combined invested capital base, limiting its influence on the broader group returns. The Hermosa project is expected to be developed by 2022, and cash costs are expected to be in the lowest quartile of the cost curve.

Management

It is fair to say management has done a pretty good job with the hand it’s been dealt in the past five years. South32 started with a solid balance sheet, with net debt of only about $400 million at end June 2015. But the financial position has generally improved, with the firm retaining net cash since 2016. That is appropriate, given the operating leverage of South32’s mines, relatively high capital intensity and cyclical commodity prices. Another reason to retain a strong balance sheet is to have the capacity to invest. South32 is slowly shaping the portfolio it has into something more much more attractive. The sale of the challenged South African thermal coal assets is a step in the right direction as it is South32’s weakest asset. Its sale, along with the development of the high-grade Taylor zinc deposit, should see incremental improvement in the portfolio’s competitive position. Getting out of thermal coal removes some carbon risk and sovereign and operating risks in South Africa.

In terms of investment, The Global Investor thinks South32 has generally managed to avoid materially overpaying for assets acquired or built. The approach to growth has been considered and patient. And shareholder distributions have correctly been a priority. South32 has flexed shareholder returns with the company’s ability to pay, which is appropriate.

Some analysts are critical of the more than $1 billion applied to shareholder buybacks between fiscal 2017 and fiscal 2020 (the share buyback program is still active), arguing special dividends would be better, which avoids the need to form a view on the value of shares being bought back. The Global Investor’s view is that directing excess cash to shareholder distributions in any form is a good thing, especially when cash flow is relatively strong. The Global Investor is encouraged by South32’s shareholder returns and competition among potential investments for excess capital, with the aim of maximizing total shareholder returns. Many mining company executives prefer to blindly spend on exploration, development and M&A – to have more toys to play – which comes at the expense of shareholder value.

The minimum 40% dividend payout ratio adds further discipline to investment expenditure. This dividend policy recognizes the importance of dividends to long-term returns, while allowing an appropriate retention of earnings, given South32’s capital needs and investment opportunities and allows dividends to rise and fall with the inevitable commodity price cycles.

The ultimate challenge for strategy from depleting and high-capital intensity operations is, of course, capital allocation. This is always a tough issue in the mining industry, but South32 looks to be allocating capital in a sensible way, focusing on low-cost production in commodities that see strong demand growth ahead and weighing up shareholder returns with capital expenditure.

Financial Health

South32 is in sound financial health, and the Global Investor expects this to be sustained. The company kicked off in 2015 with net debt of just $660 million. At the end of March 2020, the company had modest net cash of less than $0.2 billion. This conservative balance sheet is sustainable and appropriate, given the operating leverage and exposure to cyclical commodity prices.

A major acquisition is the key risk to the balance sheet; however, so far management has trodden carefully, and there is no reason to expect it will stray from this prudent strategy. A desire to diversify earnings into new commodities and the need to eventually replace reserve depletion do present a longer-term risk for risky M&A but to date, South32 has been prudent with its balance sheet and has generally retained net cash.

Risks

While the sound balance sheet is prudent, commodity prices will be the key driver of future returns for shareholders.

South32 faces environmental and operational risks associated with mining, as well as the country-specific risks associated with some of its assets with more than one-quarter of assets are in locales marked by higher sovereign risk. This includes the majority two thirds of aluminum at Hillside in South Africa, Mozal in Mozambique, and Alumar in Brazil; a minority 20% of Manganese at Hozatel and Metalloys in South Africa; all of the company’s thermal coal in the Witbank coal field east of Johannesburg in South Africa; and all of the company’s nickel at Cerro Matoso in Colombia. Government risk includes changes to taxation and royalties, a typical occurrence during commodity booms. In the longer term, the threat of environmental and community groups to new mining approvals could erode South32’s social license. This threat appears greatest in first-world countries and for coal mining, but the group is addressing this by exiting thermal coal.

South32 has about $1.5 billion in mine rehabilitation provisions, a considerable future liability that could be a future cost to shareholders. Some of this will go with the proposed sale of the South African thermal coal assets.

South32’s average reserve life of about 15 years means that significant effort is required to replenish life through exploration, acquisition, and development of new mines, adding to capital allocation risk. Capital allocation is key to South32 in the long term, and its status as a cyclical miner with meaningful operating leverage brings the risk that management will be optimistic and overpay for acquisitions or new developments during the boom peaks. However, as mentioned, we have yet to see this happen at South32. The Arizona Mining acquisition goes some way to extending South32’s average life and brings a relatively high quality, low-cost mine.

Conclusion

South32 currently trades at a discount to its peers with a price to book ratio of just 0.3x and price to sales at 1.0x. The ongoing rationalization of South32’s portfolio, along with its shareholder value-driven management team and prudent corporate strategy set the stage for a re-rating of the valuation. The other medium-term catalyst for share price strength is the group’s attractive exposure to the low carbon economy metals of aluminum, nickel, zinc and silver. These two factors, coupled with the China levered steel raw materials exposure in a year China will likely boost its infrastructure spending, should drive the company’s outperformance as well as provide investors with a good inflation hedge.

 

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SOUHY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.