South32
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 29 December 2015, 8:56 AM
- Sectors Covered:
- Mining, Energy
Key points
- We believe South32 (S32) will offer an attractive mid-cap exposure to the resource sector - but only once its key commodity markets show some signs of stabilising.
- Despite a surprisingly good cash flow performance and balance sheet, S32 remains burdened by a collection of market exposures it 'inherited' from parent BHP, all of which remain on a clear downtrend.
- S32 holds large leverage to falling commodity prices. Accordingly, we recommend waiting for the price environment to show clearer signs of stabilising before adding to positions.
Can't fight the falling tide
The severity of the current downturn in commodities has eroded our short-term conviction in the sector. Despite having a mature asset base with incremental margin growth seeming likely, we expect S32's key markets (aluminium, manganese, thermal coal, silver and nickel) will continue to struggle. In addition to the weakness in commodities, we continue to observe sustained retail selling from exiting BHP holders. Against this backdrop we expect S32 will struggle to outperform its larger peers in the short term.
Given the excessive short-term uncertainty around commodities, coupled with S32's sensitivity to commodity prices, we have applied a 0.7x risk adjustment to our sum-of-the-parts valuation.
Aluminium to remain a key struggle
A key strategic weakness for S32 is its mix of commodity exposures, which it inherited from BHP (as opposed to being able to choose markets in which to participate). While S32's basket of commodities remains depressed, we expect S32's largest division (aluminium/alumina) in particular will remain subdued over the medium term, with low-cost Chinese supply growth of the primary metal expected to offset any growth in demand. This will likely preserve the already long-run surplus in the aluminium market.
On the bright side
If broader sector conditions were to start showing signs of stabilising we would reconsider our recommendation on S32. While it is leveraged to the falling market, there also appears to be very little priced in at current levels with S32 trading on 3.2x EV/EBITDA (compared to BHP/RIO on ~7x). As a result, S32 would likely present a strong mid-cap exposure to a sector recovery scenario (if and when that happens), supported by a healthy balance sheet and cash flow generation. However, in the absence of a sector recovery, and given S32's leverage to commodity prices, we remain cautious.
We initiate coverage with a Hold recommendation.
More information
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