South32
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 24 October 2016, 10:32 AM
- Sectors Covered:
- Mining, Energy
Key points
- South32 (S32) reported a mixed 1Q17 operational result.
- The majority of divisions posted results within 2-3% of our estimates with the notable exception of met coal, which was a material miss (-30%).
- Regardless of the disappointment at Illawarra (which is back at full production), S32 still added to its net cash position faster than we expected.
- We expect S32 will generate US$877m FCF in FY17 despite a low-cycle EBIT margin of 11%, indicative of strong performance at the bottom of the cycle.
Consistent quarter outside of Illawarra
A reasonable quarterly performance across most of S32's divisions, with all coming within 2-3% of our forecasts with the notable exception of metallurgical coal (Illawarra coal). Due to geological difficulties that had to be worked through, the planned longwall move took longer than expected leading to a significant loss of productive time. As a result, metallurgical coal production for 1Q17 came in at 1,437kt, approximately 30% below our estimate of 2,040kt. S32 downgraded its FY17 met coal guidance accordingly to 7.55kt, while we similarly adjusted our numbers to fall in line (given the project is now back at full production with no further longwall moves planned in FY17).
Management discipline a big plus
S32 has shown considerable capital discipline in allowing its balance sheet strength to build since being spun off from parent BHP Billiton. Despite the lost production at Illawarra, S32 managed to outpace our estimates, finishing the quarter with a net cash position of US$554m (vs Morgans US$478m). With recent industry errors from the last cycle at the forefront of its thinking, S32 has shown a determination to create value with the drill bit as opposed to risking mass-value destruction through a transformational acquisition.
Hold it for its cash flow leverage
In FY17 we expect S32's FCF yield will exceed 10%, despite several of its major commodity exposures still trading near bottom-of-the-cycle levels (indicated by FY17 expected EBIT margin of 11% versus FCF of US$877m). We believe a continuation (and broadening) of the commodity cycle will especially benefit those established resource franchises, like S32, that are in a position to capitalise on new growth opportunities in recovering markets.
Investment view
South32 (S32) remains one of our most preferred resource sector exposures, due to:
- robustness of its overarching strategy;
- cash flow sensitivity to any recovery in commodities exposures, and;
- strength of its balance sheet.
The key risk to our call is the potential for commodity markets to underperform our forecasts.
However, S32 is trading approximately in line with our revised price target and as a result we maintain our Hold recommendation.
More information
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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.