South32: Portfolio changes adding up

About the author:

Author name:

By Adrian Prendergast

Job title:

Senior Analyst

Date posted:

08 December 2021, 12:00 PM

Sectors Covered:

Mining, Energy

• We upgrade our rating on South32 (ASX:S32) to Add, from Hold, after including the Sierra Gorda acquisition in our estimates as it nears completion.
• A solid acquisition introducing copper, molybdenum and gold to the portfolio.
• Immediately earnings accretive, +12% to FY23F EBITDA.
• S32 continues to make smart moves at a portfolio level, while promoting its position as the most diversified miner on the ASX (easily).
• A value and earnings accretive transaction that adds to S32’s investment appeal.

Event: Acquiring 45% interest in Sierra Gorda

S32 is in an advanced stage of acquiring a 45% interest in the 180,000tpa Sierra Gorda copper operation in the mining-heavy Antofagasta region of Chile.

Strategy wise S32 continues to hit the right notes, gradually working its way out from under the portfolio it inherited from parent BHP in 2015. S32 has increased its base metals exposures while reducing coal, and in the process improving the quality of its earnings, cash flow and ESG profile.

The US$1.55bn acquisition is not transformative, but combined with growth assets like Hermosa (zinc-lead-silver), S32 is upgrading its base metal business.

Analysis

We estimate group EBITDA margin to increase from 39% to 43% while adding an extra ~US$300m to FCF which we now estimate at US$1.9bn in FY23F (first full year of ownership).

The acquisition also adds low-cost organic growth potential if the JV can execute on their intention to lift output from Sierra Gorda. The operation had a troubled performance early in its life before more recently starting to hit its stride.

While at a high level S32 is incrementally improving the position of its business. Improving its exposure to ‘future-facing’ commodities like copper, exiting ‘sunset’ commodities like thermal coal, and improving its country risk (adding Chile while removing South African thermal coal and manganese alloy).

Acquiring Sierra Gorda also improves S32’s long-term production profile, offsetting declines elsewhere in the business with long-life production (20+ years).

Forecast and valuation update

We have included Sierra Gorda into our forecasts, and made a number of adjustments to production forecasts across S32’s business as part of a review of assumptions (summary of changes further).

Net of these changes our valuation on S32 has been lifted to (login to view), with EPS increasing in FY22-24F by +10%/+25%/+21%.

Investment view

We upgrade our recommendation on S32 to Add, from Hold, seeing an attractive investment proposition of upside to our target, an attractive 7.6% dividend yield FY22F, and capacity to keep pursuing new growth.

S32 also boasts superior diversification compared to its fellow ASX mining peers (with BHP divestments in oil & gas and coal, RIO’s oversized iron ore exposure, and FMG’s single exposure to iron ore and ground-floor entry into renewables).

Price catalysts

Sierra Gorda deal completion.

Hermosa progress (Taylor Deposit PFS and Clark Deposit scoping study).

Half year earnings and dividend result.

Risks

Execution risk on Hermosa and Sierra Gorda.

COVID-19 related risks to demand drivers for key metal exposures.

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