South32: Cycle acceleration offsets Hermosa slowdown

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
18 January 2022, 10:00 AM
Sectors Covered:
Mining, Energy

  • A mixed update with increases in schedule and expected capex/opex for Hermosa, while operating scale and long-term base metal outlook both move higher.
  • Unlike much of consensus we were already valuing Hermosa using a conceptual DCF, leading to a small net change to our valuation post the Taylor Deposit PFS.
  • Nearby prospectivity could see upside risk to Hermosa valuation.
  • South32 (ASX:S32) remains a top sector preference, enjoying a support upcycle in metal prices. Maintain our Add rating, with upgraded (login to view) target price.

Hermosa update: Taylor Deposit PFS & Clark Scoping Study

S32 released the results from the Taylor Deposit Pre-Feasibility Study (PFS) and Clark Deposit Scoping Study.

The largest highlight was the size of the increase in development capex. PFS estimates for the development of Taylor’s came in at ~US$1.7bn, 70% above where we estimate consensus to sit (based on Visible Alpha data). The change was attributed to increased scope of dewatering and industry-wide cost inflation.

Production-related expenses on balance came in close to our early assumptions. Based on Arizona estimates, comparable projects and our assumptions, we had been expecting mining cost of US$45/t (vs PFS estimate $35/t), processing cost of $15/t (vs PFS $13/t) and G&A of $2/t (vs PFS $10/t). While other opex ($23/t vs MorgE $8/t) was well above our expectations.

A solid positive in the PFS was the increased throughput, now estimated at 4.3mtpa, vs original Stage 1 of 3.3mtpa. Also, other nice positives in the Taylor’s PFS were higher mill recoveries and metal payabilities than we had assumed.

In terms of timing, management acknowledged that COVID and dewatering have combined to push out the schedule for developing the Taylor’s Deposit. With the project acquired in 2018, progress has been slow with S32 only completing the PFS in early 2022. First ore is now expected in 2027 (vs MorgE ~2025).

The Clark Deposit Scoping Study meanwhile has highlighted potential for a separate development that could see battery-grade manganese produced.

S32 is hopeful that regional exploration could unlock value upside that reverses the decline delivered from budget and schedule slippage. In particular S32 is excited about the nearby Peake and Flux Prospects.

Analysis

The deterioration in Hermosa fundamentals is disappointing. Especially such a large increase in capex budget. But the ultimate impact to our investment view is small – and offset by the continuing earnings upgrade cycle across metals. 

Forecast and valuation update

We have updated our Hermosa DCF to reflect the PFS estimates for Taylor’s. While not including any value for the Clark Deposit or regional exploration targets.

We have applied upgraded house commodity price forecasts (summary further) which has seen a net increase in our S32 target price to (login to view).

Investment view

S32 is one of our most preferred mining sector exposures.

We see S32 as holding superior commodity and geographical diversification (especially after exiting South African thermal coal), impressive earnings momentum across several segments, attractive earnings power (group EBITDA ~50%), solid near-term dividend (+5%), and an affordable EV/EBITDA of 4.4x FY23F (vs BHP/RIO/FMG on 6.2x/6.4x/7.4x)

We maintain an Add rating with a valuation-derived target price of (login to view).

Price catalysts

Q2’FY22 and 1H’FY22 highlighting continuing strong spot fundamentals.

Updates on Sierra Gorda.

Risks

COVID related risks to operations and demand drivers for metals.

Execution risk around growth.

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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.

Solid top-line outcome: BAP’s 1Q22 revenue was flat on the pcp, an extremely resilient result given the extent of lockdowns in the period (~70% of stores impacted) and the strength of the pcp (cycling 27% growth). Composition comprised: Trade +2%; NZ -10%; Retail -12%; and Specialist Wholesale +7%. Overall, BAP stated that non-lockdown areas are outperforming expectations. ▪ 1Q22 trade & retail: Trade/Burson revenue was up +2% on the pcp (LFL sales - 1%; cycling 8% pcp); NZ/BNT revenue was down -10% (LFL sales -15%; cycling +4%); and Retail/Autobarn revenue was down -12% (LFL sales -16%; cycling +36%). Within the Retail segment, online sales were +80% on the pcp. Stores percentages impacted by lockdown were: Trade 70%; NZ 100%; and Retail 50%. ▪ Specialist segment results: Specialist wholesale revenue is up 7% on pcp, with Auto electrical/Truckline divisions ‘performing strongly’; and WANO underperforming. ▪ GM pressure expected to be temporary: BAP stated GM was stable across Wholesale and NZ (45% of FY21 revenue); and down ~50bps Trade and Retail (~55% of FY21 revenue), driven by promotional and online pricing in lockdown areas (we assume no margin pressure witnessed in non-lockdown areas). BAP expect margins to revert once lockdowns ease. ▪ The cost base has increased vs pcp, a function of duplicated DC costs (commencement of new VIC DC), and higher group and team member support (covid related) costs. BAP noted FY22 store rollouts and refurbs are on track.

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