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Key Financial Data Open Tell me if you’ve heard this one: a mining company that had cut capital expenditure to the bone now faces limited production growth so decides to venture into a foreign land – where it spends more than a billion dollars buying a mine with promise but no output or revenue.
We’ve seen this story many times before and we know how it usually ends: with disaster. This time – gulp – things might be different.
South32 has offered to purchase the 85% of Canadian listed Arizona Mining that it doesn’t already own in a cash deal that values the explorer at US$1.4bn.
Management at Arizona, who own 34% of the stock, have already agreed to the deal and, combined with South32’s existing 15% holding, the bid should succeed.
Arizona has uncovered Hermosa, which appears to be a high-grade multi-metal mine dominated by zinc and silver. Although still in development, the mine appears to be remarkably similar in geology and metallurgy to South32’s own Cannington mine, which likely explains its interest.
Cannington, as we have previously noted, is a wonderful mine. Over a near 20-year life, it has consumed barely any capital and only cost $500m to establish.
For that sum, South32 has been gifted up to US$1bn in annual free cash flow. Short of Norlisk Nickel’s giant Siberian mine or BHP’s own Yandi iron ore mine, no other mine in the world can come close to generating such returns. Yet resources are dwindling and Cannington is now in its twilight years. Another like it would be a worthy prize.
It’s too early to tell whether they have found that but, so far, the resource appears attractive. Upfront capital costs should only be about US$500m for a 30-year mine life and, if developed, this would be one of the world's lowest-cost producers of zinc.
The orebody's limits are yet to be breached and it is potentially larger than Cannington's. It comes with rich underground potential that could turn an already impressive resource into an astonishing one especially if, as management has hinted, it also hosts copper.
South32 is paying a 50% premium to Arizona’s last traded price, which probably had already baked in some takeover potential. This is no bottom of the cycle bargain buy.
Yet measure the cost today against the potential tomorrow and this looks like an excellent deal. At this early stage the mine is thought to be worth a net present value of just under US$2bn but that doesn't include an optimised mine plan or an expanded resource base.
An exploration company with no revenue would mine the orebody differently to a large cash rich mining house. Rather than focus on early revenue and production, South32 should be able to focus on expanding the resource base and extracting maximum value from the mine. In short, it's probably worth more under South32's ownership than Arizona's. This deal gets a big tick from us and highlights exactly how miners ought to treat acquisitions.
South32 has been sitting on net cash for some time. Although its asset base is firing and generating strong free cash flow, it boasts skinny mine lives so there was some pressure to correct that flaw. We've seen these conditions lead to silly deals in the past.
Not this time. South32 hasn’t just bought a random mine to plug a production hole – it has found an asset that mimics the geology, metallurgy and production of one of their own, to ensure they can add something to the asset others cannot. They have bought with an edge rather than merely an open wallet.
Hermosa now joins the recently acquired stake in the Eagle Downs coking coal mine and South32’s stake in Trilogy Metals, as a fine collection of attractive growth options. Add to this a plan to demerge South African coal assets, and South32’s asset base is better now than when we slapped our Sell on the stock back in November 2017.
That is not enough though, at this stage anyway, to change our recommendation. This is a decent quality miner with high quality management but we must remember it is also a mining business and times are good. They won't always be.
With today’s price fully valuing the business and new growth options still in their infancy, we’re comfortable increasing our Buy price slightly, from $1.90 to $2, but we're sticking with SELL.
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