South 32: Interim result 2018
Despite a cash pile that grew to US$1.4bn, higher dividends, a special dividend and the promise of fatter returns, South32’s interim result was disappointing.
The numbers themselves were healthy. Two years ago, South32 generated about US$500m in earnings before interest, tax, depreciation and amortisation (EBITDA) in its first year as a listed miner; over the past six months it made US$1.1bn.
Cost reduction has been a large part of this success. Freed from the neglect of BHP, South32 has found efficiency gains and ways to improve productivity that its old master wasn’t bothered with.
Higher commodity prices have also helped, with manganese, coal and aluminium all showing significant gains.
Yet for all that good news we note two specific concerns.
The first is one we flagged earlier: after savagely driving down costs for years, South32 is now facing cost escalation.
Every mine and every commodity group (except the Cerro Matoso nickel mine) registered higher unit costs. Illawarra Coal saw unit costs double.
This is partly cyclical. As commodity prices have risen and mining profits have increased, competition for contractors and equipment is starting to push prices higher. That's happening across the industry.
Yet much of South32’s cost problem is specific to it. At Illawarra, for example, operating problems have forced costs higher while energy prices and South African politics have done the same elsewhere in the portfolio.
Margins have held up rather well as commodity prices have also risen but there is concern that the cycle of ever lower costs is now over.
The other concern is with South32’s best asset, Cannington. This glorious mine has been in production for twenty years and, for most of that time, has generated sensational return on assets without consuming much capital.
As Cannington approaches its twentieth year, it will require more expenditure to maintain.
More difficult parts of the orebody will now be targeted and, as resources deplete, costs will rise, especially as reserves are replaced.
There were two other developments to note. South32 has flagged it will sell its South African coal interests in either a trade sale or another spin-off.
This is understandable. South African coal has been a profitable asset, protected by generous power contracts and vital export deals. But mining in South African is getting difficult: power is expensive and sometimes scarce, and the political environment is getting riskier.
Getting out of South African mining will have a significant impact on South32. It will dramatically cut exposure to coal and open the way to new mines and, most likely, acquisitions.
South32 has made investments in several miners and has been open about ambitions in base metals, especially copper. Management has a strong track record of capital allocation so ambition in this case doesn’t frighten us the way it usually does in this industry.
On an earnings basis, South32 appears cheap, trading on a price-earnings of 12. However, higher costs and changes to commodity prices mean we shouldn’t extrapolate today’s profits. On an asset basis, South32 remains at or slightly above fair value.
We are fans of the company's management but no-one can overcome geological constraints. South32’s assets at Cannington and Illawarra are bumping up against theirs and, with the portfolio shifting, we’re narrowing our hold range and sticking to SELL.
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