South32 share price analysis

South32 Share Price and Business Analysis – Dividend Cut Ahead

When it comes to value investing, a place where one can currently find value is the commodities sector. Commodity stocks offer value because few look at them because it is boring, not sexy and extremely volatile, something investors don’t like as most are focused on short term performance and certainty. Just a look at the chart of the South32 share price analysis we are going to do today explains the situation when it comes to investing in commodities.

south32 share price
South32 share price movement – Source: CNN Money SOUHY

Before analyzing South32 share, it is important to note that South 32 Limited (SOUHY) was spun off from BHP Billiton (BHP) in 2015 where BHP got rid of all the non-core assets. Since then the stock first went straight down as those that got it, didn’t know what to do with it and the situation for commodities wasn’t positive during 2015. During 2016 and 2017 it went massively up as commodities rebounded and the world didn’t end as for 2015 predictions, only to start dropping again since the start of 2018 and then some more given the latest corona virus crisis. All in all, since the IPO, the stock is at the same level so it is interesting to see whether it is an opportunity or not.

South32 share price analysis – business overview

South32 is a globally diversified mining and metals company producing bauxite, alumina, aluminum, energy and metallurgical coal, manganese, nickel, silver, lead and zinc in Australia, Southern Africa and South America. Sounds extremely diversified but it isn’t; it is an aluminum, manganese and coal producer as 89% of EBITDA comes from related products.

south32 share price forecast
Source: South32 2019 results presentation

The business is a typical diversified mining business where the investment returns depend on the price of the commodity and few other factors.

South32 stock – investment analysis

When it comes to investing in miners, one has to calculate the future free cash flows from a cyclical perspective. Thus, estimate the long-term average price of a commodity and then plot that to the specific business a company has, to see when a stock might be undervalued. What helps in such an analysis is the above margin distribution shown in the chart.

Alumina margins have been as high as 42% in 2019 but that is likely to change as prices have dropped significantly since South32’s fiscal 2019. Current LME prices are $290 per ton. If South32 had a 42% margin on an average price of $350 in 2019, operating mining costs should be around $200 and thus keep the operations profitable even at current prices.

south32 share price analysis
south32 share price drop

However, we should expect lower margins than 42% and consequently also a lower EBITDA level in FY 2020. 2019 alumina EBITDA was $680 million and given the margins and decline in price for FY 2020, EBITDA should be about half of that. A back of a napkin initial analysis estimation would give $300 million of alumina EBITDA.

When it comes to metals and mining, the key is the cost curve and South32 with costs of about $200 per ton, should be quite low on the global cost curve which provides it with a margin of safety.

south32 share price analysis
Smelter grade alumina cost curve – Source: Alumina Limited

Given the low position on the cost curve, it is likely that South 32 will make little or no money in bad years, but doesn’t lose much on alumina, while it makes good money in good years. However, we should not expect the company to make any good money soon given that the market will be in oversupply in 2020 and the current situation in China, the main driver for the market, certainly doesn’t help.

south32 alumina
Alumina 2020 market forecast – Source: Alumina Limited

The second business is manganese with margins as high as 60% and a very steep cost curve.

South32 manganese
Manganese cost curve and price – Source: South32

A steep cost curve means that if demand is higher than supply, prices might spike as the market price is set by the marginal producer. Thus, we could see manganese prices close to $10 as it was the case in 2016 and 2018. The current level is $3.56 while the average over fiscal year 2019 was above $5. Thus, as it is the case for alumina, we can expect much lower margins for South32 in fiscal 2020.

South32 dividend
Manganese price – Source: Jupiter Mines

If they had a margin of 62% on a price of $5.5, the current average price of $3.5 would still mean a good margin as their production cost is closer to $2.2. However, cut more than half from the profits, actually at least two thirds. From about $650 million we will have about $200 million in EBITDA remaining. If and when manganese prices rebound, we might see higher earnings, but we could also see a very negative situation like it was the case in 2015 when manganese prices went below $2 which is the cost of production for the company.

However, the manganese cost curve gives an indication that prices might be stable around $4 which means the average EBITDA should be around $300 million.

The situation with coal is similar to the above explained situation with alumina and manganese. Coal prices have been down and therefore we should expect a decline in the $400 million EBITDA South32 reported in 2019.

Coal prices – Source: Trading Economics

Given the extremely low coal prices and already low EBITDA margin of 4% in 2019, it is unlikely to see any profits there, plus they are selling their coal assets in South Africa.

Summing it all up, in 2019 the $2 billion in EBITDA led to almost $1 billion in free cash flows. If I half the EBITDA for 2020, I should more than half the cash flows which would also lead to a dividend cut and slowdown in buybacks – never a good sign.

South32 is an interesting business but keep in mind it is a spin-off where BHP got rid of the non-core assets (read – lower quality). On the other hand, the company has no debt, pays a hefty dividend in good times and is unlikely to go bankrupt thanks to the cash position of $504 million. Also, the equity is $10 billion compared to the $8.3 billion market capitalization measured in US dollars.

Another thing when it comes to analyzing miners is life of mine. For how long will the company be able to mine the current deposit at the current rate and cost? With South32 it is a mixed bag with relatively short life spans considering the fact that South Africa coal has been sold.

South32 life of mine – Source: Annual report 2019

The problem with mines that have a short life span is that you have to replace them to keep the same production levels and present them to investors. That is exactly what South32 did when it acquired Arizona Mining for $1.5 billion for a project that is not even at pre-feasibility level, a risky thing to do in the mining industry.  

South32 Arizona mining acqusition
South32 Arizona mining acqusition

South32 stock investment conclusion

I must say I am not impressed with the company and BHP’s spin off was a smart thing to do for BHP to improve their financial metrics and focus on more profitable ventures. Therefore, South32 share will always be in a limbo of good, but not great. The share will consequently be volatile following commodity prices but we shouldn’t expect any miracles. Even if manganese prices go up, the Australia Manganese production will be there for only 6 years eliminating long-life upside in case of a structural shift within the sector.

South32 share price forecast and dividend

As for a South32 share price forecast, it all mostly depends on commodity prices, there is no special natural advantage that would make this keep on giving dividends and growing them without significant capital investments that take out from your dividends.

When comparing South32 to Southern Copper for example, all the factors are in favor of the latter, form life of mine, sector tailwinds and long-term profitability alongside growth. So, if you decide to invest in commodities, pick quality first, it will make you sleep better.

Sven Carlin is an independent stock market researcher at Stock Market Research Platform and passionate investor sharing his knowledge also on YouTube.