Analysts weigh in on BHP spinoff South32

In April BMO Capital Markets initiated coverage of BHP Billiton (LSE: BLT) spin-off South32, (LSE: S32; US-OTCBB: SOUHY)commenting that the shares of the newly created mining company “represent a more compelling investment than BHP Billiton at current price levels, after considering differences in commodity exposure valuation, cash-generation potential and future growth opportunities.”

The “key attraction” to South32, BMO analysts Edward Sterck and Alexander Pearce argue in a lengthy research note, is its free cash generation potential, which they estimate will reach US$1 billion in fiscal 2016, for an 11% yield. BMO forecasts that the company will generate “more than US$0.8 billion of net free cash flow (i.e., cash flow before debt movements and dividends) in fiscal 2015, rising to US$1.6 billion in fiscal 2018, for a net free cash flow yield of 10% to 19%.”

Other positives, the BMO analysts say, include a strong balance sheet, with net debt of just US$0.7 billion, and “the potential for some M&A interest,” based on a Bloomberg report that the company could be of interest to Mick Davis’ X2 Resources. “Buying S32 would certainly provide a shortcut, as X2 attempts to build a new mid-tier mining company,” Sterk and Pearce write.

The negatives, they say, are its “significant sensitivity to commodity price contractions,” and particularly to aluminum (they calculated that a 10% drop in the price of aluminum reduces South32’s earnings before interest, taxes, depreciation and amortization by 8%), its low dividend yield of 3.4% in fiscal 2016 and its average return on invested capital.

Headquartered in Perth, Australia, South32 has a US$9.6-billion market cap, and “is one of the most ‘diversified’ of the large-cap miners in terms of commodity exposure, second only to Anglo American,” the BMO report states.

South32’s valuation is mainly in Australia (45% of its gross net present value [NPV]), with 19% in South Africa, and the rest in Colombia and Brazil. In terms of commodities, BMO calculates that 40% of South32’s gross NPV stems from aluminum and alumina, with the rest split between manganese (16%), metallurgical coal (14%), thermal coal (10%), silver/lead (12%) and nickel (8%).

BMO estimates South32’s total NPV is US$13.2 billion, or £1.63 per share, and the brokerage has a target price on the stock of £1.20 per share. At press time, South32’s shares were trading at £1.12 per share in London.

According to Paul Bartholomew, managing editor for Australia at Platts, a unit of McGraw Hill Financial, South32 will “take its place among the world’s 20 largest mining companies.” Bartholomew points out in a research note that “there are few comparable sized mining companies in Australia (where it is expected to be in the top 30 ASX-listed companies) in terms of valuation, leading analysts to liken it to global miners such as Teck and First Quantum Minerals.”

While South32 is made up of what BHP Billiton identified as its non-core assets, Bartholomew notes that the new company’s mines, smelters and projects “have not been neglected in terms of investment,” and estimates that they received $9 billion in capex between 2009 and 2013.

What’s more, “receiving greater love and attention could result in improved efficiencies and productivity at South32’s mines and smelters, while a shift towards regional rather than global operational models could help bring down labour costs, along with other savings,” he writes.

South32 is also the world’s largest producer of manganese, a component in making steel. And while he concedes the market is oversupplied — putting downward pressure on prices — demand is certain to grow in countries like China, India and other developing nations that need better quality steel.

“High-strength structural steel typically contains higher manganese content,” he explains, “and China will use more of this material as it improves the quality of its construction steel, especially in earthquake-prone regions.”