BHP Billiton (BHP), the largest miner in the world by market capitalisation as of 2015, decided to demerge certain assets into a new company, named South32 (S32). S32 came into existence last year, with its first day of trading on 18 May 2015. Under the terms of the demerger, existing BHP shareholders received one S32 share per BHP share held. The reason for the demerger was to simplify BHP's operations and allow it to focus on its core areas of iron ore, copper, coal, potash and oil. S32, therefore, received alumina, aluminium, manganese, nickel, silver, lead, coal and zinc assets spread across five different countries. The new company would be free to map its own course to attempt to maximise the value of its assets while BHP would be free to concentrate on its strongest areas. The question is, has BHP simply offloaded its lower quality assets into a new company or is S32 a high quality mining company in its own right?
As a result of unlucky timing, within a couple of months of the demerger, BHP notified S32 that a US$1.9bn write-down would be recognised on the S32 assets. Further write downs of US$1.7bn occurred earlier this year as a result of the weak commodity price environment. Although write-downs are non-cash charges (simply meaning that the value of an asset as recorded on the company's balance sheet is reduced), they imply that the value that can be extracted from the asset over its remaining life is lower than previously expected. The silver lining is that while write-downs reduce profit in the period that they are taken, they actually increase profits in future periods due to reduced depreciation expense. After an initial jump, the share price began declining only a couple of days after the start of trading and continued for the rest of the year, reaching a low of $0.89 in January 2016 compared to a high of $2.45 reached soon after the demerger. Notwithstanding the significant impairments, the poor share price performance of S32 during this time more likely reflects the weak commodity price environment rather than problems with S32's assets.
During the current calendar year, commodity prices have performed an impressive rebound. As an example, both aluminium and silver prices are well off the lows reached at the beginning of the year, although they are still nowhere near former highs. The general sentiment surrounding commodities has also improved and may have been the catalyst for the strong S32 share price performance this year, with the share price today rising strongly and starting to close in on the all-time high. For investors, the benefit of periods of weak commodity prices is that it forces mining companies to work hard to reduce costs and improve operating efficiency. S32 is no exception and has worked hard on cost cutting with a goal to reduce costs by US$300m. The upside of this is that when (if) commodity prices rebound, the company is well positioned to extract maximum profit from the increased sale prices.
Strong companies tend to look for good merger and acquisition (M&A) opportunities when sentiment in a sector is depressed and valuations are low. Credit Suisse yesterday announced that they believe S32 has been too slow to respond to potential merger and acquisition opportunities that arose as a result of low valuations on potential targets due to commodity price weakness. Whitehaven Coal (WHC), for example, is cited as a potential target for S32 however the 50% increase in the WHC share price in the last two weeks makes such a deal far less attractive. Credit Suisse, therefore, believes it is possible that S32 will perform a capital return in the future if it can't find a better way to spend the cash.
With a very limited independent performance history, it is difficult to evaluate S32 on the basis of trends in operating metrics (revenue, earnings etc.). The results for the half year ended 31 December 2015 show a loss of US$1.7bn although this includes the US$1.7bn impairment charge mentioned above. Without relying on the whims of commodity price movements, profitability for S32 going forward will depend on the success of its cost cutting initiatives. Cash flow for the business is strong despite the statutory loss, with US$192m in cash generated over the half. Although no dividends have been declared yet, S32 resolves to pay at least 40% of its underlying earnings in dividends once its operations are running reliably. S32 is also heavily focussed on maintaining its investment grade credit rating. With its rating currently at BBB+, just two notches above the minimum required for investment grade, it is fully cognizant of the need to exercise prudent capital management.
A judgement of the value of S32 really hinges on the investors view of where commodity prices are heading and the credibility of S32's cost cutting initiatives. While S32 isn't a current Rivkin recommendation, there are signals it may soon be included as part of one of our Local portfolios. Readers are encouraged to join Rivkin Local to receive our official stock recommendations.