With South32 displaying ‘compelling value’ are takeover suitors circling?

Given its unspectacular listing only two months ago, during which it unceremoniously failed to captivate the market’s imagination – and with the share price still struggling to nudge above the $2.13 list price – fresh revelations of a potential takeover could be the best news yet for those who stumped up for a piece of BHP Billiton’s (ASX: BHP) non-core asset spin-off, South32 (ASX: S32).

Having shedded 16% or $1.8 billion of its market value since its 18 May listing, rumours are rife that South32 is looking increasingly attractive to potential suitors, and given the number of foreign buyers circling Australia’s distressed mining assets, this looks increasingly likely.

Adding further substance to these rumours, South32 – now Australia’s third largest miner – recently hired Macquarie Capital and Morgan Stanley as ‘defence advisers’. However, given the headwinds confronting base metals, would-be acquirers may see little value in showing their hand too soon.

Based on brokers’ highly ambitious target price of around $2.45, the general state of its balance sheet, exceptional earnings per share (EPS) growth forecast, and positive free cash flow at spot prices, South32 does appear to offer “compelling value”.

Adding to South32’s attractiveness is its diversified investment risk, through its basket of commodities, and low reliance on China – relative to other big miners – which accounts for only 11% of overall sales. The trouble for investors is that while South32 does appear better placed than most in the sector to grow shareholder returns, realising the value in its underappreciated assets is likely to be a slow-burner.

Many investors will find the prospect of future attractive dividend yields appealing. The company is committed to a distribution of at least 40% of underlying earnings in 2015-16, and (unfranked) dividend yield is expected to reach 4.8% in 2017.

Last week South32 announced a US$1.9 billion write-down on the book value of its assets, and if commodity markets don’t begin to improve more are likely.

An estimated 62 per cent of South32’s earnings before interest and tax (EBIT) is exposed to aluminium/alumina which is languishing at five-year lows amid oversupply. However, on a more positive note, metallurgical coal and manganese provided most of the growth for South32‘s 2015 year, with metallurgical and thermal coal up 25% and 12% respectively.

Following what’s been a challenging opening quarter, some analysts have been quick to [slightly] downgrade forward earnings projections for South32, citing tough operating environments in South Africa – which accounts for roughly 30% of South32’s underlying EBITDA – as part of the problem.

Watch for greater guidance in August – when South32 reports its full year 2015 result – for better a view of outlook, earnings and cash flow potential.