Today is “index changes” day, one of the four dates during the year when the S&P Dow Jones Indices re-balances its indices, and the changes take effect. What that means is that there are promotions into various indices, and there are demotions. And what that means is that from these dates, portfolios that are built to mirror indices have to own new stocks, or discard them from those portfolios.
For the stocks graduating upward into indices, this is a source of guaranteed new demand for the shares from certain portfolios.
At the top of the Australian Securities Exchange (ASX) index tree i.e., the S&P/ASX 20, there is one change, with miner South32 officially entering that index, replacing James Hardie Industries.
It is good news for South32 — but there are more reasons to buy the stock than simply replicating an index exposure.
When the diversified miner was spun-off from parent company BHP into its own separately listed entity in May 2015, it was made up of assets that BHP identified as no longer fitting its core strategy. BHP had decided to focus on its four commodity “pillars” of iron ore, oil, copper and coal, and its potash long-term growth play in Canada. Initially, South32 suffered somewhat from a market perception that it was a grab-bag of unwanted commodity assets: eight months into listed life, in January 2016, the stock was down 58%.
But South32 has more than quadrupled from that point, as the management team has forged a new mining business with growing clout.
South32 started out with a business well-diversified both geographically and by commodity, with bauxite, alumina and aluminium operations in Australia, Brazil, South Africa, and Mozambique; manganese ore and alloy operations in Australia and South Africa; the Cannington zinc-lead-silver mine (one of the world’s biggest producers of silver and lead) in Australia; the Illawarra metallurgical (steelmaking) coal operations also in Australia; thermal (electricity) coal in South Africa; the Cerro Matoso nickel mine in Columbia; the Hermosa development project (zinc-lead-silver) in USA, and a globally spread exploration portfolio.
More recently, the company has pivoted more to base metals – specifically, South32 says it is reshaping its portfolio “towardsthe metals critical for a low-carbon future.” (In addition to its climate goals, this transition generally gives South32 greater exposure to higher-margin businesses.) It particularly likes copper, nickel and zinc: in February 2022, South32 brought copper into its portfolio by buying-out the Sumitomo companies’ 45% share in the Sierra Gorda open-pit copper and molybdenum mine in Chile, a long-life deposit at which production commenced in July 2015. Last financial year, the company lifted its shareholdings in Mozal Aluminium and the Mineração Rio do Norte (MRN) bauxite mine, and decided to participate in the restart of the Alumar aluminium smelter in Brazil, which it also billed as significant steps down the low-carbon future route. South32 exited thermal coal in 2021; but retains its high-quality steelmaking coal operations in Australia.
Geographically, South32 is building-up its presence in the Americas as its Australian assets approach their life end.
As at the December 2022 half-year, steelmaking coal accounted for 30% of earnings before interest, tax, depreciation and amortisation (EBITDA), followed by manganese (17%), nickel and copper (both 13%), alumina (10%), zinc-lead-silver (9%) and aluminium (8%). Analysts expect steelmaking coal to account for about 30% of full-year FY23 EBITDA, underpinned by elevated prices.
Interestingly, however, in 2022 the company decided not to proceed with the extension of the Dendrobium steelmaking coal project in New South Wales, although it will continue mining the existing leases for high-grade premium product. There is a feeling in some quarters of the market – broker Ord Minnett, for example, has voiced this theory – that in the longer term, South32 will exit coal mining operation altogether.
In the half-year ended December 2022, statutory net profit fell by 33.6% on December 2021, to US$685 million (South32 reports results in US dollars), while underlying earnings slid 44% to US$560 million, in a result that generally beat market expectations. Revenue declined by 8%, and margins came under pressure in all six commodity businesses: overall, South32’s operating margin slid from 47% for the full-year FY22 to 32% at the December 2021 half – but, to put that in context, the company’s overall margin in FY20 was 22%, and in FY21, it was 26%, showing what a bumper year FY22 was.
The biggest influences on South32’s earnings are the aluminium price, followed by the alumina price and the steelmaking coal price (as well, the Australian dollar and South African rand foreign exchange rates are big swing factors.)
Along with strengthening commodity prices, the company’s outlook is for margins to expand in H2 FY23. Like all miners, South32 is battling to get on top of soaring costs: it said in its interim report that inflation was “most acute” in its prices for energy (42% of its costs), smelter raw materials (19% of costs) and caustic soda (14% of costs), which is used in the Bayer process, by which mined bauxite ore is refined into alumina.
On March 9, the big miner announced an interim dividend of 4.9 US cents per share, fully franked. While that was a 44% drop from the interim dividend of 8.7 US cents that was paid last year, the dividend amount was better than most analysts expected.
South32 said in its interim results outlook that China’s re-opening and global supply disruptions have underpinned a commodity price rebound, which it expects to strengthen in the current half-year. Its FY23 production guidance was unchanged, with the company saying that it is “on track for 6% production growth” in the second half of FY23. Costs are expected to be in line with or lower than guidance. FY24 production guidance implies modestly higher output in FY24.
So, at $4.12, is S32 worth buying for reasons other than simply having graduated to the S&P/ASX 20 index.
The market verdict is “yes.”
Stock Doctor/Thomson Reuters polls 18 analysts that cover South32: the consensus price target is $5.00.
On a smaller sample of seven analysts, FN Arena’s collation of analysts’ price targets arrives at a consensus figure of $4.96.
The publicly available data at financial information site wallmine.com comes up with a one-year share price target of $7.00, from an undisclosed number of broking analysts.
In addition, there is a better-than-average dividend yield implied from expectations. In US dollar terms, FN Arena’s analyst group expects 16 cents in FY23 and 18.1 cents in FY24, which at the current exchange rate represent A$ estimates of 23.8 cents and 27 cents, or dividend yields of 5.7% and 6.5% respectively, which with full franking stretch to 8.1% and 9.3% respectively.
Stock Doctor/Thomson Reuters does the foreign exchange calculations and expects 6.8% yield grossed-up in FY23, rising to 8.5% in FY24.
On these numbers, South32 looks to be a very attractive buy right now on a total-return basis.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
