South32 – good quality assets but growth questions remain

South32 has just been spun out of BHP Billiton and listed. Its portfolio of assets, across five countries, will produce alumina, aluminium, coal, manganese, nickel, silver, lead and zinc, produced US$8.3 billion of revenue in FY2014.

I recently spent a week visiting the new company’s key assets in Australia.

My main thoughts?

  1. Most of South32’s assets are good quality. There is little evidence of significant undercapitalisation of these assets, contrary to speculation that the spun-off assets have suffered from a lack of attention and resources.
  1. Most of the assets are steady-state businesses with long mine lives but limited volume-growth opportunities:
  • Illawarra Coal – Modest volume growth opportunity on these assets, but a reasonable ability to lower costs and significant scope to extend the life of these operations. The downbeat outlook for coal is the biggest challenge we see for this operation.
  • Cannington – Silver/Lead/Zinc Mine – Clear cost out opportunities, which will benefit the short and medium term earnings for this divisions. Longer term, this operation is more challenged in terms of the life of the mine and the ability to extend it.
  • Groote Eylandt – Manganese – Modest cost out opportunity. Modest volume opportunity with the addition of some 600kt p.a. of tailings retreatment capacity being installed. The bigger consideration for Manganese is the market outlook, which is closely tied to Iron Ore and Chinese steel making.
  • Worsley Alumina – Modest cost out opportunity in the short to medium term. Although this is a world class asset, volume growth will likely be very low if anything. There is a reasonable chance that coal costs for the refinery increase in the short term as supply negotiations are finalised.
  • Southern African Assets (not visited): Hosts thermal coal, Manganese and Aluminium smelting operations. Our estimation is for modest cost out opportunities at most of these operations, but the bigger, long-term issues are concerning. There are issues relating to power allocation/ cost (Aluminium), high capex requirements in replacing the coal production, rail allocation and supply concerns in the Manganese business. The issues here are likely to become more apparent and problematic towards year-end.
  • South America (not visited): This includes Aluminium smelting operations in Brazil (recently idled) and the Cerro Matoso Nickel operation in Columbia. Strangely the most valuable part of these operations is a power allocation at the idled Alumar smelting, which is being sold back into the Brazilian grid at a large margin. The sustainability of this in an emerging country with power shortages concerns us.
  1. There is little indication that management are looking to grow through acquisition in the medium term.
  1. There is the opportunity for cost-savings, primarily through headcount reductions as levels of management that are unsuitable to the down-sized company are stripped out.

S32 intends to move away from the BHP structure and implement a regional operating model, which is expected to generate cost savings in the near term that outweigh the additional costs of US$60 million per annum that South32 is expected to initially incur as a standalone company.

This opportunity is reasonably significant, but it is likely to be achieved within the first twelve months and the company will need another driver of growth beyond that.

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