Why South32 is high on cash

South32 has established itself in the global diversified mining resources market as a stock high on investor returns and low on risky merger and acquisition activity.

The firm’s surprising $1.3bn cash offer for a Toronto-listed company, Arizona Mining, earlier this year was seen as something of a once-in-a-lifetime exception to the rule, but it nonetheless led some analysts to declare high-growth season for all mining stocks formally open.

A recent report from Macquarie, the Australian bank, however, seems to support the idea that South32’s CEO, Graham Kerr, is becoming more comfortable with South32 as a growth stock, especially given the balance sheet and management capacity that is being created in the Perth-headquartered group.

According to the bank, after having met Kerr in a roundtable meeting last month, the $850m capital expenditure required to develop Arizona Mining’s key undeveloped Hermosa prospect – primarily a zinc deposit – can be easily absorbed as South32 is expected to generate $1bn a year in free cash flow between the 2020 and 2023 financial years.

“South32 confirmed that the company continues to have both excess balance sheet and management capacity to pursue further acquisitions,” said the bank’s analysts in a note dated 29 August.

“CEO Graham Kerr highlighted similarities between Hermosa and Cannington [South32’s zinc facilities in Australia] and the ability to draw on internal personnel as Cannington approaches end-of-life at a broadly similar point in time as production from Hermosa begins to ramp up,” the analysts added.

The strength of South32’s cash generation even surprised Goldman Sachs. The net cash balance at the full-year point ended 30 June, before having paid for the Arizona acquisition, was about $2bn. Goldman Sachs said this was “… higher than our forecast of $1.8bn, demonstrating strong cash generation in the second half of the year”.

The firm’s balance sheet will soon enough be supported by the proceeds from the sale of its South African Energy Coal (SAEC), which it said at its annual results presentation was now proceeding.

Some 40 unsolicited and unqualified bids had been received to date. It makes sense to make the sale if only because the coal export market is looking decidedly juicy, with prices well in excess of $100/t.

SAEC generated $353m in underlying pre-tax earnings for the 2018 financial year, equal to about 14% of the group’s total.

While hardly negligible, SAEC is not qualified to sell new sources of coal to Eskom in terms of its current ownership model. There is also a hefty $739m rehabilitation provision on the coal mines.

The mines are also highly capital intensive while its Middelburg Wolvekrans Complex (MWC) has a domestic contract with Eskom from which it struggles to make money.

It has been observed that a black-owned supplier of MWC coal to Eskom could probably negotiate a better contract given the utility’s interest in supporting black-owned businesses going forward.

Speaking to finweek earlier in the year, Kerr said that despite withdrawing from South Africa, the company hadn’t completely given up on pursuing new investment in the country provided it could secure some type of regulatory certainty in the future – a reference to the Mining Charter negotiations underway.

The company also has manganese operations in joint venture with Anglo American in the Northern Cape, so South32 is still a presence on the ground in SA, as well as a listed entity on the JSE.

Kerr said that Africa remained a potential hunting ground for acquisitions. The company operates the Mozal aluminium smelting facilities in Mozambique, a country where it has some comfort operating.

Said Kerr: “Tanzania is also interesting, but places like the Democratic Republic of Congo are not for us. Too risky now that with the divestment of Freeport there is a diminished American presence.”

This article originally appeared in the 30 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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