ANALYST’S NOTE

South32 (S32) FY18 result was solid in our view, with underlying EPS up +19% to US10.5cps, and revenue up +9% to US$7.6bn (ahead of consensus estimates), driven by stronger commodity prices and record production at Australia Manganese (up +10%) and Mozul Aluminium (up +20%).

Underlying EBITDA was up +4% to US$2.5bn, although EBITDA margins fell -160bps to 37.3% (from 38.9% in the pcp). Cost pressures are likely to presist in coal and aluminium.

However, higher commodities prices (current spot) do provide upside potential to earnings. Balance sheet remains in a solid position, net cash balance of US$2.0bn, however this will be utilised for the Arizona acquistion. A special dividend of US3.0cps was returned (with 81% franking) as part of S32’s capital management program, on top of the upcoming fully franked final dividend of US6.2cps (US$317m – representing 40% of underlying earnings in 2H18), leaving US$380m to be returned to shareholders by April 2019.

We upgrade our recommendation to Buy on valuation grounds, with the share price trading below our valuation of $3.90. S32 has a strong balance sheet, potential for additional capital management and growth options, whilst trading at a discount to peers (this should close over time).
We estimate the Company will produce approximately US$3.5bn in free cash flow over the next three years on a cumulative basis, meaning capital management remains in play despite acquisition.

• Cost pressures somewhat relieved. Despite steepening cost curves during the first half and broader inflationary pressures (most notable in the aluminium supply chain), stronger production and improvements in energy and equipment productivity have enabled S32 to achieve FY18 Operating unit cost guidance and further mitigate such pressures. The stronger U.S. dollar and lower caustic soda prices are forecasted to provide additional relief.
• Acquisition of Arizona Mining. S32 has agreed to acquire 83% of Arizona Mining for all cash offer of US$1.3bn. Whilst we expect S32’s cash balance to reduce on the back of this acquisition, we expect cash balances to build up again over the coming years as the Company produces significant amount of free cash flow. We, therefore, expect capital management initiatives to remain priority and likely in the absence of growth options.
• Capital management program. S32’s net cash position remains healthy, increasing by US$401m to US$2.0bn after US$1.0bn was returned to shareholders via ordinary dividends (US$554m). Until now, S32 has completed US$620m of the approved US$1bn capital management program (having also paid a special US$154m dividend in April 2018 and share buyback of a further 98m shares throughout FY18 for a cash consideration of US$254m). This is reflective of management’s disciplined capital management program, with the Board paying out a fully franked final dividend of US6.2cps.

• Attractive relative valuation. Relative to its peers group average, S32 is trading at a reasonable discount on the EV/EBITDA measure. On consensus estimates, S32 is trading on an EV/EBITDA multiple of 4.8x 2-Yr and 4.7x 3-Yr. Relative to its peer group the stock also offers a solid yield on top of the capital management initiatives.