Earnings beat, dividend surprise, increased buyback and positive outlook - This miner ticks all the boxes

It is amazing to think that this Aussie miner, which has just delivered a healthy profit beat and has solid prospects - according to Hendrik Bothma from Katana Asset Management - was spun out of BHP.  

For those unfamiliar, in 2015 BHP management decided to focus on a core portfolio of assets comprising its 'four pillars' - namely iron ore, copper, coal and petroleum (the latter of which has since been replaced by potash). 

In doing so, BHP management also decided to spinoff anything that was 'none-core'. Essentially, these were the afterthought assets that became known as South32 (ASX: S32) and today comprise assets that produce bauxite, alumina, aluminium, metallurgical coal, manganese, nickel, copper, molybdenum, gold, silver, lead and zinc.

S32 operates in Australia, South Africa, Mozambique, Colombia and the United States, and whilst the diversity of geographies and commodities is vast, this is one of the things that has helped the company thrive in the current environment. S32 is not overly reliant on earnings from any one commodity or region.  

None of this is lost on Bothma, and both he and Katana are backers of the stock. S32 is in the top 10 holdings in the Katana Australian Equity Fund. Bothma puts it succinctly: 

Fundamentally it's quite inexpensive, it's got an attractive dividend yield, its outlook is positive, and technically it's still in a long-term uptrend. I think there are also some drivers that could see them beat the second half, so it's definitely a buy for me.

In this wire, we discuss the recent results, why Bothma thinks the strong performance for S32 can continue, and the factors that could change his outlook - both for S32 in particular and the sector more broadly. 

Note: The interview took place Thursday 16 February 2023. S32 is a top 10 holding of Katana Asset Management.

South32 (ASX: S32) 1H Key Results

Reports H1:

• H1 underlying NPAT $560m (down 44% on last year) vs expectations of $501.8m
• Statutory NPAT $685m (down 34% on last year)
• Revenue $4.52bn ex-items vs expectations of $4.36bn
• Underlying EBITDA $1.36bn (down 27% from last year) vs expectations of $1.34bn
• Interim dividend $0.049/sh (100% franked), down from last year’s $0.087/sh

FY23 guidance:

• Production guidance unchanged
• “Operating unit cost guidance has been lowered or held largely unchanged for the majority of our operations”

Key company data for S32

In one sentence, what was the key takeaway from this result?

Earnings was a beat, dividend surprise to the upside, and the outlook is positive for a stronger second half.

What was the market’s reaction to this result? In your view, was it an overreaction, an under-reaction, or appropriate?

It fell more than 3% in early trade, which was clearly an overreaction. 

Investors might have initially been spooked by increased cost guidance at some of the projects, but overall FY '23 operating unit costs is still largely unchanged. 

The price has moved back into positive territory later in the session, which in my opinion, is appropriate given the result. The result was actually positive, so they beat consensus earnings by 14% and dividend expectations by 4%. They also maintained the FY '23 production guidance.

Were there any major surprises in this result that you think investors should beware of?

A lot of the numbers came out in the December quarterly, so nothing too surprising. 

If you have to call something out, it's the strength of their cash flow and balance sheet. This helped them pay bigger-than-expected dividends, and they also increased their remaining buyback by about $50 million.

Would you buy, hold or sell S32 on the back of these results?

Rating: BUY

It's great when you see fundamentals and technicals stack up. 

Fundamentally it's quite inexpensive, it's attractive, its outlook is positive, and technically it's still in a long-term uptrend. I think there are also some drivers that could see them beat the second half, so it's definitely a buy for me.

South32 completed improvement projects in the first half and expects the benefits of this to go through to 6% volume growth in the second half, which will obviously boost revenue and also bring overall unit costs down. 

In addition, there's also positive drivers for some of their key commodity exposure. Spot met coal has actually been in decline through the first half, pulling back from record levels during 2022. However, the price has materially increased since the start of the year and this is setting up the second half for increased earnings. And just for reference, about 15% of FY '22 EBITDA was from coal, so it's a key commodity exposure for South32.

Another area I think there's also some upside coming is aluminium which contributed about 20% of FY '22 EBIDTA. It's a highly energy-intensive material to produce, and following the high energy prices in Europe, and production caps also used by China, aluminium levels are actually 40% below their long-term average and facing another year of deficit. 

This is very supportive of strong prices which South32 will benefit from, and the timing actually couldn't be better as they look to ramp up their Brazil Aluminium Smelter.

What’s your outlook on S32 and its sector over the year ahead? Are there any risks to this company and its sector that investors should be aware of?

As you could probably guess from my previous comments, I'm positive on the outlook for South32 based on the production growth and the outlook of some of their key commodities.

That said, there's obviously risk for S32 and the sector as a whole. The resources space is highly dependent on commodity prices for their earnings, and at the moment you see commodities caught in the battle of a slowing global economy, and possible recession. And on the other side, there's been increased momentum from the reopening of China, which is supportive. 

If we do in fact see the global economy slow down meaningfully, demand for most commodities will drop, which will see weaker prices and earnings headwind for the whole space.

Another key risk is inflation and increasing costs, which is biting the whole industry. If costs do remain high while we see commodity prices come off, that spells disaster for margins.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 4

I think valuations have gotten ahead of themselves. We've all read the narratives. I think the market's become more focused on the strong second-half recovery narrative. If you're willing to look past and ride out the weak first half, there's risk of the second-half recovery not being as decent as many are hoping for.  

As we saw, the CPI print in the U.S. on Tuesday and even retail sales last night came out stronger than expected. This all means interest rates can be higher for longer, which could really dent the V-shaped recovery in the second half. For these reasons I think valuations have gotten ahead of themselves and I'm cautious in the medium term.

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