South32 is unloved right now and that might be the best thing for long term investors

There's a saying in the mining industry that there is no cure for low prices like low prices. That seems to be the thesis for South32 (ASX: S32), the $13 billion diversified miner spun out of BHP (ASX: BHP) in 2015.

Soft commodity prices and rising costs set the backdrop for a pretty uninspiring set of results. The one surprise management delivered, giving the green light on the Hermosa project, created more questions than answers for stock followers. Shares in South32 closed the day 4.5% lower and are languishing at 52-week lows - off roughly 37% over the past 12 months.

However, the silver lining for South32 might be that depressed prices don't incentivise investment in new production, which could squeeze commodity prices down the track.

I spoke with Ray David, Portfolio Manager at Blackwattle Investment Partners, regarding the South32 results. His fund owns the stock, and he is taking a contrarian view, believing that the experienced management team have the track record to steer the company through to the next cycle.

As illustrated in the slide below, the fortunes of South32 shareholders are heavily linked to the commodity price cycle that their assets are exposed to.

South32 (ASX:S32) H1 FY24 Results

• Underlying revenue down 14% to US$3.8 billion
• Profit after tax down 92% to US$53 million
• Underlying earnings -93% to US$40 million
• Dividend of US$0.04 per share (fully-franked)
• Record half-year aluminium production and a 20% increase in zinc and nickel production
• Final investment approval to develop Hermosa Taylor deposit a strategic initiative to reshape S32s exposure to critical minerals
• Learn more about South32 by heading to Market Index.

What was the key takeaway from the South32 result?

The result was largely announced, so there wasn't much surprise. The key takeaway is that soft commodity prices and cost inflation have impacted earnings. This impacted profitability, which means that if you're a Western world producer like South32 or BHP, you need much higher commodity prices to bring on new supply. If you roll that forward a decade, there's potential for a massive short squeeze of commodities for South32’s portfolio, just like we have seen with lithium and uranium recently.

Would you hold or sell the stock on the back of the result?

Rating: BUY

We'd buy the stock, and we own the stock. We think South32 is really good value and there are three key reasons.

#1 South32 is one of few large mining companies in the ASX that trades below book value. Book value is an essential metric for commodity companies because that's your mine cost. If you're trading below the cost of your mine, the market thinks your returns aren't attractive, meaning commodity prices need to be higher. That means supply won't come into the market.

#2 The second reason is that South32 is a well-diversified mining company. So, you want to avoid being beholden to a single commodity. In addition, over 60% of the portfolio is linked to commodities that will benefit from decarbonisation, such as aluminium, copper and manganese.

#3 The last point is that South32 has a good balance sheet and excellent management, and its assets are second quartile and in pretty strong sovereign jurisdictions where there's less sovereign risk.

What is your outlook for South32 and the commodities within its portfolio?

If you look at alumina, for example, the commodity price is trading around the second quartile of the cost curve. That means that 50% of the industry is loss-making, so these prices will hardly encourage new supply. As demand or economic growth picks up, you have to think it will be a short squeeze on alumina, and we've seen that happen with a big short squeeze on Coal. So coal prices are quite high, and South32 will benefit once its production improves.

Similarly, the manganese price has been so low that you've started to see supply reduction. The key driver for any commodity company is the commodity price, which has been quite weak in this first half for most of their commodities. This economic growth improves commodity prices.

The other thing to talk about was the Hermosa project update, which came as a little surprise to the market. Hermosa is a zinc mine and manganese processing facility in North America. This is a project that they purchased in 2018, and they've just pressed the go-ahead. It will start production in 2028. So that tells you that from the start to go, it will be a 10-year mine development program and they need much higher commodity prices to get an IRR of 12%

It tells you that any Western world mining company that wants to bring new supply into the market needs much higher commodity prices, and the Hermosa project is a clear example that without higher prices, it's unlikely new supply will come to market.

What are the risks for South32?

The big risk around South32 is cost inflation. If you look at costs across the group, for example, you had a 15% uplift in cost per unit of coal. In copper, there has also been a decent uplifting cost per unit.

Labour costs are increasing, and if economic growth doesn't improve and commodity prices don't lift, margins can continue to get squeezed, impacting earnings.

So, cost inflation is a real issue for Western world miners, and in the long run, it should support higher commodity prices. But in the short run, you've got this backdrop of softer commodity prices and cost inflation, which is squeezing profitability.

Are you concerned about debt?

No. If you look at the free cash flow generation in the past, it has been quite strong. They can reduce some of the development capex to repay it if they need to at current commodity prices. If they stop the capex, they should produce enough cash flow to repay that debt quickly. The company is also guiding to stronger free cash flow in the second half.

If you think about South32 management, they've come out of BHP. So they've seen 30 years of cycles. They've been through deep troughs and peaks in commodity prices. They're really good at protecting the balance sheet; for example, today, they paused the share buyback. 

The one comment that CEO Graham Kerr made is that you've got to have a strong balance sheet in commodities because if prices soften, the bankers can stop you out, and it's not a position you want to find yourself in as a mining company.

From 1-5, where one is cheap and five is expensive, how much value are you seeing in the market right now? 

Rating: 2

Materials, energy and consumer discretionary sectors look cheap. Commodities, again, like South32, stick out as one of the cheapest stocks on the market. What sectors are expensive? Usually high-growth companies.

So, if the market were to get more comfortable around economic growth and interest rate reductions, we think materials & energy and industrials significantly outperform because that's where the value is in the market.

>>Read the announcement – South32 1H24 results
>>View the presentation – South32 1H24 results

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