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Appin To Drag On South32

Australia | Jul 11 2017

This story features SOUTH32 LIMITED. For more info SHARE ANALYSIS: S32

While an extended shutdown at Appin has led to forecast downgrades, broker valuations are little changed and Buy ratings have been maintained.

– Outage timing unknown
– Earnings forecasts downgraded
– Valuations little changed

 

By Greg Peel

On June 28, diversified miner South32 ((S32)) advised it had withdrawn the workforce at its Appin underground coal mines in the Illawarra as a precautionary measure following a tripping of the circuit during work on the gas extraction plant. In layman’s terms, the canary snuffed it.

While it was subsequently confirmed there had been no breach of gas limits, a recent run of such gas issues at the company’s Illawarra operations prompted the NSW Department of Planning & Environment to issue a prohibition notice and express its concern regarding the number of such events and operating practices at Illawarra over the last nine months.

In the past, such mine outages have lasted for a couple of weeks to a month. Brokers initially adjusted their forecasts accordingly. But yesterday South32 announced the Appin 7 and 9 mines will remain suspended while a full review of operations is conducted. Management did not provide guidance on estimated timing, as it has in the past. Brokers therefore are unsure just how long it will take. As Macquarie puts it, the outage “could be for months rather than weeks”.

Appin makes up around 60% of South32’s Illawarra coal production, with Dendrobium producing the other 40%. Dendrobium will continue to operate while Appin is suspended. UBS calculates every month Appin is off line represents some 450-500kt of production and a -2% hit to earnings per share.

For brokers to adjust their earnings forecasts this time around they have to have a guess at length of downtime, which “is hard to quantify to be honest,” by Credit Suisse’s admission.

Credit Suisse is assuming at least a month followed by a cautious resumption of production. UBS is assuming two months in “an attempt to be conservative” yet Macquarie has gone for a full three months, given the number of operational issues at Appin over the past year. Unsurprisingly, Macquarie’s -16% cut to FY18 forecast earnings is the greatest of the three.

All of the eight major brokers in the FNArena database cover South32 but only three have updated their numbers to date with regard yesterday’s announcement. One thing that the three updaters do agree on, however, is that despite the earnings downgrades the impact on share price valuation is minimal. This is because Appin has such a long mine life, two or three months of outage is not material in the wider scheme of things.

Macquarie has cut its target price to $3.30 from $3.50. Credit Suisse’s valuation drops to $2.69 from $2.77 but the broker’s target is unchanged at $2.95. UBS’s valuation drops one cent, hence an unchanged $3.00 target.

All three brokers retain their Buy or equivalent ratings, ensuring a stable six Buy and two Hold ratings on the database at this stage for a consensus target of $3.20.

Underscoring Buy ratings is South32’s significant free cash flow, irrespective of the loss of Appin production. On brokers’ own commodity price forecasts, all agree the stock continues to offer value. Plug in current spot prices and it becomes a steal. That cash flow provides the opportunity for the company to extend its capital management initiatives, by boosting its share buyback and/or increasing its dividend.

Brokers nevertheless agree the market will now be more wary of management’s operational performance and until it is clear just when Appin might restart, and how much any problem-fixers might cost, investors may well stay on the sidelines.
 

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