South32 Cutting South Africa Risk

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South32 has moved towards the exit for South African thermal coal, beefing up the Klipspruit project while contemplating a listing of the division on the Johannesburg Stock Exchange.

-SAEC mining to shift from owner-operator model to contract
-Advantage in deferring closure provisions at Klipspruit for at least 20 years
–Sell down or IPO of SA energy coal a positive for South32 valuation
 

By Eva Brocklehurst

Amid uncertainties surrounding a revised South African mining charter, South32 ((S32)) will manage its South African energy (thermal) coal business (SAEC) as a stand-alone entity from April 2018.

It will also evaluate a potential listing on the Johannesburg Stock Exchange. UBS notes this would be full-circle for this segment of the company, given it was previously listed as Ingwe before being bought out by Billiton.

On the broker's long-term thermal coal price of US$55/t, and 12.5 rand to the US dollar, the energy coal business is valued at US$73m, or 1% of South32. However, including closure costs of US$348m the net value is a negative -US$275m.

In connection with the separating out of SAEC, the company has approved a US$301m expenditure plan to extend the life of the Klipspruit mine, expecting this to deliver an internal rate of return greater than 20%. South32 expects to produce 8mtpa of marketable coal from three open cut pits for an average unit operating cost of ZAR490/t and at a strip ratio of 3.0.

Macquarie still finds the project economics challenging under its bearish long-term thermal coal price forecast of US$48/t, with an internal rate of return of just 3%. The broker suggests the separation is the first stage of a disposal process and views a complete exit as a positive catalyst, with the potential to release US$746m of balance sheet liabilities.

Credit Suisse agrees the rationale is to de-leverage exposure to South Africa, given the issues with mining charters and Eskom (electricity provider) as well as a shift in the company's commodity preference to base metals from thermal coal.

South32 has stated an intention to broaden the ownership of SAEC, which, in turn, presents opportunities for BEE (Black Economic Empowerment) entities to increase their stake, currently at 8%. Yet, Credit Suisse suspects it will be a challenge to get investors excited about putting capital into South Africa.

Klipspruit

The Klipspruit extension will unlock resources at the Klipspruit South and Weltevreden deposits. Coal will be a mixture of both high-grade and low-grade. The mine life extension will honour agreements and domestic supply obligations and mining will shift from the current owner operator model to contract mining, utilising existing infrastructure, as production ceases from the existing mining areas and moves to the extensions.

Macquarie suspects that further investment will be required to meet rail and coal supply contracts and may fall below the company's internal hurdle rates. These will be still required given the onerous long-term commitments. The main advantage, the broker perceives, is the likely deferral of closure provisions for an additional 20 or more years.

Credit Suisse also notes the investment avoids the crystallisation of the liability to Transnet, delaying rehabilitation provisions, and considers this to be marginally accretive to value.

UBS is positive about the announcements as, while Klipspruit may be robust, and many South Africa-averse investors see this as a negative, the potential selling down or listing of the business offsets it to some extent. In other words, a sell down or IPO of SAEC would be positive for South32's valuation, as UBS has a negative estimate for that part of the business.

Citi already included the extension project in its base case, given the need for the company to sustain production to meet domestic supply and take-or-pay rail obligations. The broker currently values the South African coal business portfolio at US$301m, and considers the value leakage from a separate listing to be insignificant.

FNArena's database shows seven Hold ratings, as several brokers recently downgraded from Buy on the back of gains in the share price, and one Sell (Deutsche Bank, yet to comment on the update). The consensus target is $3.23, signalling -4.5% downside to the last share price.

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