Cost Pressures Mount For South32

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

Cost pressures are mounting for miner South32 but so far higher commodity prices have enabled margins to increase across the operations.

-Costs in the year-to-date already running higher than guidance
-Worsley running close to full capacity
-Special dividends may supplement buyback, brokers suggest
 

By Eva Brocklehurst

South32 ((S32)) has expanded on the outlook for its operations in FY18 and the market, fearful there may be some nasty surprises, was relieved. Cost pressures were revealed, related to uncontrollable inputs such as pitch, caustic soda and coke, yet higher commodity prices have led to increases in margins across the operations.

Total capital expenditure guidance for FY18 has been revised down to US$520m from US$550m, largely as a result of the deferral of underground development at Appin (Illawarra coal). UBS notes, except for the smelting business, where margins have contracted relative to FY17, the Worsley refinery has benefited from high alumina prices and, therefore, there's been a net margin increase for the aluminium group.

The company also provided a site tour of its Saddleback and Marradong bauxite mines, as well as the Worsley aluminium refinery south of Perth, Western Australia. There are two mining hubs producing 18wmt at a unit cost of US$10/t of bauxite. The use of caustic soda, a key cost, should improve going forward with the inclusion of West Marradong which has a low reactive silica content.

In FY17 Worsley produced 45% of supply for the company smelters in Africa. Despite an expected improvement in caustic soda usage, raw materials and inflation are expected to drive around a 4% increase in costs in FY18, to US$211/t, although Citi notes costs are already running ahead of this over the year-to-date. Deutsche Bank envisages costs increasing 5%, despite lower consumption of caustic soda because of higher grade ore from West Marradong.

Worsley

Worsley is seen operating at full capacity at current production rates around 4.0mtpa. With over 1mt of bauxite resources the mineral base is secure for the foreseeable future, while the West Marradong agreement with Alcoa, Macquarie suggests, is beneficial to both parties and should provide incremental benefits to Worsley through additional ore sources.

The broker suggests productivity at Worsley is now likely to come through improving the cost base rather than through incremental tonnage. Water availability is considered an increasingly large risk because of the consistent decline in rainfall and the company is also working on diversifying the energy base to include gas and biomass, versus the predominant coal input.

Credit Suisse is impressed with the inroads already made into costs at Worsley but acknowledges the easy opportunities have been addressed. A doubling of caustic prices is expected to affect financial performance, although there are near-term opportunities around gas re-contracting, technology and plant efficiency.

Outlook

Macquarie expects most of the company's core commodity prices will decline from current levels but there is material upside to the base case at spot prices, particularly from alumina. Ord Minnett continues to be attracted to the diversified earnings stream and strong balance sheet but considers the stock fairly valued.

UBS believes the company is in a strong position to capitalise on growth opportunities and deliver returns to shareholders, with special dividends to make up for the slow pace of the buyback. Deutsche Bank maintains a Sell rating on the stock on valuation, although acknowledging the buyback might be supplemented with a special dividend in February.

The broker is positive on the outlook for zinc silver and nickel over the medium term but cautious on manganese, thermal coal alumina and aluminium and values Worsley at $0.65 per share. Worsley represents $1.00 a share of Citi's valuation at a long-term alumina price of US$350/t.

FNArena's database shows one Buy rating (Citi), six Hold and one Sell (Deutsche Bank). The consensus target is $3.25, signalling -0.4% downside to the last share price. The dividend yield on FY18 and FY19 forecasts is 4.1% and 4.0% respectively.

See also, South32 Cutting South Africa Risk on November 28 2017.

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