Much ado about South32 - Morgans

May 20, 2015
AUSTRALIA
ROCKS & STOCKS
Much ado about South32
Notes from the Field
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James Wilson
T +61 8 6160 8707
E james.wilson@morgans.com.au
Adrian Prendergast
T +61 3 9947 4134
E Adrian.prendergast@morgans.com.au
Tom Sartor
T +61 7 3334 4503
E tom.sartor@morgans.com.au
South32 (ASX:S32) listed this week and as expected the stock is
experiencing a “washing out” period of volatility during its first week of
trading. The leverage to strong demand growth commodities such as
aluminium and nickel remain appealing but this suits investors with a
bullish medium-term view on base metals. We think the real prize is BHP,
its simpler structure, its diversified earnings stream and a strong leverage
to rebounding energy prices make it a standout in the sector.
Figure 1: South32 valuation breakdown
Chris Brown
T +61 7 3334 4885
E chris.brown@morgans.com.au
Call to action
Prefer BHP for energy exposure
BHP demerged its South32 assets this week.
As expected the volatility in the S32 share
price is playing out. Whilst we like the S32
story for a medium term base metals recovery,
we prefer BHP for its strong leverage to a
recovery in energy prices in the near term.
SOURCE: Morgans
The initial washing out period in South32 is happening now
Fundamental valuation aside, we argue that South32’s higher leverage (risk),
combined with the fall in commodity prices will generate a substantial “washing
out” period upon listing as un-natural holders (the risk averse, and mega-cap only
funds) are replaced by the natural holders (the risk tolerant, index huggers,
contrarians and M&A funds). What we’ve seen is a surprising uptick in the stock to
$2.36ps, still well below our valuation of $2.98ps (+30% upside to our target
price).
BHP is now much leaner and gets attractive below $30
Post de-merger we expect BHP will boast an enviable EBITDA margin across its
business of 47%, a forward PE ratio of 15x, a fully franked dividend yield of
~5.4% and valuation of A$33.90ps. We view these metrics as robust, with the
view that BHP will quickly start to fill the gap in its market capitalisation left by
the demerger. Furthermore, we see near-term leveraged upside in BHP’s energy
division, which represents about 31% of its valuation. The energy division is
likely to grow in proportion to the rest of BHP’s business supported by a
medium-term recovery in oil prices – it’s the sector to watch, in our view.
Prefer BHP for energy upside over S32 for base metals recovery
S32 offers an attractive suite of assets with strong leverage to upside in the nickel
and alumina divisions (49% of FY15 EBITDA earnings) but tempered by subdued
manganese prices (about 21% of FY15 EBITDA earnings) so ultimately we think a
bullish view on base metals is required to hold the stock longer term. Conversely we
have a high conviction view on BHP. The recent cost cutting in FY16 iron ore to
US$16/t (from US$20/t) and a cut in its FY16 oil and gas capex to US$1.5bn (from
US$4bn) have contributed to our price target of A$33.90ps (from $34.90ps),
which hasn’t changed a great deal despite the capital rebasing post the S32
de-merger.
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CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN 49 010 669 726) AFSL 235410 - A PARTICIPANT OF ASX GROUP
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