South32 Stock: Capital Allocation in the Spotlight (OTCMKTS: SOUHY)

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Summary in seconds

My investment rating for South32 Limited’s (OTCPK:SOUHY) [S32:AU] the stock is a purchase.

I reviewed South32’s financial performance for fiscal year 2021 (YE June 30) in my previous article which was written on September 14, 2021. I turn my attention to South32’s recent capital allocation decisions in this current update.

I am upgrading my investment rating assigned to South32 from a Hold previously to a Buy now. I am impressed with the company’s decision to reverse its earlier decision to invest in an Australian coal mine, and believe this reflects South32’s disciplined approach to capital allocation. In addition, South32 is very committed to return on shareholders’ capital (another key element of capital allocation apart from equity investment), as evidenced by the huge amount of capital returned to shareholders over the course of the year. 2022. South32 is now in a good position to take advantage of the shareholding. buybacks as a tool to create value for its shareholders and drive up its share price. Therefore, I have a bullish view of South32, which translates into a buy rating for its shares.

South32 has its shares listed in Australia and on the OTC market. SOUHY’s trading liquidity in the OTC market is reasonably good, as evidenced by its three-month daily trading value of approximately $1.5 million. Readers who value trading liquidity highly may also consider South32 shares listed on Australian stock exchanges, as shares traded in Australia with the symbol S32:AU show an even better three-month daily trading value. , greater than $50 million. Interactive Brokers is one of the US brokerages that allows investors to trade stocks listed in Australia.

Reverse course on investment in the coal mine

Looking for new Alphas reported on August 22, 2022 that South32 “will not be making an initial investment of $700 million to expand its Dendrobium metallurgical coal mine in New South Wales”.

Reference should be made to South32’s August 23, 2022 press release to understand why the company has changed its mind about investing in the Australian coal mine. In the press release, South32 noted that “this decision increases our ability to direct capital to other opportunities” which include “development options in North America” ​​regarding “metals critical to a low carbon future.” carbon”. The company also added that “the expected returns from the ‘planned $700 million investment in the coal mine in Australia’ are not sufficient to sustain an investment over the alternatives.”

On the point of focusing on “essential metals for a low carbon future”, it’s very clear that South32 has a preference for base metal projects.

Following the August 23, 2022 announcement, South32 unveiled its “Climate Change Action Plan” on September 9, 2022, which stated that its priorities were “to reshape our portfolio towards base metals” and “decarbonize our operations”. In my view, shares of South32 support a positive revaluation of the company’s stock in the time ahead as the stock becomes more attractive to investors with a strong focus on environmental, social and governance issues. company or ESG.

Furthermore, it is encouraging to see that South32 considers returns on investment and opportunity costs when deciding how to allocate its capital.

During the company’s 2022 fiscal year earnings call on August 25, 2022, South32 noted that it was considering “the trade-off of investing the capital in Dendrobium Next Domain (mine expansion) versus pursuing mining in Zone 3 (current mining region), but at a slower pace.” The company mentioned on the recent investor call that it has finally made the decision to withdraw the planned expansion from Australian coal mine based on “simple economics” and what “made more sense”.

More importantly, South32 is in a good position to further optimize capital allocation with the recent decision to cancel coal mine expansion plans in Australia. In addition to investing in more base metal projects to improve its ESG profile, South32 will most likely allocate a greater amount of excess capital to dividends and share buybacks, and this is the subject of the next section. of this article.

Excellent return on shareholders’ capital for fiscal 2022

South32 has done an excellent job returning excess capital to shareholders for fiscal 2022, and a better-than-expected shareholder return on capital going forward will be a significant share price driver for the company.

As highlighted in the company’s fiscal 2022 annual report, South32’s total dividends increased by +273%, from $0.069 per share in fiscal 2021 to $0.257 in fiscal year most recent. Specifically, the company’s ordinary dividends and special dividends per share increased by +363% and +50% to $0.227 and $0.030, respectively, for fiscal 2022. Ordinary dividends distributed for fiscal 2022 represented 39.5% of South32’s earnings for the prior fiscal year, and this is in line with the company’s policy of paying out at least 40% of its net earnings as dividends to shareholders.

In fiscal 2022, South32 also repurchased 46 million of its own shares for approximately $128 million. In total, the company has allocated $1.32 billion to dividends and buybacks over the past fiscal year, which is about 11% of the stock’s current market capitalization.

Going forward, an increase in the proportion of excess capital allocated to share buybacks is probably the most critical capital allocation-related catalyst for the South32.

Redemptions represented only 10% of the share capital returned to South32 shareholders in fiscal 2022, with ordinary and special dividends representing 90% of the return on capital in the prior fiscal year. South32’s undervaluation is a valid reason for the company to step up its pace of share buybacks in the near future.

South32 is now market-valued at a consensus FY2025 EV/EBITDA of 3.1x according to S&P Capital IQ evaluation data. Using fiscal year 2025 as the basis for South32’s forward valuation multiple recognizes that fiscal year 2022 was an exceptional year for the company due to high commodity prices, and that operating profit of South32 should gradually normalize over the next few years. Based on market consensus financial forecasts from S&P Capital IQSouth32’s EBITDA is expected to decline from $4,755 million in fiscal 2022 to $3,155 million in fiscal 2025. Even after adjusting for South32’s expected contraction in operating profit in the Looking ahead (using FY2025 as a valuation basis), South32’s FY2025 consensus EV/EBITDA multiple in the low single digits looks very attractive.

As such, it will be the right move for South32 to buy back more shares of the company at current price levels. Comments from South32 management at the recent earnings briefing suggest there is a strong likelihood that South32 will engage in more share buybacks. In its FY2022 investor briefing, South32 noted that its share buybacks over the past year had been “value accretive”, and it pointed out that there had been a shift “between buyback of shares in the market and dividends as our share price moves through the cycle” in the past.

Final Thoughts

South32 stock is classified as a buy it now. A low single-digit EV/EBITDA multiple is attractive, and the company’s stock could easily reprice when South32 picks up the pace of share buybacks.

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