South32 Stock: Capital Allocation In The Limelight (OTCMKTS:SOUHY)

Elevator Pitch

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

I reviewed South32’s fiscal 2021 (YE June 30) financial performance 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 upgrade my investment rating assigned to South32 from a Hold previously to a Buy now. I am impressed by the company’s move to reverse from an earlier decision to invest in an Australian coal mine, and I believe this is a reflection of South32’s disciplined approach towards capital allocation. In addition, South32 is very committed to shareholder capital return (another key component of capital allocation apart from capital investment), as evidenced by the huge amount of capital returned to shareholders in fiscal 2022. South32 is now in a good position to leverage on share buybacks as a tool to create value for its shareholders and push its stock price up. 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 on the OTC market is reasonably good as evidenced by its three-month daily trading value of around $1.5 million. Readers who place a strong emphasis on trading liquidity can also consider South32’s shares listed on the Australian Securities Exchanges, as the Australia-traded shares with the ticker S32:AU boast an ever better three-month daily trading value in excess of $50 million. Interactive Brokers is one of the US brokerages that allows investors to trade in Australia-listed stocks.

Reversing Course On Investment In Coal Mine

Seeking Alpha News reported on August 22, 2022 that South32 “will not proceed with a $700M upfront investment to extend its Dendrobium metallurgical coal mine in New South Wales.”

It is worth referring to South32’s August 23, 2022 media release to understand why the company changed its mind about investing in the Australian coal mine. In the press release, South32 stressed that “this decision increases our capacity to direct capital towards other opportunities” which includes “development options in North America” relating “metals critical to a low carbon future.” The company also added that “expected returns from” the planned $700 million investment in the coal mine in Australia “are not sufficient to support an investment relative to alternatives.”

With regards to the point about focusing on “metals critical to a low carbon future”, it is very clear that South32 has a preference for base metals projects.

Subsequent to the August 23, 2022 announcement, South32 revealed its “Climate Change Action Plan” on September 9, 2022, which stated that its priorities are “reshaping our portfolio to the base metals” and “decarbonizing our operations.” In my view, South32’s actions are supportive of a positive valuation re-rating of the company’s shares in time to come, as the stock becomes more appealing to investors with a strong emphasis on Environmental, Social and Corporate Governance or ESG issues.

On a separate note, it is encouraging to observe that South32 considers investment returns and opportunity costs in deciding on how it should allocate its capital.

At the company’s full-year FY 2022 earnings call on August 25, 2022, South32 highlighted that it considered “the trade-off of putting the capital into Dendrobium Next Domain (mine expansion) versus actually continuing to actually mine in Area 3 (current mining area), but at a slower rate”. The company mentioned at the recent investor call that it eventually made the decision to pull back on the planned expansion for the Australian coal mine based on “simple economics” and what “made better sense.”

More importantly, South32 is in a good position to further optimize capital allocation with the recent move to call off expansion plans for the coal mine in Australia. Besides investing in more base metals projects to enhance its ESG profile, South32 is most probably going to allocate a greater amount of excess capital to dividends and share repurchases, and this is the topic of the next section of this article.

Excellent Shareholder Capital Return For Fiscal 2022

South32 did a great job in returning excess capital to shareholders for FY 2022, and better than expected shareholder capital return going forward will be a significant share price catalyst for the company.

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

In FY 2022, South32 also repurchased 46 million of its own shares for around $128 million. In aggregate, the company allocated $1.32 billion to dividends and buybacks in the most recent fiscal year, which represents about a significant 11% of the stock’s current market capitalization.

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

Buybacks only accounted for 10% of the shareholder capital returned to South32’s shareholders in FY 2022, with ordinary and special dividends making up 90% of capital return in the prior fiscal year. South32’s undervaluation is a valid reason for the company to increase its pace of share buybacks in the near future.

South32 is now valued by the market at consensus forward fiscal 2025 EV/EBITDA of 3.1 times as per S&P Capital IQ’s valuation data. Using FY 2025 as the basis for South32’s forward valuation multiple acknowledges that FY 2022 was an exceptional year for the company due to high commodity prices, and South32’s operating earnings should gradually normalize in the next few years. According to the market’s consensus financial forecasts taken from S&P Capital IQ, South32’s EBITDA is expected to decline from $4,755 million for FY 2022 to $3,155 million in FY 2025. Even after adjusting for the expected contraction in South32’s operating income going forward (by using FY 2025 as the basis for valuation), South32’s consensus forward fiscal 2025 EV/EBITDA multiple in the low single-digit seems very attractive.

As such, it will be the right move for South32 to buy back more of the company’s shares at current price levels. South32’s management comments at the recent results briefing suggest that there is a high probability that South32 will engage in more share buybacks. At its FY 2022 investor briefing, South32 noted that its share repurchases in the past one year have been “value accretive”, and it highlighted that there has been a shift “between the on-market share buyback and dividends as our share price moves through the cycle” in the past.

Closing Thoughts

South32 stock is rated as a Buy now. A low single-digit forward EV/EBITDA multiple is attractive, and the company’s shares could easily re-rate when South32 steps up the pace of share repurchases.