Why you shouldn't invest in South32 Ltd just yet

The risks of investing in South32 Ltd (ASX:S32) before it releases its first full year results must be considered before making an informed investment decision.

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South32 Ltd (ASX: S32) was recently created after a demeger from its parent company BHP Billiton Limited (ASX:BHP) at an estimated cost of  US$738m.

In the recent demerger documents BHP Chairman Jac Nasser stated the demerger "simplifies BHP Billiton and enables us to further focus on generating value from our core portfolio. This portfolio comprises our exceptionally large long-life petroleum, copper, iron ore, coal and potash assets (which collectively generated 96% of the Group's underlying EBIT in 2014). We believe that South32's portfolio of high quality assets will benefit from the focus of a dedicated board and management team."

The investment thesis for South32 pushed by BHP and most analysts is the potential for cost reductions, increased efficiency and better capital allocation across the collection of assets. No longer having to compete for capital against the higher quality and more valuable assets of its parent, South32 should be able to focus on improving its assets which have been neglected during the past decade.

This is achievable in theory, however it is not something a smart investor should base their investment thesis on. After spending the last five years in operational roles working on some of the biggest and smallest mine sites around Australia, I for one would not rely on these potential future benefits to justify my investment in the company.

Whilst I have no doubt the competent new management team and corporate structure can deliver cost savings in the long term, I think investors would be wise to watch the company for the next year (or longer) and see if there is concrete evidence of improvements rather than investing on expected achievements to come.

Here are some other things potential South32 investors need to be mindful of.

No official operating results

As a standalone company South32 has just begun its life and has no official operating results for investors to analyse. In this respect, the forecast underlying earnings provided by BHP are similar to those provided for an IPO. Investors will not know the true performance of the company until it reports for the first time.

The demerger documents state the new regional corporate structure of South32 "is expected to generate cost savings in the near term that outweigh the additional costs of US$60 million per annum that South32 is expected to initially incur as a standalone company." This statement alludes to the fact that improvements and cost reduction measures on mine sites, especially on mature sites operated by a world class miner like BHP, take time to be implemented and come to fruition.

Commodity Exposure

Alumina/aluminium, coal and manganese comprise 80% and 69% of South32 revenue and underlying EBITDA respectively; the company is diversified yet concentrated. The price of these commodities, like many others, have declined significantly over the past year which will put extreme pressure on South32 when it reports results for the first time.

Just yesterday, South32 released an ASX announcement warning investors that they are delaying the start of 3 of 4 furnaces at its Metalloys manganese plant in South Africa, one of the largest in the world. Some investors may approve of the decision not to operate at a minimal margin but it is concerning that one of the largest plants in the world is not able to operate at an acceptable profit margin at current market prices. Also flagged in the announcement was the potential for an impairment of South32's manganese business after the review of its fair value is completed in the near future.

South32 Breakdown

Lower quality assets

South32 ended up with the assets that didn't meet the size, quality and commodity criteria required to be considered BHP core assets. In general, these assets have lower ore reserve lives, lower operating margins, and less mining time remaining until costly rehabilitation begins (hence why South32 has started its life with a $1.5 billion closure and rehabilitation provision).

The Grant Samuel expert opinion document stated that "South32's operations are relatively mature. For some of the assets, there are limited opportunities for significant life extensions or project expansions." Considering the low commodity prices, I think investors expecting numerous profitable brownfield expansion opportunities to open up under the new management team may be disappointed.

Decreasing capital expenditure

Active mine sites require significant amounts of capital expenditure to operate. Not only are huge amounts of equipment and machinery required to run the mine, exploration and grade control drilling is required to ensure sufficient ore reserves are maintained. Exploration is usually the first area hit in cost cutting cycles. BHP has been reducing and delaying capital expenditure over the past few years which will likely result in higher expenditure requirements in the future.

For more South32 information, fellow contributor Ryan Newman listed 10 things you need to know about South32 Ltd. Or, if you have a few months to spare and a lot of knowledge of mining operations, refer to the 1,354 page South32 pre-listing document for everything you need to know about the company.

Should you invest

South32 holds some high quality assets but as commodity prices continue to decline I fear the first operating year may be a baptism of fire for the new company and investors would be wise to wait for the first set of full year results before making any investment decision.

I prefer to invest my money in companies that aren't highly sensitive to the commodity cycle and those that also deliver a good dividend like the Motley Fool's Top Dividend Stock for 2015-2016:

Motley Fool contributor Mitch Sonogan has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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