South32 Ltd (ASX: S32) demerged from mining giant BHP Billiton Ltd (ASX: BHP) in May this year, with the former receiving BHP's "non-core assets" comprising its aluminium, manganese and nickel businesses. BHP retained its best-performing coal, copper, iron ore and oil assets, leaving many wondering whether South32 was always primed to head south.
A history of demergers
History shows that demergers usually result in the demerged entity outperforming the parent entity, post demerger. The reasons for outperformance are varied, with many believing management's sole focus on the smaller company creates more efficiencies, resulting in the demerged company outperforming the larger group.
In South32's case, the demerger strategy has not worked with the company dropping 39% from a post-demerger high of $2.45. In the same period, BHP's shares only dropped 14% indicating clear underperformance by South32.
What is the problem?
South32's underperformance raises concerns for why it diverged from the historical norm of demergers. I believe the pressures keeping a lid on South32's share price are threefold.
Firstly, global fears over China have dampened investor appetite for commodities, resulting in most commodities trading at decade lows. This places strain on even the strongest balance sheets (such as South32).
Add into that Glencore Plc's recent debt struggles and you've got reason number two; many believe most resources companies are facing big problems. It appears South32 has not created a reputation of strength just yet.
Finally, South32 is perceived as BHP's collection of "junk assets" it did not want; this adds to headwinds for South32's share price on concerns that its assets are inferior.
Let's look deeper
Management — led by Graham Kerr — has a proven track record for success and South32's assets are enticing for any would-be suitor "at the right price". From a fundamental perspective, the company appears well placed to deliver market-beating performance as it carries zero debt, is well diversified and generates plenty of free cash flows at current commodity prices. This makes South32 a takeover target.
In its most recent results, South32 disappointed with a maiden underlying profit of US$575 million. However, even at current spot prices, the company managed to generate US$1.7 billion in free cash, leaving it with ample headroom to make acquisitions at the current point in the commodity cycle. This ability to fund acquisitions makes South32 a takeover predator.
Foolish takeaway
South32's success seems inextricably linked to commodities. It has potential to make acquisitions, or be acquired, and so may prove history right yet by outperforming BHP in the long run. Whilst many shareholders may feel underwhelmed by South32's performance so far, the company is poised to take advantage of a low-point in the commodity cycle and should come out of it stronger than ever when the cycle recovers. Accordingly, it is one company to keep an eye on.
