Can South32 Ltd shares go higher?

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On Monday morning, the Fairfax Press reported that analysts at Credit Suisse believe South32 Ltd (ASX: S32) is on track to return $500 million in cash to shareholders by the end of this financial year. The investment bank’s comments come after shares in the BHP Billiton Limited (ASX: BHP) spin-off continue to hit new highs amidst a resurgence in commodity prices, as South32’s shares year-to-date rally eclipses 230%.

The question on everyone’s lips now is whether this trend can continue.

The demerger

South32 demerged from Anglo-Australian miner BHP in July last year, sent on its way with BHP’s “non-core assets” of aluminium, manganese and nickel as its core businesses. At the time, BHP retained its better performing coal, copper, iron ore and oil assets, leaving naysayers concerned about South32’s long-term prospects.

Over 12 months on and the demerger strategy appears to be doing wonders for shareholders who held or acquired South32 after listing, as a profound recovery in metallurgical coal and rising commodity prices does wonders for South32’s free cash flow. This has sent its shares soaring in 2016.

Although a rally in iron ore, copper and coal prices has lifted BHP’s shares over 25% since the start of the year, shares in the diversified mining giant have underperformed South32’s returns 10-fold.

As a matter of fact, with the exception of Whitehaven Coal Ltd  (ASX: WHC), South32 has outperformed most resources companies including the likes of Rio Tinto Limited  (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG).

I believe this out performance is, in part, thanks to South32’s strong financial position.

Financial prowess

In its 2016 full-year results, South32 announced it generated US597 million in free cash flows, as a robust operating performance and controlled cost savings of US$386 million allowed the S&P/ASX 200 Indexs (ASX: XJO) newest miner to report underlying earnings (EBITDA) of US$1.1 billion.

Although this number was down 39% on 2015 results, South32’s disciplined cost control and focus on efficiency enabled it to pay its maiden dividend of US 1 cent per share, ending the year with net cash of US$312 million.

Credit Suisse expects this figure to swell to $1.1 billion by FY17.

Capital management

According to analysts at Credit Suisse, the recent uptick in commodity prices puts South32 on track to generate approximately US$780 million in free cash flows in the current financial year, with the company hitting $1.8 billion in net cash by the end of the 2018 financial year (if current commodity prices persist).

Whilst the likelihood of commodity prices remaining at current highs is quite slim, the prospects of South32 upping its dividend is high. With approximately 5.3 billion shares on issue, Credit Suisse believes the Perth-based miner can pay almost US 10 cents per share as dividends in 2017. This would place it on handy yield of over 4% at current prices, meaning investors should take note.

Foolish takeaway

Before going out and buying South32 shares on the back of Credit Suisse’s analysis, investors must remember that South32’s success is inextricably linked to commodity prices.

Whilst its shares have defied gravity in 2016, I don’t expect commodity prices to continue their meteoric rise going forward. As such, long-term investors are better off waiting for a pullback before purchasing shares.

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Motley Fool contributor Rachit Dudhwala owns shares of South32 Ltd. 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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