South32 Limited (S32) Earnings Call Transcript & Summary

Well, good morning, and good evening to everyone, and thank you for joining the South32 presentation. My name is James Redfern, and I cover the Australian mills and mining sector for BofA Securities in Sydney. I'm pleased to introduce our next speaker, Mr. Graham Kerr, Chief Executive Officer of South32. Graham was appointed CEO of South32 in 2014 and prior to that was the Chief Financial Officer of BHP. Graham then led the South32 spin-off, resulting in the IPO listing of the South32 in Australia, South Africa and London in 2015. Graham, thank you very much for your time today. And I'd now like to hand the call to you for your presentation, and then we'll have some Q&A after that. Thanks, Graham.

Sure. Thanks, James. Look, it's great to be back presenting at the Global Metals, Mining and Steel Conference albeit in a different way this year. Next week, we'll see the fifth anniversary of South32 becoming a stand-alone company. Our strategy and capital management framework has been at the heart of establishing our resilience, and I will take you through that and set out how this has shaped our response to the challenges of COVID-19 and explain what we are doing as a company to ensure we successfully navigate this unprecedented event. Moving to Slide 2. I briefly draw your attention to the important notices. Moving to Slide 3. At South32, we are focused on consistently applying our strategy, safely and sustainably improving our operating performance and responding decisively to meet market conditions to protect our strong balance sheet. We continue to reshape and improve our portfolio as we look to exit low-returning businesses and embed growth options with a bias to base metals. We are doing this in a way that maintains our disciplined approach to capital management. Moving to Slide 4. Our strategy remains unchanged. It's built on a disciplined approach and strong financial position, which means we are well placed to navigate the great uncertainty of COVID-19. The pandemic has created economic shocks that are flowing around the globe, impacting demand for some of our key commodities. Our response to COVID-19 is built around 3 areas: keeping our people safe and well, maintaining safe and reliable operations and supporting our communities. We have adapted working practices at every site to protect our people and ensure continued supply to our customers, and we have stopped all nonbusiness-critical work to focus on what matters most. We have contributed USD 7 million to our communities, and we are also helping to provide water, medical supplies, hygiene kits and assisting medical clinics to boost capacity in local health care systems. To protect our strong financial position, we have rapidly responded to adjust our capital expenditure priorities and suspend our own market share buyback. COVID-19 is one of the biggest challenges to global growth we have seen in our lifetimes. We must continue our focus on weathering this storm and emerging as a stronger company. Moving to Slide 5. Optimize, unlock and identify have been our strategy since day 1 and remains fit-for-purpose in these uncertain times. We optimize through making sure everyone goes home to safe and well at the end of each shift while delivering safe and predictable performance and continually improving the competitiveness of each operation. We unlock value through our people, projects and technology, and we identify opportunities to continually reshape and improve our portfolio and create enduring social, environmental and economic value. This strategy is underpinned by our disciplined capital management framework and strong balance sheet. Moving to Slide 6. In 2015, we inherited a portfolio that was diversified globally and by commodity with large positions in manganese and alumina. Since day 1, we have looked to improve that portfolio, moving further upstream and adding development options and forming exploration partnerships targeting base metals, a market where we expect growth as the world transitions to a lower carbon economy. Slide 7 highlights our diversified portfolio. While we are seeing some of the benefits of this diversification in the current environment, the foundation of our portfolio is high-quality manganese ore, aluminum and metallurgical coal operations. We have existing base metals production and want to grow this exposure through our development options at Hermosa and Ambler. Conversely, we continue to pursue a strategy of exiting lower-return businesses, including energy coal and manganese alloys, that will improve margins and lift group return on invested capital. Moving on to Slide 8. Our portfolio has generated earnings and cash through the cycle. Historically, we have earned an average underlying EBITDA of USD 2 billion per annum and an operating margin of 32%. Excluding SA Coal, our operating margin is 36%. Further in moving the processing businesses, that margin increases to 50%, demonstrating the quality of our upstream operations. As the chart on the right demonstrates that the periods of lower commodity prices, where our earnings have compressed, our conversion of profits to cash has still been high with cash from operations far outstripping capital expenditure. We have been disciplined in how we've allocated that cash, including improving our portfolio, returning it to shareholders and building a stronger balance sheet. Moving to Slide 9. Our strong balance sheet is at the core of our strategy. While we started with the strong balance sheet we have over the course of the past 5 years, we strengthened this even further. We consider this to be paramount for us as we enter this new phase and hold strong to the belief that we don't want to mix operating and financial leverage. With net cash, no term debt and an undrawn revolving credit facility, we currently have substantial liquidity ahead. On Slide 10, you can see how our disciplined approach extends to our capital management framework, which remains unchanged. This framework prioritizes running safe and reliable operations and also our investment-grade credit rating. In response to COVID-19, we adjusted our spending priorities to rapidly defer, rescope or cancel our noncritical projects. This has resulted in a 14% reduction in FY '20 capital expenditure and a further 18% cut in FY '21. FY '21 excludes South Africa Energy Coal, with the divestment left business on track for completion in the December half, subject to a number of material conditions. The divestment of South Africa Energy Coal will meaningfully reduce the group's capital intensity, having contributed 17% to our sustaining capital expenditure and 24% to our total capital expenditure since FY '16. Our next priority is to return a minimum of 40% of underlying earnings to shareholders through our flexible dividend policy. This is something we've been able to do every 6 months since our first dividend in September 2016. That policy also remains unchanged with a flexible payment that protects our strong balance sheet in the lows and allows our shareholders to share in the upside. Moving to Slide 11. Our capital framework is designed so that excess capital then competes through a home. We have developed a strong track record of returning excess capital to shareholders, including USD 1.3 billion through our flexible capital management program that was returned in the form of a nonmarket share buyback and special dividends. Combined with the USD 1.6 billion in ordinary dividends, we have returned approximately 48% of our current market capitalization to shareholders over the past 5 years. But we do believe this approach requires discipline and balance, and that is why we recently took the decision to suspend our on-market share buyback in response to the unprecedented shock caused by COVID-19. That's also why we invested in improving our portfolio, acquiring Hermosa and our option at Eagle Downs and through our greenfield exploration partnerships that led us to Ambler Metals. Ultimately, the decision to make it hopefully a development decision for these opportunities will need to pass strict return profiles so we deliver on the intent of our framework, which is to grow the group's return on invested capital and value per share. Moving to Slide 12. I will now briefly discuss the markets for our key commodities. If we look to the manganese market first, since late last calendar year, the market started returning to balance with meaningful volumes of high-cost South African trucking and other marginal producers exiting the market. In the first quarter of this calendar year, prices remained resilient even as Chinese imports fell 18% with in-country logistics impacted by the COVID-19 lockdowns. More recently, we have seen prices increase sharply in April as disruption to supply from South Africa, Brazil and other markets impacted more than 40% of global supply. While we expect prices to normalize once production has resumed, we will monitor the potential for persistent logistical challenges in South Africa to impact seaborne supply. With respect to alumina on Slide 13. We have seen prices for aluminum lower. Our current spot price is more than 50% of Chinese aluminum supply is loss-making. This situation is less dollar for the rest of the world, where you can see on the cost curve here that many refineries still remain on the correct side of the current spot price. This dynamic has supported the arbitrage window for flowing into China, and accordingly, we have seen a return into imported material. Long term, our view for the market outlook has not changed, and we expect alumina prices to be set well above current spot prices by new Chinese and Indonesian refineries that are induced to support and return to growth in demand for aluminum, and in turn, alumina. Moving to metallurgical coal on Slide 14. Ex China steel cuts in April have dampened the strong start to the year, driving spot price lower as lockdowns across Europe, and in particular, India had an impact. While we are observing some high-cost supply exit in the market, primarily out of North America, further cuts are required to bring the market back into balance with a strong demand response from steel restarts. Although we do note Chinese import restrictions may cap any potential upside in the near term. Moving now to Slide 15 and an update on our operations and development options. In Australia, production and sales volumes have not been impacted to date by COVID-19 with the exception of our GEMCO manganese ore operation in the northern territory, where production guidance was recently reduced by 5%. At Illawarra Metallurgical Coal, we have now restarted the third longwall with the operation having stabilized over the past 2 years and an existing 2 longwall configuration delivering strong output. We have commenced the review of the operation's long-term configuration that is going to look at optimizing production, sustaining capital and operating costs to maximize long-term value. At our Worsley Alumina Refinery, we lowered unit cost guidance 4% to USD 210 per tonne, reflecting a weaker Australian dollar and lower caustic soda prices and consumption rates, combined with the delivery of further cost initiatives as we focus on ensuring the refinery remained globally competitive on its journey to return to nameplate capacity. At the Eagle Downs Metallurgical Coal project, we have completed the remaining resource drilling with the interpretation of these results to inform the ongoing feasibility study. Given the current market uncertainty, we are prioritizing work with our joint venture partner to complete the current studies and ensure we preserve the value of our investment beyond the investment decision scheduled for the end of this calendar year. Moving to Slide 16 in South Africa, where our energy coal and manganese operations were initially impacted by the nationwide lockdown which commenced on the 26th of March. Since the easing of restrictions and in accordance with guidelines from the government, our export coal and manganese ore operations have resumed production, albeit at reduced rates. Our domestic coal production was largely unaffected. However, reduced power consumption during the national lockdown has had an impact on coal demand. As a result, we have reduced our FY '20 production guidance of coal to range at 21 million to 23 million tonnes as we continue to adjust volumes to maximize margins. At our South African manganese ore operations, we have lowered FY '20 production guidance to a range of 1.7 million to 1.85 million tonnes, with the delivery of this guidance subject to the pace of ramp-up and inland logistics performance. The Metalloys alloy smelter ceased operations under the nationwide lockdown, and subsequently an in-principle decision has been made with our joint venture partner to place Metalloys under temporary care and maintenance. Lastly, moving to the Americas on Slide 17. Given the national lockdown in Colombia that commenced on the 24th of March, we have deferred our planned refurbishment of one of the furnaces to the first half of FY '21. As a result, we have increased our FY '20 production guidance and lowered our operating unit costs to USD 3.73 per pound. At our Brazil Alumina refinery, despite an increase in the spread of the virus in Brazil, production has not been impacted to date by COVID-19 with the record achieved for the year to the end of March. We are, however, continuing to monitor the situation closely with our partners. As you can see, both of our development options have been impacted by minor delays given the restrictions on the movement of goods and people, and I will now step through each of these in more detail. Moving to Slide 18, our Hermosa project in Arizona. We broke the project into 3 pieces: Taylor, Clark and the region. The initial mineral resource of the Taylor deposits derisked our investment with drilling targeting possible extending to the resource, which remains open at depth and laterally. The prefeasibility study for Taylor is expected in the September 2020 quarter. To date, we have directed our efforts at Hermosa after progressing this study as well as understanding the resource, completing important land acquisitions and establishing surface infrastructure. The picture on this slide shows a tailings storage facility after the completion of the voluntary remediation program and down in the distance of the portal and the water treatment plant. Moving away from Taylor on Slide 19. We have increased our land holdings at Hermosa by 50% since the acquisition and identified 15 new exploration targets across the land package with drilling work already commenced on many of these. Separately, today, we announced the first-time mineral resource for Clark, the zinc-manganese oxide deposit. The resource measuring 55 million tonnes potentially provide future exposure to emerging battery markets. And we have commenced a scoping study to evaluate these options and further assess the opportunities in these new markets. Moving to Slide 20. The Ambler Metals project is located in Alaska and can also be broken into 3 parts: the VMS-style high-grade polymetallic Artic deposit, the Bornite copper deposit and an attractive regional exploration holding. And the metal sits behind most in terms of sequencing and is still at an early stage. The JV partners have commenced a prefeasibility study for Arctic. The key here is an access road to unlock the region. An EIS on the road has been through public consultation and submitted by the U.S. Bureau of Land Management with the record decision expected this calendar year. Moving to Slide 21. We are reviewing our work program for the calendar year in Ambler to take into account restrictions related to COVID-19. When we do undertake this work, our focus for Artic will be on resource definition drilling to support development studies and the prefeasibility study, which is underway. Our drilling will also be focused on exploration targets within the Ambler VMS belt, where Arctic resides, given the propensity for deposit of this nature to repeat. To Slide 22. In summary, we have a consistent strategy, the portfolio of assets that generated cash through the cycle. We have a disciplined approach to capital allocation and our balance sheet is strong with significant liquidity. This approach has enabled us to invest in our business, improve our portfolio and bid exciting growth options and returning nearly half of our market cap to our shareholders in the form of dividends and buybacks over the past 5 years. We are on the pathway to reshaping our portfolio by exiting low-returning businesses and are well placed to navigate these difficult times, keeping our people safe and well and supporting our communities while maintaining safe and reliable operations. Thank you.

Thanks, Graham. That was excellent. Just -- I've got a few questions I prepared. But we've got the question from the audience, and we'll ask that first. And the question is, if you think about the pitch on South32 when it was first spun from BHP, do you think you had delivered? Put another way, has capital deployment taken longer than you might have expected?

Yes. Look, James, a good question. Obviously, something I always challenged myself because 5 years into the journey, I would always like to be more advanced than where we are today. I think we've been very, if you like, progressive and fast in adding options to the group. Because when we started the journey, as people are aware, the cupboard was really bare in terms of development options. We now have Ambler, which has multiple options; Hermosa, which have multiple options; and Eagle Downs as future investment options to compete for capital. I think what I would say though is that as we move through the businesses in terms of what we don't want in the portfolio, that is probably taking probably a little bit longer than what we expected when we started the journey. But obviously, a big milestone for us will be the completion of the SAEC transaction by the end of this calendar year because that greatly reduces the complexity of the business, the number of people we employ, the regions where we operate, the [ lath ] of security issues, the community issues and things like our closure rehab, [ all in all ] parts along with that business, which really reshapes, if you like, South32. So I would like to have completed that 12 months ago, but we're on track to complete it by the end of this year.

Okay. Graham, I might start with the divestment of South Africa Energy Coal. You mentioned it's due to be completed by the end of this year. Just wondering, are there any risks in this transaction not completing given the COVID crisis and the decline in thermal coal prices? So just wondering like are there any risks in this transaction not closing? And can you perhaps talk to the logic of this deal for both Seriti and South Africa?

Yes. So maybe if we talk a little bit about Seriti first, James. Seriti is a black-empowered group where the CEO is Mike Teke. He has a large percentage of ownership in the company. They did purchase from Anglo their domestic coal business a couple of years ago. So today, they run a business in South Africa across multiple mines, and it's a cost-plus arrangement with Eskom. So the current thermal coal price that you see in the export market is not really impacting that financial viability. Part of the reason why this deal is attractive for them is they are seeking to build some new projects at land that they already have. They're looking to also leverage some of their existing operations by sharing the infrastructure that our energy coal business has today that is underutilized. And that includes things like rail capacity, draglines. They're also looking, at the same time, to have the opportunity to actually tap the export market. And not only do we have export quality material they can use such as the Klipspruit Extension project. They will also get our entitlement to actually use the rail and also become a part owner of the port. So that gives them a whole new opportunity in that space. I've talked to Mike on a regular basis. Mike is still very committed to the deal, continues to talk publicly about why it makes sense to him. And certainly in our discussions, he's looking to progress it as fast as he can. So from his side, I see no moving away. From a South African perspective, I think, look, it meets the criteria that they're looking for around local ownership, black-owned businesses and actually putting particularly the strategic commodity of thermal coal back in the hands of South Africa. So I think that sort of works from their side. If you think about the deal itself, as we've said from day 1, there are a number of approvals and conditions that we need to complete. The real approvals, the Department of Minerals and Resource of Energy (sic) [ Department of Mineral Resources and Energy ] Section 11, that's making good progress. We're comfortable with how that's going. The second one is around South African competition, which has 2 leanings: one will be around public interest, which I think we spoke about, which is clearly in favor of South Africa; the second piece will be around concentration of supply, which will be a discussion with Eskom. But even together, the combined group of Seriti and our South Africa Energy Coal business will not sort of tip their mental position, where I think that will be problematic. Probably the other thing we need is a couple of things from Eskom. One is consent for the transfer of the long-term commitment contracts around feeding the Kendal power station from Khutala and the Duvha power station from the WMC Complex, and in particular, Seriti. They will require Eskom’s consent. If you remember the Duvha contract, that is something we have publicly spoken about on a number of cadence, which is a bit of a challenge contract because we essentially lose money on every single tonne that we produce. A sign, I guess, of the progress we’re making with Eskom and the government is we do have interim [ high relief ] agreed between the parties, which effectively means for that Duvha contract now, we are not taking losses, we are getting our costs covered. And we believe that provides a good basis for a long-term discussion between Seriti and Eskom. And the advantage for Eskom of putting the assets together is that we actually, together, can provide more coal to Eskom at a lower cost than what we're actually seeing today. Now from our perspective, obviously, it'd be nice if thermal coal price was stronger for the export market. The domestic business hasn't really changed. And clearly, the export business will ride out the prices the market has. But Seriti today is as keen as they have been, and we certainly believe that they can build and transform and sustain a business that ticks all the criteria South Africa is looking for.

Okay. Great. Switching gears a little bit. If you look at South32's commodity exposure, the 2 main commodities are manganese and alumina. I know that manganese prices have increased by around about 50% year-to-date due to a supply side response as the high-cost trucking operations were curtailed. And also, we saw some lockdowns in South Africa. You talked about manganese prices normalizing at some point. The spot price stays around $6 to $7 to be on what we're looking at. So where do you see manganese prices normalizing? And then on alumina, prices are quite weak due to weak demand and excess supply. How do you think about the alumina price out looking into medium term? And what's going to be the catalyst to see prices moving higher?

Sure. Perhaps we'll tackle manganese at the moment. And clearly, that's a market where we are in a strong position at the moment. It is a market that over the last 5 years, it's pleasing to see that it has followed, if you like, the economics that we would expect in terms of demand and supply. To start, what’s happened in that place is that Kalahari is the world's largest station of manganese ore. It has generally being constrained by rail and port capacity, particularly rail. And when prices get to a certain level, it induces trucking in South Africa, which means more volume comes to the market which pushes down the price. Over the last couple of years, you really see China's demand of the product change as their own domestic production has basically degraded. They're now importing about 90% of their needs, and that will continue to become challenging for them, but they'll need more and more order come in. So I think that's a healthy dynamic in terms of demand for manganese ore. One of the advantages, obviously, in manganese ore is that you actually need to reapply it even when you recycle steel, unlike some of the other input such as iron ore and met coal. When we look at the market today, clearly, COVID-19 has had an impact. If we look at our forecast for the calendar year '20, we would see a global ore deficit of about 2.2 million tonnes, about 5% of the market, given the supply disruptions we've seen in South Africa, Gabon and Brazil. I guess with the government in South Africa relaxing in early May some of their conditions, we are starting to see obviously ourselves but also our peers in the industry start to reopen their South African mines. And they're all across South Africa at the moment as you can basically run 100% of your -- the capacity 100% for open pit mines and 50% of your underground mines. Majority of mines in the Kalahari are predominantly open pit. And I would expect there's a lot of cost barriers on most of those operations starting up. I think the one thing we need to watch with interest will be around what happens with Transnet. It's a state-owned enterprise who runs a rail and port system. They've probably been slightly slower coming back up to speed. They have had a number of, if you like, incidences around COVID-19 that they’re managing in a good way, but they still got some challenges. So I think for the next 2 months, it will take them a little bit of time, if you like, to sort out some of those logistical issues. Probably one of the other questions we got asked a lot today and during the week has been, has the actual inducement pricing for trucking changed? Yes, the world has seen lower oil prices, but the reality is when you look at what comes out of the bowser in terms of diesel in South Africa and you look at the movement in the rand, it's probably they negate each other. And as a consequence, the inducement price is still somewhere around $3.75 to $4 on a 44% equivalent basis. But trucking isn't the ultimate solution because unlike the train, we have rapid train load-out facilities. You cannot load the trucks in the same way in terms of volumes. And likewise, the roads that the trucks are using are not maintained and obviously have the same kind of unloading challenges and issues when you get to the port at the other end. So rail is still always the most attractive way to go. But we would expect towards the back end of the year, as you see supply come back onboard out of South Africa and other parts of the world, there will be downward pressure on the 44% price. And as a consequence, we will also see price move as it has in the past. We'll see the trucking come in and out. The one thing we have seen in the 5 years again in South Africa is the economics play out every cycle. And we probably had 3, 4 cycles of this now since we've been as a stand-alone entity. Does that sort of -- James, that covers you on manganese?

Yes, it does Graham. And alumina would be excellent too, if you could provide some color there.

Yes. Look, alumina is obviously a market that we would describe as Ambler at the moment. If you look at the current prices of around $243 a tonne, you'd probably say about 36% of the global market for supply and 56% of Chinese supplier losing money. So it's tough in the industry, and it's not an easy industry to actually close down existing operations. I think what we do take some positive signs away would be if you talk about Chinese capacity, and 12 months ago, in calendar year '20 and '21, the majority of people, including ourselves, are forecasting roughly 20 million tonnes of additional capacity coming into China. Based on the latest estimates over that same time frame of 20 to '21, we're seeing more like 6.3 million tonnes of additional capacity coming into the marketplace. I think, however, as we look at the actual prices now, it is clear that the prices have rebounded from where they were, and that's really being driven by the tighter Chinese supply. And that sort of provides a little bit, if you like, arbitrage between the local domestic product and also the imported products. So around the $240, $250 market is making a difference. I think long term, we haven't changed our view in terms of the price. It's basically going to be set by a refinery in Indonesia using domestic bauxite. Or it's going to be used -- it's going to be set by a Chinese refinery that's importing bauxite in somewhere likely. I would make the comment that if you look at Worsley to sort of give you a perspective how Worsley is performing, Worsley for us is quite a mature asset. We have been on a journey to hit the nameplate capacity at the E&G Project we finished in 2013. And that's required over the last 18 to 24 months of investment in fixing the calciners. The majority of that money is actually behind us. And if you think about the unit costs that we quoted in the first half of FY '20, so July and December last year, we talked about $225. We've given full year guidance up until June to be $210, which effectively means in the second half of this year, we're running Worsley at about $196 a tonne. Keeping in that right spot on the cost curve, I think, is incredibly important for us. And it just reflects the high-quality nature of that asset.

Okay, Graham. It's amazing how fast time flies. Unfortunately, we're out of time. I'd like to thank you very much for your presentation and your time this evening. I know it's getting late in Perth. Thank you, everyone, for joining the call. And we're going to conclude it there. Thank you.

Thank you.