South32 Limited (S32) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the South32 sale of Illawarra Metallurgical Coal Teleconference. [Operator Instructions] I would now like to hand the conference over to Mr. Graham Kerr, Chief Executive Officer. Please go ahead.

Thank you. Good morning, everyone, and thank you for joining our call to discuss this morning's announcement of our agreement to sell Illawarra Metallurgical Coal for a total consideration of up to USD 1.65 billion. Before we get into the questions, though, I'd first like to start with some opening remarks. Today's announcement represents an important milestone as we reshape our portfolio for a low-carbon future. I've always said that any divestment of Illawarra Metallurgical Coal or any asset in the portfolio would need to create value for shareholders, and it is our belief that this transaction will realize significant value. With attractive cash consideration of USD 1.3 billion and exposure to future metallurgical coal price upside through contingent price-linked consideration of up to USD 350 million, this represents a transaction multiple of approximately 7.2x annual average free cash flow from Illawarra over the period from FY '16 to FY '23. The transaction will streamline our portfolio to focus on our operating positions and growth options in the aluminum value chain, base metals, and manganese, which have attractive commodity outlooks and the transition to a low-carbon future. The transaction will strengthen our balance sheet, unlocking capital to invest in our development projects in copper and zinc, which have the potential to increase our base metals production by approximately 45% from FY '23 levels. It will also reduce our operating footprint and our functional support and substantially reduce the group's capital intensity, leaving us well placed to capture higher margins through the cycle. Following completion of the transaction, we will allocate the proceeds in accordance with our capital management framework, which is designed to support investment in our business, ensure an investment-grade credit rating through the cycle and support returns to shareholders in the most efficient and value-accretive manner. The transaction is expected to complete in the first half of the 2025 financial year, subject to conditions, including foreign investment review board approval and the waiver or non-exercise of preemption rights held by BlueScope. As the key ingredient in the production of steel, we have always believed there will be a strong demand for the premium quality metallurgical coal that Illawarra Coal produces until a low carbon steel becomes economically viable on a commercial scale. Whilst we still have that view, the strong output put forward by GEAR and M Resources provides an opportunity to realize significant value for our shareholders and simplify our portfolio towards critical commodities consistent with our strategy. The offer recognizes the excellent work by the team Illawarra to set the operation up for long-term success. As established participants in the Australian Metallurgical Coal industry, we believe that together GEAR and M Resources are the right owners to take Illawarra Metallurgical Coal into the future. They have a strong commitment to environmental and safety standards and are well positioned to continue Illawarra's contribution to the local community and steel industry. We look forward to working closely with everyone involved to support a successful transition of our ownership. I will now hand back to the operator and look forward to taking your questions.

[Operator Instructions] Your first question comes from Lyndon Fagan from JPMorgan.

Just wondering if you could start by defining a bit more around the use of the proceeds. So specifically, where do you see buybacks fitting into that picture?

Yes. Look, Lyndon, and good question. I'm sure it's on many people's minds. Look, from our perspective, I'll start by saying, look, one of the discussion points we've been having over the road show was what does our second half actually look like from a cash flow generation perspective. And just as a reminder, we expect to see a 7% increase on production. We're spending about $96 million less CapEx versus the first half. We've got about $100 million unwind of working capital to come. We've also either lowered or kept constant our unit cost guidance across the majority of our operations. And if you look at some of the key value drivers such as metallurgical coal and alumina, we've either seen continued strong prices or an increase in pricing. So we believe that sets us up a strong cash flow generation in the second half. When the proceeds come in, which obviously we expect to be in the first half of FY '25, and we should still have hopefully strong operating performance as well as cash flow generation from good prices, we will actually look at that pool of cash the same way we always have. We will look at that in the terms of our capital management framework, which always starts at that invest in new business to make sure it's safe and sustainable, keep that investment-grade credit rating through the cycle, pay out a minimum underlying earnings as a dividend, and then think about any excess cash, what do you do with it? We've spoken about the Taylor project. We've given a clear indication of the time frame of when that capital will be spent. The other big probably capital project ahead of us will obviously be around the fourth grinding line at Sierra Gorda. We've been clear that we probably think our preference of that is to actually fund that from the joint venture. What, obviously, we will lose over time is some of the cash flows that were coming from the future business from Illawarra, but we are getting those upfront and we are getting those actually, if you like, derisked, which I think is a real positive for us. So from our perspective, we would treat that excess cash like we have in the past. And historically, we've had a strong preference to sort of look at that excess cash in a way that's the best use for our shareholders, that probably hasn't changed, Lyndon. So I think the bottom line is when we have all the cash in the bank, we'll apply the same rules we have since we started in day 1 and treated very similar. There's not a big change in the actual capital profile from what we spoke about this week and last week.

And just a quick follow-up. Just in terms of the portfolio reshaping, it was recently when you said you wanted another asset in the portfolio. I mean just interested in how you -- what your vision is today and how manganese now fits in considering everything else has more of a base metal flavor?

Yes. Good challenge. I mean, we've always started with the portfolio we inherited even though we had some hand in shaping at the start of the life of South32 almost 9 years ago. We didn't expect that to be the same portfolio by the end. We've divested South Africa Energy Coal. Today, we announced the divestment of Illawarra. We've closed Metalloys, sold TEMCO, bought Sierra Gorda, bought into [ Hermosa ], announced the expansion or announced the initial, if you like, expansion of that first project in terms of building Taylor. So we certainly have shifted, if you like, not only the geographic location, but the spread of what our commodities look like going forward. Manganese is an interesting one. We believe that GEMCO still is the best manganese operation in the world. It has a life expectancy at the moment that depending on what happens around some future areas, somewhere between 6 to 8 years, that business is still a strong cash flow generating business for us, and it's important as we actually think about how we fund our continued shift into that base metals exposure. On top of that, as you're aware, our Clark with manganese, we're exploring the option of can we use that, obviously, in the battery space, particularly in the U.S. because of where it's located. And some, if you like, the opportunity to exist in the U.S. market. But I don't think that we should not also look at those options potentially around GEMCO and HMM. Today, we see battery manganese demand of about 1% of total demand. We could see that easily rising by 2030 to about 12-ish percent. So I think there's an opportunity there. But it does become a smaller and smaller part of our business. Your question, sorry, Lyndon, about another operating asset. Look, our focus, if you like, at the moment, is completing this deal now. Our focus is doing the first stage of Taylor well and importantly, getting that operational stability, if you like, back in the base business, doesn't mean we don't look at opportunities that come across our table, but the reality is they're far and few between, as we've seen over the last 8.5 years.

Your next question comes from Rob Stein from Macquarie.

Graham, just a couple of ones for me. When we look at the NPAT impact of this divestment, are you going to sort of rebase line up what your payout ratio will be, given that potentially you are losing by numbers anywhere from 12% to 17% of NPAT over the next 3 years. How will you sort of keep distributions flat on a compared basis and not drop your dividend on a payback basis?

Yes. So maybe, Rob, if I start with that one, I would like to comment and say, look, our capital -- our returns back to shareholders have always been more than just the base dividends. We've had the special dividend plus above the on-market buyback. I don't think we'd be looking to change our 40% earnings if underlying earnings, if you like, as a payout ratio. As commodity prices shift up and down, obviously, shareholders get the benefit on the upside of that. It protects the balance sheet on the downside. But like we have done in the past, if we are carrying excess cash that we don't have a need for, we'll look at the most efficient way to get that back to our shareholders. So if we don't have a way to create value for our shareholders who are investing in the business, then we'll look at the same mechanisms we have in the past. We're very conscious around obviously shareholders of balancing the growth of the organization. but also what the total cash flow year looks like, which is more than just the dividends.

And in terms of balance sheet moving forward, this does destress potentially what was a negative perception -- a negative perception coming out of the result. In terms of complete -- in about 6 months' time, are you looking to be conservative over the next sort of 12 months as you look to grow the business sort of links back to Lyndon's question about assets that you're looking to potentially enter into the future?

Yes. Look, good question. I mean, again, I'll probably slightly push back there and say, look, the deal still has to complete when we have the money in the bank, we'll have a look at what the best way is to use that money, but we'll also look at our operating performance between now and when the deal completes. And if we do have that excess cash that doesn't have allocation within the organization, we'll look at the best way to use it. The guide I will give you is we've always thought about having an investment-grade credit rating through the cycle. And when we say through the cycle, we test that in a sustained low environment, we don't plan to change the way we look at that. Our capital management framework remains the same. Obviously, the competition of the group changes. But how we use that methodology, we think it works in all the different models.

Your next question comes from Glyn Lawcock from Barrenjoey.

Graham, can we just get it on the record then? So the cash has to be in the bank first. So a buyback right now, you wouldn't do it based on the pro forma balance sheet, we're going to have to wait for 6 months' time, say when deal closes?

So I'd be very clear in category. Like we've always said from day 1 when we started buybacks and we looked at excess cash, it's never on prospective cash flows. It's always based on cash in the bank. We're not changing our philosophy on that. We said same approach to capital management framework. So the same rules apply.

Okay. So you came out 2 weeks ago and probably scared the market a bit by saying you're now going to operate in the $1 billion to $1.5 billion net debt range. Is that pro forma net debt is going to be 0 obviously, with this deal, does that still hold? Or do you push that back down? Or do you have what you think you need to run this business at now for the next 3 years to deliver on all your growth objectives?

So I would have -- a couple of comments around that Glyn, there's one, obviously, between now and when it closes, we expect to have that stronger operating cash flow in the second half of the year versus the first half of the year for all the points I made earlier, so I won't repeat those. The second thing is when we have the money in the bank, obviously, we'll have a look at what the position is there. We're -- that amount of debt that we've talked about as a guide has always been a proxy or a that calculation to investment-grade credit rating. So I'd say that number will shift. It will shift based on our EBITDA focus -- forecast and cash forecast going forward. I wouldn't say our capital profile is expected to change because the big items that are in the portfolio going forward, like most are in the fourth growing line. I don't expect those numbers to shift. Obviously, if you look at the forward cash flows, you will lose the future cash flows from Illawarra you're getting them upfront. But likewise, you'll lose some of that high capital expenditure that we've been experienced from the life of that asset. So what I'd say as we get closer to that point of time, we'll rebalance what we think the right net debt number is around then, Glyn, but it will move. I'd expect it to move lower than what we spoke about the $1 billion market.

Okay. And then just a final quick one. You made a comment in the opening remarks or in one of the questions about $100 million unwind of working capital in the second half. It was $276 million build in the first half, still a bit low, only $100 million unwind in the second half? Or is that just -- is there something I'm missing?

No. Probably the $100 million, I'm zeroing on is predominantly those 3 large shipments of aluminum that sort of came out of -- came out of Hillside that we've missed just in terms of shipping days. I think, look, there are some other movements that go up and down. We're also very conscious at the same time we're rebuilding, if you like, back up to nameplate capacity at Mozal and we're also with our color operating, the Alumar smelter building up there as well. So I'll probably more focus, and I know for sure, those 3 shipments will be unwinding.

Next question comes from Paul McTaggart from Citigroup.

Graham. Just a simple one. So what liabilities will pass across to the purchaser? I'm thinking in terms of pension liabilities, long-term provisioning, all that kind of stuff. I mean, what sort of liabilities will go across for this transaction that will come off your balance sheet?

Yes. So the way I think about it in simple terms, all the assets and liabilities will go across as part of this, including if you like, our rehab liability which is probably something that generally we show at the half year we show on the back of our investment pack. So for example, when we're talking about the liability to the rehab provision, it was about $237 million at the end of 31st of December 2023 or 10% of the group, which is a number that a lot of people don't include in their valuation, to be very clear. So that and all things like pension liabilities, any other liabilities and assets will go across completely with the sale. The thing you will have is customer in these kind of deals, is will have a look at working capital because there's a target working capital range. And that -- if that's sort of out of whack, that will be a slight adjustment, but we don't expect that to move materially.

Okay. But is it fair to assume what the purchase is paying is the headline number depending on the contingent payments plus rehab, et cetera, that goes across?

Yes, absolutely. I mean the other obviously advantage between now and if you look at some of the consensus NPVs until the deal closes, as you'd expect, we have full exposure to any cash or that turned down at Illawarra between now and then on top of, obviously, what we're going to receive and also the liabilities such as the close of liability going with the deal as well.

[Operator Instructions] Your next question comes from Paul Young from Goldman Sachs.

Firstly, well done, I guess, selling Illawarra above consensus NPV. So that's probably the first point to make. Graham, I missed the first bit of the call, so I might be asking you questions someone's already asked. But I know just -- I guess just on that as far as the good outcome on valuation is concerned, I know you, in the last 12 months, you've been talking about how bullish on met coal you are and also the fact that Appin is going into harvest mode in the next 12 months with the move to one longwall. So you derisking and you've spent -- you've had 2 years of sort of hard [ yakka ] and big spend getting to this point. So I guess the question I have is just how did you -- how did the Board -- how do you value Illawarra and how do the board get comfortable with the purchase price?

Yes. So a good challenge, Paul. I mean we're pretty simple on this. I think multiples, why we look at them as a secondary measure to see how we're tracking. We essentially value the business on an NPV. We understand the cost base, the capital base and obviously, the production profile probably better than anyone. Clearly, price is always an area that everyone has their own crystal ball, what we do believe is between now and when the deal closes, obviously, the coal price is quite high now. So we'll receive the benefits of that. And we believe the contingent piece we've got in place ensures we have a piece of any continued higher price that has achieved over the next period of time. The Board itself got comfortable around what we value that plus the transfer, if you like, of the liabilities across, plus those cash flows for the next period of time until this deal closes in the first half of FY '25, together, we saw that as greater value for our shareholders because of derisked execution risk. Execution risk as you know on a longwall as always, the longwall gets stuck or you have more gas than you expect. But the other one, while it has been a capital-intensive business, not all that capital is yet to be spent. They bench out 7 and 8, still have a considerable amount of money to be spent in '25 as well as '26. I think the other piece for us is the added benefit around the simplification of the portfolio. This has roughly 13% of our employee base because of the nature of the business with regards to mining underneath the water catchment because of the relationship, obviously, if the steel works, it's got a very high public profile. And permitting is getting harder and harder in this part of the world as well. We also have the benefits of reducing obviously Scope 1, Scope 2, Scope 3 emissions. And at the same time, we have an opportunity once this is settled to actually have a look at our model and say, okay, if you remove 13% of your employee base, what does that mean for your group overheads, how are you structured? How can you further simplify the business and think about where you're going in the future? So we think there's a lot of clear benefits from a dollar perspective that we know well. But we think on top of that, there's a lot of other benefits around simplification for the portfolio as well, Paul.

Okay. And then second question, how do you comfortable -- have you got comfortable with GEAR and M Resources sort of funding sources or ability that provide funding?

Yes. So obviously, it's a deal that's not conditional on financing to be clear. But look, from our side, obviously, we did due diligence to understand what do they like from a financing position. They both obviously have a stake in Stanmore. So it's a lot they knew to the metallurgical coal space. They both also, particularly GEAR have other investments in Australia that they have been making over the last couple of years. So we've done a fair bit of work to understand their financial strength. And we always got asked a question about Illawarra for probably the last 6 or 12 months. We've always said there's been deals on the table where the value rather hasn't been attractive, and it's been an executable deal. All the value has been, if you like, super attractive, we do think a deal could get executed. We think this deal has both. We think it's an attractive day for our shareholders. And we think, absolutely, they have the capability to execute this deal and actually take Illawarra forward in a way that I think is good for the people of the team at Illawarra, the local community and also BlueScope, which I think is important as well.

Okay. That's great. And last one, was this competitive? Were there other buyers in the data if you did have that open?

Yes. So we have had a number of approaches over probably the last 9 to 12 months. There's been a number of, obviously, transactions in the marketplace. It wasn't a sole process in the end. So we certainly knew what the optimum, if you like, value was from our perspective.

[Operator Instructions] Your next question comes from Lachlan Shaw from UBS.

Graham, thanks for the time. Maybe just one here, I suppose, portfolio and price. So you have done -- achieved a good outcome, selling the asset at above consensus NPV. But then if I sort of look at Hermosa and Taylor, we're investing here pretty reasonably high CapEx, 12% IRR at a zinc price is 20% above the consensus. Can you help me understand sort of -- how you sort of think about, how the Board thinks about that relative value between selling out to IMC and the Hermosa, Taylor investment?

Let's maybe break that into part is, one, again, we think we're getting a fair value for the business and the liabilities going with it and exposure to met coal prices, at least into the first half of [ FY '24 ]into FY -- first half FY '25. From a value perspective, we're thinking we're realizing that value from the sale of Illawarra, plus we've got the contingent piece. When you talk about Taylor, I always come back to the whole Hermosa piece. There's a bigger play here at play. If we sort of talk about the zinc price interesting that people use a spot price to say how does that compare against our price, how does consensus price compare. But the reality is if you took the last 10-year average for zinc, lead and silver and run it through the model, you probably get an IPR, which is much closer to 15%. If you look at some of the people on this call, Barrenjoey, Goldman's, their zinc prices a lot closer to ours. If you look at [ Teck ], you look at WoodMac, their's a lot closer when you look at some of the people who basically market product in terms of the traders, they would have a price above ours. So we don't think our zinc price is actually that -- I think what I'd say is consensus isn't necessarily detailed remodeled by everyone when it comes to zinc because it's not such a big exposure in commodities such as copper. So we're comfortable around our zinc price. When it comes to Taylor in the investment, and let's say, it's a 12% to 15% IRR, depending on, which zinc price you want to use. What I would sort of point out is a comment we made over the last couple of weeks is one, we're probably spend a big capital at Taylor, about 27% of that or $663 million since the prefeasibility study is actually shared infrastructure that creates the opportunity for Clark, Peake and Flux. The approval we're getting for Taylor will cover Taylor, Clark, a lot of Peake and enable some things on Flux as well. So Taylor is carrying a high burden on that. What excites me over the next 18 months of the Hermosa basin will be really, can we drill and prove the Peake over the next 18 months is connected to the bottom of Taylor steep. That's an option where no one has any kind of value fall. You talk about a kilometer long strike of copper. What would we have to do to sort of realize that value, probably spend about $40 million to $50 million to add an additional circuit to our plan, we've allowed services, and we've allowed if you like the space, and you end up producing a zinc, a lead and a copper con, and that's nothing anyone has in their model at the moment. On top of that, Clark were in the process of finishing the decline in the bulk sample. That's going to cost us about $60 million of which we would expect by halfway through this year to get some kind of a grant assistance from the Department of Defense. And then as we sort of talk to our 19 or so customers, then we'll give them enough material on that site to try and go to the next stage. So again, I wouldn't get focused just on Taylor. While that's got to wash its own face and create value and have upside, which it does around the resource, it does enable a lot of other options, if you like, in that Hermosa plant as well.

Great. And then maybe just a follow-up if I may. So a few weeks ago, you sort of laid out I guess, strategy balance sheet, $1 million to $1.5 million net debt target, factoring in the capital investment coming into Taylor. I suppose question I have is why -- why do this deal now? Is it sort of an offer too good to refuse or what else is at play there?

Yes. So I guess what I'd say is deals like this don't sort of happen overnight. Like I said, we've had a number of offers in the past where we've had people talk to us. Those deals are that haven't been at the right value that we think is right for our shareholders or they haven't been executable. We've had some deals that we thought were an attractive deal, I need to sort of fall away at the last moment. For Us, this is the reason we're doing this deal is we think, a, it's a great deal from our perspective around derisking those future cash flows, values, the business, which I think is great for our shareholders. Did it sort of appear overnight? No. Have we sort of been working through lots of negotiations and discussion around price probably over the last 4 months? The answer would be yes. Did we know we're going to have a complete deal probably not before just last night. So when we talk about that range of balance sheet, that's on the facts we knew at the time.

Your next question comes from Glyn Lawcock from Barrenjoey.

Graham, just after the technicalities of the structure of the deal as we walk forward in the next 6 months, I mean GEAR is a foreign entity, you operate in and around the water catchment area for Sydney. So a few people have asked me this morning, do you think there's going to be any issues around selling to a foreign entity? And then secondly, does BlueScope have to preempt now? Or do they wait to see if the deal closes first before they have to come back to you on their preemption?

So what I would say is that, look, let's take a step back first. And when we talk about GEAR, this is not their first time in investing in Australia. If you look who they are, they've made substantial investments in other parts of the resource base. They are substantial shareholders actually in Stanmore. They also own some other assets. They own 50% of One Rail Australia, 51% of Metarock and some other. So they've sort of been involved in things before both parties and they've actually been through, particularly GEAR has been served a number of times before. So they know this process, so they are no one's entity. So that will go through the thought process like everyone else, but it's not like they are new to this industry, and it's not new to investing in Australia. I think look, on the BlueScope thing, obviously, there is some sensitivities around this, but the preempt is a CP to the deal, i.e., it has to be done before completion. What does the CP give them? It gives them the right to basically transact on the same terms. They either exercise or they don't.

Okay. So they have the exercise before they know whether the deal is actually going to complete?

Correct.

And can GEAR come back and increase their offer? Or is it, that's it?

Look, we would sell -- the way that works will be on the same terms to basically BlueScope. It's not an option to retrade.

The GEAR count up their bid.

Yes.

That does conclude our time for questions. I'll now hand back to Mr. Kerr for closing remarks.

Look, thanks, everyone, for taking this call on such short notice. Look from my perspective, I think this is a very good deal for our shareholders. There's attractive cash consideration of $1.3 billion, price link consideration of $350 million. We obviously keep as met coal prices are high, we keep exposure to the commodity until this actually closes, which is not included, if you like, in most of the consensus valuations. We also move across those closure liabilities, which also has been included in most people's valuations. And on top of that, it allows us to streamline our portfolio, allows us to move more towards our base mills exposure or the metals that are critical for the future. It does actually allow us to reduce and simplify our business as we go forward. And I think it also sets up Illawarra with an owner going forward who believes in coal, and we'll look to invest and grow that business. So from our side, it's a big win. And again, I would like to thank everyone for taking this call on such short notice. And if there's any other follow-up questions, just reach out to the IR team. Thanks, everyone.

That does conclude our conference for today. Thank you for participating. You may now disconnect.