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Potential For Further Returns At South32

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Manganese ore production was the highlight in the December quarter for South32 ((S32)), offset by weaker production from the company's Worsley (alumina) and Cannington (silver, lead and zinc) mines.

The company maintains FY18 guidance, although lifts forecast for South African manganese by 8%. Maintenance activities at Worsley and an electric arc incident at the aluminium smelter in South Africa resulted in weaker production at both sites. UBS suggests it may be challenging for these assets to hit FY18 guidance.

The December quarter was expected to be about mending operating issues at Illawarra (coal) and Cannington. At Illawarra, production has improved by 200,000t but a full recovery is expected to take 12 months.

Still, Ord Minnett expects achieved prices will likely reflect the benchmark. Illawarra production was broadly in line with Macquarie's estimates and the product mix included a positive skew to coking coal relative to its forecasts.

Meanwhile, Cannington is currently mining lower grades and has reduced the mill throughput, lowering production. UBS points out the company is relying on higher grade stopes in the second half as well as a commissioning of the crusher in March to ensure guidance is achieved. 

Brokers note the lower grade has now pressured the asset to lift its performance substantially in the second half. First half silver production was equivalent to just 36% of the full year guidance. Credit Suisse suggests, as Cannington moves into its last decade, variable grades and production should not come as a surprise.

South African and Australian production of manganese were the highlights in the report, exceeding broker estimates substantially, and increasing 28% and 11% quarter on quarter, respectively.

Macquarie estimates the company ended the first half with a net cash position of US$1.9bn. Net distributions of US$238m received from equity accounted investments in the first half were significantly higher than Macquarie's base case estimates.

South African coal production was flat, although export volumes were up 13% because of a reduction in domestic demand. The company has stated this may imply downside risk to FY18 production guidance.

In turn, Deutsche Bank suggests it implies more exports of higher margin coal. Nickel production was -14% lower quarter on quarter but still well ahead of the broker's forecast.

Deutsche Bank expects the company to finish the December half with a flat cash position, despite a better dividend from manganese. The main negative is higher working capital because of the build up in inventory and receivables. The company expects the build up in working capital to unwind in the second half.

Shareholder Returns

Citi downgrades to Neutral from Buy believing that, although the company has a strong balance sheet that will provide the potential for further returns to shareholders, it offers limited growth from the existing portfolio.

If spot prices were maintained, the broker's FY19 estimates for operating earnings (EBITDA) would be 45% higher, at US$3.5bn, and the company would generate US$2.2bn in free cash flow that could further top up returns to shareholders through either buybacks or dividends.

Credit Suisse also elects to downgrade the stock, to Underperform from Neutral, given continued strength in commodity prices has meant the stock has rallied almost 17% since Christmas.

The broker looks for a lower entry point but concedes that, if commodity prices hold up for longer than currently assumed, value will remain compelling because of the state of the balance sheet and the capacity for further shareholder returns.

The company has committed to return US$750m to shareholders by the end of October. UBS suspects the on-market buyback program is unlikely to meet this timetable and assumes a higher dividend payout ratio for FY18, at 70% versus 50%, to take up the shortfall.

While the company has completed $305m of the $750m capital return, Ord Minnett does not expect a top up and forecasts a US7c interim dividend. As the stock is trading around the broker's fair value estimate, a Hold rating is maintained.

FNArena's database has two Sell ratings, five Hold and one Buy (Morgan Stanley, yet to comment on the report). The consensus target is $3.50, signalling -8.0% in downside to the last share price. Targets range from $3.08 (Morgans, yet to comment on the report) to $3.85 (Ord Minnett).

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