It has been a trying couple days for South32 (ASX:S32) shareholders with a 16% plunge in the share price. The impetus for the sell-off was a recommendation by the Western Australia Environmental Protection Agency (“EPA”). 

The EPA is recommending approval of its proposed expansion of bauxite mining operations to supply its Worsley Alumina refinery. The EPA’s conditions restrict access to certain higher-grade areas and also increase operating costs, threatening the continued operation of the refinery should the Western Australian government agree with the EPA’s recommendations.

While South32 plans to appeal the decision the announcement rattled investors. Investors also reacted to modestly disappointing fourth-quarter and fiscal 2024 sales, and lowered fiscal 2025 production guidance for Worsley alumina, Sierra Gorda copper, and its Cannington silver, lead, and zinc mine.

We think the market’s reaction is overdone, and modestly reduce our fair value estimate for South32 by 4%, to $3.50 per share.

Shares trade about 16% below fair value. After incorporating updated fiscal 2025 guidance, we reduce our forecast alumina, Sierra Gorda copper equivalent, and silver sales, by 9%, 5%, and 6%, respectively, to around 4.9 million metric tons, 85,000 metric tons, and 11.3 million ounces, respectively.

We assume production issues driven by lower grades at Worsley Alumina and Sierra Gorda continue into fiscal 2026, with our forecast alumina and copper equivalent sales now 4.9 million metric tons and 87,000 metric tons, respectively, down 9% and 2%, respectively. Unit costs for each of these operations are also increased accordingly for fiscal 2025 and 2026.

We assume grades improve at Worsley alumina and Sierra Gorda in fiscal 2027, with our forecast alumina and copper equivalent sales of 5.4 million metric tons and around 90,000 metric tons, respectively, unchanged. While we modestly reduce our forecast silver, lead, and zinc sales at Cannington over the remainder of our five-year forecast period as the underground mine nears the end of its life, our other long-term forecasts are broadly unchanged.

Business strategy and outlook

South32 is a diversified midtier global mining company spun out from BHP in 2015. South32 has commodity diversification and its operations are generally in the bottom half of their industry cost curves. However, they generally lack maintainable competitive advantage given relatively high capital intensity, a lack of barriers to entry, and in some cases, relatively short reserve life.

South32's alumina operations are in Australia and Brazil, and it also has aluminum operations in Brazil, South Africa, and Mozambique. Aluminum smelting and alumina refining assets are generally in the bottom half of their respective industry operating cost curves. Similarly, South32's Cerro Matoso nickel mine is in the second cost quartile of the cost curve. However, NSW Metallurgical Coal is located in the upper half of the industry cost curve.

The highest-quality operations are Australian manganese and Cannington silver/lead/zinc, both of which are in the lowest-cost quartile of the cost curve and have historically generated strong returns. We expect strong returns to continue, with the outlook for precious metals, including silver, more positive thanks to demand from emerging-market consumption. However, we do not consider Cannington a moaty asset, as reserve life is less than 10 years.

The purchase of the Hermosa Project with the acquisition of Arizona Mining in 2018 brings the low-cost Taylor zinc/lead/silver asset, similar in quality and output to Cannington once developed. High grades support cash costs in the lowest quartile of the zinc cost curve and resource life is long, sufficient for about 30 years production. South32 also entered the copper business in 2022 via the purchase of a 45% stake in the Sierra Gorda mine in Chile. While Sierra Gorda is located in the second quartile of the copper cost curve, it was an expensive purchase.

A number of South32's operations are in higher-sovereign-risk locales, including Hillside aluminium in South Africa, Mozal in Mozambique, Alumar in Brazil, South Africa Manganese, and the company's nickel operations at Cerro Matoso in Colombia.

Moat rating

As a commodity producer, South32 is a price taker and needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat. We forecast midcycle returns on invested capital in the midsingle digits, below its weighted average cost of capital of about 10%. As South32’s midcycle ROIC is below its WACC, we don’t assign the company a moat.

In terms of commodity prices, our midcycle assumptions for alumina, aluminum, copper, silver, and metallurgical coal are about USD 330 per metric ton, USD 0.80 per pound, USD 3.65 per pound, USD 32.30 per ounce, and USD 155 per metric ton, respectively, from 2028 based on our estimates of the marginal costs of production. We also assume nickel prices of about USD 8.30 per pound and manganese prices of USD 370 per metric ton from 2025 based on spot.

In calculating ROIC, we have added back to invested capital about USD 7.5 billion of asset and intangibles write-downs taken over the past decade on the basis that these amounts relate to assets developed or acquired in the ordinary course of business and so should be included when calculating ROIC. Some of the more material amounts include USD 2.4 billion in relation to aluminum, USD 1.7 billion in relation to its now-sold South Africa Energy Coal business, USD 1.3 billion in relation to its potential Hermosa development in Arizona and USD 1.1 billion in relation to manganese.

Looking at each of South32’s segments in turn:

Aluminum (no moat): South32’s 86%-owned Worsley Alumina operations, which include a bauxite mine and refinery, and Brazil Alumina, which includes a 33%-owned bauxite mine and the 36%-owned Alumar alumina refinery in Brazil, are in the bottom quartile of the industry cost curves.

In contrast, the company’s three aluminum smelters sit in the second quartile of the cost curve. However, we note that its 40%-owned Alumar aluminum smelter and 63.7%-owned Mozal Aluminium smelter in Mozambique are hydro-powered, which may provide future benefits to their relative cost position if governments impose carbon and/or other taxes on carbon dioxide emissions. At our assumed midcycle alumina and aluminum prices of about USD 330 per metric ton and USD 0.80 per pound from 2028, respectively, and once historical asset and intangible write-downs are added back, we forecast mid-single-digit return on invested capital (“ROIC”) in fiscal 2028. As such, we don’t deem the aluminum segment moatworthy.

Nickel (no moat): South32’s 99.9%-owned Cerro Matoso nickel operations in Colombia have cash operating costs that are in the second quartile of the nickel cost curve, and in our view, are likely to remain so over the forecast period. At our assumed midcycle nickel price of USD 8.30 per pound from 2025, we forecast the nickel segment will generate a midcycle ROIC in in the low single digits, far below South32’s weighted average cost of capital (“WACC”) of around 10%. Cerro Matoso also has less than a decade of reserves remaining and so we don’t consider it moatworthy.

Manganese (no moat): Through its 60%-owned Samancor joint venture with Anglo American, South32 is the biggest manganese producer in the world, supplying around 20% of the seaborne market. Its Gemco business in Australia produces around 60% of total segment production and is one of the largest, lowest cost, highest-grade manganese mines in the world, more than compensating for Samancor’s lower-grade South Africa operations which are located in the second quartile of the cost curve. At our assumed midcycle manganese price of USD 370 per metric ton from 2025, we forecast the manganese segment will generate a midcycle ROIC materially above South32’s WACC of roughly 10%. But Gemco has a remaining mine life of less than a decade and so we also don’t deem the manganese segment moatworthy.

Cannington (silver-lead-zinc) (no moat): Cannington is a very high-grade silver mine and also produces material amounts of lead and zinc as byproducts. Cannington is in the lowest quartile of the cost curve and at our assumed midcycle silver price of around USD 32.30 per ounce from 2028, we forecast Cannington will generate a midcycle ROIC in the triple digits, far above South32’s WACC of about 10%. However, with a mine life of less than a decade, we don’t deem it moatworthy.

Taylor zinc-lead-silver project (no moat): We think the Taylor project is likely to start production toward the end of our five-year forecast period and ramp up to full production by the end of this decade. Taylor is a low-cost project located in the first quartile of the cost curve with a likely initial mine life of around three decades. However, as we think it will be unlikely to generate midcycle ROIC above South32’s WACC of about 10%, we don’t deem it moatworthy.

Copper/Sierra Gorda (no moat): While Sierra Gorda is located in the second quartile of the copper cost curve, South32’s 45% stake was an expensive purchase. At our assumed midcycle copper price of about USD 3.65 per pound from 2028, we forecast the copper segment will have a midcycle ROIC in the high-single digits, below South32’s WACC of around 10%. As such, we don’t deem the copper segment moatworthy either.

Metallurgical (or steelmaking) coal (no moat): The company’s Illawarra Metallurgical Coal business is located in the upper half of the industry cost curve. South32 has agreed to sell the business, likely effective in the third quarter of 2024.

Exploration projects (no moat): These are an immaterial part of South32 and way too early in their potential development to assign any of them a moat. However, for context, South32’s expenditure is modest relative to earnings, spending about USD 40 million in fiscal 2023 versus about USD 1.6 billion in earnings before interest and taxes (“EBIT”).

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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