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Morgans Financial alarmed at South32's strategy shift

Morgans Financial Ltd. expressed alarm at South32 Ltd.'s "deteriorating" key assets and the miner's apparent rethinking of its entire regional operating model strategy, cutting its rating on the BHP Billiton Group spinoff.

The miner said Feb. 15 that it would double shareholder dividends and boost investor rewards after reporting a 14% lift in underlying profits for the first half of the 2017-18 financial year, but Morgans senior mining and energy analyst Adrian Prendergast scratched beneath the surface of those stellar results and did not like what he saw.

High unit costs plagued South32, which reported a decline in EBITDA margin to 31% from 33% despite sustained commodity price strength. The company reported softer than expected first-half net profit after tax of US$544 million, less than the US$579 million result Morgans expected. South32 also experienced higher costs from all but one of its divisions and reported broad fiscal year 2018 cost guidance downgrades.

The first-half results confirmed Morgans' economic concerns for the diversified miner, with unit costs for most of its operations now at levels near or even above where they were when BHP owned them before South32 debuted on its own on the ASX in May 2015.

Prendergast found that result "amazing" considering the "lack of focus" those assets were reportedly receiving from their parent.

He said Morgans had been growing "increasingly concerned" over the past nine months with "the apparent deterioration" of the operational and unit cost performance of some of South32's key assets.

"This situation is showing little sign of improving with South32 posting cost guidance downgrades across the board along with its [H1'18] result," the analyst said in a client note Feb. 15.

South32 also again downgraded its fiscal-year 2018-19 production guidance for Cannington while outlining major changes to its mine plan.

Morgans has now revised its forecasts in line with the changes to cost and production guidance, which has seen the firm's valuation of South32 drop from A$3.54 per share to A$2.97 per share, and moved its recommendation from "hold" to "reduce" on the miner's continuing operational underperformance and questions over shifting strategy.

South32 said it was "well positioned" with a net cash balance of US$1.4 billion despite a reduction in future Cannington processing rates and metal production, as South32 expects its working capital to also partially unwind.

South32 pointed out in its latest earnings that it also achieved higher realized prices for most of its commodities during the period, which helped deliver a US$273 million lift in sales revenue despite the significant reduction in coal and metal production at Illawarra and Cannington, respectively.

The miner's further announcement that it planned to make its South African energy coal assets a standalone business with the intention of broadening ownership also had Morgans worried.

"Also a concern, South32 now appears to be rethinking its entire regional operating model strategy, with the CEO [Graham Kerr] commenting that now is the time for change as it looks for ways to lower its ownership in South African thermal coal and potential acquisitions outside its current regional footprint," Prendergast said.

"This marks a material shift away from the regional operating model that South32 adopted as the centerpiece of its strategy when it was spun off from BHP and is of deep concern to us in measuring how effective their overarching strategy has been."