Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

For all the debate about activist investor Elliott Management Corp.'s assault on the mining company now rebranding itself as BHP, there's another question investors should be pondering: What's going to become of Billiton?

South32 Ltd., the company spun out of BHP Billiton Ltd. in 2015 and consisting largely of sub-scale assets brought into the business in its 2001 merger with Billiton Plc, has put in a creditable performance of late.

They Grow Up So Fast
South32 has outperformed its former parent BHP Billiton since their 2015 split
Source: Bloomberg
Note: Rebased. May 22, 2015=100.

As Elliott would be happy to point out, South32's shares have risen about 28 percent since the split, compared with a 21 percent drop at its larger sibling. After two years of losses, analysts expect $1.24 billion of net income in the year through June. In a mining industry still groaning under the weight of its debts, South32's $859 million net cash pile is the biggest after Coal India Ltd. and Hindustan Zinc Ltd.

A problem looms on the horizon, though -- because South32 is living on borrowed time. 

Every resources company has to deal with the fact of its own mortality. Unlike shoe factories or social-networking apps, mineral deposits have a finite lifespan. Mining bosses are in a constant race to extend their reserve base faster than their drills and dump trucks can exhaust it.

That's a major challenge for South32. Its crown jewel -- the Cannington zinc-lead-silver mine in northwestern Australia, which generated almost 70 percent of Ebit in the most recent fiscal year -- is almost tapped out, with just six years of reserve life left at current mining rates.

It's not the only pit that's almost empty. Based on Chief Executive Officer Graham Kerr's presentation Tuesday to a mining conference in Barcelona, the only assets likely to be in operation 10 years hence are a handful of unprofitable manganese, coal, nickel and alumina mines. (That's unless extension projects or higher commodity prices change the picture.)

Best Before Date
The reserve life of Teck's mines skews longer than at South32
Source: Company reports
Note: Quebrada Blanca extension is included since the project is at the environmental-permit stage. Other extension projects that are only at the study stage haven't been included.

Here's a potential solution: a merger with Teck Resources Ltd., the Canadian zinc and coal miner that survived a near-death experience during last year's commodity crash.

As in all good marriages, each side would bring something useful to the party. Both have expertise in coking coal and zinc, two of the better-performing commodities of late, plus options to expand in an array of other commodities.

Meanwhile, South32 has an excellent balance sheet but a thinning reserve base. Teck, with $4.77 billion of net debt alongside copper and coking coal deposits that could be mined for 20 years or more, is in the opposite situation. In return for the stability of South32's cash, Teck could offer the longevity of its assets. 

The market capitalization of the two companies has been tracking closely since South32 was spun off from BHP, so a share-based merger would make a lot of sense. Based on Bloomberg's merger calculator, South32 could offer a 30 percent premium to Teck shareholders using its stock as currency and still generate an 11 percent improvement in earnings per share this calendar year, followed by a 16 percent gain in 2018.

Blood Brothers
The market capitalizations of Teck and South32 have been tracking each other for two years
Source: Bloomberg

What are the objections to such a deal? Geographically, a combined South32-Teck would be somewhat complicated -- but South32 already operates across Australia, South Africa and Brazil, so adding Canada and the U.S. to the mix wouldn't be a dramatic leap. Kerr, a former chief financial officer of BHP, is used to operating on a global scale.

A more significant hurdle would be the fact that Teck is more or less controlled by its founding Keevil family, thanks to a dual-class structure that gives the A-shares in which they dominate 100 times the votes of the more widely held B-shares.

There's reason to believe that's changing. Chairman Norman Keevil is almost 80, and after many years of B-share issuance the family has only about a third of the voting rights. It would be a foolish bidder who attempted to make an offer in defiance of the Keevils, but they seem less insistent on their control than they have been in the past. Teck has even explored a merger with family-controlled British-Chilean copper miner Antofagasta Plc, Bloomberg News reported in 2015.

If it wants to thread that needle, South32 should work to assemble evidence that its mineral resources can be easily converted into more tangible reserve assets.  Shareholders already think the two companies are about equal, but founding families tend to keep an eye on their long-run legacies. Persuading them to walk down the aisle will require the promise of a richer dowry.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Mineral resources are physical deposits of metal contained in ore. Reserves are those portions of resources that are economically feasible to dig up.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net