Strong Foundations, Heavy Lifting Ahead

South32’s (ASX: S32) FY26 result shows that its retained copper, zinc and silver assets are producing stronger earnings, while the planned aluminium sale should sharpen the portfolio. We don’t believe the market is fully pricing the shift in the business, given our constructive view on commodities.  We upgrade to BUY. Underlying earnings rose 55% to US$1.03 billion and underlying EBITDA rose 28% to US$2.46 billion, lifting the operating margin from 26.3% to 31.0%. Higher copper, silver, zinc and lead prices helped, but so did stronger production from the Sierra Gorda copper mine in Chile, the Cannington silver-lead-zinc mine in Queensland, and the recovery at Australia Manganese. Those are the assets that remain once the aluminium value chain is sold to Alcoa for an implied enterprise value of up to US$5.6 billion, a transaction expected to complete in the second half of FY27.

South32’s returns on capital over the past five years have been soft, with the aluminium business being the main reason. Removing it leaves a portfolio more strongly weighted to copper, silver and zinc. These metals align nicely with our commodities supercycle view. On forward numbers, the stock trades on about 6.6 times EV/EBITDA. We see scope for upward revisions in earnings estimates over the coming quarters as more of the market comes to share our view about the commodity cycle.

We upgrade our rating on South32 (ASX: S32) to a BUY.

Turning to the charts, and since our last update, South32 has broken out to new record highs. As we highlighted last month, we believed it was only a matter of time before the shares advanced into uncharted territory above $5.50. Following the decisive breakout above the $4.90 resistance level at the top end of its previous range, key support is now well-defined at that floor. We maintain a bullish outlook on commodities and base metals, where South32 is well-positioned across the resource complex and holds an increasingly committed strategic focus on copper.

Trading Update – FY26

Sierra Gorda is the clearest source of future earnings growth. South32’s 45% interest generated US$758 million of underlying EBITDA in FY26, with a 66% operating margin. The Chilean mine sells copper, molybdenum, gold and silver, so its cash generation benefits from more than one commodity. Copper-equivalent production is expected to rise 5% in FY27 and another 2% in FY28 as the mine moves into higher-grade areas. That would lift sales volumes and help offset cost inflation.

The resource base has also improved. Infill drilling raised Sierra Gorda’s ore reserve by 61% to around 1.1 billion tonnes on a 100% basis, extending its reserve life by about five years to 2045. The approved fourth grinding line is expected to lift production by about 30% from FY31. The project will require about US$725 million of capital on a 100% basis through FY30, but existing water and power infrastructure should reduce the cost and execution risk relative to a wholly new mine development.

Source: S32 FY26 Presentation

Hermosa is the other major value driver, but it is also the cash-flow constraint. South32 spent US$711 million at the Taylor zinc-lead-silver project in FY26 and expects to spend US$1.0 billion in FY27. First production is expected in the second half of FY28. Taylor is forecast to generate around US$650 million of annual EBITDA at steady state, but its US$3.3 billion development cost means the value case depends on construction remaining on schedule and within budget.

The group has capacity to fund this investment, but cash generation should be read carefully. Net cash rose to US$283 million, and South32 retains an undrawn US$1.4 billion facility. However, free cash flow from its operations excluding equity-accounted investments was only US$107 million in FY26 after Hermosa expenditure. Net distributions of US$503 million from Sierra Gorda and manganese supported overall liquidity. These joint-venture payments are real cash, but the distinction matters because South32 does not fully control their timing or capital-allocation decisions.

The final fully franked dividend of US 5.4 cents per share takes FY26 total ordinary dividends to US9.3 cents, a 55% increase, and represents 41% of underlying earnings. The company has extended its capital-management programme to September 2027, with US$209 million remaining for shareholder returns. Dividend calculations will continue to include aluminium earnings until the Alcoa sale is complete; the more relevant test is whether the smaller, post-sale portfolio can maintain distributions while funding Hermosa and Sierra Gorda expansion.

What could weaken the case is a fall in copper, zinc or silver prices, or cost and schedule pressure at Hermosa. Either would reduce cash available for investment and capital returns just as the group becomes more concentrated in base metals. We will continue to assess Alcoa-transaction progress, Sierra Gorda’s FY27 production growth, Hermosa’s capital spend and construction milestones, then update members on whether the reshaped business is increasing per-share cash generation.

Summary

The reason to buy S32 here is company becomes, once the aluminium sale completes, expected for 2H FY27, subject to the usual approvals. It will be a leaner group built around Sierra Gorda, Cannington and manganese, with Hermosa coming into production from the second half of FY28, and without the assets that have held group returns down. The transition has its costs, with a big build at Hermosa, but we see this as worth doing. We see the market as still partially valuing South32 on the earnings mix it is leaving behind rather than the one it is moving to, and on commodity price assumptions we believe are too low. Alcoa completion, higher grades at Sierra Gorda, and Hermosa meeting its construction milestones are events we are watching for and will update members on, alongside other material news. We upgrade our rating on S32 (ASX: S32) to a BUY.

Disclosure: Interests associated with Fat Prophets hold shares in South32.