Pan African Resources — Return to dividend paying status in FY19 a priority

While Pan African’s pre-tax profit for the year to end-June 2018 was within 5% of our prior forecast (on an underlying basis, excluding impairments), bottom-line results were materially ahead of our expectations as a result of a tax credit applied not only to the Evander underground operation, which was closed during the period, but also to Evander Mine’s continuing operations. Results were otherwise dominated by the decision to close Evander underground operations during the period – leading to an impairment of £106.3m (cf £177.2m of group net assets attributable to Evander, excluding goodwill, as at 31 December 2017), the fact that Barberton Gold Mines suffered 58 days of lost production owing to industrial action and community unrest, and a strong rand leading to a weak gold price in local currency terms. As expected, the board elected not to recommend a final dividend this year. While FY18 was thus a challenging year for Pan African, an idea of its future financial potential may be gleaned from the fact that underlying earnings from continuing operations nevertheless amounted to £19.6m, or 1.08p per share. In addition, Barberton recorded one million fatality-free shifts and there were no fatalities across the group over the entire 12-month period. Results for the full year, on a variety of different reporting bases and in conjunction with Edison’s prior expectations, are shown in the table below:

Note that Exhibit 14 is presented on the basis of the FY18 column (column 6, above) where ‘discontinued operations’ are fully consolidated. Normalised profit before tax of £2.4m in Exhibit 14 may be reconciled to the above table from FY18 mining profit of £4.4m (column 6) less £0.6m in royalties and a further £1.4m of net interest. The difference in PAF’s underlying profit after tax of £12.9m (column 8 of the above table) and headline earnings of £13.3m is a £0.3m “adjustment on sale of asset held for sale” and a £0.1m rounding difference.

Otherwise, costs of production for continuing operations (including realisation costs) increased by 4.4% in rand terms, the main contributors being as follows:

The other major feature of the company’s results was a higher than expected capex number and therefore a higher level of net debt at the year-end, as capital expenditure relating to the Elikhulu project, in particular, accelerated in line with the project’s development timeline from FY19 into FY18. Whereas we had been expecting ZAR902.1m in capex related to the Elikhulu project to be expended in FY18 therefore, in fact ZAR1,256.1m was expended. As a result, instead of ZAR537.8m being expended in FY19, we are now expecting this figure to reduce to ZAR300.0m – notwithstanding the decision to increase the project’s throughput by 200ktpm in December in order to incorporate the existing ETRP throughput to benefit from the larger project’s economies of scale.

In the meantime, management is reviewing the merits of mining the Evander 8 Shaft pillar, which may extend the final closure date of the shaft, generate positive cash flows and provide further employment opportunities for those affected by the Evander Section 189 retrenchment process.

Management reiterated its production guidance of 170,000oz in FY19, reflecting the fact that commissioning at Elikhulu is reported to be progressing “very well”, with 56kg (1,800oz) of gold produced from 1–19 of September and with a forecast of 90–100kg (2,894–3,215oz) for the month as a whole. By November, the plant is expected to be operating close to 1Mt, producing 145kg (4,600oz) gold, per month. Otherwise, underground operations at Barberton met their production targets towards the end of the financial year under the influence of two (cycling) production platforms. Management is now in the process of establishing a third such platform, which will increase underground mining flexibility still further and intends to increase underground development rates by c 60%. Finally, a 1.7MW re-grind mill has successfully been installed at the BTRP, which will allow it to efficiently treat coarser fraction tailings and open up the older, (albeit lower grade) Harper dumps for processing. A summary of our (unchanged) production expectations, by business segment is as follows:

Note that, all other things being equal, the level of production implied from Elikhulu for FY19 suggests 81% capacity utilisation during the year or, alternatively, that it will operate at the equivalent of full capacity for 9.7 months out of the 12-month period.

The development of Elikhulu should increase group-wide output at Pan African to c 181koz in FY20 and will largely replace production lost from Evander underground, albeit at a much higher margin – which underpins our longer-term earnings and cash-flow expectations.

At the same time, however, the price of gold has fallen by 8.2%, or more than US$100/oz, from over US$1,300/oz in the first five months of CY18 to under US$1,200/oz at the time of writing – only partially offset by a 5.3% decline in the value of the South African rand relative to its FY18 average. As a result, we have reduced our gold price forecast for H119, which has reduced our earnings and cash-flow expectations (all other things being equal) and, consequently, our absolute value of PAF (based on its four producing assets) from 13.01p per share (see EGM’s Parthian shot, published on 19 July 2018) to 12.50p per share, based on the present value of our estimated maximum potential stream of dividends payable to shareholders over the life of its mining operations (applying a 10% discount rate).

In the wake of the Evander underground closure, PAF could deem the Evander underground resource to be one of its assets, albeit one that should now be valued as an in-situ resource, rather than, as previously, on the basis of future earnings, cash flows, dividends, etc. At the current time, we estimate the underground resource at Evander (including 7 Shaft vamping, Rolspruit, Poplar and Evander South, but excluding 8 Shaft and Egoli, which is valued separately – see Exhibit 7) to be 20.1Moz, categorised as follows:

The value of Witwatersrand basin resources (where Evander is located) has proven to be persistently difficult to place within a global context – a problem exacerbated by an absence of pure Wits basin exploration companies. PAF bought Evander from Harmony in mid-2012 at a price equivalent to US$5.26 per resource ounce (albeit the gold price was then materially higher, averaging US$1,668/oz in that year). Since then, we estimate that PAF has mined 415,840oz from Evander excluding the ETRP (389,229oz from underground sources), ie implying only 1.2% depletion relative to the acquired underground resource of 32.52Moz. More recently, Sibanye acquired Wits Gold (although not then a pure exploration company) at a price equivalent to US$0.22/oz, at a time when the gold price was c US$1,225/oz. Otherwise, a value for in-situ Witwatersrand gold ounces may be imputed from the US$2.78/oz value calculated by us for Bushveld platinum equivalent ounces (there still being pure platinum explorers in South Africa) in our report, Mining overview: Unlocking the price to NPV discount, published in November 2017 – contingent on investors accepting the similarities between Bushveld and Witwatersrand geology in terms of depth, reef width and continuity, mining methods, etc. On the basis of these three valuation points, the in-situ value of the Evander underground assets could range from 0.23–5.49 US cents per PAF share, as shown below:

Note that, relative to the equivalent valuation in our report entitled Pan African Resources: EGM’s Parthian shot, published on 19 July 2018, the only change in our valuation in Exhibit 6 reflects changes in prevailing forex rates.

Other major assets attributable to Pan African include the Egoli project (formerly the 2010 pay channel project) at Evander, the Fairview sub-vertical shaft project and the Royal Sheba project.

The results of a recent optimisation study based on an earlier DRA Global feasibility study on Egoli are:

Adjusting our existing model (see our note Pan African Resources: A second glance at the first half, published on 23 April 2018) to incorporate the higher capex and opex than previously forecast, we calculate an NPV for potential dividends payable by Egoli to investors of £68.0m, at its customary 10% discount rate, or 3.53p/share. Readers should note, however, that while still attractive, management is not making the Egoli project a priority in the foreseeable future owing to its deep level ‘Witwatersrand’ nature.

Recent drilling at Royal Sheba has increased resources once again, most recently from 720koz to 899koz – 39% of which is at or near surface at a grade of 3.81g/t. The mineralisation is encapsulated in a shear envelope of the Sheba Fault, ranging in width from 5–25m, with gold occurring in sulphide minerals and as native gold. In-situ grades range from 0.5g/t to 174g/t. Significantly, however, the mineralisation is non-refractory and amenable to processing via normal CIL methods and, as a result, could increase gold production from Barberton “significantly” in future years by a means of an open pit and a simple expansion of processing capacity. Management expects to finalise a definitive feasibility study for Royal Sheba by February 2019. However, it is expected that this project will be financeable from debt and cash flows only, without recourse to the equity market. In the meantime, at Pan African’s prevailing enterprise value rating of US$10.13 per resource ounce, Royal Sheba’s resources are worth a pro-rata US$9.1m, or 0.47 US cents, or 0.36p, per share.

Following the success at Royal Sheba, Pan African has also embarked on an extended exploration programme within Barberton Mines’ mining right at both the Sheba and New Consort mines around historical workings and for potential new satellite deposits.

Finally, Pan African has commenced construction of a new sub-vertical shaft at Fairview to bypass the hoisting bottleneck at its No 3 Decline and to facilitate improved access to additional mining platforms below 42 Level at the high grade 11-block of the MRC. Project capex is forecast to be ZAR105m over two to three years. Following commissioning of the shaft, it is expected that productivity improvements will yield an additional 7–10koz of gold per annum owing to the increased hoisting capacity.

Including its growth projects, a summary of our overall valuation of PAF is therefore now as follows:

Note that the valuation changes to the Fairview Sub-Vertical Shaft project also reflect changes to prevailing foreign exchange rates only.

Exhibit 8, below, depicts PAF’s average share price in each of its financial years, from FY10 to FY17 and compares this with normalised HEPS in the same year. For FY19 to FY20, the current share price (of 7.90p) is compared with Edison’s forecast normalised HEPS for FY19 to FY20. As is apparent from the graph, PAF’s price to normalised HEPS ratio for FY19 is already towards the bottom of its recent historical range (based on our forecasts – see Exhibit 14, below), with this ratio having been lower in FY18, FY13 and FY10 only. Moreover, it falls well below the range in FY20, by which time we expect Elikhulu to be operating at full capacity.

Stated alternatively, if PAF’s average contemporary price to normalised EPS ratio of 9.4x in the period FY10-18 is deemed to be ‘correct’, then its share price should be 10.2p in FY19 and 17.2p in FY20.

In the meantime, over the next two years PAF remains cheaper than its South African and London-listed gold mining peers on at least 91% of valuation measures (33 out of 36 measures in the table below on an individual company basis) using our forecasts, or 94% of measures (34 out of 36 measures) using consensus forecasts:

PAF has a target dividend pay-out ratio of 40% of net cash generated by operating activities, after allowing for the effect of sustaining capital on cash flow, contractual debt repayments and one-off items. As previously forecast by Edison, the Pan African board elected not to recommend a final dividend for the 2018 financial year. However, it stated that recommencing distributions to shareholders is a priority for the future. On the basis of the aforementioned policy, coupled with our expectations, we estimate that the company will be capable of paying a dividend of 0.47p per share in FY19, in which case it will have the eighth highest dividend yield of the 65 ostensibly precious metals’ companies paying dividends to shareholders within the course of the next 12 months:

PAF had £91.0m of net debt on its balance sheet as at 30 June 2018 (cf £42.2m as at December 2017, £7.0m as at June 2017 and £33.2m as at December 2016). As such, net debt equated to a gearing (net debt/equity) ratio of 78.6% and a leverage (net debt/[net debt + equity]) ratio of 44.4%.

FY18 net debt was higher than our previous forecast (see Pan African Resources: EGM’s Parthian shot, published on 19 July 2018). However, this merely reflected higher than expected investment in Elikhulu as capex was brought forward from FY19 into FY18 in line with the project’s accelerated timeline. Whereas we had been expecting ZAR902.1m in Elikhulu capex in FY18 therefore, in fact ZAR1,256.1m was expended. As a result, instead of ZAR537.8m being expended in FY19, we are now expecting this figure to reduce to ZAR300.0m – notwithstanding the decision to increase the project’s throughput by 200ktpm in December in order to incorporate the existing ETRP’s throughput to benefit from the larger project’s economies of scale. PAF’s major immediate capital requirements continue to relate to the Elikhulu project. However, as at end-June, the most intense phase of capex has been completed. Including the project to expand Elikulu’s throughput capacity by 200ktpm from December 2018 to incorporate the existing ETRP feed, our forecasts for PAF’s immediate future capital expenditure commitments relating to the project (including sustaining capital) are as follows:

After accelerating capex into FY18, from FY19, however, we anticipate that Pan African will record (albeit marginal) positive cash flow in FY19 before taking off thereafter to c £40m per annum thereafter, such that, while maintaining a dividend policy of 40% of free cash flows less sustaining capital, debt repayments and exceptional items, its net debt funding requirement, on our estimates, will evolve as follows in the period from FY16 to FY24e:

Debt is financed via a ZAR1bn revolving credit facility (£53.0m at current exchange rates) plus a ZAR1bn facility relating to the Elikhulu project and a banking facility. Principal on the Elikhulu facility is payable in equal instalments until maturity in June 2024, while the RCF itself has been restructured to extend its maturity from mid-2020 previously to at least beyond mid-2024 currently. The group’s revolving credit facility (RCF) debt covenants and their actual recorded levels within recent history are as follows:

Note that the net debt:EBITDA covenant is measurable only on 31 December 2019 in order to accommodate the construction of the Elikhulu project, while the interest cover ratio has temporarily been reduced to 2.3:1 until December 2018.

On 7 September, PAF announced that Barberton Mines Pty Ltd had successfully concluded a three-year wage agreement with the National Union of Mineworkers (the NUM) and the United Association of South Africa (UASA), which together represent the majority of workers at Barberton. The agreement provides for an average annual wage increase of approximately 6.5% and 5.5% for NUM and UASA members respectively over three years in local currency terms. The negotiations were successfully concluded with no industrial action or work stoppages, which compares with a settlement of +8% per annum after 2.5 days of stoppages in the equivalent negotiations last year.