Pan African Resources — EGM’s Parthian shot

On 12 July 2018, Pan African Resources released an operational update stating that production for the group for the 12 months to 30 June was 160,421oz, compared with prior guidance of 157-160koz for the year, with the outperformance exclusively accounted for by underground operations at Evander. A comparison of our prior expectations for both H218 and FY18 (which had previously been towards the bottom of management’s guidance range) and actual production figures is provided in Exhibit 1, below. More significantly, for the first time management has provided guidance for the FY19 financial year. This was 29,659oz, or 21.1%, above our prior expectations, at 170,000oz, reflecting that construction at Elikhulu has continued to progress “ahead of schedule” such that the construction teams are now entering the commissioning phases of the project in anticipation of a two-month ramp-up to full production and first gold being produced in August 2018. A summary of our production expectations, by business segment (and now aligned with management guidance) is as follows:

Note that, all things being equal, the implied level of production 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.

On 31 May 2018, Pan African Resources announced it had been notified that PAR Gold had disposed of 130m shares in PAF, representing 5.8% of the issued share capital of the company, at a price of ZAR1.15 per share. In the aftermath of the disposal, PAR Gold has continued to hold 306.36m Pan African Resources shares, representing 13.7% of the issued share capital of the company. The Pan African Resources shares held by PAR Gold are treated as treasury shares and eliminated on consolidation for the purposes of calculating earnings per share. Following the disposal, the number of shares issued by PAF is therefore as follows:

As an indirect 49.9% shareholder in PAR Gold and, given the economic rights attached to its shareholding, Pan African has received the majority of the proceeds from this disposal, amounting to approximately ZAR126m, net of costs and capital gains taxes, which it will use for general corporate and liquidity purposes and to fund the expansion of the Elikhulu project’s throughput to 1.2Mtpm.

As a result of the considerations outlined above, our detailed financial forecasts for PAF for H218 and FY18 are now as in Exhibit 3. Note that, as previously, the ZAR160m (£9.5m, US$13.0m) cost relating to the closure of the Evander 8 Shaft underground operation has been included under other income/(expenses) in H218 (and therefore also FY18). As such, it is included in our forecast of EPS and HEPS, but not in our forecast of normalised EPS (also in Exhibit 15 on page 9). In the meantime, group net assets attributable to Evander (excluding goodwill) amounted to £177.6m as at 31 December 2017, of which Edison estimates that the majority were accounted for by Evander underground operations (as opposed to the ETRP). The decision to close Evander underground operations could therefore result in an impairment in this order of magnitude (which has also been excluded from our forecasts below). When Pan African does report its FY18 results in September therefore, it may also opt to disclose them with Evander 8 Shaft underground reflected as a discontinued operation. Our estimates of PAF’s FY18e results, excluding the contribution from underground operations at Evander, is shown in the penultimate column below.

Edison’s FY18 EPS forecasts (above) compare with a mean consensus estimate of 0.643p (cf 0.886p in May) and a median consensus estimate of 0.426p within the range 0.000-2.400p (source: Bloomberg, 13 July 2018).

Our (normalised) forecast of 1.55p for FY19 compares with our previous forecast of 0.92p and with a mean consensus of 1.217p (cf 1.392p/share in May) and a median consensus estimate of 1.000p within a range of 0.669-2.900p/share. Note that our gold price forecast for FY19 remains unchanged at US$1,291/oz.

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. In addition, in recognition of the possibility that operations at Evander’s existing infrastructure could cease in the foreseeable future, on 28 March PAF announced it would reassess the feasibility study on the Egoli project (see A second glance at the first half, published in April 2018) as a standalone project, and this reassessment is expected to be completed imminently. Otherwise, the Evander Tailings Retreatment Project (ETRP) effectively represents a substantial pilot plant, designed to prove metallurgical recovery and cost parameters, before the development of the much larger Elikhulu project (see A second glance at the first half, published in April 2018). To benefit from Elikhulu’s economies of scale; however, management has stated that Elikulu’s capacity will be increased by 200ktpm from December 2018 to incorporate the existing ETRP throughput. The additional construction associated with this initiative will increase capex by c ZAR65m (US$4.9m, or £3.7m at prevailing forex rates), which is assumed to have occurred in H218 and H119 (as previously), but is not expected to alter the timeline at Elikhulu, with first gold still expected in August 2018 and full commissioning at the end of September 2018. However, management will continue to source material for toll-treatment with grades higher than the ETRP’s reserve and resource grades, thereby taking commercial advantage of the fact that it is the only retreatment operator in the area and is therefore (effectively) the buyer of choice – or even the buyer of last resort – for tailings assets in the region.

The development of Elikhulu (which is now entering commissioning) should increase output to c 181koz in FY20. As such, it will largely replace production lost from Evander underground (see Exhibit 1) – albeit at a much higher margin – which underpins our longer-term earnings and cash-flow expectations.

In the meantime, the value of the South African rand has fallen 8.6% against the US dollar and 4.4% against sterling compared to the average rate prevailing in H218 (ie January-June 2018), with the result that our absolute value of PAF (based on its three producing assets plus Elikhulu) has increased from 12.59p per share (see Finishing unfinished business, published on 16 May 2018) to 13.01p 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 continue to count the Evander underground resources as one of its assets, albeit one that would 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 8) to be 20.1Moz, categorised as follows:

The value of Witwatersrand basin resources (where Evander is located) has proved 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 then not 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 note Finishing unfinished business published on 16 May 2018, the only change in our valuation here reflects the increased number of shares effectively in issue as a result of the PAR Gold sale of Pan African shares detailed on pages 2-3.

Including its growth projects, as discussed in our note A second glance at the first half, published in April 2018, a summary of our overall valuation of PAF is therefore now as follows:

Note that the valuation changes to Egoli and the Fairview Sub-Vertical Shaft project reflect changes to timing (ie rolling forward our base valuation year for the purposes of our dividend discount model from FY18 to FY19), the number of shares in issue and prevailing foreign exchange rates only.

Exhibit 9, 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 FY18 to FY20, the current share price (of 7.95p) is compared with Edison’s forecast normalised HEPS for FY18 to FY20. Although PAF’s price to normalised HEPS ratio for FY18 is above the top of its recent historical range (based on our forecasts – see Exhibit 9, below), it once again falls well below it in FY19 (based on our upgraded estimates) and falls further below it 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 9.7x in the period FY10-17 is deemed to be ‘correct’, then its share price should be 15.1p in FY19 and 18.7p 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 41% of valuation measures (15 out of 36 measures in the table below on an individual company basis) using our forecasts, or 58% of measures (21 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 cash flow effect of sustaining capital, contractual debt repayments and one-off items. On the basis of this policy, coupled with our expectations, we estimate that the company will be capable of paying a dividend of 0.67p per share in FY19, in which case it will have the third highest FY19 dividend yield of the 65 ostensibly precious metals’ companies paying dividends to shareholders:

PAF had £42.2m of net debt on its balance sheet as at 31 December 2017 after the payment of a net £8.1m final dividend in late December (cf £7.0m as at June 2017, £33.2m as at December 2016, £22.8m as at 30 June 2016, £16.2m as at 31 December 2015 and £18.0m as at 30 June 2015). As such, at the interim stage, net debt equated to a gearing (net debt/equity) ratio of 19.9% and a leverage (net debt/[net debt + equity]) ratio of 16.6%.

PAF’s major immediate capital requirements relate to the development of the Elikhulu project. At end December 2017, ZAR511.7m in capex had been expended on the project and ZAR671.4m is expected by mid-February 2018 (excluding capitalised borrowing costs). Including the project to expand Elikulu’s throughput capacity by 200ktpm from December 2018 to incorporate the existing ETRP feed (see page 4), our forecasts for PAF’s immediate future capital expenditure commitments for the project are as follows:

As a result, after investing activities we estimate that PAF will experience a net negative cash flow in FY18 and FY19, before a positive trend sets in once again from FY20 onwards. Maintaining a dividend policy of 40% of free cash flows less sustaining capital, debt repayments and exceptional items, PAF’s net debt funding requirement, on our estimates, will evolve as follows in the period from FY16 to FY22e:

Note that Edison’s estimate of PAF’s maximum net debt funding requirement of £65.7m (cf £90.3m previously) in FY19 equates to ZAR1,160m at prevailing forex rates, or contemporary gearing (debt/equity) of 28.0% and leverage (debt/[debt+equity]) of 21.9% (cf 42.0% and 29.6% previously, respectively).

Debt is financed via a ZAR1bn revolving credit facility (£56.6m at current exchange rates), of which ZAR676.6m (£38.3m) was drawn down as at end-H118, plus a banking facility. To ensure the group has adequate working capital and continuation of funding for operations and growth projects, Pan African has also finalised an additional standby facility of approximately ZAR100m. Also, in the past Rand Merchant Bank (a division of First Rand) has provided PAF with all the necessary approval for a ZAR1bn underwritten five-year debt facility for Elikhulu.

The group’s revolving credit facility (RCF) debt covenants and their actual recorded levels within recent history are as follows:

Note that on our FY18 forecasts, we predict that PAF will ‘break’ its net debt:EBITDA and interest cover covenants. However, this contingency has already been pre-empted by management and the providers of the RCF, which have agreed to temporarily waive the net debt:EBITDA condition during the period in which capex relating to Elikhulu is at its most intense.