Pan African Resources — Elikhulu underpins recovery

Pan African is a South Africa-based gold mining group, which has dual primary JSE and AIM listings and operates three major assets in South Africa: Barberton (target output 95koz Au pa), the Barberton Tailings Retreatment Project (20koz) and Elikhulu incorporating the Evander Tailings Retreatment Project (55koz + 10koz).

In the medium to longer term, we estimate that Pan African is capable of generating average earnings of c 1.97p/share and paying average (maximum potential) dividends of approximately the same order of magnitude. At currently prevailing forex rates, we calculate that the net present value of such a dividend stream is 12.32p (discounted at 10% pa), to which an additional 5.37p can be immediately added for new business projects, which should increase once the details of the Royal Sheba feasibility study are known in a few months’ time. In the meantime, Pan African is cheaper than its immediate peers on at least 70% of a range of valuation measures. On our forecasts, it will record a dividend yield among the top ten of the 51 precious metal miners expected to pay a dividend over the course of the next 24 months, if not in FY19 then almost definitely in FY20 (subject to there being no other new, major value-accretive projects competing for funding internally).

PAF had net debt of £102.7m on its balance sheet as at 31 December 2018 (cf £91.0m as at June 2018, £42.2m as at December 2017 and £7.0m as at June 2017). As such, net debt equated to a gearing (net debt/equity) ratio of 82.2% (cf 78.6% as at end-FY18) and a leverage (net debt/[net debt + equity]) ratio of 45.1% (cf 44.4% as at end-FY18). As at end-December 2018, however, the most intense phase of capex at Pan African relating to Elikhulu has now been completed and we expect group capex to decline sharply to ZAR163.2m in H219 compared to ZAR585.9m in H119, with the result that negative cash flows before financing activities in H119 will reverse to become positive before financing activities in H219. While we forecast these to approximately cancel each other out in FY19, such that net debt at end-FY19 will be approximately that at end-FY18, beyond June 2019 we expect PAF to pay down its net indebtedness at a rate in excess of £20m per annum (excluding potential dividend distributions), such that it will be net debt free in early FY24 (all other things being equal).

Our valuation of Pan African (above) has been conducted at an average long-term gold price of US$1,382/oz until 2040. Apart from gold price risk, other risks include the sovereign risk relating to South Africa, and normal geological and engineering risks relating to underground mining (albeit c 48% of future production is expected to be derived from tailings retreatment operations). However, note that this underground mining risk is considerably less than that normally associated with underground mining operations in South Africa, as Pan African’s operating underground mine is located on a greenstone belt in Mpumalanga at Barberton and is not therefore a Witwatersrand asset in terms of either geology or the depth to which it mines (eg 1,700m), which is more typical of a Canadian underground mining operation than a South African one. Otherwise, normal commercial risks include exchange rate movements (in particular the rand/dollar and rand/sterling rates and, by extension, the sterling/dollar rate), regulatory risks and workforce risks.

Earnings and output in H1 were consistent with our prior FY19 expectations, with a 54.2% increase in gold produced from continuing operations (to 81,014oz) and a 23.1% decline in AISC (to US$975/oz) combining to result in a 116.7% increase in EPS in sterling terms to 0.38p, despite a barely changed gold price in either US dollar or rand terms. Notable operational features of the results (compared with the prior six-month period – ie H218, rather than H118) were as follows:

The other major feature of the results was the continued acceleration of capex into earlier time periods. In this case, group-wide capex was ZAR585.9m, with a ZAR494.9m contribution from capex related to Elikhulu, which thus comprised 84.5% of the total. While this contributed to an increase in group net debt, from £91.0m as at end-June 2018 to £102.7m as at end-December, hereafter capex is expected to decline sharply (to ZAR163.2m in H219 – Edison estimate) at precisely the time when earnings and cash flow are expected to leap ahead owing to increased production from higher-margin operations (see Exhibit 1):

Note that Exhibit 17 is presented on the basis of the FY18 column (column 4, above) where ‘discontinued operations’ are fully consolidated.

Otherwise, in the wake of the closure of large-scale underground mining operations at Evander, Barberton accounted for 62.4% of group-wide costs of production and provides some idea of inflationary pressures in the period under review (H119 vs H118):

Management reiterated its production guidance of 170,000oz in FY19. This reflects:

A summary of our (unchanged) aggregate production expectations – albeit honed for H119 results and forecast H219 performance – by business segment, is as follows:

In addition to reiterating its production guidance for FY19, management provided production guidance for FY20 at the same level. However, while no change is expected at the aggregate level, we anticipate that there will be no contribution to production from underground operations at Evander at all, while all of the ETRP’s output will henceforward be directed via the Elikhulu plant to benefit from cost synergies and economies of scale.

At the same time, the price of gold has increased by more than US$100/oz (or 9.8%) in US dollar terms, from c US$1,202/oz in mid-November to c US$1,300/oz currently, while the rand (which otherwise often performs in counter-phase to the gold price) has done little more than arrest a declining trend in its value versus the US dollar:

The three effects (forecast production, gold price and forex) serve to underpin our ostensibly unchanged longer-term earnings and cash flow expectations, and consequently our absolute valuation of PAF (based on its existing producing assets) at 12.32p per share cf 12.50p previously (see Return to dividend paying status in FY19 a priority, published on 11 October 2018), 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).

Note that our updated (normalised) EPS forecast of 1.14p in FY19 (see Exhibit 17) compares to a mean consensus forecast of 1.52p within a range 1.00–2.00p (source: Refinitiv, 12 March), while our FY20 forecast of 1.72p compares to a mean consensus of 2.08p within a range 1.80–2.70p.

Other major assets attributable to Pan African include the residual resource at Evander (including the Rolspruit and Poplar projects), Egoli (formerly the 2010 pay channel project), the Fairview sub-vertical shaft project, the Evander 8 Shaft Pillar project and the Royal Sheba project.

In the wake of the Evander underground closure, we deem the Evander underground resource to be one of PAF’s assets, albeit one that should now be valued as an in-situ resource, rather than on the basis of future earnings, cash flows, dividends, etc. As at 30 June 2018, the underground resource at Evander (including Rolspruit, Poplar and Evander South, but excluding 8 Shaft and Egoli, which are valued separately – see Exhibit 10) amounted to 19.2Moz, categorised as follows:

The value of Witwatersrand basin resources (where Evander is located) has proved 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). 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. On the basis of these two valuation points, the in-situ value of the Evander underground assets could range from 0.22–5.24 US cents per PAF share, as shown below:

In the meantime, management commissioned a feasibility study into the merits of mining the Evander 8 Shaft pillar and high-grade areas in proximity to the pillar in order to 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. Total resources at 8 Shaft (incorporating the 8 Shaft pillar), which are not included in those in Exhibits 6 and 7, above, amount to 4.6Moz, as follows:

The feasibility study on the 8 Shaft pillar project has recently been completed and a decision on whether to proceed or not with the project will be made in the next few weeks. A summary of results of the feasibility study are as follows:

A detailed production model relating to the Evander 8 Shaft pillar project is not currently available to investors. However, making a number of other assumptions regarding unit working costs, the timing of capex and taxes etc, we calculate an NPV for potential dividends payable by the project to investors of £11.2m, at its customary 10% discount rate, or 0.58p/share.

The Egoli project contains more than 1Moz of gold in the measured and indicated categories of resources. Unlike historical operations at Evander’s 8 Shaft, where mining operations were located some 10km in tramming distance from ore hoisting infrastructure, the tramming distance between the Egoli ore body and 7 Shaft is no more than 4.5km. Furthermore, Egoli would not suffer from 8 Shaft’s inability to process ore and waste streams separately. As a result, the ore body may be accessed within in a relatively short time frame and with relatively little risk.

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

On the basis of these, plus a number of other assumptions, we calculate an NPV for potential dividends payable by Egoli to investors of £69.1m, at our customary 10% discount rate, or 3.59p/share. While management is not making the Egoli project a priority owing to its deep level ‘Witwatersrand’ nature, it is, nevertheless, studying a number of scenarios whereby the project can be started on a small scale, only evolving into a larger-scale operation over time and funded via its own internally generated cash flows.

Recent drilling at Royal Sheba comprised 40 holes with lengths of 80–250m completed in November 2018 and increased resources from 720koz to 757koz – 49% of which is at or near surface at a grade of 1.96g/t over a 900m strike length and with a 150m down-dip extension to the south at an angle of 50°.

The mineralisation is encapsulated in a shear envelope of the Sheba Fault, ranging in width from 8–25m, with gold occurring in sulphide minerals and as native gold. In-situ grades range from 0.5g/t to 174g/t. Significantly, the mineralisation is non-refractory and amenable to processing via normal carbon-in-leach (CIL) methods and, as a result, could increase gold production from Barberton ‘significantly’ in future years by means of an open pit and a simple expansion of processing capacity. Management has commissioned a definitive feasibility study at Royal Sheba, which it expects to finalise in the coming months. Among other things, the study will now include a review of possible near-term improvements to underground ore handling logistics and infrastructure, and existing processing plant throughput capacity. Under almost any circumstances, however, it is expected that the project will be financeable from debt and cash flows only, without recourse to the equity markets. In the meantime, at Pan African’s prevailing enterprise value rating of US$11.77 per resource ounce, Royal Sheba’s resources are worth a pro rata US$8.9m, or 0.46 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 the New Consort mine. The programme is centred around historical workings and is targeting the Main Maiden Reef (MMR) as a potential new satellite deposit for Royal Sheba

The first phase of drilling eight holes is now 75% complete and is testing the orebody on a single 100m x 100m slice. The assay results from four of the six completed holes indicate discrete zones of mineralisation occurring as lenses within a 40m zone in the footwall of the Consort bar up to the first serpentine contact. In addition, the drill holes also intersected another amphibolite-serpentine contact around 70–80m further into the footwall and assay results indicate that pay shoots of mineralisation exist near this contact as well.

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. To date, development of top and bottom access is reported to be nearly complete with shaft development commencing shortly. 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, an updated summary of our overall valuation of PAF (including the 8 Shaft pillar project for the first time) is therefore now as follows:

Note that the increase in value of PAF’s shareholding of 13.1m MC Mining shares reflects merely the increase in the latter’s share price from c ZAR4.50/share prior to November 2018 to c ZAR9.99/share currently (adjusted for the appropriate forex rate effect into sterling).

Exhibit 11, 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 9.0p) 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 remains below the average of its recent historical range of 9.4x (based on our forecasts – see Exhibit 17, below) Nevertheless, it is set to fall further – to a record low within the context of the time frame – in FY20, assuming that it meets Edison’s (and consensus) earnings’ expectations including the first full year of contribution from Elikhulu.

Stated alternatively, if PAF’s average contemporary price to normalised EPS ratio of 9.4x in the period FY10-18 is deemed ‘correct’, then its share price should be 10.7p in FY19 and 16.1p in FY20 (with further increases anticipated from FY21 onwards).

In the meantime, over the next two years PAF remains cheaper than its South Africa- and London-listed gold mining peers on at least 70% of valuation measures (20 out of 30 individual measures in the table below), regardless of whether Edison or consensus forecasts are used.

PAF has a target dividend payout 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. After sustaining the costs related to the Evander underground closure in FY18, the Pan African board elected not to recommend a final dividend for that year. However, it stated that recommencing distributions to shareholders is a priority for the future.

Cash flows before financing activities were negative £14.3m in H119 and we forecast that they will be positive £11.3m in H219 under the influence of an improved operating performance, a better gold price, a steady rand and very significantly reduced capex. As a result, we expect group indebtedness at the end of FY19 to be similar to that at the end of FY18. Given that PAF’s dividend policy is for a payout of 40% of net cash generated by operating activities after allowing for the effect of sustaining capital (but not expansionary capital other than value accretive new growth projects), we believe there is scope for the board to recommend a dividend up to 0.38p/share this year. Self-evidently, the extent to which this is done will depend on developments between now and September 2019 as well as due regard for PAF’s banking covenants (see Exhibit 16). However, given that any dividend declared for FY19 would be paid in FY20, such a distribution would not affect the ratios pertinent to PAF’s banking covenants for end-FY19, but rather H120 (ie at 31 December 2019), when we forecast that PAF will be in the process of paying down net debt at a rate in excess of £20m per annum (excluding dividend distributions). If our dividend forecast is correct, however, then Pan African will still have a dividend yield in the top ten of the 51 ostensibly precious metals companies paying dividends to shareholders over the course of the next 12 months. Note that there is no certainty nor guidance that an FY19 dividend will be paid; however, we observe that, in extremis, Pan African could fund our forecast FY19 dividend via the realisation of its shareholding in MC Mining. Should it pass its dividend for FY19 however, then we would regard it as an almost racing certainty (all other things being equal) that it would make a full distribution to shareholders in FY20 (see Exhibit 13, below). If it were to pass its dividend in FY19, it would also create the possibility that the company could instigate an interim dividend payment to shareholders in H120 in recompense.

PAF had net debt of £102.7.0m on its balance sheet as at 31 December 2018 (cf £91.0m as at June 2018, £42.2m as at December 2017 and £7.0m as at June 2017). As such, net debt equated to a gearing (net debt/equity) ratio of 82.2% (cf 78.6% as at end-FY18) and a leverage (net debt/[net debt + equity]) ratio of 45.1% (cf 44.0% as at end-FY18).

However, as at end-December, the most intense phase of capex relating to Elikhulu has now been completed and we expect group capex to decline sharply to ZAR163.2m in H219 compared to ZAR585.9m in H119, with the result that negative cash flows before financing activities in H119 will reverse to become positive cash flows before financing activities in H219. While we forecast these to approximately cancel each other out in FY19, beyond June 2019 we expect PAF to pay down its net indebtedness at a rate in excess of £20m per annum (excluding potential dividend distributions), as follows:

Debt is principally financed via a ZAR1bn revolving credit facility (£54.6m at current exchange rates) plus a ZAR1bn term loan 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 revolving credit facility (RCF) itself has been restructured to extend its maturity from mid-2020 previously to at least beyond mid-2024 currently. The group’s RCF debt covenants and their actual recorded levels within recent history are as follows:

Note that, with the agreement of its bankers, PAF’s net debt:EBITDA covenant is measurable only on 31 December 2019 to accommodate the construction of the Elikhulu project, while the interest cover ratio was reduced to 2.5:1 as at December 2018 (with the requirement that it be 4:1 thereafter).

On 7 September 2018, 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 in 2017.

Separately, management has announced that the group’s presentation currency is expected to change to US dollars, from sterling, for Pan African’s results for the full year to end-June 2019.