Pan African Resources — Entering harvest mode

Pan African’s results for the full year to end-June 2019 were reported within the context of the group having outperformed its own production guidance (and Edison’s prior expectations) by 1.4% in aggregate, after especially strong performances at Barberton and Evander’s underground operations:

While overall production did not match the record performance reported in FY16, it was consistent with FY15 and FY17 and 7.5% higher than FY18, after only a partial contribution from Elikhulu – thereby confirming management’s assertion of a year ago that production from Elikhulu would largely make up for production lost from the closure of large-scale underground operations at Evander. Highlights for the period were as follows:

A summary of PAF’s production profile, by quarter, is as follows:

Investors should note that four quarters of production at the Q4 level of 48,671oz per quarter would imply group production in FY20 of 194,684oz – ie 5.2% above current management guidance (see below).

Consistent with a number of statements throughout the year, Pan African changed its reporting currency in the year to end-June 2019 from pounds sterling to US dollars. The table below converts PAF’s results back into sterling terms for the purposes of comparison with our prior forecasts and FY18 in particular.

The table below, by contrast, presents PAF’s results, as reported, with FY18 results (and our prior expectations) converted from sterling to US dollar terms:

In both cases the main differences between our forecasts and the actual outcome for FY19 were the US$17.9m impairment reversal relating to Evander Mines’ 8 Shaft infrastructure and ‘other’ expenses, which included the group’s cash-settled share option costs (which Edison typically declines to attempt to forecast). Excluding exceptional and one-off items, Edison’s HEPS forecasts for H219 and FY19 (highlighted) were within £150,000 of those actually reported.

Relative to the 54.1% increase in its gold production from continuing mining operations, the group’s cost of production from continuing operations (see columns entitled ‘FY18 (underlying)’ and ‘FY18 (as reported)’ in Exhibit 4) increased by only 42.9% in US dollar terms. Within this:

In the wake of the closure of large-scale underground mining operations at Evander in May 2018, Pan African’s two most important producing assets are Barberton underground (42% of Q419 production) and Elikhulu (34%).

An analysis of Barberton underground’s H219 performance, relative to H1 plus our expectations for FY20, by half-year, is provided in Exhibit 5, below. Of note, within this context, is the decline in underground tonnes milled in H219. This was augmented by tonnes milled from surface sources and PAF indicates that c 5,000oz will be produced from surface sources in FY20. The inclusion of surface sources also helped to keep cash costs (measured in ZAR/t) low in H219. Nevertheless, after an implied ZAR132.5m in capex, it is likely that Barberton’s net cash flow in H219 was negative. Our forecasts for FY20 assume that underground operations at Barberton return to their previous levels in terms of both tonnes milled and head grade. This is consistent with production in Q419 (see Exhibit 2, above), but is slightly ahead of official guidance of 80,000oz of production for FY20 – albeit this is balanced by our expectations at Elikhulu (see below).

Exhibit 6 similarly provides our analysis of Elikhulu’s H219 performance compared with H1 and also our expectations for H120 and H220. Of note is the above-nameplate throughput in H219 and the higher than expected metallurgical recoveries, but slightly lower head grade. We expect FY20 to be characterised by full-capacity throughput, a recovery in grade and a small decline in total cash costs (in ZAR/t terms). For the moment, we are assuming a return to the average levels of metallurgical recovery anticipated in the project’s feasibility study, such that output is 62,334oz for the 12-month period. This is slightly lower than official guidance of 65,000oz for the complex for the year, but may be easily made up by either a higher metallurgical recovery (eg in line with H219) or a higher head grade (eg in line with H119). Investors should note that, inasmuch as our output expectations for Elikhulu are slightly below official guidance, they are balanced by output expectations that are slightly above official guidance at Barberton (above) and, in aggregate, are conservative in that they assume higher production from the lower margin operation and vice versa.

Apart from Barberton and Elikhulu, the BTRP (12% of production in Q419) performed closely in line with both our expectations and H119 (but materially ahead of FY18 and most previous years of operation), following the successful commissioning of a 1.7MW BTRP regrind mill in May 2018 that has allowed it to efficiently treat coarser fraction tailings, such as the older (albeit lower-grade) Harper dumps for processing. At the same time, we estimate that 85.4kt of material from surface feedstocks was treated through ETRP infrastructure in H219, which, at a head grade of 2.62g/t and after metallurgical recovery of 50.9%, resulted in the production of 3,654oz gold – demonstrating, among other things, the flexibility that Pan African has developed in processing such feedstocks (from either internal or external sources) now that the ETRP’s primary material stream has been diverted through the expanded Elikhulu plant.

In its operational update for the nine months ended 31 March 2019, released on 17 May, Pan African confirmed that the feasibility study on the Evander 8 Shaft pillar project had been completed and that the board of directors had sanctioned its development. Whereas Edison had originally assumed that commercial production from this project would not be achieved until after the end of FY20, in fact development and equipping of this area of the mine is now in progress and first gold has already been poured – effectively replacing production from the remnant underground mining and vamping operations that had been ongoing at Evander since the decision to close large-scale operations there in May 2018 (see Exhibit 1). PAF expects the 8 Shaft pillar project to contribute, on average, 30,000oz of production per annum to the group over the next three financial years, including c 20,000oz in FY20.

A summary of the (updated) results of the Evander 8 Shaft pillar project feasibility study are as follows:

Critical to the success of the project is the requirement to de-stress the orebody while mining is underway, to which end Pan African has already commissioned a backfill plant at surface with the ability to pump a mixture of concrete and waste rock underground to selectively support areas of the orebody.

A comparison of Edison’s forecasts for FY20 compared with official guidance is as follows:

As noted previously, inasmuch as our output expectations for Elikhulu are slightly below official guidance, they are balanced by output expectations that are slightly above official guidance at Barberton (above) and, from a financial perspective, may be considered conservative in that they assume higher production from the lower-margin operation and vice versa.

In addition to our output forecasts, we have also adjusted our gold price assumptions to those set out in our recent report, Portents of economic weakness: Gold – doves in the ascendant, published on 14 August 2019. The principal near-term changes to our forecasts are provided in Exhibit 8 below:

Pan African has two forms of relatively modest hedging contracts currently in place solely for the purposes of guaranteeing debt serviceability and covenant compliance. The first is a gold loan of 20,000oz that locks in a gold price of approximately ZAR633,347/kg (US$1,415/oz), representing approximately 11% of the group’s anticipated production for the 2020 financial year. The second is a series of zero cost collar contracts over 29,550oz gold in H120 and 50,400oz gold in H220 that cap the likely gold price received by Pan African at ZAR666,000/kg (c US$1,403/oz) and ZAR836,000/kg (c US$1,761/oz), respectively, but also floor it at ZAR604,000/kg (c US$1,272/oz) and ZAR655,000/kg (c US$1,379/oz), respectively.

Given our current gold price expectations (see Exhibit 8), we do not expect the call options written at ZAR836,000/kg to be exercised in H220. However, we do expect the ones written at ZAR666,000/kg to be exercised, which, together with the gold loan, we expect to result in a loss of US$4.6m in FY20, which we have included in ‘other income/(expenses)’.

As noted previously, Pan African changed its reporting currency in the year to end-June 2019 from pounds sterling to US dollars. As a result, all of Edison’s historical results and future forecasts have been restated into US dollars, and should therefore not be directly compared with previous notes on the company except via the application of the appropriate foreign exchange rate.

Updating our long-term forecasts to reflect our revised gold prices and prevailing forex rates in particular, our normalised headline earnings per share (HEPS) forecast has risen fractionally, to 2.46c/share (cf 1.88p/share previously). This compares with a consensus EPS forecast of 3.47c/share, within a range 2.31–5.15c/share (source: Refinitiv, 2 October 2019). At the same time, we have introduced formal forecasts for FY21 for the first time, based on production of 216.3koz, including 94.6koz for Barberton underground and 36.7koz from the Evander 8 Shaft pillar project. In this case, our normalised HEPS forecast for FY21 is 3.75 US cents and compares with a consensus of 3.73c, within a range 2.95–4.54c (source: Refinitiv, 2 October 2019).

In the meantime, our absolute value of PAF (based on its existing four producing assets only) has increased from 14.05p/share in June to 17.89c/share (ex-div) currently, 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, all other things being equal, this valuation may be expected to rise to 20.29c/share in FY23 (the ‘discounted dividend valuation line’ in Exhibit 9, above).

Including its other potential growth projects (ie the Fairview sub-vertical shaft project and Egoli) and assets (ie the residual Evander underground resource and its shareholding in MC Mining), a summary of our updated valuation of Pan African is as follows:

Relative to our previous valuation in June, the decline in the value of PAF’s shareholding of 13.1m MC Mining shares reflects merely the fall in the latter’s share price from ZAR8.49/share to ZAR6.28/share currently (adjusted into sterling at the appropriate FX rate).

Exhibit 11, below, depicts PAF’s average share price in each of its financial years from FY10 to FY19, and compares this with normalised HEPS in the same year. For FY20 to FY21, the current share price (of 11.3p) is compared with Edison’s forecast normalised HEPS for FY20 to FY21. As is apparent from the graph, PAF’s price to normalised HEPS ratio of 5.7x for FY20 (based on our forecasts – see Exhibit 18, below) is already below the bottom of its recent historical range of 6.7–14.8x for the period from FY10–19. Moreover, assuming it meets Edison’s (and consensus) earnings expectations, this measure of value is set to fall further to a new record low of just 3.8x for FY21 (see below):

Stated alternatively, if PAF’s average contemporary price to normalised EPS ratio of 9.6x in the period FY10–19 is deemed ‘correct’ then, given our normalised earnings forecasts, its share price should be 18.9p in FY20 (cf 17.6p previously) and 28.9p in FY20.

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. 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 was a priority for the future.

At the time of our last note (see Solid push towards year end, published on 19 June 2019), we estimated that there was scope for the board to recommend a dividend of up to 0.30p/share for FY20. In the event, the board recommended a dividend of ZAR50m, or approximately US$3.4m, which equated to ZAR0.022375 or c 0.12660p or 0.15169 US cents per share, which it described as a ‘signal’ of its intent to resume more meaningful distributions to shareholders in the future. As pre-financing cash flows increase however at the same time as capex reduces, we believe that there will be ample scope to increase the dividend in future years, notwithstanding the group’s debt repayment schedule. In the first instance, we estimate that this could include a dividend of as much as 0.46c/share in FY20. If this proves to be correct, then Pan African will have a dividend yield in the top third of the 52 ostensibly precious metals companies paying dividends to shareholders over the course of the next 12 months.

In the meantime, over the next two years PAF remains cheaper than its South Africa- and London-listed gold mining peers on at least 83% of common valuation measures (25 out of 30 individual measures in the table below), regardless of whether Edison or consensus forecasts are used.

PAF’s cash outflow before financing activities was US$14.1m in FY19 after an outflow of £14.3m (US$18.5m at the then prevailing foreign exchange rates) in H119, thereby implying a cash inflow of c US$4.4m in the second half of the financial year, under the influence of reduced capex, an improved operating performance, a better gold price and a steady rand.

Including its liabilities to non-financial institutions, PAF had net debt of US$132.5m (US$128.4m excluding non-financial institutions) on its balance sheet as at 30 June 2019 (cf £102.7m as at 31 December 2018, £91.0m/US$120.0m as at June 2018, £42.2m as at December 2017 and £7.0m/US$9.1m as at June 2017). As such, net debt equated to a gearing (net debt/equity) ratio of 72.2% (cf 82.2% as at H119 and 78.6% as at end-FY18) and a leverage (net debt/[net debt + equity]) ratio of 41.9% (cf 45.1% as at H119 and 44.0% as at end-FY18).

As of the current time, the most intense phase of capex relating to Elikhulu has now been completed and we expect group capex to more than half, from ZAR802.0m in FY19 to ZAR385.5m in FY20 (NB capex has already more than halved from ZAR585.9m in H119 to ZAR216.1m in H219), notwithstanding the development of the Evander 8 Shaft pillar project. As a result, henceforward, we expect Pan African to become strongly cash-generative, such that it will pay down net debt at a rate in excess of US$20m per annum (before dividend distributions). As a consequence, we predict that Pan African will be net debt free by the end of FY23, even allowing for dividend distributions at the levels predicted, above):

Debt is principally financed via a ZAR1bn revolving credit facility US$67.7m 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 2.3:1 as at December 2018 (with the requirement that it be 4:1 thereafter).

Pan African has four potential organic growth projects at various stages of development, namely the Fairview sub-vertical shaft project (adding 7–10koz to production pa), the Royal Sheba project (c 30koz pa), Egoli (optimised 34% IRR and ZAR1.04bn pre-tax NPV) and the 8 Shaft pillar project (US$25.8m pre-tax NPV). Two – the 8 Shaft pillar project and the Fairview sub-vertical shaft – are already in development.

At the same time that it approved the Evander 8 Shaft pillar project, the group concluded that it would not pursue mining the near-surface Royal Sheba resource on a standalone basis, but that it would instead upgrade the existing Barberton Mines processing plant infrastructure to take Royal Sheba ore. Development of the orebody will be in two phases:

At the same time, the Dibanisa project will integrate Sheba and Fairview infrastructure, such that Fairview will be able to accommodate Royal Shaba ore. Tailings from the Royal Sheba operation will then be available for processing via BTRP infrastructure in addition to the latter’s traditional sources. Among other things, this method of development will help to expedite the environmental licensing process, shorten the timeline to production, enhance returns and negate the need for external capital funding.

In contrast to the other three projects, Egoli (formerly the 2010 Pay Channel project) – with a peak funding requirement of ZAR862m (US$58.4m at prevailing forex rates) – will require external funding. The project involves extracting c 1Moz of gold at a rate of c 100koz per annum at a total cash cost of c ZAR300,000/kg (US$632/oz at prevailing rates). While superficially comparable to former underground operations at Evander 8 Shaft however, there are a number of important differences, which are summarised below:

In the light of the requirement for external funding, Pan African is studying a range of development options, including ring-fencing the operation in a separate vehicle. In the meantime, a final, optimised feasibility study on the project is expected to be completed imminently.