Pan African Resources — Exceeding expectations (as usual)

Pan African announced its operational results for the year ended 30 June 2021 on 13 July. Production in H121 was already known; nevertheless, production for the full year was 6,609oz (3.4%) higher than PAF’s own guidance of 195,000oz from as recently as May 2021, and 7,383oz (3.8%) above Edison’s forecast for the year. As a result, the group’s production profile grew, rather than declined, in H221 compared to H121. In percentage terms, the increase was enhanced when analysed on a half year basis, as shown in the exhibit below.

While production from the Barberton complex was broadly in line with our expectations and that from Elikhulu was slightly below, all of the outperformance could be attributed to operations at Evander underground. Output at Evander underground was restrained by a ventilation shaft lining fracture in H121 as well as technical difficulties relating to the pseudo packs used for ground support (now overcome) and lower than usual metallurgical recoveries (although this was, to some extent, counterbalanced by head grade, which, at an estimated 8.51g/t, was 11.0% above our prior forecast of 7.67g/t). In the event, however, Evander’s performance in H221 not only returned output levels to those expected for the six-month period, but also more than made up for the shortfall in the first half as well. Over the same period, production at Barberton underground benefited from increased mining footprints on the 256, 257, 258 and 358 platforms, thereby engendering greater mining flexibility. Throughput at Elikhulu was restricted on account of remedial work on the its tailing storage facility’s lower compartment. This was largely anticipated in our note at the time of the company’s interim results (see Record interim profitability, published on 3 March 2021). In addition, however, unexpected concentrations of carbonaceous material in the lower benches of the Kinross dam negatively affected gold recoveries, which we estimate must have been in the order of 42.6% (in line with H220 and H121 but below our prior expectation of 47.8% for H221).

We have updated our forecasts for H221 and FY21 in the light of the production results reported by Pan African as well as a slightly lower gold price during H221 (US$1,805/oz cf our previous forecast of US$1,828/oz) and a slightly stronger rand against the US dollar, in particular (ZAR14.54/US$ cf our previous forecast of ZAR14.60/US$). While our estimate of full-year revenue has increased by US$12.1m to reflect higher than expected production during the year and half year, this increase was counterbalanced by an only slightly smaller increase in cash costs as higher-margin production from Elikhulu was supplanted by lower-margin production from Evander to leave our earnings expectations, to all intents and purposes, unchanged – albeit at levels for the half year that are more akin to those typically earned within a full financial year historically.

In the context of the above forecasts, readers should note that we estimate that US$23.1m (or 57.0%) of our estimated full-year tax charge for FY21 will have been in the form of deferred taxes and that cash taxes will have accounted for only US$17.4m (or 43.0%) of the total tax charge of US$40.5m.

Our updated normalised FY21 headline earnings per share (HEPS) forecast of 4.24c/share compares with a range of analysts’ expectations from 3.01–3.72p/share, or 4.16–5.14c/share (source: Refinitiv, 21 July 2021).

In addition to its production results for FY21, Pan African also confirmed guidance for production from the group for FY22 of 195,000oz, including 55,000oz from Elikhulu. Edison has interpreted this guidance as implying the following levels of production from each of the group’s mines during the course of the year, which we have compared to FY21 and our prior expectations for FY22, as follows:

We have now adjusted our financial model to reflect PAF’s guidance. While this has involved an increase in forecast production in FY22, guidance for FY22 appears somewhat conservative in the context of production in FY21. Moreover, there is probably a degree of uncertainty regarding likely output from Evander in FY22. For the moment, we have retained production from Evander underground at 26,400oz reflecting solely anticipated output from the 8 Shaft Pillar project, in this case, supplemented by production of 9,118oz from tolling from surface sources through the ETRP plant to result in total output from Evander of 35,518oz. However, it is possible that production from Evander underground will be augmented by the execution of the 8 Shaft decline project (see below) to maintain production at approximately 34,000oz per annum for the Evander 8 Shaft complex as a whole. In this case, any additional production from tolling from surface sources (historically of the order of 10,000oz pa) through the ETRP is likely to result in overall output from Evander in excess of 35,518oz. The effect of Edison’s adjustments to its model has resulted in a modest, 4.6% decline in normalised earnings in FY22 to US$99.9m (cf US$104.6m previously) and a similar decline in normalised HEPS from 5.43c/share to 5.18c/share, albeit with the production caveat noted above and the observation that this will still represent an increase relative to FY21 and therefore record earnings and profitability for the group. This compares with a range of analysts’ expectations of 3.60–4.93p/share, or 4.98–6.81c/share (source: Refinitiv, 21 July 2021).

Pan African has recently added two new projects to its existing portfolio of growth projects (already including Royal Sheba, the Fairview sub-vertical shaft, Rolspruit, Poplar, Evander South etc) in the form of the Mintails/Mogale project and the 8 Shaft decline 24 Level project.

One of the assets with the most immediate optionality in the company’s portfolio is Mintails/Mogale, which could yet prove very similar in nature to Elikhulu, and into which PAF is currently conducting due diligence with a view to acquiring.

On 6 November 2020, PAF announced that it had entered into a conditional agreement with the liquidator of Mintails’ assets for the purchase of the total share capital and associated loans of Mogale Gold Pty Ltd and Mintails SA Soweto Cluster Pty Ltd. Due diligence has been extended until January 2022. In the meantime, PAF has successfully concluded both a fatal flaw analysis and a high-level financial evaluation of the project, which would be similar in nature to Pan African’s flagship Elikhulu project. Key outcomes of the financial evaluation are as follows:

The concept study did, however, identify areas that will require further evaluation, including:

In the meantime however, by way of comparison, investors should note that Mintails’ and Mogale’s aggregate resource of 2.36Moz compares favourably to Elikhulu’s original resource of 1.7Moz and its initial reserve of 1.5Moz, but at a fractionally higher grade of 0.30g/t (cf Elikhulu’s 0.29g/t). PAF announced the results of an independent definitive feasibility study (DFS) on Elikhulu on 5 December 2016, which demonstrated an NPV9 of US$75.9m (or, then, 5.0c/share, or US$40.95 per resource ounce) at a gold price of US$1,180/oz and a forex rate of ZAR14.50/US$. At the time, Edison estimated Elikhulu to be worth US$69.9m (or 4.6c/share) at a 10% discount rate and to be capable of adding 1.33p to EPS in the first eight years of its operation (albeit there are now 28.0% more shares in issue). Now however, with capex having been expended (but with not all associated debt having been repaid), we estimate a current valuation for Elikhulu of c US$136.32 per initial resource ounce or US$179.08 per residual resource ounce. As such, and albeit with suitable caveats such as the Mintails/Mogale assets developing in a similar fashion to Elikhulu, PAF could acquire for US$1.31/oz an asset that should be worth US$9.88/oz as an in-situ resource (see Gold stars and black holes, published in January 2019), could be worth US$40.95/oz (pre-production) and may be worth up to US$191.94/oz (post-initial capex and debt repayment).

Pan African has continued to maintain the integrity of the underground infrastructure at Evander even after the end of high-volume, deep-level underground mining in May 2018. While limited vamping operations have continued since then, PAF has now concluded an internal technical and economic study into the merits of mining the number 2 decline on 24 Level at 8 Shaft (Phase 1 of the project) with an option to extend mining to levels 25 and 26 at a later date (Phase 2).

An integral component of the Phase 1 study was the identification of pre-May 2018 problems at Evander underground and appropriate mitigation of the major challenges encountered during the mining of the Kinross orebody. These included:

To date, the study has yielded the following results for the project:

While not large by the standards of some of Pan African’s other recent projects, the 8 Shaft no. 2 decline 24 Level project will extend the 8 Shaft Pillar project’s 2.5-year life by a minimum of another 2.5 years at approximately the same level of production of c 34,000oz per annum.

As a consequence of the positive concept study on Mintails/Mogale and the group’s assessment of the opportunity provided by the 24 Level project at Evander, Pan African has now reprioritised its capital expenditure programmes as follows:

Full details regarding Pan African’s growth projects will be released in due course, in particular with respect to the phasing of the development of the Egoli project. Until such time as these details are known, Edison is maintaining its valuation of Pan African (below) based on its prior assumptions regarding its growth projects’ developments. However, it is not unreasonable to assume that any refinements to the projects’ timings and developments should be value adding and, in that respect, Edison’s valuation (below) could be regarded as being conservative.

In the light of PAF’s operational update for FY21 and fractionally revised external factors such as the gold price and forex rates, our absolute value of the company (based on its existing four producing assets plus Egoli) has increased very slightly to 36.52c/share (cf 36.42c previously), on the basis of 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):

Including its other potential growth projects and assets (ie the residual Evander underground resource and its shareholding in MC Mining), our updated total valuation of PAF is as follows:

Of particular note to readers is the increase in the valuation of Pan African’s interest in Mintails/Mogale on the basis of its fatal flaw analysis and high-level financial evaluation of the project (see above). Self-evidently, this valuation is contingent upon Pan African concluding its agreed acquisition of these assets and its subsequent development of them.

Exhibit 7, below, depicts PAF’s average share price in each of its financial years from FY10 to FY20, and compares this with normalised HEPS in the same year. For FY21 and FY22, the current share price (of 16.66p) is compared with our forecast normalised HEPS for FY21 to FY22. As is apparent from the graph, PAF’s price to normalised HEPS ratio of 5.4x and 4.4x for FY21 and FY22, respectively (based on our forecasts – see Exhibit 13, below) is very close to the bottom of its recent historical range of 4.1–14.8x for the period FY10–20:

Stated alternatively, if PAF’s average contemporary price to normalised EPS ratio of 9.1x in the period FY10–20 is applied to our normalised earnings forecasts, then it implies a share price for PAF of c 27.9p in FY21 and 34.0p in FY22.

Over the next two years, PAF remains cheaper than its South Africa- and London-listed gold mining peers on 66.7% of comparable common valuation measures (20 out of 30 individual measures in the table below) if Edison forecasts are applied or 50% if consensus forecasts are applied.

Readers should note that PAF’s P/E ratio and dividend yield, calculated on the basis of consensus forecasts, appear to suggest that EPS and DPS will both fall in FY21 relative to FY20, which we believe is unusually pessimistic and especially so in the context of the company’s interim results (see Exhibit 2).

Otherwise, applying PAF’s peers’ average year 1 P/E ratio of 7.3x to Edison’s forecast normalised HEPS forecast of 4.24c/share for FY21 implies a share price for the company of 22.6p at prevailing forex rates, while applying its peers’ average year 2 P/E ratio of 7.6x to our forecast normalised HEPS forecast of 5.18c/share implies a share price of 28.5p.

PAF reported that group net senior debt had decreased by 45.5%, from US$62.0m at end-June 2020 to US$33.8m at end-June 2021, a decline of US$28.2m over the course of the full 12-month period, but a decline of US$26.1m in H221 alone. We estimate that this level of debt equates to a gearing ratio (net debt/equity) of 14.1% (cf 24.5% at the interim stage) and a leverage ratio (net debt/[net debt+equity]) of 12.4% (cf 19.7%). This figure is probably not complete in that it will exclude IFRS 16 lease liabilities of c US$5.0m and an (albeit negligible) instalment sale liability. However, it does nevertheless represent the vast majority of the group’s net debt, as shown in the table below:

Most notable within the context of the above table is the extinction of the liabilities relating to PAF’s gold loan and derivative financial instruments in H121, which represented the last vestiges of the company’s revenue protection hedging contracts, which have now all been terminated.

PAF’s reported year-end net senior debt of US$33.8m is also very close to our prior forecast of US$29.8m, with the difference being easily attributable to changes in working capital. Notwithstanding capex commitments, we are therefore continuing to forecast that the company will achieve net debt free status during the FY22 financial year:

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