Pan African Resources — Finishing unfinished business

On 27 February, PAF confirmed that Evander (EGM) is in a consultation process with its labour in terms of section 189 of the South African Labour Relations Act, which provides that, before retrenching, employers must consult any person whom they are required to in terms of the collective agreement. On 2 May it announced that, after both internal and external reviews had concluded there was “no realistic prospect of mining on a sustainable and profitable basis from [Evander 8 Shaft underground] in the current weak rand gold price environment”, the decision had been taken to shut the operation by the end of May, with the loss of 1,700 jobs and at a cost of c ZAR160m (US$13.1m, or £9.5m; which includes redundancies). In consequence, Evander Mines’ gold production for FY18 is now expected to be c 46koz compared to a prior expectation of 67-69koz. A table of Evander’s performance by half-year period is provided below, including our updated and prior forecasts in the light of PAF’s updated guidance:

Note that, owing to Evander’s predominantly fixed cost base, aggregate costs in rand terms have been left unchanged (pro-rata for five months, instead of six), and that otherwise plant throughput is presumed to have declined markedly. Foreign exchanged rates have been honed to reflect a recent, very minor weakening of the rand against both the US dollar and sterling. Nevertheless, even prior to the decision to shut the 8 Shaft underground operation it was notable that, while EGM was expected to account for c 36.7% of PAF’s group-wide gold output in FY18, it was expected to account for only c 0.6% of gross profits. Moreover, even if costs were to return to our forecast, long-term steady-state level of ZAR2,671/t, it would have resulted in an average EBITDA margin only 14.7% over the life of operations, ie EGM underground would still have been the lowest margin of PAF’s operations.

The Evander rehabilitation provision is fully funded by means of a ZAR311.0m (£18.4m at prevailing forex rates) rehabilitation trust and these funds will be used to finance Evander’s underground closure costs and associated rehabilitation. In the meantime, the group 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 assist with further employment opportunities for those affected by the Section 189 process. Moreover, 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 our note entitled, Pan African Resources: A second glance at the first half, published in April 2018) as a standalone project. This is expected to be completed by the end of the current financial year.

At the same time, Edison has reduced its production forecasts for the ETRP by 891oz to bring them exactly into line with the upper end of management’s guidance range for the full year. In this case, tonnes processed from surface feedstocks is presumed to have settled at approximately the level as in H118, but at a fractionally lower grade (see Exhibit 2, below). Nevertheless, the plant will still achieve a high level of capacity utilisation (91.0% vs a management target of 150-160ktpm, or 75-80%, on a sustainable, long-term basis). Metallurgical recoveries are similarly expected to moderate to their long-term, sustainable target level of 45% (vs 56% in H118).

Effectively, the ETRP represents a substantial pilot plant, designed to prove recovery and cost parameters, before the development of the much larger Elikhulu project (as before, see Pan African Resources: 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$5.3m, or £3.9m), 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 toll-treatment material with higher grades 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.

After producing 85koz of gold in H118, our updated group-wide production estimate (as per Exhibits 1 and 2) in FY18 is 157.6koz, which correlates closely to management’s updated guidance of 156-158koz (thereby implying production of 92-96koz in H218):

Note that our forecast of group-wide production of 140.3koz in FY19 is exactly in line with that set out in the Sensitivities section of our note Pan African Resources: A second glance at the first half, published in April 2018, in which we considered the possibility of the Evander 8 Shaft underground operation being closed. Within the historical context, a degree of risk is probably attached to our production forecasts at Barberton in FY19, but that this is offset (in roughly equal degree in our opinion) by the upside risk to Edison’s production forecast at Elikhulu and the ETRP. Inasmuch as Elikhulu and the ETRP are (and are expected to be) higher-margin operations than Barberton, the financial consequences of this aggregate risk may be regarded as ‘conservative’.

As a result of the considerations outlined above, our detailed financial forecasts for PAF for H218 and FY18 are therefore now as shown in Exhibit 4. Note however that, when Pan African does report its FY18 results in September, it may well opt to disclose them with Evander 8 Shaft underground reflected as a discontinued operation (which will be the subject of a separate note towards the end of the financial year).

Note that management’s anticipated cost of ZAR160m (£9.5m, US$13.1m) relating to the closure of the Evander 8 Shaft underground operation has been included under ‘Other income/(expenses)’. As such, it is included in our forecast of EPS and HEPS, but not in our forecast of Normalised EPS in Exhibit 16 on page 12. In the meantime, our FY18 EPS forecast of a loss of 0.56p per share (above) compares with a mean consensus estimate of 0.886p, within the range (0.10)-2.40p (source: Bloomberg, 3 May 2018, excluding Edison). Our (normalised) forecast of 0.92p for FY19 compares with our previous forecast of 1.22p (including a full contribution from Evander) or 0.99p/share (excluding Evander) and with a mean consensus of 1.392p/share, within a range of 0.669-2.90p/share. Note that our gold price forecast for FY19 remains unchanged at US$1,291/oz.

More significant to PAF in the medium to long term, the development of Elikhulu (which is now underway and fully funded) should increase output to c 181koz (cf 250koz including Evander previously) over the next two financial years. As such, Elikhulu will largely replace production lost from Evander underground – albeit at a much higher margin – which underpins our longer-term earnings and cash-flow expectations:

As a result of Evander’s relatively high-cost and low-margin profile however, the effect of its closure on earnings and our valuation is much more muted than the effect on production. Updating our long-term forecasts to reflect the closure of Evander’s underground operations, our average EPS forecast during the period FY20-31 (based on PAF’s existing three producing assets only) reduces by 12.1%, from 2.48p/share (including Evander, previously) to 2.18p/sh excluding Evander (vs 2.20p/share excluding Evander previously). Our absolute value of PAF decreases from 15.74p/share (including Evander underground) to 12.59p/sh excluding Evander underground (vs estimate of 13.20p/share excluding Evander previously, but also excluding exceptional closure costs), 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 partial recompense, 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 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 9) to be 20.1Moz, categorised as follows:

The value of Witwatersrand resources has proved persistently difficult to place within a global context – a problem exacerbated by an absence, currently, 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 during the year). Since then, we estimate that PAF will have mined 411,841oz from Evander excluding the ETRP (385,230oz from underground sources), ie implying only 1.2% depletion relative to the acquired resource, on a contemporary basis). 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 0.25-5.89 US cents per PAF share, as shown below:

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

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

Notwithstanding the fact that PAF’s price to normalised HEPS ratio is above the top of its recent historical range (based on our forecasts), it falls to well within the range (and below the average) in FY19 and to well below the minimum of the recent historical range assuming the recovery anticipated 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 8.9p in FY19 and 21.3p 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 44% of valuation measures (ie 16 out of 36 measures in the table below on an individual company basis) using Edison’s forecasts or 80% of measures (ie 29 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. In addition, in FY17, the board took the view that the proceeds from the sale of Uitkomst were eligible to contribute to the dividend payout on the grounds that they constituted a viable return to shareholders relative to the original price paid for the investment.

Despite our assumption that PAF is now likely to pass its FY18 dividend, within the global context and on the basis of our FY19 expectations, PAF continues to have the sixth highest dividend yield of the 62 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 requirement relates to the development of the Elikhulu project. As at end-December 2017, ZAR511.7m in capex had been expended on the project and ZAR671.4m 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), Edison’s forecasts for PAF’s immediate future capital expenditure commitments on the project are shown in Exhbit 13:

As a result, after investing activities, we estimate that PAF will experience 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 funding requirement, on our estimates, will evolve as follows in the period from FY16 to FY23e:

Note that PAF’s maximum funding requirement of £90.3m in FY19, as estimated by Edison, equates to ZAR1,524m at prevailing forex rates, or contemporary gearing (debt/equity) of 42.0% and leverage (debt/[debt+equity]) of 29.6%.

Debt is financed via a ZAR1bn revolving credit facility (£59.3m at current exchange rates), of which ZAR676.6m (£31.8m) 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, in the light of the closure of the Evander 8 Shaft underground operations, Pan African is in the process of finalising 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 approvals 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 current FY18 forecasts, we predict that PAF will ‘break’ its net debt:EBITDA and interest cover covenants. However, this contingency has already been partially 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.