Pan African Resources — H120 confirms FY20 forecasts

Pan African’s results for the half year to end-December 2019 were reported in the context of known production (from the group’s operational update of 24 January), and indicated EPS and headline earnings per share (HEPS) ranges (from its trading statement of 31 January).

While 14.7% higher than in the prior year period, production in H120 was comparable to production in H219, despite challenges including electricity supply constraints and illegal mining activities at its operations. Otherwise, highlights for H120 compared with H119 were as follows:

As a result, Pan African has reconfirmed its production guidance for the year of 185,000oz for FY20, including 100,000oz from the Barberton complex (underground plus BTRP) – implying, inter alia, production from Barberton underground of c 42,644oz in H220.

The table below presents PAF’s H120 results compared with both H119 and H219 (implied) and also Edison’s updated expectations for FY20 in the light of the interim results reported:

As a group, Pan African sold 2,339oz less than it produced in H120. Should this be sold in H220, it would add c US$3.7m to revenue. Note that Edison has included a notional loss of US$2.4m in H220 from PAF’s derivative contracts (and in particular its gold loan – see below) within ‘other income/(expenses). Otherwise, the principal operational assumptions on which the above forecasts are based are set out in the ‘H120 analysis’, below.

Relative to the group’s 14.7% increase in gold production and its 32.8% increase in tonnes milled and processed (H120 vs H119), the group’s cost of production increased by 26.5% in rand terms and 22.1% 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 (41% of production in H120) and Elikhulu (32%).

An analysis of Barberton underground’s H120 performance plus our expectations for FY20, by half-year, is provided in Exhibit 3, below. Of note is the fact that the operation recorded its highest level of tonnes milled during a six-month period since at least H112. In addition, it recorded its highest adjusted EBITDA number since H117 and easily covered capex of ZAR107.0m, despite facing challenging geological conditions at Fairview and the need to put enhanced security initiatives in place in order to curtail illegal mining activities.

Our forecasts for FY20 assume that underground operations at Barberton return to their previous levels in H220 in terms of both tonnes milled and head grade (Exhibit 3), albeit this will leave output for the full year of 77,737oz probably causing it to just miss its guidance of 100,000oz for the complex for the year (including 20,619oz from the BTRP). Readers should note that our forecasts for Barberton for H220 are inherently conservative in terms of costs – especially given our assumption of continued production from surface sources (which tends to depress average ZAR costs per tonne milled) and also in light of the costs achieved in H119, H219 and H120. Underground operations at Barberton will also benefit from the establishment of the 257 platform, thereby allowing three platforms to cycle production on the high-grade MRC orebody.

Exhibit 4 similarly provides our analysis of Elikhulu’s H120 performance. Notwithstanding the fact that it produced c 32% of Pan African’s gold during the period under review, it accounted for 47% of group adjusted EBITDA of ZAR712.1m and was the largest single contributor to the same, while simultaneously accounting for only a very small fraction (7%, or ZAR13.8m) of group capital expenditure. Of note was the continued high level of metallurgical recoveries in H120, despite operations being severely affected by heavy rains (eg 36cm/14” in two days) in December. Nevertheless, a new satellite pump station was successfully commissioned at the end of 2019, which is expected to increase plant feed grades and plant feed rates for the remainder of the financial year. We therefore expect H220 to be characterised by full-capacity throughput as it (re-)mines through a high-grade area of its dumps to result in full year production of 60,468oz (65,199oz in conjunction with surface material treated via the former ETRP infrastructure). In this context, it is notable that PAF reported that January had been a month of record production at Elikhulu, with output of almost 180kg (5,787oz) of gold which, pro-rata, would imply H220 production from Elikhulu alone of 34,723oz. As such, our forecasts for production (see Exhibits 4 and 6) may still prove conservative. In addition, our forecasts for H220 are conservative inasmuch as they assume a decline to life-of-mine metallurgical recoveries, whereas higher metallurgical recoveries are typically coincident with higher grades.

Apart from Barberton and Elikhulu, the BTRP (11% of production in H120) performed closely in line with our expectations, guidance and the mine plan. At the same time, 123.9kt of material from surface feedstocks was treated through ETRP infrastructure, which, at an estimated head grade of 2.25g/t and after metallurgical recovery of 53.0%, resulted in the production of 4,731oz gold in H120 – 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.

Also at Evander, access development at the 8 Shaft Pillar has now been completed with the project producing its first gold in August 2019. To date, the 8 Shaft Pillar is reported to have produced 2,335oz gold, albeit the revenue and costs associated with the project are being capitalised until steady-state production is achieved next month.

By the end of FY20 all nine underground stoping crews will have been migrated to the 8 Shaft Pillar and PAF expects the project to contribute, on average, 30,000oz of production per annum to the group over the next three financial years at materially higher margins (see H220e column in Exhibit 5, below, which demonstrates the first effect of this) than the current remnant underground mining and vamping operations.

A summary of the results of the Evander 8 Shaft Pillar project feasibility study are provided below:

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 grout plant at surface with the ability to pump a mixture of concrete and waste rock underground to selectively support areas of the orebody. At a recent site visit to the 8 Shaft Pillar project, attended by Edison, the short distance between the shaft bottom and the stoping areas was immediately apparent (ie 10 minutes – in sharp contrast to PAF's previous operations at 24 Level at 8 Shaft, which had an approximate 100 minute commute to the working faces), which will allow miners increased face time. In addition, the working faces are close to an intake airway (negating the need for refrigeration) and the ore will only need to be handled about four times before reaching surface (cf 22 times previously) and will require only c 4km of tramming (cf c 14km previously). This last point is significant in that Evander has a high percentage of fine gold in its ore and, historically, it has been estimated that up to 1% of this gold is lost per kilometre of distance trammed. This combination of fewer transport points and systems is therefore anticipated to have a materially beneficial effect on the overall operation’s mine call factor. The other thing that was very apparent during the site visit was the development in technology around pillar mining and especially the use of pseudo-packs and rapid reaction pit props (rather than the matt packs of old) for 'intelligent' rather than passive ground support – thereby materially de-risking the operation from both an environmental, social and governance (ESG) and a financial perspective.

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

Our gold price forecast for H1 CY20 (or H220) is US$1,565/oz. Our longer-term gold price forecasts were set out in our recent report, Portents of economic weakness: Gold – doves in the ascendant, published on 14 August 2019, and are summarised in the table 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$1,326/oz at current forex rates), representing approximately 10% of the group’s anticipated production for the 2020 financial year. The second is a series of zero cost collar contracts over 50,460oz gold in H220 that cap the likely gold price received by Pan African at ZAR836,000/kg (c US$1,750/oz), but also floor it at ZAR655,000/kg (c US$1,371/oz).

Given our current gold price expectations (see Exhibit 7), we do not expect the call options written at ZAR836,000/kg to be exercised in H220. However, we estimate that the gold loan will result in a notional loss of US$2.4m in H220, which we have included in ‘other income/(expenses)’ in our forecasts (NB Pan African reported ZAR29m, or US$2.0m, in realised hedging losses in H120).

Updating our long-term forecasts to reflect interim results, the gold price and prevailing forex rates in particular, our normalised headline earnings per share (HEPS) forecast remains substantially unchanged at 3.02c/share (cf 2.46c/share previously). This compares with a consensus EPS forecast of 2.0c/share, within a range 1.2–2.7c/share (source: Refinitiv, 2 March 2020). Our forecasts for FY21 remain substantially unchanged, based on production of 216.3koz, including 94.6koz for Barberton underground and 35.7koz from the Evander 8 Shaft pillar project. In this case, our normalised HEPS forecast of 5.32 US cents and compares with a consensus of 3.3c, within a range 2.9–3.8c (source: Refinitiv, 2 March 2020).

As a result, our absolute value of PAF (based on its existing four producing assets only) has also risen, to 22.43c/share (cf 17.89c/share previously), 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 24.69c/share in FY23 (the ‘discounted dividend valuation line’ in Exhibit 8, 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 October, 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 ZAR6.28/share to ZAR3.20/share currently (adjusted into US dollars at the appropriate FX rate).

Exhibit 10, 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 11.66p) 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 5.0x for FY20 (based on our forecasts – see Exhibit 16, 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 2.8x 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 might be expected to be 22.3p in FY20 and 39.2p in FY20.

PAF has reiterated its dividend policy of having 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.

This duly occurred when the board recommended a final dividend of ZAR50m, or approximately US$3.4m for FY19, which equated to ZAR0.022375 or c 0.11725p or 0.15179 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 0.86c/share in FY20 (cf 0.46c/share previously). If this proves to be correct, then Pan African will once again have a dividend yield well inside the top ten of the 52 precious metals companies paying dividends to shareholders over the course of the next 12 months (based on either Edison or consensus market forecasts).

In the meantime, over the next two years PAF remains cheaper than its South Africa- and London-listed gold mining peers on at least 96% of common valuation measures (29 out of 30 individual measures in the table below) on the basis of Edison’s forecasts and at least 73% of the same measures on the basis of consensus forecasts.

Including its liabilities to non-financial institutions, PAF had net debt of US$130.7m on its balance sheet as at 31 December 2019, compared to US$132.5m as at 30 June 2019. This compares with historical net debt numbers of US$133.2m/£102.7m as at 31 December 2018 (restated), £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 64.8% as at end-H120 (cf 72.2% as at end-FY19, 86.7% as at H119 (restated) and 78.6% as at end-FY18) and a leverage (net debt/(net debt + equity)) ratio of 39.3% (cf 41.9% as at FY19, 46.4% as at H119 (restated) and 44.0% as at end-FY18).

While the decline in net debt on this basis may seem modest, it was adversely affected by two one-off movements in working capital, relating to payables and inventories, which had an aggregate (negative) effect on cash flows in the sum of US$8.7m. According to our calculations, the amount of inventory on PAF’s balance sheet has expanded to 11.1 days (H120 annualised basis), while the amount of payables has declined to 62.0 days (similar basis). As such, the number of inventory days is now almost double its historical average of 6.3 since 2010, while its payable days are 9.1% below their historical average of 68.2, suggesting that, while there is only modest scope for payables to increase in the future, there is considerable scope to bear down on inventory levels. We calculate that a return to historical averages for both measures would result in a future one-off net benefit to PAF’s cash flow in the order of US$6.4m.

Excluding non-financial institutions, Pan African had net debt of US$105.7m, cf US$128.4m as at end-June.

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 halve, from ZAR802.0m in FY19 to ZAR364.6m in FY20 (NB capex has already more than halved from ZAR585.9m in H119 to ZAR211.5m in H120), 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$25m per annum. Consequently, we now predict that Pan African will be net debt free in FY22, even allowing for dividend distributions at the levels predicted (above):

Debt is principally financed via a ZAR0.7bn (US$49.7m) term loan facility plus a similar-sized revolving credit facility and a ZAR121.5m general banking facility. As at 31 December 2019, approximately ZAR424.5m (US$30.1m) remained available to Pan African under its banking agreements.

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:

Pan African has five 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), the 8 Shaft pillar project (US$25.8m pre-tax NPV) and the extraction of the Prince Consort shaft pillar (3,900-7,800oz pa). 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, PAF concluded that it would not pursue mining the near-surface Royal Sheba resource on a standalone basis, but that it will 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 – scheduled to be completed in FY21 – will integrate Sheba and Fairview infrastructure, such that Fairview will be able to accommodate Royal Sheba ore. One of the immediate advantages of this will be that additional available shaft-time will assist with the development and mining of Royal Sheba. Once in production, the Sheba plant will be available to process both surface material and Royal Sheba uppers (ie Phase 1). 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. Development of Royal Sheba will extend operations at Sheba by 10 years to 19 years in total. In addition, optimised usage of infrastructure is also anticipated to reduce all-in sustaining costs to c US$1,000/oz (management estimate). Design has been completed for the early extraction of the western block in Phase 1 (above the historical workings). In the meantime, development from the Sheba ZK shaft on 23 Level is only 390m away from Phase 2 reef intersection and a preliminary economic assessment for Phase 2 is underway and expected to be completed in Q420. Management has indicated that it would require an internal rate of return in excess of 20% in order to proceed with the project. In this event, it anticipates that it would take approximately one year to open and develop the orebody, such that mining of the uppers (Phase 1) would commence in c 12 months’ time and the mining of the lowers (Phase 2) in c 18 months’ time.

In contrast to the other five projects, Egoli (formerly the 2010 Pay Channel project) – with a peak funding requirement of ZAR862m (US$58.0m at prevailing forex rates) – will require external funding. Following dewatering, standard footwall development, further deepening of the decline and on-reef development and associated engineering is required before mining can commence. Once in production however, the project involves extracting c 1Moz of gold at a rate of c 90koz per annum at a total cash cost of c ZAR300,000/kg (US$628/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:

As with the 8 Shaft Pillar project, the lower number of transport points and systems is significant given that a high percentage of gold in the Evander ore is in the form of fine gold, which is otherwise estimated to be lost a rate of 1% per kilometre of tramming distance.

In the light of the requirement for external funding, Pan African is studying a range of development options, including equity partners, gold streaming and ring-fencing the operation in a separate vehicle. An optimised mining feasibility study on the project was completed at the end of 2019 and PAF is currently in the process of finalising a definitive feasibility study, including a third-party independent review.

Despite historically being the highest grading operation at Barberton, the Consort mine has recently also become one of its highest cost operations. In order to address this, management has determined on an immediate initiative to mine the Prince Consort (PC) Shaft pillar, which boasts a mineral resource of 48.82kt at a grade of 25.54g/t (0.82oz/t), containing 40koz gold. At the same time, it will explore the 36 exploration targets that have been identified at New Consort for potential future exploitation.

Development towards the PC Shaft pillar is on track completion during April 2020, after which the operation will produce at a rate of 3,900–7,800oz per annum at a targeted all-in sustaining cost (AISC) of c US$1,200/oz over a period of approximately three years. In addition to underground ore, additional material from surface stockpiles at Consort will maximise and extend plant capacity.

Evander mining rights (which account for 48.5% of PAF’s gold production and 57.4% of its adjusted EBITDA) are valid until 2038. Barberton’s (from which it derived 51.5% of its gold in H120 and 42.6% of its adjusted EBITDA) are scheduled to formally expire in 2021, in respect of which Pan African has already submitted a renewal application, which is currently being processed via South Africa’s Department of Mineral Resources (DMR).

According to section 24, sub-section 25 of South Africa’s Mineral & Petroleum Resources Development Act, “A mining right in respect of which an application for renewal has been lodged shall despite its expiry date remain in force until such time as such application has been granted or refused.”

Pan African has lodged all documents required for the renewal of its mining rights. From now on therefore, the process of renewal is a purely bureaucratic and administrative matter. By law, as long as Pan African has complied with its obligations, the mining rights have to be renewed.

While Pan African is less exposed to load-shedding than its deep level South African peers by virtue of 48% of its gold being derived from tailings and other surface sources and its having spare plant capacity in general, recent outages have nevertheless had a disruptive effect on operations at Elikhulu, which has been operating close to 100% of capacity since June 2019. The plant requires 10MVA of power and, in order to address potential future disruption, management has completed a bankable feasibility study on a 10MVA solar plant at Evander (actually 9.99MWA so as to avoid the need for NERSA regulatory approval) and is exploring non-dilutive funding options for such a plant’s development.