Firing on four cylinders

Pan African’s interim figures were better than both of the two prior periods (ie H115 and H215) and also Edison’s expectations, reflecting a return to profit at Evander and a return to normal at Barberton and despite a 9.8% year-on-year decline in the average price of gold, to US$1,110/oz (vs US$1,231/oz). Compared to the prior year period (ie H115) gold produced and sold increased 17.4% (or 15,122oz) to 101,797oz, while cash costs of production fell by 25.7%, to US$740/oz, aided by a 23.9% decline in the ZAR/US$ exchange rate and a ZAR25.5m (£1.1m) inventory adjustment at Barberton. Nevertheless, there was little evidence of inflation (or, alternatively, there was solid evidence of diligent costs control). Aggregate underlying costs (ie excluding the Evander Tailings Retreatment Project [ETRP]) rose only 1.4%, from ZAR947.5m to ZAR960.5m in local currency terms, despite the group’s salaries and wages bill (49% of total costs at Barberton, excluding the Barberton Tailings Retreatment Project [BTRP], and 50% of costs at Evander, excluding the ETRP) increasing by 9.4% and its electricity costs (10% of total costs at Barberton, excluding the BTRP, and 22% of costs at Evander, excluding the ETRP) increasing by 11.9%, year-on-year, compared to a 12.7% increase in the NERSA approved electricity tariff over the same period.

In general therefore, not only were costs lower than our expectations, but depreciation, royalties and net finance costs were also lower than our expectations, albeit these were partly offset by an increase in ‘other’ expenses as a result of the inclusion of an unrealised derivative cost collar mark to market fair value adjustment of ZAR40.6m (£1.8m) at Barberton (see page 14).

On 8 February, Pan African (PAF) updated its earnings guidance for H115 to reflect the material changes in forex rates since early December (eg ZAR/£ -7.8%, ZAR/US$ -13.2% and £/US$ -4.8%) and actual vs expected production in H116, which was 5.5%, or 5,583oz, above our expectations. Whereas Edison had expected the outperformance to occur in Pan African’s underground operations however, in general it occurred in its tailings retreatment operations (the BTRP and ETRP). The following analysis therefore compares actual operational results with our expectations of 10 December 2015 and 11 February 2016.

Evander’s most significant achievement during the period was to return to profitability for the first time since H114 (ie July-December 2013). Throughput was closely aligned with our expectations, suggesting that the earlier underground challenges and infrastructure constraints (especially those relating to conveyor belt availability) had been successfully overcome and, as a result, there was no low-grade ore processed from surface sources. Albeit the (underground) head grade was lower than our (augmented) February 2016 forecast, it was still higher than our December 2015 forecast and, importantly, consistent with Evander exiting its low-grade mining cycle (see below). Unit working costs were ZAR2,450/t milled, which was 2.9% above our February 2016 forecast, but only 3.1% above our H215 underground unit working cost estimate of ZAR2,376/t (cf our target of ZAR2,159/t). As a result, gross total cash costs increased back to the levels of H214 and H115; however, this was more than offset by the increase in revenue as a result of the planned concentration of mining activities on the newly established, higher-grade areas of 25 level.

Level 25 at 8 shaft has now been firmly established, with the majority of crews working in the high-grade area of the mine. As a result (and significantly), the actual head grade mined at Evander exceeded management’s expectations (September 2015 guidance) in two of the final three months of the year, as shown in Exhibit 3.

In addition to the head grade, a number of other operational parameters at EGM improved during the period, including the mine call factor (from 59% in H115 to 65% in H116 versus a target of 73%), face advance (from 7.9m in H115 to 8.4m in H116 versus a target of 12m) and stoping width (reduced from 131cm in H115 to 127cm in H116 versus a target of 125cm). By contrast, while throughput matched our expectations, utilisation at 8 shaft remained relatively low at c 78.6% over the six-month period and with only one month in which it achieved its 35-40ktpm capacity. In the short to medium term, management will focus on improving this performance. In the meantime however, the situation in which the majority of crews are focused on the high-grade areas of the mine is expected to pertain for at least the next two years and head grades are therefore expected to remain in the range 6.0-7.0g/t for the next three to five years. In the immediate future, operations at Evander will involve advancing from 25 to 26 level in approximately nine months’ time. This will increase the number of conveyor belts from 11 (over 5km) currently to 12, and proportionately increase the amount of associated maintenance required. However, it will also improve access to more high-grade panels and allow management to manage and blend the ore mined towards achieving its target of 110,000oz of annual gold mined at EGM by selectively reducing mining at the lower-grade extremities of the Kinross pay channel.

In the longer term, management believes that a grade of 7.2g/t is possible. Note that, had an underground head grade of 7.2g/t prevailed in H116 (and applying the group’s H116 marginal tax rate to the incremental profits), we estimate that it would have added c 0.26p to both Pan African’s EPS and headline EPS in H116 (ie 0.52p, or ZAR0.11 per share, on an annualised basis). Had an underground head grade of 7.2g/t prevailed in H116 and a gold price of US$1,234/oz, then we estimate that 0.42p/share would have been added to EPS and HEPS in H116. Had an underground head grade of 7.2g/t prevailed in H116 and a gold price of US$1,466/oz (Edison’s average real, long-term gold price, see pages 15-16), then we estimate that 0.70p/share would have been added to EPS and HEPS in H116.

As with Evander, throughput at Barberton was closely aligned with our prior expectations and, while the head grade was not as high as our (augmented) February 2016 estimate, it was still noticeably higher than our December 2015 one and displayed a material increase compared to the (implied) grade in H215. Metallurgical recoveries increased to 92.0%, such that both throughput and recoveries have now returned to levels that are consistent with those pre-dating the contamination of the Biox plant with oil at Fairview in May 2014 (ie H214). Unit working costs were 9.6% and 18.0% below our two prior forecasts, respectively, aided by a ZAR23.5m gold inventory credit adjustment relating to 58kg (1,865oz) of unsold gold inventory concentrates held in the Fairview Biox plant (NB equates to US$811/oz of concentrate). Excluding this credit, unit working costs would have been ZAR3,066.54/t – ie on a par with H115 and therefore once again demonstrating diligent cost control, year-on-year.

Principal sources of cost inflation and deflation in rand terms over the year were as follows:

Capital expenditure was ZAR55.9m in H116 and was thus consistent with FY15’s figure of ZAR112.6m, almost all of which is now classified as either ‘maintenance’ or ‘development’ after the conclusion of the BTRP’s construction.

Finally, after exploration drilling in FY15 confirmed the down-dip extension of the high-grade 11-block of the MRC orebody by a further 170m, thereby increasing the life of BGMO’s operations by 5.3%, from 19 to 20 years (company estimate), a further two holes are planned again later this year.

In contrast to BGMO and Evander, PAF’s retreatment operations typically outperformed our expectations. In the case of the BTRP, the head grade was maintained at an elevated level, resulting in materially higher metallurgical recoveries, while costs returned to levels of H214 and H115, resulting in unit costs of production falling to an unprecedented US$367/oz and gross profits increasing in rand, dollar and sterling terms.

Nameplate capacity at the BTRP is 100ktpm and management is expected to work towards achieving this level in H117. For the moment, Edison is continuing to anticipate a moderation in grade and metallurgical recoveries. However, management has also recently been investigating the potential to reduce retention times, while maintaining metallurgical recoveries at relatively high levels. To the extent that it is successful, our forecasts may therefore prove to be relatively conservative.

In the longer term, approximately two-thirds of the tailings being treated at the BTRP originated from the Fairview concentrator at a grade of c 1.6g/t. The remaining third are from the same origin, but are supplemented with material from the Biox plant at a grade of 3-10g/t. As a result, a substantial portion of the resources being treated by BTRP exists at a grade in excess of 1.6g/t and there is therefore ample opportunity for management to pursue higher-grade strategies in order to increase financial returns.

The ETRP operated at 74.2% capacity utilisation in H116. However, metallurgical recoveries were materially higher than expected, at 63% (vs 48% expected) on average, which could be attributed to the processing of higher-grade surface material, which achieved a recovery rate of 78.3% vs 52.7% for tailings.

The grade of the dam being re-mined at the ETRP is 0.3g/t. However, the operation is commercially viable given its ability to fill unutilised capacity in the Kinross plant and the fact that it therefore attracts only incremental operating costs (broadly 14 additional employees). Re-mining is being conducted without breaching the dam wall and the tailings are being redeposited at Winkelhaak, thereby simplifying the environmental requirements (ie the Environmental Impact Assessment) with respect to re-filling the Kinross dam at a later date.

Nameplate capacity at the ETRP is 200ktpm and management’s target is to achieve 150-160ktpm (75-80% capacity utilisation on a sustainable, long-term basis). At ambient head grades (0.32g/t) and metallurgical recoveries (45%), this should result in the production of 10,000oz per annum at a total cash cost of US$807/oz (Edison calculation), based on the ETRP’s current cost base of ZAR130m per annum. In the meantime however, management will continue to source toll-treatment material with higher grades than the ETRP’s reserve and resource grades. Note that, in this respect, it is at a commercial advantage in 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 destined for retreatment in the region. As a result, currently it has approximately 12 months of such surface material on hand to process – a similar quantity to March 2015.

Effectively, the ETRP represents a substantial (10,000oz per year) pilot plant, designed to prove recovery and cost parameters, before a decision is taken on the much larger Elikhulu project, which would process 12Mtpa (cf the ETRP’s 2.16Mtpa) to produce c 50koz per annum, but would require c ZAR1.5bn (US$93.2m, or US$1,863 per annual ounce of production) in third-party capital investment and would need to support an independent cost base (cf the ETRP, which supports only an incremental cost base).

Phoenix’s performance was transformed in H215 by IFM’s resumption of mining at its underground Lesedi Mine, which provided sulphide material for treatment in the CTRP (vs oxide material from Skychrome previously). This, in combination with an improved reagent suite and the processing of higher sulphide content tailings contained in number 4 dam, resulted in a materially improved plant recovery and financial performance. With the descent of IFM into Business Rescue proceedings (akin to Chapter 11 in the United States) in H116 however, Phoenix’s performance similarly regressed, exacerbated by a shortage of water on account of a drought in the North West province, which resulted in the loss of three weeks of production, and lower platinum group element (PGE) prices.

Year-on-year contributors towards upward cost pressures in FY15 were:

In addition to current arisings from Lesedi (typically c 20% of its feedstock), Phoenix also sources electricity, water and certain other services from IFM. Management maintains that “is not in a position to fully assess the impact of the Business Rescue proceedings” on Phoenix. On a group level, Phoenix’s contribution to Pan African’s profits is small (Edison estimates £0.5m at a gross level in H216). However, in the event that the business rescue proceedings are finalised and the Lesedi mine is put on care and maintenance indefinitely and the current PGE market conditions persist, Phoenix’s effective life would reduce from 28 years to nine to 12 years, in which case “there is a risk of an impairment of Phoenix Platinum’s carry value at financial year end” – albeit, this is clearly a non-cash cost. It will also place on Phoenix a requirement for a new, permanent tailings storage facility (at an estimated cost of c ZAR30-40m). In the meantime however, Phoenix remains a ‘strategic’ investment for Pan African, providing it with an entry into the PGE market. Moreover, on 15 September 2015, the administrator opined that there is a reasonable prospect of rescuing IFM (South Africa) via a sale of its assets/business and/or equity, albeit the process would probably take two to three months, to which end stakeholders are currently considering a bid for the company from Samancor.

In addition to its existing operations, Pan African has four near- to medium-term expansion opportunities: Elikhulu, Uitkomst, Evander South and the Evander 2010 pay channel at 7 shaft.

The total resource at Elikhulu is 165Mt at a grade of 0.28g/t, containing 1.5Moz, which management envisages is capable of supporting an operation processing 12Mtpa to produce 50,000oz per annum for the first eight years of its life, followed by 38,000oz per annum for the remaining six at a capital cost of c ZAR1.5bn (US$93.2m, or US$1,863 per annual ounce of production), operating costs of less than US$500/oz and with a payback period of less than four years.

PAF is in the process of completing a definitive feasibility study (DFS) to assess the development options for Elikhulu and is scheduled to conduct a review of the project in June/July 2016.

In June 2015, Pan African entered into agreements to acquire the Uitkomst colliery, near the town of Utrecht in KwaZulu-Natal, from Oakleaf Investments Holding 109 Proprietary and Shanduka Resources for a cash consideration of ZAR200m (US$12.4m, or £8.9m, at current exchange rates vs £9.3m at the time of our December note). The colliery is already operational, at the following rates:

The mine produces high-grade thermal, export-quality coal with metallurgical applications to both the export and domestic markets, including a potential long-term contract with the South African electricity supplier, Eskom.

The acquisition remains subject to Section 11 DMR approval. However, management anticipates it to be immediately earnings- and cash-flow accretive. Moreover, while the headline consideration is ZAR200m, this will include cash of c ZAR25-35m, working capital of a similar figure and a ZAR85m debt facility. As a result, the net cash outflow relating to the transaction from Pan African is forecast by management to be in the order of ZAR80m only (£3.6m at current forex rates).

As with Sibanye’s recent initiatives regarding coal, Uitkomst also effectively provides Pan African with a natural hedge against energy prices in South Africa. Until the transaction closes, however, it remains excluded from our forecasts.

Evander South has an estimated mineral resource of 20.1Mt at a grade of 7.7g/t, containing 4.9Moz from a depth of only 300m below surface. Significant technical work has already been completed on the Evander South project and this is now being advanced into a preliminary economic assessment (PEA).

Historically, Pan African has had good relations with the unions. Evander negotiates as part of the collectivised bargaining process, under the auspices of the South African Chamber of Mines, while Barberton negotiates separately.

For the half-year under review, PAF’s salary and wage bill increased by 9.4% to ZAR497.6m, which is consistent with its announcement, on 13 October 2015, that it had concluded multi-year wage agreements with both the NUM and the UASA to the effect that the average Barberton salary and wage bill for FY16 and FY17 will increase by c 9% per year (effective from 1 July 2015) and the average Evander salary and wage bill for FY16, FY17 and FY18 will increase by c 7.8% per year (effective from 1 July 2015).

Evander is supplied by only one feeder cable from Eskom (vs four at BGMO). This increases the operational risk of being affected by power outages. However, Evander has also been designated as a ‘key industrial customer’, with the result that it is the last operation to be affected in its region and has never experienced an uncontrolled power cut. Unlike Barberton, however, it lacks the capacity to support itself on self-generated power, with the exception of the winders, emergency pumps and fans.

As has been well documented, South Africa is currently suffering from a shortage of effective generating capacity as older power stations on the historic Eastern Transvaal coalfields approach obsolescence.

In response, Eskom has commissioned two new power stations in South Africa’s Limpopo and Mpumalanga provinces. Known as Medupi and Kusile, respectively, each plant will have a generating gross capacity of c 4,800MW, with Medupi representing the largest investment in Eskom’s 84-year history and the first base-load project to be built in the country in 20 years. The combined output of the plants represents c 23% of the country’s current power generating capacity.

However, the completion of Medupi has faced numerous setbacks, from procurement, technical issues, labour problems, and claims of mismanagement. Whereas Eskom initially estimated that Kusile/Medupi would power up in 2011 and that the total duration of the project would be no longer than four years at the time of its commissioning, commencement of the project was subsequently delayed by two years to 2013 while, to date, only one unit of 794MW capacity has been built (out of six). As a result, Medupi, which witnessed its first unit go online in 2015, will now not see its final unit go live until May 2020:

While the news of Medupi’s synchronisation into the grid is positive within the context of South Africa’s electricity tribulations, it represents only one-sixth of design capacity and only 1.9% of Eskom’s current capacity of c 42,000MW. Moreover, capital expenditure on the two new power stations has exceeded the budget, such that Eskom has needed to turn to the South African Treasury for additional funding. As a result, in addition to the three 8% per year increases agreed between Eskom and the regulator, NERSA, in 2013, there was one further increase of 4.69% from 1 April 2015. Nevertheless, at c ZAR0.92-0.97/kWh (c US$0.059/kWh), electricity remains cheap in South Africa relative to the rest of the world – not least as a result of the depreciation of the rand, which has resulted in the equivalent US dollar price falling from US$0.060/kWh in the past three months. In addition, all operations at Pan African are engaged in a process of load shedding and power clipping aimed at minimising electricity consumption wherever possible. Note that the cost of self-generating power at Pan African’s mines is typically 3-4x the cost of grid power.

At least until the two power stations are commissioned and synchronised into the grid, South Africa appears likely to continue to experience intermittent load shedding and power outages. However, this is almost invariably directed towards residential, rather than industrial consumers. By contrast, industrial consumers are typically required to reduce their consumption by 10% or, at worst, 25%. As a consequence of this situation, it is supposed that the South African government will look more favourably on independent power producer-generating solutions for South Africa’s future electricity needs. It will also focus on the previously largely unexploited resources of the Waterberg coalfield in the Limpopo province for its energy source (NB readers are directed to Sibanye’s recent private sector initiative in this region).

In the interim however, Eskom CEO Brian Molefe has expressed confidence in the current strength of South Africa’s power system, saying that the country should not see any load shedding until at least May 2016.

Shanduka Gold is Pan African’s primary black economic empowerment shareholder; its sole asset is a 23.8% interest in Pan African.

On 25 February, Pan African announced that it had entered into an agreement whereby it will acquire a 16.9% interest in Shanduka Gold from The Standard Bank of South Africa Ltd. The acquisition purchase consideration is confidential until after the closing date of the transaction. However, it is reported that the consideration has been calculated at a discount to the prevailing Pan African share price and hence the transaction should therefore be both earnings enhancing and value-enhancing to the company.

Upon completion, the transaction will result in an effective circular holding of Pan African in itself. Prima facie, this would equate to an interest of c 4%. However, given the vendor financing arrangement of Mabindu’s 49.5% interest in Shanduka, this becomes an effective 8% circular interest of Pan African in itself (for accounting purposes) which will then be consolidated out of any subsequent accounts. In the absence of any substantive details to date however, the Shanduka transaction has been excluded from Edison’s detailed forecasts for the moment. In addition, it remains subject to termination at Pan African’s election, until the fulfilment or waiver of the suspensive conditions to the agreement on or before 15 April 2016.

Pan African’s strategy is not to hedge its gold production forward, except in specific circumstances and to provide protection against specific risks.

In July 2015, to protect its operational revenue, Barberton Mines entered into a short-medium zero cost collar via the following instruments:

As a consequence of the subsequent rise in the gold price to ZAR530,000/kg, there was a mark-to-market fair value adjustment of ZAR40.6m (£1.8m) included in ‘other’ expenses in PAF’s H116 income statement.

In addition, PAF has a gold loan, valued at ZAR110.4m as at 31 December 2015 – equivalent to 6,706oz of gold.

At the time of writing the rand price of gold is ZAR638,824/kg. For the purposes of its financial forecasting, Edison calculates mark-to-market fair value adjustments based on its gold price forecasts for the year in question and the intrinsic value of the option contracts (ie no time value is included). Henceforward, these are included in Edison’s forecasts of ‘other’ expenses in Pan African’s income statements, although obviously to the extent that these reflect a forecast loss, this will be more than offset by increased profits from the remainder of Pan African’s production being sold at higher gold prices.

We have updated our forecasts for FY16 based on the estimates made for each of the precious metals’ operations highlighted above (as stated above, forecasts exclude both the Uitkomst colliery acquisition and also the Shanduka transaction, pending the disclosure of additional, more detailed, information). Note that, on this basis, Edison’s forecasts are for production of 205koz of gold in FY16 plus 9koz of PGE, compared to management guidance of 200koz of gold plus 9koz PGE. Within this context, our detailed financial forecasts for PAF for H216 and FY16 are as follows.

Note that our FY16 headline EPS forecast of 1.74p per share compares with a mean consensus estimate of 1.65p, within the range 1.20-2.00p (source: Bloomberg, 16 March 2016). Our forecast of 3.08p for FY17 compares with a mean consensus of 2.27p within the range 1.20-2.70p (excluding Edison); however, this Edison forecast depends on a gold price of US$1,372/oz. In the event that the gold price remains at the prevailing spot price of US$1,234/oz, our forecast declines to 2.54p – albeit this remains near the top of the range of analysts’ forecasts.

Updating our long-term forecasts to reflect these changes, our absolute value of PAF increases from 25.24p in February to 25.33p currently, based on the present value of our estimated maximum potential stream of dividends payable to shareholders over the life of its mine operations (applying a 10% discount rate).

The above profile assumes that the grade profile at Evander will average 6.43g/t from FY17-30. We assume gold prices of US$1,372/oz in FY17 and US$1,378/oz in FY18. Note that average EPS from FY17-30 of 3.10p is approximately equal to double H116 EPS of 0.60p plus a 0.70p premium in the event that the Evander underground head grade reaches 7.2g/t and the gold price averages US$1,466/oz.

In the long term, the key sensitivity affecting our forecasts is the real gold price. Currently, our forecasts for FY17-39 are for an average price of US$1,454/oz and for CY17-39 are for an average price of US$1,466/oz.

If the gold price remains at US$1,234/oz in real terms, however, our absolute value of PAF would reduce from 25.33p to 19.59p (all other things being equal), as shown in the chart below:

In US dollar terms, Pan African remains the second best performer of the London-listed gold miners, since March 2010:

Of as much significance, PAF remains notably cheap (based on our updated estimates) when compared with its South African peers in Exhibit 14, below.

As such, Pan African is cheaper than its peers in 100% of cases in which P/E and yield measures are considered (whether using Edison forecasts or consensus forecasts) and at least 75% of cases in which EV/EBITDA measures are considered.

Within the global context, meanwhile, it has the third highest dividend yield of the 36 ostensibly gold counters paying dividends to shareholders (including royalty and streaming companies):

Pan African had £16.2m in net debt on its balance sheet as at 31 December 2015, compared to £18.0m in net debt at 30 June 2015, implying c £11.5m of cash inflows for the period before a dividend payment of £9.7m for FY15. Net debt currently equates to a gearing (net debt/equity) ratio of 12.7% and a leverage (net debt/[net debt + equity]) ratio of 11.3%. Net debt is forecast to be eliminated under the effect of the improved H216 cash flows engendered by the improved operational performance described above before consideration relating to the acquisition of Uitkomst (assuming DMR approval) of ZAR200m before cash acquired of c ZAR25m (£8.9m at current exchange rates), a full-year dividend of a further £9.9m and the Shanduka Gold transaction consideration. Debt is financed via a ZAR800m revolving credit facility (£36m at current exchange rates), of which ZAR225.2m (£10.1m) is currently drawn down, but which can be expanded to ZAR1,100m (£49.0m), plus a gold loan of ZAR110.4m (£4.9m) and a banking facility of ZAR10.2m (£0.5m).