Pan African Resources — Disposals hone investment case

Pan African has made a number of announcements since Edison’s last note in May, including an operational update, the conclusion of the Uitkomst disposal and the disposal of Phoenix Platinum, which are considered in the current report.

On 20 July, Pan African provided an operational update, including production data for FY17, plus its expectations for gold output in FY18. The salient features of the update were as follows:

Subsequent to its operational update, on 31 July, PAF further announced that it had successfully concluded a conditional agreement with Sylvania Platinum whereby Pan African will dispose of all of its shares and loan accounts with its wholly-owned subsidiary, Phoenix Platinum, to Sylvania for a total cash consideration of ZAR89m (£5.2m, US$6.8m or US$10.80 per Phoenix resource ounce). Note that this resource multiple of US$10.80/oz is actually accretive relative to PAF’s current group-wide resource multiple of US$8.40/oz. The deal is subject to due diligence and the other conditions precedent typical for such a transaction, but is nevertheless expected to be finalised by 31 October. More significantly, it will allow Pan African to focus on its remaining five core assets (having already sold its Uitkomst colliery earlier in the year), as well as further improving its financial position prior to incurring the major portion of the capex (ZAR869.6m) relating to Elikhulu over the course of CY19.

Confirmation that 173koz of gold was produced in FY17 compared with prior guidance of 181koz and Edison’s prior expectation of 183.8koz and was attributed to “the slower than anticipated restart of the underground mine at Evander…and operational challenges experienced at Barberton…which have now been remedied.” For the purposes of Edison’s financial modelling, it has been assumed that the difference between actual and expected output was equally apportioned between Barberton and Evander, but that the Barberton variance was attributed to grade, while the Evander variance was attributed to gold lock up when the plant was restarted.

In addition, on 26 June, Pan African announced that all conditions precedent relating to the disposal of its interest in the Uitkomst colliery had been fulfilled and that the effective date of the transaction would be 30 June 2017, when Coal of Africa would take ownership, control and management of PAR Coal and Uitkomst (vs Edison’s prior expectation of 1 July). Note that the effective date of the transaction is consistent with PAF’s past practice of timing major corporate transactions to coincide with an appropriate quarter’s end. At the same time, Pan African also received its consideration, namely:

As a result, we have brought the cash-flow and £3.9m estimated exceptional gain occasioned by this disposal forward, such that it now appears in FY17’s accounts (included in ‘Profit/(loss) on group disposal’ in Exhibit 1, below), rather than FY18’s as previously.

Finally, with respect to its Phoenix Platinum transaction, we have assumed that the effective date of the disposal will be early in the first half, such that Phoenix will make no material contribution to PAF’s income statement from FY18 onwards. In the meantime, we estimate that the sale is likely to crystallise a loss for Pan African relative to book value. Pan African’s carrying value for Phoenix in FY16 was £9.1m in net assets. As such, we estimate that a cash consideration of £5.2m for this asset will lead to an impairment of £3.9m in the financial results for FY17. We have also adjusted for recent movements in foreign exchange rates. Finally, 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 however, in order to protect its operational revenue, Barberton Mines entered into a short-medium zero cost collar via the following instruments:

The decline in the price of gold, from ZAR625,886/kg on 30 June 2016 to ZAR506,917/kg on 31 December 2016, resulted in a mark-to-market fair value profit of ZAR90.0m (£5.3m) in H117, which was included in ‘other’ income in PAF’s income statement. As at 30 June 2017 the rand price of gold was ZAR521,661/kg and consequently we expect the contribution to ‘other’ income from hedging in H217to be negligible.

Note that Edison’s forecasts are based on a gold price of US$1,239/oz in H217 and US$1,248/oz in FY18. They compare with consensus EPS forecasts (source Bloomberg, 23 August 2017), as follows:

Ultimately, Edison’s valuation is based on the present value of our estimate of the maximum potential stream of dividends payable to shareholders over the life of PAF’s mining operations. After producing 173koz of gold in FY17, management has now indicated that it expects production of gold in FY18 in excess of 190koz. Edison’s group-wide production estimate is 197koz in FY18, apportioned between its four remaining producing operations (ie excluding Phoenix), as follows:

Clearly, within the historical context, there must be a degree of risk attached to our production forecasts with respect to PAF’s underground operations (Barberton and Evander). However, this is balanced (in our opinion roughly equally) by the opportunity (or upside risk) presented at its tailings retreatment operations. More significantly, the development of Elikhulu (which is now underway and fully funded) should increase output to c 250koz over the course of the next two financial years, which will underpin our longer-term earnings and cash-flow expectations:

In the aftermath of the empirical factors considered, our valuation has risen by 1.00p to 21.22p cum-FY17 final dividend (at Edison’s standard 10% discount rate) cf 20.22p previously.

In the meantime, its shares remain noticeably cheap, within the historical context, when considered relative to our forecasts of normalised headline EPS in FY18 compared to prior years:

In relative terms, it also remains cheaper than its South African and London-listed peers on at least 70% of valuation measures (ie 21 out of 30 measures in the table below on an individual company basis) regardless of whether consensus or Edison forecasts are used:

Finally, it has the second-highest consensus, forecast dividend yield of the 57 precious metal mining companies paying dividends to shareholders, globally (including selected royalty companies):

Note that, in this respect, Pan African’s forecast dividend yield is 2.49 standard deviations above the average yield of the population of 2.32%.

In addition to Elikhulu, which ‘is progressing according to plan with project completion and first gold expected in the last quarter of the 2018 calendar year’, Pan African has two significant growth projects, namely the Barberton Mines Sub-Vertical Shaft Project at Fairview and the Evander Mines 7 Shaft Number 3 Decline and 2010 Pay Channel project.

The Fairview mining operation is currently restricted by the hoisting capacity of its No. 3 Decline, which is used to access workings below 42 Level. This decline is currently used to transport employees, material and for rock hoisting and, with no modifications, future mining at depth will be compromised by increased travelling distances, reduced employee face time and a lack of sufficient capacity to ensure both adequate ore replacement and exploration development. With this in mind, Pan African has now completed a study with DRA to investigate the feasibility of constructing a raise-bored, sub-vertical shaft from Fairview’s 42 Level to 64 Level and, potentially, in future, to 68 Level. The sub-vertical shaft will then be used to transport employees and material to the working areas, while No. 3 Decline will be used exclusively for rock hoisting, thereby significantly increasing overall capacity and production from this high grade mining area.

Estimated capex for the project (including contingencies) is ZAR105m (£6.1m) and would result in estimated, additional output of 7,000oz gold per annum, which ‘can be optimised further to more than 10,000oz per annum.’

Assuming that construction takes place in CY18 and CY19 and that production begins in CY20 with cash costs of c US$800/oz over 15 years, we estimate that this project could be worth in the order of US$29.3m (1.32p/share) to Pan African, rising to US$42.8m (1.95p/share) in the event of optimisation (at Edison’s standard 10% discount rate) – which compares with a current valuation in the order of US$1.0m if valued at PAF’s current group-wide resource multiple.

The 2010 Pay Channel contains an estimated 2.19Moz of resources and is c 3km in tramming distance from 7 Shaft, which is currently used by EGM for hoisting to the Kinross metallurgical plant (cf 8 Shaft, which is c 10km distant). Harmony Gold Mining had previously developed the 7 Shaft mine working towards the 2010 Pay Channel, but discontinued the initiative in 2009, allowing the controlled flooding of the development ends and 7 Shaft’s No. 3 Decline, from 22 Level to 18 Level.

To date, two boreholes have successfully been drilled into the 2010 Pay Channel, intersecting the Kimberley reef at a depth of c 2km. The first yielded a reef intersection with a width of 49cm and a grade of 36.04g/t (a metal content factor of 1,766cm.g/t), while the more recent recorded a width of 6cm and a grade of 36.8g/t (a metal content factor of 221cm.g/t). Additional drilling deflections will be performed to further delineate the orebody. In the meantime, in order for mining to commence, the infrastructure would need to be dewatered and only standard footwall and on-reef development (with associated engineering infrastructure) completed. With this in mind, a Pan African project team has been created and has commenced a feasibility study relating to the 7 Shaft No. 3 Decline and 2010 Pay Channel resource, which will initially consider the following issues:

The feasibility study is expected to be completed in the first quarter of the 2018 calendar year (ie H218). In the meantime, Pan African’s management is of the opinion that, ‘The 2010 Pay Channel can potentially increase Evander Mines’ underground gold production significantly at a relatively low capital cost, using Evander Mines’ established shaft and metallurgical facilities.’

Pro-rata to its resource of 2.19Moz, at Pan African’s group-wide average resource multiple, the 2010 Pay Channel project should be worth in the order of US$18.3m, or c 1.02 US cents per share. In all probability, management would probably hope and expect that this project would yield an NPV10 to the company of several times this value in the event that its development is sanctioned by the board, subject to capex, opex etc.

On 15 June 2017, the South African minister of mineral resources, Mosebenzi Zwane, announced the latest version of South Africa’s Mining Charter, which became effective immediately. The charter has been championed by the South African President, Jacob Zuma, who has described it as representing “radical economic transformation”, although others have interpreted his support as an attempt to distract observers and voters from a growing spate of corruption scandals. Either way, within hours of its gazetting, the Chamber of Mines of South Africa issued a public statement to the effect that the process followed by the Department of Mineral Resources in drawing up the charter was seriously flawed and, consequently, that it rejected its unilateral imposition on the industry. The Chamber confirmed that it would seek an interdict to suspend its implementation and that it will also seek a court declaration on the ‘once empowered, always empowered’ principle.

Details of the charter are, inter alia: 1) new prospecting rights will be granted only to entities that are majority black-owned, 2) new mining rights will be granted only to entities that are 30% black-owned in prescribed categories of shareholders, 3) existing prospecting right and mining right holders top up to 30% black-ownership in 12 months, 4) 80% of total spend on services and holders to top up to 30% black-ownership in 12 months, 4) 80% of total spend on services and 70% of total spend on mining goods is to be sourced from prescribed categories of South African-based companies; and 5) increased employment quotas. Other requirements are that new mining rights’ holders must pay 1% of turnover to their black shareholders on top of any dividends enjoyed by all shareholders and that 8% of black empowerment shares must be held on behalf of communities in a new agency called the Mining Transformation & Development Agency. This agency will also receive 2% of mining companies’ payrolls as part of the 5% of payrolls that must be allocated for skills development. Non-compliance with certain of the targets will be regarded as a breach of the Mineral & Petroleum Resources Act, which could entitle the minister to suspend mining operations and to cancel rights granted and to pursue a criminal prosecution.

Since the publication of the charter, charges and recriminations have flown on both sides, with questions being raised about the extent to which the Chamber of Mines had been consulted as well as the ANC’s own internal Economic Transformation Committee. A number of corporate executives have said that they believe that the charter is “contradictory to company law”. No lesser personage than the Deputy President (and former General Secretary of the NUM) Cyril Ramaphosa has called for the charter to be reconsidered and the African National Congress has noted that the legislation may cause job losses. The minister responded by saying that, “Those who have made it their mission to preserve middle-class interests at all costs will oppose attempts to deepen transformation in the mining sector.”

Earlier in July, the Chamber of Mines said that it would apply to the high court to stop the implementation of the new charter. Describing aspects of it as “illegal” and “unconstitutional”, it went on to say that it “represented a most egregious case of regulatory over-reach” and that it amounted to “law-making without going through the legislative process”. In the short term, the submission requests that an urgent intervention be made in order to protect the industry and that, to this end, the charter be set aside as an unlawful exercise of power and then be interdicted while the High Court considers the merits of the review.

As such, there are two legal processes running concurrently – one being an application for an interdict and the other being an application for a judicial review (widely seen as the Chamber of Mines’ ultimate goal). The intention of the interdict is to halt the implementation of the charter pending the outcome of the Chamber of Mines’ application for judicial review of the charter. Both the DMR and the CoM have agreed to ask for the interdict application to be heard in September, which will give the former time to file its answering affidavit in opposition to the interdict application. In the meantime, DMR has agreed not to take any steps to actually implement the charter. As a result, on 14 July, the minister Mosebenzi Zwane said that he would be suspending the implementation of the charter pending the court case.

If the court grants the interdict, implementation of the charter will remain suspended until the review process is completed. If the interdict is not granted, the department could technically go ahead with implementation, although professional opinion appears to incline against this before the conclusion of the review.

With respect to the review, the court could declare invalid the minister’s decision to promulgate the charter on a variety of grounds. If this is the case, it could order him to reconsider his decision or possibly even replace it with the court’s own decision. If it does find that the Mining Charter is the result of unjust administrative action however, professional opinion appears to be that it will most likely order him to reconsider the decision and begin the process of consultation all over again.

No sooner had the minister announced that he was suspending implementation of the charter pending the court case however, than the NUM said that it would go to court in an attempt to force the DMR to implement the charter as planned on the basis that it will immediately benefit workers and related mining communities.

Pan African is currently empowered via PAR Gold (formerly Shanduka Gold), which has a 19.53% headline stake in the company, plus its employee share ownership schemes. Self-evidently, this arrangement could be expanded and/or restructured. Nevertheless, the share prices of South African mining shares have fallen by an average 7.7% (on an unweighted arithmetic basis for the sample of six mining companies shown in Exhibit 9, below), after having fallen by as much as 13.3% in the 18 days immediately following the announcement of the new charter. Moody’s has inveighed that the proposals are credit negative for mining companies and stated that ‘…current shareholders are unlikely to support a further dilution of their equity interests’.

As can be seen from the above graph, Pan African was initially one of the best performing South African mining shares in the immediate aftermath of the announcement of the charter, although it has arguably been slower to recover since mid-July with the exception of AngloGold Ashanti.

In its operational update, Pan African reported that it had net debt of ZAR66.7m (£3.9m) as at 30 June 2017 cf £33.2m as at 31 December 2016. However, this excludes ZAR127.5m (£7.5m) of financial investments in the form of Coal of Africa shares which were issued to PAF in consideration of its sale of the Uitkomst colliery to CoAL on 30 June. Note that, for the purposes of Edison’s financial forecasts, these are included in cash, such that we estimate that PAF had net cash of £3.6m as at 30 June.

From here, our forecasts for Pan African’s immediate capital expenditure commitments related to Elikhulu by financial year are as follows:

Elikhulu’s permitting process is reported to be progressing well. In the meantime, maintaining a dividend policy of 40% of free cash flows less sustaining capital, debt repayments and exceptional items, we estimate that Pan African’s funding requirement will evolve during the period in which Elikhulu is being developed from FY16 to FY21, as follows:

Note that PAF’s maximum group net funding requirement of £17.8m in FY19, based on our estimates, equates to ZAR304m at prevailing forex rates, or gearing (debt/equity) of 7.8% and leverage (debt/[debt+equity]) of 7.3% - and is self-evidently well covered by PAF’s existing debt facilities of ZAR880.2m (as at 30 June 2017), including a ZAR800m revolving credit facility (which can anyway be expanded to ZAR1,100m) as well as its new ZAR1.0bn underwritten seven-year debt facility with Rand Merchant Bank specifically relating to the development of Elikhulu.