End-game for SA Gold Inc

The situation is frustrating, to put it mildly. The gold price has blasted through US$1 500/oz but gold equities have dropped across the board in response and South African gold equities in particular remain stuck in a rut of underperformance. RBC Capital Markets (RBCCM) analyst Leon Esterhuizen says: “South African gold shares are trading at all-time low valuations relative to the gold price. That’s due to a significant political discount but also reflects low or no profitability from SA’s asset base over the past 10 years.”

It’s cold comfort that SA’s gold producers find themselves in good company for a change.

For example, take Canadian heavyweight Kinross Gold. The company’s share price is down 25% since it bought gold junior Redback Mining for C$7,4bn last year. Even mighty Barrick – the world’s largest gold producer – is down 12% since it announced plans on 25 April to buy copper miner Equinox for C$7,3bn.

Gold “guru” Martin Murenbeeld, of DundeeWealth Economics, explains it this way: “Management isn’t always able to convert higher gold prices into more profit for the shareholder. Gold mining is energy-intensive: when energy prices rise at least as fast as gold prices and other material costs rise, the ‘margins’ an investor may expect when gold prices surge will not be the ‘margins’ gold mining companies will realise. That sets up the possibility of investor disappointment.”

Outspoken Randgold Resources CEO Mark Bristow is a lot more pointed. He reckons investors are objecting to hefty premiums being paid for mediocre assets. He says groups with excess cash should pay it back to their shareholders rather than do deals which don’t add value to the business.

Bristow says: “The Equinox deal is confusing. Last year Barrick opted to get out of Africa by putting all its Tanzanian assets into separately listed African Barrick. Yet now it goes and buys a copper play in Zambia?”

So radical corporate action isn’t a universal panacea. However, that’s what Esterhuizen is recommending AngloGold Ashanti [JSE:ANG] (AngloGold) should do to improve its investment rating. In a major research report published on 20 April Esterhuizen states AngloGold should take over either Gold Fields [JSE:GFI] or Harmony Gold Mining Company [JSE:HAR] and then split its operations into separate South African and overseas vehicles.

That would inevitably trigger a major restructuring of what’s left of SA’s gold mining industry, which has fallen on greatly reduced circumstances over recent years, dropping to fourth place in the world gold producer stakes.

That, of course, isn’t new. It’s the much speculated “end-game” scenario for the SA gold sector.

JPMorgan Cazenove analysts Steve Shepherd and Allan Cooke published a report on that topic in June 2008 entitled “Buy one, get one almost free – SA assets attracting rock bottom valuations. Something’s got to change.”

They returned to the subject in March last year in a report specifically targeting Gold Fields titled “Oil & water – time to repackage”. It recommended Gold Fields split its SA and offshore operations.

Following publication of that report Gold Fields CEO Nick Holland confirmed the group had held “high level discussions and conversations” with AngloGold over a possible combination of their SA operations. Holland stressed at the time nothing substantive or formal had come from those.

 Gold Fields investor relations executive Sven Lunsche says the group “declines to comment on such market speculation” when approached for reaction to the latest RBCCM report.

It’s clear the opinions of analysts and mining executives are heavily divided on whether such radical action will ever happen, citing – among other factors – the problem of the “egos” involved.

“The most obvious combination would be AngloGold with Gold Fields. But both sets of mines are making profits and I just don’t see it happening,” comments SBG Securities analyst David Davis.

A leading gold analyst (speaking on condition of anonymity) says: “You can justify it and it should happen sooner rather than later, because the longer AngloGold leaves it, the more expensive Harmony’s share price will become as investors understand the value of Wafi-Golpu.”

Village Main Reef Gold Mining Company [JSE:VIL] (and former Harmony) CEO Bernard Swanepoel reckons there’s justification for industry consolidation but is highly pessimistic about the probability of it actually happening. Says Swanepoel: “It makes great sense – but I wouldn’t put a single rand on it happening. I tried, didn’t I?”

That’s a reference to the failed hostile bid for Gold Fields that Swanepoel launched in 2004 when running Harmony.

But Swanepoel also believes the fundamental business circumstances South African mines have to deal with have changed markedly since then – making even a “friendly” merger far more difficult to carry out. He says: “The good old days are gone. There are now a number of major unknown factors to deal with, including the transfer of mining rights and all the environmental and people-related liabilities.

“The environmental and people-related liabilities make the valuation of mining assets very difficult. Doing such a deal could be a very stupid decision if you’re out in your calculations on those factors. It will be challenging for a ‘bottom-feeder’ to take over mining assets unless there’s clarity on those liabilities.”

“Bottom-feeder” is the term applied to smaller gold companies looking to acquire lower-quality mines the major producers no longer want to own. Harmony was the ultimate bottom-feeder in its day, with the most prominent recent example being Simmer & Jack Mines (Simmers).

This time last year both Holland and AngloGold CEO Mark Cutifani indicated their overriding strategies were to “fix the problem” with their mining groups and both have gone a long way towards achieving that since then. Yet they have to be worried their share prices have done so little in response to the rising gold price and their improving fundamentals. If nothing else, that keeps them at a disadvantage to their more highly-rated competitors overseas when it comes to raising funds or doing deals using their equity.

Cutifani describes Esterhuizen’s report as “market speculation” on which he won’t comment, but adds: “The topic is raised frequently by shareholders of all sizes and, typically, increases in prominence with each speculative report.”

Esterhuizen says: “Industry consolidation or rearrangement is, in our opinion, now a foregone conclusion. All three majors are promising good growth in the near future: we believe there’s no better time to act than right now.”

Esterhuizen sums up the situation facing SA’s gold mines as: “The country is globally recognised as a non-friendly mining destination at present.” Reasons cited include, “unnecessary complication with regard to black empowerment, severe uncertainty with regard to availability of power, constant rumblings of nationalisation, ongoing labour disputes and the still outstanding issues about permitting of mining rights”.

Cutifani singles out the nationalisation debate as “a perceptual drag for investors”. He comments: “Notwithstanding the strident opposition of our Government to nationalisation at the most senior level, this issue commands much air time and its speedy resolution would be most desirable to improving the rating of the sector.”

Esterhuizen says all SA’s gold majors are aiming to resolve the SA discount by expanding their offshore production bases aggressively but the decreasing exposure in SA still remains in place “constantly distracting from achieving the objective of higher valuation multiples”.

He believes AngloGold is the best placed to act to change that situation. “On our numbers, a combination with Harmony makes a little more sense but a combination with Gold Fields is almost as attractive. Combining with Gold Fields could deliver a growth vehicle in both the South African and international space, with both vehicles being ‘heavyweights’ in terms of size.

“The merger of AngloGold’s cash-generating South African assets with Gold Fields SA assets would, we believe, also be positive, as it would provide the requisite capital to complete the development of the ongoing capacity expansion at South Deep and maybe even pushing the top production range above 1m oz/year.

“The projected growth in an AngloGold/Harmony tie-up is slightly better than an AngloGold/Gold Fields tie-up and, although such a tie-up clearly comes at a somewhat higher risk – given Harmony’s lack of performance over the past 10 years – it doesn’t yet take full account of what Wafi-Golpu is becoming.”

Australian major Newcrest – which is Harmony’s 50:50 joint venture partner in the Wafi-Golpu gold/copper project in Papua New Guinea – recently put a target of 40m oz gold and 15m t of copper on the size of the deposit, which amounts to a total of 130m “gold equivalent” ounces.

Esterhuizen also says such corporate action could have significant “knock-on” effects in SA. “The combined SA group could further improve its investment rating by selling off some of its more marginal assets to the bottom-feeders,” he says. He identifies possible candidates for such disposal as Gold Fields’ Beatrix mine “and even Kloof-Driefontien” as well as Harmony’s Evander and Free State operations.

The new SA gold group could be used to pursue growth in the rest of Africa, which is the strategy behind the creation of African Barrick.

Esterhuizen says: “Bear in mind SA only produces 7% of annual global mined gold and that continues to drop. This asset base should be positioned such that it’s capable of once more – maybe for the last time – pumping strong enough profit and cash flow to be able to find a new base on which to continue: most likely positioned in the rest of Africa while still utilising SA as the administrative and financial hub.”


The Harmony way

There are four main “bottom-feeders” that could benefit from a radical restructuring of South Africa’s gold industry should the “end-game” scenario actually play out

They are: Village Main Reef Gold Mining Company [JSE:VIL] (Village, which now owns Simmer and Jack Mines [JSE:SIM]), Gold One International [JSE:GDO] (Gold One), Pan African Resources [JSE:PAN] (Pan African) and DRDGOLD [JSE:DRD], depending on what it does with its Blyvooruitzicht (Blyvoor) mine.

It should come as no surprise that three of those operations are headed by executives who have graduated from the “Harmony School of Mines” – given it was Harmony that pioneered this particular mining business model.

Village CEO Bernard Swanepoel was CEO of Harmony in its heyday, prior to the failed bid for Gold Fields. For most of the time he ran Harmony, his “Mr Fixit” – the executive he put in place to sort out newly acquired mines – was Neal Froneman, who is now CEO of Gold One.

One of those mines was Evander, where Pan African CEO Jan Nelson worked for Froneman as a senior geologist and subsequently mineral resources manager.

DRDGold CEO Niel Pretorius is a lawyer by training but the company he runs was – like Harmony – spun out from the former Randgold when it was restructured in the mid-Nineties by Peter Flack.

Swanepoel dubbed his new mining approach “the Harmony way” and it focused on “removing the fat” in the operations through ruthless cost-cutting, raising the recovered grade and reducing the layers of management. It worked – for a few years, at any rate – because there was a lot of fat in the old school SA mining system and because conditions were initially favourable, with a rising gold price driven by a weakening rand.

The share prices of Harmony and DRDGold rose spectacularly and then crashed and burned just as spectacularly. Reasons were a strengthening rand put the squeeze on revenues while working cost pressures increased. Harsh reality was that you can take cost-cutting on a mine only so far before you damage the business.

Cutbacks on development capital – the money needed to open up new sections to be mined – inevitably return to bite management a few years down the track in lower production rates. That phenomenon is usually referred to in quarterly reports by using the euphemism “lack of mining flexibility”.

After all, such mines are marginal operations, meaning they have lower than average grades combined with higher than average working costs – which is why their original owners wanted rid of them.

They operate perpetually close to the edge. And nothing has changed, judging by recent comments by Pretorius on the future of Blyvoor.

The gold industry will shortly begin wage negotiations and Pretorius has just warned prolonged strike action would kill Blyvoor. “We’ve made it clear to the unions that the day the Blyvoor workforce embarks on extended strike action will be the day they effectively resign their jobs – without getting a retrenchment package,” says Pretorius.

Even so, it seems SA may be in for another round of that game if the rand gold price – now back above R330 000/kg – continues to rise.

Though DRDGold has just put Blyvoor up for sale, Pretorius makes it clear the mine’s future could be positively influenced if it could acquire some assets from its neighbours, which include Gold Fields’ Kloof/Driefontein Complex and AngloGold’s Savuka mine.

Both Froneman and Swanepoel are already well down the road towards picking up older mining assets they think they can do something with.

Gold One is paying US$250m to buy Rand Uranium, which owns the high uranium grade Cooke 3 dump near Randfontein, but also the operating Cooke 1, 2 and 3 shafts, which produced 160 000oz of gold in the year to end-June 2010.

Froneman says Gold One is currently well positioned to play a major role in the consolidation of SA’s gold sector, which he believes needs to happen. “Every company goes through a tough first phase, but Gold One is through that now. We’ve said consistently for the past few years there was little we could do until our share price was rerated by the market. That’s now happened and you’ve seen us move very quickly. This is also not all about acquiring old assets. We’re prepared to build new mines using new approaches to access the ore bodies.”

Froneman declines to specify any particular assets he has his eye on, but says Gold One isn’t prepared to go after the really deep mines. “That’s somewhere we aren’t going to go. Those mines don’t fly in the rest of the world and I think there are other companies in SA better placed than us to operate them.”

The reasons for his caution are obvious. Simmers has poured hundreds of millions of rand into Buffelsfontein (Buffels) since it bought the mine in 2005. But Buffels is still losing money.

Simmers also bought the nearby – profitable – Tau Lekoa mine from AngloGold. However, Swanepoel noted recently Tau Lekoa was performing worse under Simmers’ management than when it was run by AngloGold.

Other examples of mining companies coming to grief trying to turn around old and deep South African shafts are legion. Think Pamodzi Gold, Aurora, Central Rand Gold and Thistle Mining for starters.

Swanepoel says he’s got his hands full running the assets Village has already acquired, which include the Consolidated Murchison gold/antimony mine and Lesego Platinum, as well as the two Simmers mines. “We’ve got plenty of toys to play with for the next two to three years, after which we’ll surface and see what the world looks like,” he comments.

Pan African appears set on a strategy to become a broader precious metals group, expanding into platinum to diversify its existing Barberton gold mining operations. Nelson stresses that whatever Pan African does in future he intends avoiding mining operations deeper than 2km. “We’re looking at some interesting new gold and platinum opportunities, but assessing such projects carefully takes time. We won’t be rushed because we’re about to double our profits over the next 18 to 24 months through organic growth from our existing operations without having to come to our shareholders to ask for money.”

Market sources reckon Pan African’s longer-term strategy is likely to be heavily influenced by that of its powerhouse black empowerment partner – Cyril Ramaphosa’s Shanduka Resources.

 Ryan holds shares in Pan African, Harmony and Gold Fields.
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