End-game for SA Gold Inc

[miningmx.com] — THE situation is frustrating, to put it mildly. The gold price has blasted through $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 (AngloGold) should do to improve its investment rating. In a major research report published on April 20 Esterhuizen states AngloGold should take over either Gold Fields or Harmony Gold Mining Company 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.

The opinions of analysts and mining executives are heavily divided on whether such radical action will ever happen.

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 (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 article first appeared in Finweek. The writer owns shares in Harmony and Gold Fields.