In this special report, we outline the case for buying the South African miners on this break out in gold, concluding that the market is overly pessimistic on those assets, especially the quality of their resources, and misunderstands the nature of the risks associated with mining there. In light of the outlook for gold we perceive opportunities at the deep end of the value pool to be timely for investors who do not wish to take on the additional risks of investing in exploration and development juniors yet want above average upside exposure to gold prices or production growth.
One special situation, and personal favorite of ours, rising from the ashes of the blow dealt to the country's mining industry from various social, political and structural shocks over the past few years is a gold miner that has only just emerged as a producer with a unique focus on relatively "shallow" deposits in Africa (its flagship mine is only 300-550m deep for example). Its shares are trading at less than 3x expected 2010 cashflow, less than half its "risk-adjusted" net asset value, and the market is awarding its shallow ounces less than 20% of the average market cap that junior miners get today. As cash flow starts pouring in, we argue that the shares will see a strong re-rating.
We touch on the company a little further below but for a full research report contact us at: firstname.lastname@example.org [To ensure receipt, please include name, city and state in your email]
Our call on South Africa is that the South African miners are set to outperform. However, the average risk is still higher than investing in North American based miners, and accordingly, we prefer not to overweight South Africa.
This report aims at investors with 0% current exposure to South Africa in their gold stock portfolios, or those with more but looking to add, or replace what they currently own with something that potentially unlocks alpha values.
Gold Market Update
Chart Suggests $1150 Target En Route to $1450 High in 2010
The fall has been busy for gold bulls as the precious metal finds itself breaking out of a seven month triangle - a textbook price and volume formation on the chart - with an implied objective near US$1150 per ounce.
We also note the breakout is simultaneously occurring from the much larger and bullish 18 month (textbook) head & shoulders formation - where the triangle above forms the right shoulder just below the neckline at US$1040 - and which some bulls anticipated would develop well before the market broke out.
This latter formation implies a target round about US$1450, say within an intermediate time frame - 6-12 months.
Such is the classical (Edwards & Magee) interpretation of this move in gold.
Tea leaves, probably, but depends on how you use it.
Should the chart be right, you'll hear calls for gold US$2000, $3000, and higher... they will be loud, and convincing.
That they are not all that convincing yet bodes well for the bulls.
If one asks what's driving it, we'd tell them the market is looking ahead at the lagged effects of near record growth rates in M1, M2 and AMS/TMS (-Austrian School measures), and the likelihood that Obama's report card will begin to wilt - prompting, of course, another round or two of "stimulus" and other bonehead inflation-driven policies.
Besides the obvious effects of the inflationary policy (rising prices, business cycle, wealth & income redistribution), there are others that are like offspring, or potential bullish catalysts for which the policy provides flint, such as,
- Trade wars? -it is not 1929, but some issues coming to a boiling point
- Iran-Israel flare up or Afghanistan/Iraq situation boils over -let's hope not
- Political threats by China/Japan to liquidate dollars and go to gold, or calls to create new reserve currency
Some of these things have already started making their way into the market, as has the dollar's shrinking role as a reserve currency. What's more, nothing goes straight up. October is weak, seasonally, and the dollar bears are a little crowded (in the short term). What's more, the prospect of another stock market rout could raise the specter of deflation, and other folly. With the Fed quickly approaching its stated limit on buying Treasuries, the markets are all likely to tense up a little until it is clear whether or not the central bank intends to continue its purchases regardless. But we're not forecasting the next 50 points.
In the gold sector, value is not easy to find in the large caps, at least not broadly speaking.
We like a few, and feel the segment will continue to generally outperform gold prices and other equity sectors in the medium term, but it is difficult to call them cheap today, and it is more difficult to find values than it was last fall.
Excluding South Africa, there is precious little trading for less than US$150 in market cap per global resource ounce (in the ground), or for less than 7-10 times expected forward operating cash flows. Most of these stocks, moreover, trade at a premium to their net asset value. If investors are willing to move up the risk curve, the values are more compelling in the exploration and development juniors. But, what about the besieged South African "producers"?
First, some facts. Notice in the table below the gap in valuations between the South Africans and the average, as well as compared to select non South African juniors operating in countries with at least as much political risk.
One can also see that, using Gold Fields as a proxy, since 2002, the South African shares have kept up with neither the average gold stock nor the average South African stock,
Indeed, the performance of South African shares in general suggests that the deep discounts awarded to the South African miners have little to do with the inherent politics of South Africa.
South African Shares Outperform S&P 500
The South African Rand has seen three relatively wide swings over the past 10 years, trading as low as 12 Rand to the US dollar back in 2002, a level it approached again last year, and as high as 5 or 6 Rand to the US dollar back in 2004-05. Over this period, despite these gyrations, one could say the currency hasn't really gone anywhere, which makes the uninterrupted outperformance of South African shares over the S&P 500 all the more remarkable.
This is not to say that debasement is not a factor in the appreciation of stocks in South Africa. It is just not more so than anywhere else. Adjusting these returns for inflation in the lay sense of the term (i.e. changes in the CPI) will change this picture some, since the Rand CPI grows at 3 times the US rate - but not enough to change the gist of the fact that the South African stock averages have not only bettered the S&P, they've kept up with or outperformed gold - while the S&P 500 is down 75-80 percent on gold - in the same period. It is beyond the scope of our point to explain the possible reasons for this, except to argue that it's more than the South African beta (note the one way volatility in the statistic) and that it contradicts most of what we read about the country.
One could argue, of course, that the South African currency is overvalued - given the more inflationary Reserve Bank (relative to the Fed for example).
Perhaps a combination of weakness in the dollar and/or capital controls account for its strength, or perhaps specific transactions. However, in a presentation given by South African economist, Dr. Roelof Botha last May, we saw evidence of favorable investment flows, capital formation, and other signs of growth, including:
- Growth in Gross National Income per capita has outpaced the US, Brazil, Germany and Japan since 1992
- Budget balanced, gov't capex spending as % of total is declining, and BOP accounts are stable
- Disposable incomes and "real" GDP both grew at >5% per annum from 2004-07
- Capital expenditures by private sector has grown from 8 to 12% last decade
- CPI annual % rate has fallen to the 6% range from over 15% in the early nineties
- Public debt to GDP fallen from almost 50% in the mid nineties to under 25% today
- Inflation adjusted per capita disposable incomes up 38% over past 10 years
These data further contradict the many bearish presuppositions about investing in South African assets.
Dr. Botha added that he saw these trends continuing, with an emphasis on the liberalization of the banking sector; also cited was the beneficial relationship between South Africa and China, with South Africa benefitting from the investment flows (in return for resource access). The Heritage Foundation ranks South Africa as the third freest out of 46 countries in the sub-saharan Africa region, behind Mauritius and Botswana, and above the world average in eight out of ten categories. Furthermore, it notes, "only eight enterprises remain state-owned... government expenditure equals less than 30 percent of GDP," and, "the financial system is one of the most developed in Africa."
Investors Fear Zuma May Turn SA into Zimbabwe
At a population size 1/6 of the United States, South Africa produces only 1/35 (3%) of the GDP of the USA, and on a per capita basis less than 25% of the goods and services - with significantly less variety.
Everyone knows the country is immersed in poverty, gross inequality, an AIDS epidemic, strife and xenophobia... and that its labor force is largely illiterate and unskilled. Most people disagree about the solutions, but many folks that ultimately determine the fate of capital flows also believe that the political situation is grave in the hands of a socialist government throwing its weight around in a hopeless effort to level the playing field, led by a revolutionary that has been criticized for taking the country as his prize and leading it down the same road travelled in Zimbabwe.
We couldn't disagree with this conclusion more. We'll concede the social and political landscape is unsatisfactory, as well as too much bureaucracy, rigid labor and race laws, and other misguided policies - especially those that pose the greatest burden on wealth generating activity in the primary industries. But the fact is that the ANC's hold on government has been eroding, and hope springs eternal that generations old conflicts are being resolved - and that South Africa will take the lead in uniting the rest of Africa. Besides, things are looking up in Zimbabwe.
The South African Discount
So why is it that the South African gold miners get such a deep discount in the market for their assets?
Given the performance of other assets in South Africa, we contend that it has little to do with the general economic landscape. Moreover, on the whole, based on the above data, and other sources, South Africa is a better place to do business than two thirds of the world. The Heritage Foundation, which ranks economic freedom, ranks it above places like Romania, France, Colombia, Turkey, Kazakhstan, the PNG, Greece, India and most of Africa.
Yet miners in these places get many times the dollar value for their ounces in the ground that the average South African miner gets... many of these are exotic, unexplored exploration territories - and the politics and lack of infrastructure are often even more prohibitive - yet they still get better values than Gold Fields or Harmony gets.
The South African gold deposits are still among the vastest and richest in the world.
Even after a persistent drop in annual production (beginning in the 1970s) has pushed output to an 85-year low, the country is still the second largest gold producer in the world contributing over 10% of total world production.
Common objections include,
- Unpredictable and large bureaucracy
- Rigid race and labor laws
- Aggressive tax and royalty structure
- Affirmative action policies (BEE charter)
- Mine fatalities persist above the world average
- Low quality (inaccessible) resources
- Rising production costs and power shortages
To the extent that valuation is relative, we argue that many of these factors, as bad as they may be, are no worse than in many other mining regions in the world, especially when we take existing infrastructure into account. Costs of production have risen no more than they have for Newmont or the industry average over the past ten years, and while labor costs are on the rise, they are still cheap on an international basis. What is troubling, however, is the crime, and the overly frequent news of fatalities at mining operations in the country, even though they're in decline.
Also deserving a discount is the availability of power for the deep miners and the long term effects of BEE (Black Economic Empowerment) type charters. However, on our visit to South Africa, we learned that one of the primary causes of fatalities in South Africa's mines is the unpredictable nature of seismic activity, especially at "depth." We also learned that the South African Discount has less to do with the political or economic outlook for South Africa than with the high costs associated with mining at great depths (the average in South Africa is >3000m). Additional problems at depth include dealing with rock pressure and heat - i.e. the pumping of water becomes a major task.
Labor costs are high as special skills are required, and narrow reefs don't lend themselves to mechanization;
Productivity rates are low as many man-hours are wasted transporting the crew to and from the mining levels;
And complex and sometimes very old / deep shaft systems require intensive ongoing capital to upkeep.
Even though these mines operate at higher margins than their peers in the Americas, these things have caused their capital requirements to become an excessive drain on cash reserves in recent years. Thus, many analysts have concluded that the ounces at depth in South Africa are of lower quality than anywhere else in the world.
In our view, this is true and is the source of most of the discount attributable to South African assets.
Gold One International is a Shallow Miner
Gold One International is a recently emerged shallow gold miner that has started up two producing mines on the East Rand this year, and as one of just two shallow miners in South Africa, it has insulated itself from the primary source of many of the problems afflicting the other South African miners - mining at depth.
A brand new plant, shorter traveling distance for employees, hydropower, and no seismicity in the vicinity will keep capital requirements to a reasonable minimum (US$100/oz). The company has already achieved the safety standards of Australian miners, and its small power requirements mean it is unlikely to feel the pressure of power shortages. Moreover, with most of its capital invested in the first brand new plant on the East Rand in three decades its capex requirements are behind it.
Gold One has a pipeline of additional shallow exploration and development assets on the East Rand and other parts of the Wits Rand Basin in South Africa - including its next potential flagship (Ventersburg) - as well as a 100% interest in one deep mining prospect with a 5Moz NI 43-101 (part of which is shallow), an IOCG target in Namibia; and greenstone and alluvial prospects in Mozambique (blue sky). Its shares are listed on the Johannesburg and Australian Stock Exchanges under the symbol GDO, and its American Depository Receipts trade on the OTCBB under symbol GLDZY at a ratio of 10 ordinaries per ADR.¹
The flagship Modder East mine has produced over 6,000 ounces since startup in July.
It is on track to produce 20,000 ounces of gold in 2009, 140,000 oz in 2010 and 180,000 oz per year from 2011 to 2013 with production from the BPLZ reef tapering off after that out to 2016. Our forecast for total cash costs is an average US$303 per ounce over the life of the mine (GDO forecasts US$250), and below that from 2011 to 2013.
Management said in its most recent update that it has developed over 400 meters of reef at Modder, and has been finding higher grades further west than originally thought "leading to a gain in mineable ground." Additionally, as the reef is opened up, through mining, the company will have the opportunity to upgrade its reserves to "proven."
We expect Modder East to generate US$60-80 million in free cash flow during 2010 and twice that in 2011, funding the company's development pipeline - especially Ventersburg, Tulo and Bothaville - ultimately targeting an output of as much as 500,000 ounces per year by 2014 (these are all shallow prospects with low technical risk and costs).
Gold One offers substantial rerating potential. The company has a strong pipeline of exploration and development projects with its next flagship (Ventersburg), slated for production in 2014, potentially twice the size of Modder East.
We feel it is unfair to impose South African valuations on Gold One's shares. Its valuation reflects the misconception that its assets, like other South African assets, are inaccessible, deep, and therefore of lower quality. We believe Gold One will unlock significant value as its operations reach steady state.
GOLD ONE INTERNATIONAL, HIGHLIGHTS
- Landmark Year: transformed from South African development junior to international miner and producer
- Attractive relative and absolute Valuation with significant re-rating potential
- Flagship Modder East plant poured its first gold on 21 July 2009 (3 months ahead of schedule)
- Exceptional potential to establish >5Moz resource at Ventersburg (fast tracking feasibility)
- Listed on the Australian Stock Exchange via RTO in May 2009
- Sub Nigel 1 mine/shaft successfully recommissioned in January (producing at about 85% of targeted rate)
- Ample Project Pipeline with multi-million ounce exploration targetsin Mozambique and Namibia
- Shallow mining niche insulates company from the costly problems associated with mining at depth in SA
- Targeting Australian mine safety standards by 2012
- Modder East plant is the first new processing facility built on the East Rand in three decades
- Innovative, experienced Management group brought two mines on line under budget and ahead of schedule
- SAMREC, JORC, NI 43-101 compliant resources, reserves
- BEE Transactions negotiated, subject to final approvals by government to become effective
- Sound balance sheet with recent A$37.5 million financing
- Fundamentals for bull market in gold intact
- East Rand is most prolific gold field in Wits Rand, historically producing a quarter of South Africa's gold
- Football (Soccer) World Cup 2010 could be turning point for South African awareness
Gold One Int'l Snapshot Page
For a full research report on Gold One International (GLDZY) contact Ed Bugos at: email@example.com
[To ensure receipt, please include name, city and state]
For further information about this research please phone,
Strategic Energy Research & Capital
436 Springfield Avenue
Summit, NJ 07901
Disclaimer: Mr. Bugos does not own shares in Gold One, but may in the future, and may own any of the other names mentioned also; he is not directly compensated for this, or any specific report, though he may have corporate finance or other relationships with any of the companies mentioned herein.
¹ About 12 million ADR's issued as of the end of August