South African platinum miners 2012
01 October 2012 - Neill Young
The tragic events at Marikana and their likely long-term consequences may cause investors to question whether there is any reason to continue investment in the platinum group metals (PGM) miners. The market certainly seems to reflect that sentiment – since the Marikana incident on 16 August the PGM basket has increased by 20%, yet the platinum share index is largely unchanged.
Lower levels of production and structurally higher costs are not attributes one would usually seek out when assessing a potential investment. However, we believe that there is a compelling case to be made for certain, but not all, companies operating in this sector.
Fundamentals of the PGM industry
While South African PGM miners extract a basket of precious and base metals from their reserve deposits, it is platinum that has the most significance. Platinum accounts for about 50% of the metal produced from a tonne of ore, and at current metal prices contributes roughly 65% to the revenue line of the industry. South Africa produces 75% of the world’s mined platinum, and if one includes Zimbabwean mines (controlled by the South African miners), the number increases to 80%. The autocatalyst industry is the dominant source of demand for the metal (45%) followed by industrial demand (30%) and jewellery (25%). These market
dynamics are key:
- A significant proportion of primary supply is concentrated in southern Africa.
- A large proportion of demand is driven by regulation in the form of tightening vehicle emissions controls.
Companies in extractive industries can be challenging to value. They tend to go through deep cycles, and as a result their cash flow streams are inherently volatile, sometimes placing significant strain on balance sheets. When thinking about these businesses, we try to devote the appropriate amount of attention and thought to the key drivers, namely normal prices, production levels and costs. One then needs to apply an appropriate multiple to the resulting cash flows, and carefully consider the sensitivities to the assumptions made.
One could draw the simple conclusion from the factors described above that higher producer costs should automatically translate into higher metal prices. While we are of the view that the industry has some pricing power, and certainly more than most other South African miners, there are some nuances to the industry
fundamentals that need to be considered.
A near-term consideration is that within the auto sector, platinum is used primarily in autocatalysts fitted to diesel-engine cars and trucks (palladium is used predominantly in gasoline vehicles). Europe is the only market in which diesel autos make up a significant portion of the passenger vehicle fleet, and hence roughly half of platinum auto-catalyst demand depends on European auto sales. With the economic woes facing the region, auto sales are weak, forecasts are continually being revised downwards, and inventory levels are building. Some of these are mitigated by the global introduction of emissions standards for heavy duty and offroad diesel vehicles, but this will do little to offset the impact of a weak Europe.
Jewellery demand is dominated by China – in 2011 it made up roughly three-quarters of global volume. This is a far more price elastic source of demand, implying higher prices are likely to result in less consumption. In years gone by jewellery was seen as a useful release valve to prevent price spikes in times of market
shortages. Today it is a vital source of demand required to compensate for weaker autocatalyst volumes. Much hinges on the strength of the Chinese middle income consumer. A more important longer-term consideration is the growth in autocatalyst recycling. Currently this contributes an additional 20% to global platinum supply. We believe this proportion could double over the next 30 years as scrap collection rates improve and metal loadings on new autocatalysts stabilise or decline.
Production and costs
South African platinum production peaked in 2006 at 5.3 million ounces. By 2011 production had dropped by nearly 10% to 4.8 million ounces. The disruptions ex-perienced year-to-date are likely to remove a further 500 000 to 600 000 ounces from the market. The five-year decline stems from various issues: increased depth, more challenging ore bodies, declining grades, increased labour disruption and reduced productivity. Underground mining is a comparatively fixed-cost business. Over the same five-year period, declining production, combined with high levels of mining inflation, has resulted in a doubling of unit costs. This is despite some stringent cost-cutting efforts by Anglo Platinum. The rand basket price has increased only 17% over the same period, resulting in immense pressure on industry free cash flows. The chart below shows the long-term trend in unit revenues and costs (including all capex) and the resultant owner earnings margin.1
1 Owner earnings are defined as free cash flow after all capex The SPOT data point shows the first half of the year’s costs and metal prices at the end of September. At this point, the industry is overall in a breakeven position after all capex, but there is a reasonably wide dispersion around this mean point.
A clear consequence of the events at Marikana is a step change in costs. Labour makes up roughly 50% of the industry cost base, and wage increases in the order of 15% have already been agreed at Lonmin and Implats. We expect there will be pressure to do the same at the other miners. In addition, an increase in regulated community and social spend is likely to come in time. Couple this with above-inflation utility escalations and the impact of a weaker currency on imported consumables, and the cost pressures are clear. If one normalises Implats’s unit costs for the impact of a six-week strike and assumes a simplistic assumption of an across-the-board 12% escalation to the first half of the year’s unit costs, roughly 50% of industry production is currently owner earnings negative.
Metal prices are clearly too low to sustain the entire industry and need to move up if new investment is to be encouraged. The question is, by how much? Clearly equity prices are not discounting current metal prices into perpetuity, but if one is to find value in the share prices of the high-cost producers, one must build in either much higher normal prices or lower unit costs.
Is this realistic?
To drive prices higher, one needs to assume that demand exceeds supply. Excluding investment demand, the platinum market has been in fundamental surplus since 2006. This has been during a period of economic hardship, and our research suggests that deficit markets will return in time. Due to the production losses suffered thus far, the market is likely to end 2012 in balance or a small deficit. But the issues raised in our discussion on prices, particularly the threat posed by recycling, as well as thrifting and substitution efforts (no doubt given renewed impetus during this period of supply disruption), cleaner engine technologies, and comparatively high levels of above-ground stocks cause us to be cautious on assuming very large fundamental deficits in future years.
To bring down unit costs, the primary tool available to producers is increased production to leverage the fixed cost base over more ounces. Until recently this was the principal strategy of the high-cost producers. The risk to this strategy is the feedback loop to metal prices from increased supply. Stretched balance sheets and the events of the past few months have, however, resulted in a turnabout. High cost shafts have been placed on care and maintenance at Aquarius and Lonmin, and we expect the same to happen at Anglo Platinum. This may be supportive of metal prices, but it benefits those not required to curtail production, or curtail to the same extent.
Coronation investment approach
Given our more cautious outlook on longer-term prices and costs, our preference is to invest in those companies that are sustainably positioned in the bottom half of the cost curve – in other words, Implats and Northam.
We would consider the following attributes key in maintaining this cost position:
- Access to high-quality ore bodies.
- Consistent capital investment to sustain or increase production.
- Robust balance sheets.
Implats and Northam both have a comparatively high exposure to Merensky ore in their South African operations, which typically provides high grades and good recoveries. This results in a high yield of metal per tonne of ore mined, as highlighted in the chart below.
In addition, Implats has exposure to two Zimbabwean platinum mines of very high quality in Zimplats and Mimosa. The requirement to meet indigenisation laws calls into question how much of these assets Implats may eventually end up owning (we assume some dilution will take place), but the quality of these assets is undeniable. The ore body is shallow, comparatively easy to mine and contains high base metal credits. The labour force is highly skilled and productive, and there is scope to significantly increase production at relatively low capital cost. These mines sit firmly at the bottom of the industry cost curve.
Over the past five years, Impala has invested R21 billion in capex at its Lease Area on the Western Limb of the Bushveld. Over the same period Anglo Platinum has invested about R17 billion at its three Western Limb mines (Rustenburg, Amandelbult and Union) which have produced nearly 50% more tonnes than the Implats mine. Over a 10 year period2, capital investment at the Impala Lease has averaged R161 per tonne of ore milled, compared to R127 per tonne at the three Anglo Platinum mines, and R139 per tonne at Lonmin’s Marikana mine (also on the Western Limb.)
A large portion of the Implats capex has been invested in the sinking of three new deep-level shafts to ensure the sustainability of production at the mine. As these shafts come on stream the proportion of high-quality Merensky ore will increase, and mining efficiencies should improve. Northam requires relatively low sustaining capex. It is, however, currently spending on deepening the main shaft at its existing mine, which we expect will achieve a similar outcome to the new Implats shafts. In addition,it is building a new mine on the Eastern Limb of the Bushveld. Booysendal is expected to commence production in the current financial year, and should benchmark very similarly to the low-cost Two Rivers joint venture in which Implats has a share. The mine is shallow and largely mechanised. Hence execution risk is comparably low, and payback is much quicker than a conventional deep-level shaft. In addition, there is scope to significantly expand over time at the mine.2 2002 to 2011. 2012 has been excluded due to the distorting effects of the strike at Implats
The capex chart to the left indicates how Implats has increased its capital spend over the last five years, while Anglo Platinum has been forced to cut. This is largely a function of the relative strength of their balance sheets. At the top of the cycle in 2008 both Implats and Northam had significantly positive net cash positions,
in contrast to Anglo Platinum and Lonmin. Both of these companies carried net debt at the time and both were subsequently forced to recapitalise. Implats and Northam are currently both in a net debt position, but at very manageable levels which are appropriate for this stage of the cycle, and which do not require a curtailment of investment. Lonmin, in contrast, looks as though it is headed for another rights issue.
Enormous uncertainty surrounds the PGM miners in the short term. The challenges brought about by the developments with labour could result in production cuts across the industry. Metal prices are likely to be volatile as speculators attempt to capitalise on these events, and near-term earnings forecasts could fluctuate
significantly (in both directions, but more likely downwards) as a result.
This presents opportunity. We attempt to look at a more normalised environment, where we consider ourselves to be cautious on the upside in PGM prices. In Implats and Northam we believe our clients are invested in superior-quality defensive assets. Our assessment of normal earnings suggests that these companies trade on PE multiples of less than 10 and have comparatively less sensitivity to changes in our assumptions. Looking at it another way, we believe that at current market prices one is not paying for the Zimbabwean assets in the case of Implats, and for only the first phase of development of the new Booysendal mine in the case of Northam. This, we believe, makes a compelling investment case in a market where many stocks appear fairly fully valued.
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Notes to the editor:
Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the September 2012 quarter-end, assets under management total R339 billion.