| 2012 | 2013 | ||||||
| Price: | 7.23 | EPS | $0.37 | $1.42 | |||
| Shares Out. (in M): | 39 | P/E | 11.6x | 5.2x | |||
| Market Cap (in $M): | 278 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | 0 | EBIT | 21 | 98 | |||
| TEV (in $M): | 278 | TEV/EBIT | 5.8x | 3.0x | |||
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DRDGOLD (DRD), listed on the NYSE, has been mining gold for over 100 years. DRD produces 140 000 ounces of gold per annum and only trades at 3 times it’s earnings power. There is a strong argument that DRD should trade at a premium to the industry multiple of 5.4 promising an upside of at least 55%.
My main argument for a premium multiple is the fundamental principle that a investor should pay a higher multiple for a business which uses a small, rather than a large amount of capital, to operate.
DRD is in the process of putting the finishing touches to a 4 year transformation from an “underperforming-capital-intensive-underground-miner” to an “asset-lite-gold-factory”. From February 2012, DRD will be more of a factory than a mine as it exits it’s last underground mine (Blyvoor) and focuses on extracting gold from the tailings left from dormant mines following a century of gold mining.
The repositioning of DRD as an “asset-lite-gold-factory” and the tweaking of the dividend policy to reflect the “new” business model should see DRD trading at a premium to the industry multiple.
The catalyst to the trade is the announcement of the new dividend policy on the 14 Feb 2012and a clearer set of financials without all the “noise” from the transformation.
Gold Stocks Under Perform the Boom in the Gold Price
The boom in the gold price over the last few years has been disappointing for investors in listed gold stocks. While the gold price is up 150% over 5 years, NEM is only up 50%, ABX=0%. DRD is down 30%.
As far as I am concerned the main reason for the underperformance is the endless need for capex to keep these mines running. As a result of the high capex bill there is very little cash left for dividends. This has meant that despite the rise in the gold price the payout ratios of most mines are an embarrassment. For instance, NEM has a payout ratio of 18%, ABX = 11%, KGC= 14%, GG=20%, AU=38%, RGLD=30% etc. The low payout ratios translate into poor dividend yields ranging between 0% and 2%. An extremely bitter pill for shareholders given the boom in the gold price.
I have generally avoided gold mines because of their continuous capex requirements. I have also rarely been convinced that the capital invested generated acceptable returns (especially given the risks of mining) and have seen too many cases where the returns barely beat the WACC. On these occasions I am assured by management that “if the gold price does this, and, the exchange rate does the other, then, there will be some blue sky”. Hey, if I wanted optionality, sleepless nights and no dividends I may as well just gamble on out-the-money call options.
Given my strong aversion to gold mining, why am I recommending DRD? I like DRD, because, unlike the other gold mines that cross my path, DRD will require very little capital to keep running, and, for once I am optimistic of a generous dividend.
The board is in the process of discussing a “new” dividend policy. My guess is that, after applying a payout ratio of 40%, the dividend could be 35c, implying a dividend yield of close to 5%. DRD will guide on this when results are released onFebruary 14, 2012.
(Note, DRD report is South African Rands. I assume a gold price of $1 750 and a ZARUSD=7.50 throughout the report.)
Brief History and Transformation of DRD
The following comment from the DRD CEO sums up most of which you need to know about DRD’s history.
"We are now close to completing our transition from an operator of both deep-level,underground gold mines and surface retreatment operations in South Africa to an operator of lower-risk, lower- cost, higher-margin surface gold recovery operations in South Africa."
DRD has been mining gold in South Africa for over 100 years. Four years ago DRD operated mines in South Africa, Fijiand and Papa New Guinea. After disasters in Fiji and PNG, DRD sold these mines in October 2008 to focus on South Africa.
In October 2008, ERPM a 100 year old underground mine was closed because of operational and safety issues.
In December 2012, DRD received an offer of $25mil for Blyvoor. Blyvoor, which has been in-and-out of receivership a couple of times over the last few years, is DRD’s last underground mining operation.
Following the sale of Blyvoor, all that is left is DRD’s 83% interest in Ergo. Ergo is a surface retreatment operation which processes the tailings left by mines in the historically famous gold mining region close to Johannesburg, South Africa. DRD have spent over $120mil consolidating and expanding these retreatment plants which included a 30 mile pipeline that links the tailings (mine dumps and slimes dams) to the 4 re-treatment plants.
The point I want to emphasize is that four years ago DRD was a basket case, but, will be a very different animal going forward. I don’t believe the market has kept pace with these changes, as trading in DRD is still dominated by speculators wanting a leveraged bet on the gold price. DRD intend to address the problematic shareholder register by marketing the transformed DRD to institutional shareholders.
Earnings Power
DRD’s surface operation has access to over 600mil tons of tailings (mine dumps and slimes) left over from 100 years of mining to the South and East of Johannesburg. This guarantees a life of over 20years.
These tailing are currently pumped over a pipeline to 4 re-treatment plants. For the 12 months ended September 2011, these plants treated 20.5mil tons of tailings producing 143 647 ounces of gold. Production over the last 12 months was slightly below normal due to the commissioning of new tailings deposits as existing sites become exhausted. To give some idea of the scale of these tailings, one of the new sites will take 42months to reclaim and is expected to yield 76 000 ounces.
With the completion of a 30mile pipeline in February 2012 the number of processing plants will be cut from four to two, Ergo and Knight.
A major refurbishment of the Ergo plant (completed in December 2012) will expand it’s production from 14.4mil tons per annum to 21.6mil tons. Knight will process 2.4mil tons per annum.
The grades at Knight are 0.38grams per ton and it should produce 28 300 ounces per annum. Ergo will conservatively produce 113 500 ounces per annum for a total production of 141 800 ounces.
Management are guiding production for Ergo between 140 000 to 150 000 ounces. While I will use 140 000 ounces to calculate the earnings power, I am aware that this is a conservative estimate which takes into account potential teething problems following the switch from four plants to two. Once these new circuits have settled down, production should be closer to 150 000 ounces.
To date, the grades achieved from the Ergo plant have been below initial guidance. This is a sensitive issue for the current management team who are reluctant to guide on grades. Fortunately the volumes processed by Ergo have been above guidance, which is something the management team is willing to talk about.
As a result of the lower than projected grade, a pilot plant has been built to experiment with the extraction process. Results from this plant indicate that the grade can be improved by 20% at a capex cost of $34mil. Extracting an extra 20% from Ergo will add 22 700 ounces a year (revenue of $5.3mil). This should all drop straight to the bottom line.
The directors are currently considering this capex and I would not be surprised if DRD announce the go ahead in the December 2011 quarterly results presented tomorrow. The $34mil capex could delay a more generous dividend if management decide to use equity to fund the asset. While, the funding decision is being debated it is encouraging to hear that management are considering using existing debt facilities to fund a portion of this capex.
On the cost side of the EBITDA calculation I will assume a cash cost of production of $1 100 per ounce. The break-down of the costs are 30% for mining contractors, 20% on consumables (e.g. cyanide) and the remainder is water and electricity. It is striking that after the sale of Blyvoor, the number of employees will fall from over 5000 to 500. This is a big win given the regular strikes which plague the South African gold mining sector.
Putting the above together I calculate an EBITDA of $75mil per annum for DRD.
Earnings Power
Gold Produced (oz) 140 000 (low end of guidance)
Gold Price/oz 1 750
Cash Operating Cost/oz 1 100
Maintenance Capex/oz 42
Cash Oper Profit/oz 608
Cash Operating Profit($) $85mil
Head Office Costs $ 10mil
EBITDA $75mil
Please note the following with regard to the above calculation
Valuation
The valuation of DRD has some twists and turns as it is complicated by a BEE minority shareholder. (BEE stands for Black Economic Empowerment and South African mining companies are required to have 25% of their shares held by a BEE shareholder.)
Currently BEE shareholders effectively own 83% of Ergo’s equity. For my valuation I have cut this to 75%, which, prudently assumes that a further 8% of Ergo is granted to BEE shareholders for no compensation. This is not likely, but, I want to be conservative.
A further twist to the BEE structure is the use of debt to fund mining assets. Obviously, if a large portion of the assets are funded with debt then the 25% BEE equity stake is worth less. To increase the proportion of debt funding at Ergo, DRD’s has lent $107mil to Ergo.
With this background DRD owns the following assets
Valuation of Ergo
The earnings power of Ergo is $75mil (see above). Using a multiple of 3 implies a value of $225mil for the operating assets.
Ergo, currently has a tax loss of $107mil. Using a tax rate of 28% the value of the tax shield is $30mil.
Added together, Ergo’ assets are worth $255mil. Knocking-off $107mil for the inter-company loan and $47mil for an unfunded environmental liability implies a value of $101mil for Ergo’s equity. DRD’s 75% share is worth $76mil.
If one uses a more realistic industry multiple of 5.5, then DRD’s 75% share increases to $216mil.
ERPM Extention 1&2
ERPM Extention 1&2 consist of a gold deposit of 18mil ounces (9 grams/ton) at a depth of 700 meters.
Fortunately, DRD do not want to develop this mine, but, want to enhance it’s value with the intention of selling it in 1 to 2 years time. Using a recent sale of a similar deposit as a marker the deposit is worth $33mil. DRD’s 75% share = $25mil.
Ergo (75%) $ 76.0mil
Loan to Ergo $107.0mil
Blyvoor Proceeds $ 25.0mil
ERPM (ext 1+2) $ 25.0mil
Net Cash $ 40.0mil
Q4 Cash Generated $ 18.0mil
Value $291.0mil
No Shares 385mil
Value/Share $7.55
DRD is currently trading at $7.23 which implies that the market currently values DRD below 3 times it’s earnings power. Using the industry average multiple of 5.4 for Ergo, DRD’s value increases to $11.20 for a potential upside of 55%.
Ergo (75%) $216.0mil
Loan to Ergo $107.0mil
Blyvoor Proceeds $ 25.0mil
ERPM (ext 1+2) $ 25.0mil
Net Cash $ 40.0mil
Q4 Cash Generated $ 18.0mil
Value $431.0mil
No Shares 385mil
Value/Share $11.20
I would argue that the upside could be more as DRD should trade at a premium to the industry average.
I would also not be surprised if DRD becomes a take-over target. Corporate activity amongst smaller mines in South African has been fairly robust, and, at the current multiple, a wise buyer could effectively buy DRD and achieve a guaranteed three year payback by hedging out three years of gold production.
To Hedge or not to Hedge ???
As with any gold mining company there is no denying that DRD is a bet on the gold price. DRD appears to be cheap, but, what happens if the gold price falls to $1 000 an ounce?
I have run DRD through various regression models and I regret to report that I can’t find a decent statistical hedge using a combination of gold stocks and the gold price.
I realize that some investors may want some exposure to the gold price, but, for those who want to hedge out this risk it seems that the most sensible option is to arbitrage the gap between the EV/EBITDA multiples. Long cheap (DRD), short expensive.
While there are more expensive gold stocks, I believe it may be more appropriate to consider the other South African gold stocks listed in theUSas potential hedges. (AU, HMY, GFI)
Annualizing the last reported quarters results, AngloGold Ashanti (AU) trades at a 5.5 times EV/EBITDA multiple, Harmony (HMY) = 5.9 times and GoldFields (GFI) at 4.7 times. The average multiple is 5.4 versus a 3 multiple for DRD.
The mining operations of AU, HMY and GFI all use lots of capital leaving a small slice of free cash for a dividend. Again annualizing the last dividends, AU trades on a 1% dividend yield, HMY = 1% and GFI should yield 2%.DRD’s yield could approach 5.0%.
I am betting that the divergence in the dividend yields will be the signal that drives the compression in the multiples.
Risks
I have argued that DRD should trade at a premium multiple to other gold mining stocks. The driver of the multiple expansion is a “new” dividend policy which will reflect the “new” asset-lite business model.
While I am confident that DRD’s dividend yield will exceed those from other gold mines, the full dividend potential could be delayed by the $34mil expansion of the pilot plant.
Management have also been complaining about the high insurance premiums to cover DRD’s environmental liabilities, and, are considering using some of the cash flow to self-fund a portion of this liability. I am not in favor of this as the potential savings do not beat DRD’s WACC. I would far prefer the dividend and am seeking the support from other investors. Anyone ?
In summary, when putting these risks into perspective one must remember that at the current gold price DRD will easily generate $75mil in cash per annum. The above items are the last potential uses of these cash flows and the full dividends will eventually flow, but, with a lag.
Conclusion
The “old” DRD was a scary stock to own and deserved to trade at a discount to the industry. However, following the transformation, the “new” DRD deserves to trade at a premium to other gold stocks.
Investors have not kept pace with the transformation. I expect this to change with the publication of a less cluttered set of financials and the announcement of a more generous dividend that matches the new asset-lite business model.
Oh, one more risk. Helicopter Ben finds the secret to a free lunch. Despite printing trillions, paper money retains its purchasing power.
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