February 17, 2009 - 6:44pm EST by
2009 2010
Price: 12.55 EPS $0.18 $0.51
Shares Out. (in M): 419 P/E 91.0x 25.0x
Market Cap (in $M): 5,251 P/FCF 42.0x 15.0x
Net Debt (in $M): 120 EBIT 0 0
TEV ($): 5,371 TEV/EBIT 23.0x 16.0x

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Harmony Gold 4.875% Convertible Bonds maturing in May 2009 ("Bonds") look extremely cheap, are low risk and as they mature in approximately 3 months have a short term catalyst that will allow the 'cheapness' to be realized quickly.

Key points:

  • Profit of 13-20 Bond points in 3 months, representing an IRR of 66-108% (see "Bond Valuation" below for more details);
  • Harmony is cash flow positive and has low leverage: 
    • Net Debt / Market Enterprise Value: ~2%
    • Net Debt / EBITDA: 0.3x (31-Dec-08 Net Debt, 2009E EBITDA based on Bloomberg Consensus)
  • No other debt falls due before the Bonds mature in May 2009;
  • Harmony has already outlined how it intends to repay the Bonds if holders do not elect to convert the Bonds into shares


Company Overview

Harmony Gold is one of the largest gold mining companies in the world with the majority of its producing assets in South Africa.  The Company has a market capitalization of approximately ZAR52 billion (~US$5.2 billion) with a primary listing on the Johannesburg stock exchange and ADRs listed on the New York Stock Exchange.  In FY08 the Company produced 1.55 million ounces of gold and it currently has over 53 million ounces of proved gold reserves and over 281 million ounces of gold resources.

At 31 December 2008, Harmony had net debt of approximately ZAR1.2 billion (~US$120 million).  Net Debt / 2009E EBITDA is 0.3x (EBITDA based on Bloomberg Consensus).  The Company's next debt maturity is the Convertible Bond in May 2009. 

To further strengthen its balance sheet, Harmony completed the sale of certain Uranium assets in November 2008.  All conditions precedent to the sale were fulfilled in November 2008.  The payment due to Harmony under the sale agreement is payable in three instalments:

(1)     US$40 million on the effective date of the transaction - this was received on 21 November 2008;

(2)     US$157 million plus interest of 5% p.a. on 22 April 2009; and

(3)     US$12 million as soon as the second stage of the transaction related to the old Randfontein assets is completed (expected shortly after 22 April 2009)

Receipt of the second and third instalment of the sale proceeds will take Harmony into a pro forma net cash position.  A summary of Harmony's net debt at 31-Dec-08 (and pro forma debt position adjusted for the Uranium asset sale) are shown in the table below. 



(ZAR Million) 31-Dec-08 
Secured Borrowings 198 
Westpac Bank Limited 209 
Africa Vanguard Resources  748 
 Unsecured Borrowings  
 Convertible Bond  1,672
 Africa Vanguard Resources  32
Total Borrowings 2859
Cash  (1645)
Net Debt / (Cash)  1,214
Sale Proceeds (Uranium Assets) - 2nd Instalment (1644)
Sale Proceeds (Uranium Asets)  -3rd Instalment (126)
Net Debt / (Cash) (555)


Convertible Bond Overview

Key Features of the Bond:

  •          Face: ZAR1,000,000
  •          Total Issue Size: ZAR1.7 billion (~US$165 million)
  •          Maturity Date: 21 May 2009
  •          Interest: 4.875% per cent per annum, payable semi-annually in equal instalments on 21 May and 21 November
  •          Conversion Ratio: each bond can be converted into 8,264.46 shares.  Bond holder can elect to convert anytime up to close of business on the 7th day prior to Maturity Date
  •          Conversion Strike Price: ZAR121 per share


Repayment of the Bonds

Harmony has stated publicly that it intends to be debt free by June 2009 after the Bonds have either converted into equity or have matured (i.e. repaid by Harmony with cash).  Once the second instalment of the Uranium sale proceeds are received Harmony will have sufficient cash to repay the Bond maturity.  Additionally, based on the current gold price, Harmony should generate in excess of ZAR500 million of free cash flow (after capex and taxes) each quarter. This in addition to current cash in hand of ZAR1.6 billion will be sufficient to repay the Bonds. 

However, in the (unlikely) event that the second instalment of the Uranium sale proceeds are not received and Harmony is not cash flow positive in H109, the Company still has several options available to generate liquidity to repay the Bonds.  Some of these include:

  • Given the Company's very low leverage increasing the size of its loan facility with Nedbank should be possible (note: this facility was scaled down at the election of the Company in December 2008);
  • Equity Issue: Harmony completed a small equity issue (ZAR979 million raised, ~2.6% of shares outstanding) in November/December 2008 by selling shares directly into the market.  A further equity issue to cover the Bond should be achievable (note: the total value of the Bond outstanding represents ~3% of the Company's current market cap);
  • Asset sales: I believe there are numerous willing purchasers of the Company's assets in the event these needed to be sold.  For example, Harmony's JV interest in the Hidden Valley project in PNG is worth far more than the Bonds and could easily be sold to its JV partner Newcrest Mining (Newcrest is an ASX listed company with ~US$10 billion market capitalization)


Bond Valuation

The Bonds are currently trading at 104.  

There are three ways I think about valuation:

1)       Parity (current share price x Conversion Ratio) is approximately 106 (based on a share price of ZAR128 which is today's closing ADR price converted to ZAR). The Bonds are currently convertible at the option of the holder.  Therefore, if you purchased one bond today and simultaneously shorted 8,264 shares you could realize 2 bond points of arbitrage (gross) (note: this is not the optimal trading strategy because it does not allow you to fully realize the value of the embedded call option.  It does however illustrate the cheapness of the Bonds);

2)       Monetize the call option - there is an actively traded option market for Harmony's ADRs.  Therefore, it is possible to monetize the call option embedded in the Bond by selling May 2009 $12.5 strike call options (note: $12.50 strike options equate to a strike price of approximately ZAR128 at current FX rates).  The current price for one $12.50 strike call option is $1.75.  Therefore an investor can monetize approximately ZAR148k for each ZAR1m Bond by selling call options over the shares the Bond is convertible into (i.e. $1.75 per option x 8,264 options x 10.25 USDZAR FX rate).  Monetizing the call option as described above reduces the purchase price of the Bond to approximately 89.2 (i.e. 104 purchase price - 14.8 realized from the sale of the call options).  

Returns in this scenario are as follows:

  • Harmony share price <$12.50 - Call options written expire out of the money. Bond holder puts the Bond to Harmony at face value and also receives the final interest payment, both on 21 May 2009.  Returns (based on ZAR1m face value of Bonds): Profit: 120k; Return (IRR): 66% (see table below for more details on calculation);
  • Harmony share price >$12.50 - Call Options expire in the money.  Bond holder elects to convert the Bond into shares.  The shares offset the obligation under the call options written.  Bond holder also receives the final interest payment on 21 May 2009.  Returns (based on ZAR1m face value of Bonds): Profit: 179k; Return (IRR): 108% (see table below for more details on calculation)

(Note: an investor does take some FX risk if monetizing the call option, however this can also be hedged if the investor chooses to do so)




(All Amounts in ZAR Million)                                  Harmony ADR Price                                             
<$12.50 >$12.50
Date Call not exercised Call Exercised
Bond Purchase Feb'09 -1,040,000 -1,040,000
Call Option proceeds Feb'09 148,236 148,236
Net Bond Purchase Feb'09 -891,765 -891,765
Cash proceeds at maturity May'09 1,000,000 0
Bond Interest May'09 12,154 12,154
Call Option exercise proceeds May'09 0 1,058,825
Profit 120,390 179,215
Return (Gross)  13.5% 20.1%
Return (IRR)  66.2% 108.4%


        3)       My valuation of the bonds is approximately 115, using today's closing ADR share price, a credit spread of 500 and stock volatility of 65%. 


While I currently see lots of instruments that look cheap, I believe a large advantage of these securities is that the existence of traded call options allows approximately ZAR148k of the value of these instruments to be monetized immediately.   This allows you to both de-risk the investment and also crystallize/monetize the increased volatility the underlying stock has been realizing recently.   Further, the remainder of the value will be crystallized no later than May 2009 when the Bonds mature (or earlier if the market mispricing of the instrument is reversed).



The major risks I see with this investment are as follows:

  • Significant decline in the gold price
  • Operational issues impacting cash flow (however this is somewhat mitigated by the large number of operating mines Harmony currently has) 
  • Second instalment of Uranium asset sale is not received on time (see discussion above)
  • Company squanders cash (e.g. acquisitions, large green field developments, etc.).  Note: this seems unlikely as the Company has repeatedly stated that its goal is to be debt free by June 2009
  • Bonds are very illiquid and only generally trade in small parcels

Overall, given the 3 month maturity of the Bonds and the Company's strong capital structure I regard the overall risk to this investment as very low.



Considering the short term catalyst, ability to immediately monetize the embedded value of the call option in the Bonds and Harmony's low leverage / low risk capital structure the Bonds are a very low risk investment that is trading well below intrinsic value. 




Bonds mature in May 2009. 

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