Value Investors Club / HARMONY GOLD MINING CO LTD (HMY)

Description

Harmony Gold : Short Idea

Harmony Gold is in the process of acquiring Anglogold’s short life Moab (Eastvaal) and

semi-dormant Great Noligwa (Southvaal 8 shaft) mines for $300m in cash. This represents

a large premium to our calculation of fair value of +-$160m at current exchange rates and

spot price of gold. The acquisition comes heavily laden with environmental liabilities that

expose the group to the increasingly aggressive oversight of the authorities on assets that

have been in production since 1968 and 2003 respectively. An estimate of these

environmental liabilities is extremely difficult, but we believe they vary between $100m

and $300m, implying the likelihood of Harmony paying for assets with no net value.

The transaction has the support of several large shareholders and could therefore be

approved at the meeting set down for February 1. Should the acquisition be approved, we

recommend a Short on Harmony at the current price of $1.78

Harmony is a South African gold miner listed in Johannesburg, with an actively traded

ADR on Nasdaq. Average daily trade is 3m shares on Nasdaq and 2m on the JSE. The

stock is easy to borrow.

The group owns 11 operating mines, producing 1.1m ozs of gold p.a. and owns 50% of a

JV with Newcrest on a large but marginal Copper/Gold underground exploration project in

Papua New Guinea. The 11 mines have a short remaining life, with several due to close in

the next 5 years (see below). If one strips out one-offs, the group is operating at the upper

end of the industry cost curve with less than a 10% pre-tax margin, despite a concerted

effort to high grade some of the mines (AISC of $1182/oz in the financial year to June

2017).

Harmony’s existing mines that face near-term closure also have significant environmental

and closure liabilities that will change from accounting entries to cash outflows. As the

“last man standing” in certain mining camps, Harmony will be increasingly exposed to

disaffection from unemployed ex-workers and illegal mining.

The only way that Harmony can get out of this downward spiral is to make clever, well-

priced acquisitions of long life, opencast, cash producing assets outside South Africa for

paper, staggered payments or royalties/streams. Management is clearly aware of the risk of

doing nothing, but the Moab acquisition is precisely the wrong transaction.

What’s wrong with Moab

The purchase price of $300m exceeds the independent geologists’ value of $260m ($150m

- $350m range, with selected value of $260m)

The purchase price is large vs the market cap of $783m

The environmental liabilities are potentially a further $300m (Total cost of up to $600m)

The price is payable all in cash in a single upfront payment, leaving Harmony overgeared

Moab has a life of only 5 years, with production almost halving in 2021 and 2022

The mine is in South Africa

Moab operates at a depth of 10,000 feet in extremely complex geology

The growth that Harmony postulates for Moab is open to factual challenge (see below)

Harmony’s current CEO, Peter Steenkamp, was appointed in January 2016. His previous

experience includes an unfortunate episode as CEO of the JSE listed Pamodzi Gold. Under

his leadership Pamodzi acquired several marginal gold mines in South Africa at elevated

prices – mostly against debt. The group was finally liquidated in 2009, after investors

showed little appetite to invest in Pamodzi shares. This was in the post-Lehman’s phase,

with gold breaking through $1000/oz, but the Rand exchange rate recovering strongly and

the mines battling with electricity supplies and cost pressures.

The decision to acquire Moab is Steenkamp’s third important strategic move since taking

office at Harmony. The first was to high grade the Kusasalethu (Elandsrand) and

Masimong (Erfdeel) mines, sacrificing life for cash flows, which we applaud.

The second was the controversial decision to acquire the other half of the Hidden Valley

gold and silver mine in Papua New Guinea from Newcrest for $1. Hidden Valley has a

history of weak management, unpredictable output and of consuming a never ending

stream of cash. Steenkamp’s new strategy at Hidden Valley is to invest in a major push

back of the open pit, reconfigure the ore belts, invest in larger yellow equipment and

dramatically increase production to achieve a lower unit cost. For a small group such as

Harmony, this is a do or die strategy with significant risk. The risk of failure also extends to

Harmony and Newcrest’s reputation in PNG, where they hope to build the large Wafi

Golpu underground Copper/Gold mine. (See below)

Our fundamental thesis is that Steenkamp could easily have walked away from the Moab

deal or bid a lower price, given the extent of the environmental liabilities and scarcity of

cash flush, likely buyers. The willingness to overpay with borrowed money for a

challenging asset, seems eerily reminiscent of the Pamodzi story.

Moab shaft (Middle Mine)

The Ore Reserve as postulated by SRK, basis 1 January 2018 is 1.37m ozs, with the budget

showing a significant improvement in ore grade, as tonnage declines over the next 5 years.

While we’re skeptical of this ability to raise the recovered ore grade from 7.5g/t to 9.2 g/t

(2017 and 2021), we used these in our model. Where we differ from SRK is in our estimate

of unit cost per ton of ore. We expect unit costs to already climb this year, as underground

volumes drop off and potentially if Kopanang’s ore is no longer treated at the Great

Noligwa metallurgical plant.

On that basis, the model delivers highly taxed earnings in 2018, 19 and 20, before

potentially showing losses in the last 2 years of operation. Any plans to treat the Mispah

slimes dam will therefore have to be executed rapidly, so as to avoid missing the tax shield

of the next 3 years. By spending capex on Mispah, net cash will be reduced in the short-

term.

Great Noligwa shaft pillar

On paper, the Great Noligwa (GN) shaft pillar is a great concept. Instead of mining bitty

blocks of ore far from the shaft, the project can be accessed in close proximity to the shaft

at lower cost and higher productivity. This is what Harmony has delivered in superb

fashion at the Bambanani mine in the Free State.

The reality at GN is markedly different.

The target ore body is modest in size. Anglogold estimated this at 590,000 ozs Measured &

Indicated Resource, with SRK estimating 390,000 ozs. The Resource grade is 14.9 g/t in

situ, but after applying the dilution factors at GN, this translates to only 6.6g/t in the mill.

This compares to Bambanani’s recovered grade of 10.5 – 14.0 g/t.

The rock mechanics at GN is also markedly more complex. The principal reef at GN is the

Vaal Reef, which is bounded by friable reef sequences above and below it (the hanging

wall and footwall). In addition, the GN shaft pillar is bisected by a massive dyke (vertical,

east west trending wall of lava). These dykes are known to cause significant instability

(rock mechanic risks), requiring significant bracket pillars and other measures that all

reduce profitability.

While SRK are comfortable that the rock mechanics will be under control, they don’t

regard the GN shaft pillar as a Reserve, as it has not been subjected to the rigor of a Pre-

feasibility study (p.81) They also point out that the shaft pillar cannot be mined until the

end of the Life of Mine of Moab, as it is required for water pumping. In other words

Harmony has to choose between the Zaaiplaats growth narrative and extracting the GN

shaft pillar.

Zaaiplaats

Moab (Eastvaal) was sunk from 1993 onwards with the express aim of gaining access to

the deeper and highly faulted blocks of ground southwest of the Moab shaft (Vaal Reefs 11

shaft). These blocks are separated by a 2,000 foot down throw fault from Moab Middle

Mine. Due to shockingly poor disclosure by Anglogold, the information on why this project

is not being pursued is sketchy.

Suffice it to say that Anglogold executed a new high definition seismic survey of the area

in 2014 and suddenly stopped several boreholes mid-campaign. It appears that not only is

the ground more faulted than expected, but that there is a major dyke running through the

Zaaiplaats ore block called the Karel dyke. At the postulated depth of 12,000 feet, the

combination of massive faulting as well as a dyke just spells costs and safety risks. This

echoes the demise of Buffelsfontein’s $1bn Strathmore shaft 6 miles northeast of Moab

shaft, which was never mined, despite ore grades of 3 ounces per ton in places.

SRK politely side stepped the issue by saying that the project has a negative NPV at a 7.5%

real Discount Rate (p.81). In reality, Zaaiplaats will never be commissioned, as the tax

shield that could have part funded the project has already been exhausted. We therefore

strongly disagree with Harmony’s touting of Zaaiplaats as a “quality long-term project”.

Environmental Liabilities

As part of the transaction, Harmony is acquiring the following environmental obligations

without compensation from Anglogold;

The Moab slimes dam (Mispah) is situated on a dolomitic compartment and is not

plastic lined. The 70mt of sulphide ore in the slimes leaches sulphuric acid, uranium and

other chemicals into the dolomite. Previously, a sinkhole formed at the toe of the Mispah

slimes dam, which required filling with concrete. The groundwater plume extends to the

Vaal River.

The Moab and Great Noligwa shafts both have large dumps of sub-economic waste

rock, which also leach into the dolomite.

The Margaret Water Company (MWC) has an obligation to pump underground

water from the Vaal Reefs complex in perpetuity. This obligation is shared jointly and

severally between Harmony (as successor to ARM), Village and Anglogold, with Harmony

acquiring Anglogold’s share of the obligation as part of the transaction. This is based on

the Appeal Court ruling of 2013, which requires the MWC to also purify the polluted water

to “general effluent standards”, before discharge into the Vaal River.

The Margaret shaft from where MWC pumps the water, does not comply with

mining safety regulations. These require all underground shafts to have a second escape

route for emergencies. The severe earthquakes in the KOSH area have thus far not had any

impact on the Margaret Shaft, but in extremis, all the workers manning the pumps could be

cut off underground if the shaft was damaged. There is no clear solution for this problem,

other than relocating the entire MWC pumping infrastructure to another shaft. This will not

only imply significant capital costs, but also increased pumping costs.

Harmony is acquiring the Nuclear Fuels Corporation (NUFCOR) and all its

environmental liabilities. NUFCOR and its predecessor were formed in 1951 and have

treated some 200,000 tons of yellowcake slurries through a calcine process to produce

Uranium oxide, mostly for export.

These environmental liabilities have not been independently quantified, or if they have

been, the studies are unavailable. Suffice it to say that if Lloyds of London or Berkshire

Hathaway was asked for a quote on a permanent indemnity, our estimates of $100m -

$300m might prove conservative.

Short-term catalysts :

Harmony places shares at a deep discount to help pay for Moab

Dividend passed due to capex / strained balance sheet

Unisel closes down this year (earlier than signaled)

Inability to generate cash at Kusasalethu and Joel

Moab faces rising unit costs as volumes and grade drop in Calendar 2018 (Budget)

Disenchantment among investors as they wake up to reality of Moab

In summary, Harmony’s short remaining life, value destructive Moab acquisition, cash

consuming strategy in PNG and large environmental liabilities add up to an attractive

cocktail for short sellers.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Harmony places shares at a deep discount to help pay for Moab

Dividend passed due to capex / strained balance sheet

Unisel mine closes down this year (earlier than signaled)

Inability to generate cash at Kusasalethu and Joel

Moab unit costs rise due to drop in volumes and ore grade

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			2018	2019
Price:	1.78	EPS	0	0
Shares Out. (in M):	440	P/E	0	0
Market Cap (in $M):	783	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost