/ 13 July 2001

Slide won’t save miners

The track record of SA’s gold mining companies suggests they will not be able to capitalise on rand weakness

David McKay

South Africa’s gold mining companies stand to add 2% to 3% to their operating margins following this week’s weakening of the rand. Rand weakness has seen the rand gold price nearing record levels of about R2207 an ounce, equal to about R71000 a kilogram of gold produced. The all-time high for the rand gold price is R2299 an ounce, or about R73500 a kilogram, achieved in May.

However, analysts don’t think there is grounds for jubilation on the potential effects of rand weakness because South Africa’s gold miners’ track record suggests they will not be able to capitalise on it. The rand has depreciated about 35% since 1998, but industry cash flows, after capital expenditure, are still at levels recorded three years ago about R600-million to R700-million a quarter. There was a spike in cash flow during the third-quarter of 1998 when about R1-billion was generated from South Africa’s gold producers. “The big question is whether the South African gold miners can keep control of their cost base,” says JP Morgan’s gold analyst James Wellsted. The performance of South African gold mines in the last quarter of last year was typical: “Costs in Q4 1999 of R1473 per ounce have risen to R1613 for Q4 2000, eroding much of the benefit the industry should have derived from a 14% rise in the average rand gold price over the same period,” Wellsted wrote in a report. Another analyst, who declined to be named, says on an inflation-adjusted basis South Africa’s gold mining companies have “done spectacularly poorly” in producing more cash from the weaker currency. In addition, they have suffered from a pronounced drop in average grades. Still, with an improvement in the operating margin of 2% to 3%, analysts reckon net earnings will increase by 5% to 10%. This estimate assumes the rand stays at its current R8,30 to the dollar level for an entire quarter. However, in the case of the more marginal players earnings will be improved markedly. Companies such as Durban Roodepoort Deep and individual operations, including AngloGold’s Free State province gold mines and the Oryx and St Helena mines in the Gold Fields stable, will see earnings increase by 15% to 20%. Harmony Gold’s Free State mines also will benefit from rand weakness. But certain operations seem doomed to failure, no matter what the rand does against the dollar. AngloGold’s Free State mine Joel is heading for certain closure. In the first quarter of this year, the mine received R99000 a kilogram of gold produced, owing to a hedge AngloGold had in place. Despite this impressive revenue figure, the mine still recorded an operating loss. About 1200 employees have taken voluntary retrenchment this year and analysts believe a similar number of workers risk losing their positions when the mine is closed by year-end. AngloGold said at the end of the March quarter that it would give the mine two quarters to turn in a profit. Rand weakness is unlikely to restart currently mothballed projects such as Harmony’s Doornkop operation. “It would be foolish to base a project with long lead times on the function of a currency in a single quarter,” an analyst said. Rather, the performance of the dollar price of gold will be the sole determinant of this. Most brokers have been caught cold by the rand’s move to a new low of R8,33 to the dollar, with JP Morgan and Deutsche Bank economists expecting an average rate of R7,90 for this quarter. Absa set the rand at R8, Lehmann Brothers at R8,05 and Rand Merchant Bank at R7,90, while the most pessimistic outlook was R8,12 by PSG. On Thursday the rand was trading at R8,20 to the dollar.

@Silence gives Regal founder the credibility he craves

BOARDROoM TALK

Alec Hogg

There’s been plenty of response to the spirited retaliation by Regal founder Jeff Levenstein’s on the collapse of his “beloved bank”. None of it, though, from the people he alleges took advantage of the company’s shareholders and depositors.

The way Levenstein tells it, a ploy he proposed last Sunday to take temporary retirement from public positions at the bank was abused by his enemies. He exonerates himself from any blame. The silence from these parties gives Regal’s eccentric founder the credibility he craves. Investec, which according to Levenstein stole R50-million from Regal’s shareholders through last week’s fire-sale purchase of the bank’s loans, “refuses to dignify his allegations with a comment”. Regal chairperson Derek Cohen won’t talk either, referring enquiries to the bank’s recently appointed curator, Deloittes banking specialist Tim Store. For his part, Store has not responded because he “doesn’t want to get into a slanging match”. Plus a footloose response from the CEO of structuring house Mettle, Gavin O’Connor, who is in no mood to talk of such weighty issues as he’s holidaying in the southern Cape. By holding its collective tongue, the anti-Levenstein camp is trusting that the truth as they see it will emerge through what has been an active whispering campaign. Comments on the Moneyweb forum, reflects the talk at business lunches and dinner parties, with suggestions that Levenstein should switch his pinstriped suit for a straitjacket. Some former Regal employees have suddenly lost their coyness, regaling acquaintances with stories of Levenstein’s quirks, like a passion for collecting hunting knives. Even those who were previously close to significant deals with Regal now say (off the record, of course) that discussions never got past a superficial level. An obvious question is why these issues about Levenstein took so long to surface? If his deficiencies were so deep and that well known, why the apparent conspiracy of silence? Or is this simply another reflection of an unfortunate human trait of needing a scapegoat? The longer Levenstein’s enemies allow him to hold the floor unchallenged, the more credence his assertions will attract particularly a contention that Cohen acted in haste when issuing last Monday’s official statement, unwittingly wreaking havoc while trying to take advantage of Levenstein’s two-day absence. The most potent weapon Levenstein has is documentation by board member and leading legal light Henry Vorster. As recently as March, Vorster expressed a written opinion that there was nothing legally wrong with share trusts that are at the centre of the controversy trusts which between them own 45% of the banking group’s shares. It was the market’s interpretation of the role of these trusts in artificially supporting the Regal share price that sparked the run on the bank. Much, it seems, has been assumed.

@What’s Westcon worth? Westcon’s listing in the US promises to unlock considerable value for Datatec

Tim Wood in New York

Datatec’s quest to unlock value within its corporate structure has slowed because of ratty market conditions, but it is proceeding nonetheless and a new vision seems to be taking shape.

Gone is the two-year-old idea of creating a top-flight global-integrated networking services group under one brand. The trail of acquisitions and corporate structuring until early last year made that intention clear, but since then the Datatec strategy has diverted to one that is less interested in synergies than maximising the return on individual business units. The logic is simple and sound. If the individual business units are lumped together then the whole is unlikely to achieve a solid rating because distribution will always be the lowest common denominator that skews perceptions.

Consequently, Datatec has lined up its business units to be independently notable. That leaves the holding company more likely to be viewed as a royalty vehicle in future; almost an operational tech investment fund.

Westcon has twice walked away from the IPO altar, which hasn’t endeared it to investors or its underwriters. But nobody wants to take vows in the backwash of the tech bubble and the IPO pipeline is at a virtual standstill. There’s still no firm date for the listing and it is unlikely to be any time soon for fear of leaving too much money on the table.

It’s impossible to get good inside information on Westcon, but the basic facts show that Westcon carries a lot of clout for Datatec and could dwarf it even if it pressed on with the listing in this market.

Its primary competitors Ingram Micro, Scansource and Tech Data trade at an average price to earnings ratio of 12,86. That’s some way off the multiples achieved in 1999/2000, but it’s not shabby at all for companies lumped into the computer wholesaler category.

On net asset value alone Westcon is worth R8,94 a Datatec share half Tuesday’s closing price of R17,70. It’s not hard to see that the other divisions are worth a lot more than the other half of the price. So what might Westcon be worth? Distribution businesses are usually valued on the basis of a price to sales ratio. It’s the most conservative route so it’s worth using it as the base calculation. Assuming that Westcon sales are unchanged from the latest fiscal year and that Datatec’s current 85,2% stake is reduced by 25%, it would be worth R31,05 a Datatec share, or 175% of its current value. It could go as high as 200% of the present price if sales grow by just 15%. But it’s a much cheerier picture based on a price to earnings model. There, the worst-case scenario would see Westcon worth R24,91 a Datatec share. On a modest best-case calculation, it could be worth R42,54 a share. While the numbers have a positive ring for Datatec, whichever way you run them, the reality is that South African companies seldom achieve the “see-through” value from foreign listings.

Nevertheless, common sense says that Westcon combined with the expected merger or listing of Mason adds up to a whole lot more than R17,70 a share. Whichever way you slice it, Datatec is very cheap at these levels. Could a profit warning do more damage? Undoubtedly and R10 has been called as the short covering target. But private investors may not be able to time it that sweetly so nibbling at these levels with the long-term in mind could be fruitful. A well-placed insider insists that sales are steady and margins intact, so the risk of a profit warning in the next 12 months is reduced. Ultimately, Datatec needs to escape its automatic South African discount for a transparent valuation. Just how the value will be transferred offshore and into what vehicles is the long-term key for shareholders. A straightforward London or New York listing la Dimension Data is not a possibility.

@Recession threat is not receding

AMERICAN NOTES

Tim Wood

The United States economy is expected to recover in the fourth quarter after a year of dicing with recession. But the reasons for optimism are waning and 2002 may be quite old before there is any real recovery. A grab bag of sunny forecasts over the past two months by the leading investment houses suggested the slow down in the American economy was temporary and almost inconsequential. The facts are less sanguine. Last week’s poor unemployment report put the skids under the major indices with the Dow Jones Industrial Average recording its worst points loss in three months. A cynic might say the market was more shocked by the realisation that last Friday was tax freedom day in the US the first day in the year when the average working American starts working for himself rather than to pay taxes. The June unemployment rate came in at 4,5% as manufacturers slashed jobs and with employment in the once hot service industry drying up. That’s bad news for consumer confidence and its corollary spending. Consumer spending has kept a recession at bay so far, but at considerable cost with credit debt growing at a monthly average of 13% this year. That rate is comparable with last year’s first quarter when the boom was peaking. With nearly one million recorded job losses, a critical pillar of support for consumer confidence is gone and with it the power and propensity to spend.

Without regular incomes the enormous national credit card debt growing at an astounding annualised rate of 17% is particularly vulnerable.

The latest data is a serious blow to Federal Reserve chief Alan Greenspan who is already under pressure after the market’s limp reaction to the most recent interest rate cut. To add to the woes, wages are rising, which threatens to undo the productivity miracle that Greenspan praises for giving the US low inflation and strong growth. He has a tricky task. If consumer spending continues unchecked, then the Fed cannot afford to cut interest rates any more for fear of stimulating inflation. But if corporate profits do not recover, then further interest rate cuts and easier money will be needed to prevent a deep recession. The slew of recent profit warnings hints that inflation fears may have to take a back seat. Profit warnings are supposed to be rare by now, but pockmarked income statements from earlier months are being carpet bombed into oblivion. If the fourth quarter is supposed to show a recovery, there’s no evidence for it in the decline in second quarter corporate profits; the worst in a decade. No one is panicking yet, but there’s palpable unease. The Fed has cut interest rates six times this year and the response has been muted. The yield curve on government debt remains positive and money supply is growing faster than ever, but the economy remains sluggish and unresponsive to all the orthodox levers. There will be little assistance from President George W Bush’s tax cut. Although he is often cast as a Reagan supply-sider, his rhetoric and advisers identify him as a conservative Keynesian. Indeed, the intention of the tax cuts was to improve demand, but the total amount is miniscule especially since it’s spread over 11 years. By the time taxpayers get this year’s refund it will be well into the fourth quarter and that amount will get lost in traditional holiday spending.

Without more aggressive and accelerated reductions of marginal tax rates Bush’s stuttering fiscal initiatives may see him in power for just one term. With his opponents scheming to undo the tax cut and even reverse it with lots of fresh spending, politics looks certain to trump economics in this cycle. Indeed, politics may be the least considered, or at least remembered, issue that impedes a recovery. The balance of power in Washington has moved from mutual blocking to one favouring populist causes such as patients’ rights and free prescription drugs for the elderly. The Congress is also increasingly protectionist having convinced Bush to protect the local steel industry. The new administration has also applied less critical thinking about environmental issues of late and the net effect is concern that the politically benign period that underlay the bull market is over.

Given the poor conditions in Europe and Japan, there’s no reason to expect help from abroad so investors will probably have to sit on their hands for the rest of the year. But what’s one mediocre year when 10 superb ones have passed?

@Iscor’s way out of debt

Stewart Bailey and David McKay unveil details of Iscor’s plan to put an end to Saldanha Steel’s debt nightmare

Iscor is hoping to resolve its crippling $728-million debt by way of an elaborate financial plan in which the mining assets cross-subsidise the ailing steel venture, Saldanha Steel. Against this backdrop, no wonder it’s taking Iscor so long to deliver on its restructuring plans, which include splitting out its mining assets into a separately listed company to be known as Kumba.

In a nutshell, Iscor management is prepared to have its fledgling mining company shoulder R4,2-billion in debt, while its less profitable steel business carries roughly half of this amount. In effect, Iscor is raising R4-billion in fresh debt of which half is secured by Kumba. The net result is that Saldanha Steel’s R5,8-billion debt is rubbed out. Saldanha Steel is an enterprise on South Africa’s west coast that was jointly developed with new-business agency the Industrial Development Corporation (IDC). The project has hit massive capital overruns and is struggling to make profits in the current steel market. Iscor has managed to get itself into the unenviable position of owing no less than R6,2-billion to creditors. Of that, R3,3-billion sits on its own balance sheet, while the remaining R2,9-billion is its attributable portion of Saldanha’s total debt. The Saldanha debt is made up of about R1-billion in project finance funded by the IDC, R3,5-billion owed to foreign banks (secured by Iscor and the IDC) and R1,5-billion borrowed from South African banks, which is totally unsecured.

While the restructuring of Iscor has always been on the cards, the treatment of Saldanha has been a bone of contention with the IDC, proving an almost insurmountable obstacle. Iscor is proposing its R3,3-billion debt (exclusive of Saldanha) be shared among its component parts, with Kumba shouldering R2,2-billion and Iscor Steel taking on R1,1-billion. Kumba will then raise R2-billion in fresh debt on its own balance sheet, which it will effectively give to Iscor Steel. The net result is that Kumba is left with net debt of R4,2-billion and Iscor Steel has a net cash position of R900-million. Another way of viewing this potential outcome is that Kumba is buying its freedom from Iscor, although it must be said that this is not an ideal way of launching a mining-focused company amid a cyclical downturn in commodity prices.

The onus is then on Iscor Steel to wipe out its half of the Saldanha total debt package, about R2,9-billion in all. To pull this off, it will also have to raise another R2-billion in yet more fresh debt. Again, the net result of this would be that Iscor Steel has R2-billion in debt and Saldanha’s debt is erased. Crucially, the IDC has to stump up its half of the steel mill’s debt or this plan won’t fly. Phaldie Kalam, an Iscor representative, says the debt allocations were made in line with the projected cash flows of the steel and mining businesses. “We looked at what debt each company could legitimately sustain,” says Kalam, although he stops short of saying the banks are thrilled at the planned debt shift. “They are generally comfortable with the debt spread between the two companies. They would like to see the recapitalisation of Saldanha and our negotiations with the IDC are going along that route.” Kalam says the banks are holding back on their approval for Iscor’s restructuring blueprint until Iscor has reached a final agreement with the IDC.

But the South African banks are unlikely to quibble too much with the restructuring proposal. As things stand, their R1,5-billion exposure to Saldanha is unsecured and shifting it into two more focused entities must be a preferred option. It all sounds nice and neat, but there are issues that have not yet been settled chiefly, what the IDC gets for its half of a debt-free Saldanha Steel. Secondly, will the IDC’s 50% of Saldanha be put into Iscor before or after the unbundling? Despite the tough road ahead, South African fund managers remain bullish about prospects for a restructured Iscor. “At R26,35 a share, Iscor is the biggest steal on the market at the moment,” says NIB Franklin Templeton fund manager Steve Arthur. He acknowledges, however, that the logistics of the debt resolution still have to be thrashed out.