The De Beers empowerment deal announced this week appears to be on shaky blue ground, and heavily dependent on solid dividend flows and rand depreciation.
This week, the world’s largest diamond miner unveiled a R3,8billion deal in which the Ponahalo consortium will acquire 26% of De Beers Consolidated Mines (DBCM), the South African arm of the group.
But preliminary calculations suggest the consortium might struggle to meet its debt repayment obligations.
By assigning a value of R3,8billion to 26% of local operations, the deal values total local operations at R14,6billion. De Beers is unlisted, and is thus not compelled to disclose its value. The best valuation one gets is from Anglo American, its listed 45% owner.
According to a Merrill Lynch research note published at the end of October, Anglo values its 45% stake in De Beers at R27billion, which puts De Beers’ total value at R60billion. This means that local operations account for 23% of De Beers and the Ponahalo stake accounts for 6%. It is entitled to a similar proportion of dividend flows.
According to De Beers’ annual report, its final dividend distribution for last year was $200million, of which 6% is $12million. At Wednesday’s exchange rate, this equals roughly R80,4million. The company has to set aside R10million a year for other investments. It also has to set aside a further R5million to invest in social responsibility projects in the proximity of De Beers mines. This would leave R65million to service debt, an amount that would cover financing and interest costs, but hardly makes a dent in the R3,8billion capital.
The deal will benefit from dividend growth. Between 2001 and last year, De Beers’ headline earnings grew from $450million to $652million, an increase of 44%. Dividend growth would most likely follow a similar trend. Additional flows are likely to be improved by returns from other investments. A guaranteed special dividend seems the most likely way for the consortium to pay its debt.
De Beers spokesperson Vukani Magubane said: “We don’t comment on speculation. We have made public comment on the improved outlook for DBCM and we are very confident that the deal is financable from the dividend flows.”
The deal would have to be structured on highly favourable terms, or De Beers would have to provide some form of guarantee to the empowerment partners.
Whatever means are used to protect the empowerment partner in the event of a dividend shortfall, it emphasises the cost that shareholders of selling companies have to bear in order to embrace an empowerment partner. For listed companies, the cost is reflected by dilution of share price that is either a result of a share issue or a direct discount sale.
The deal also raises timely issues about empowerment.
It reminds us that we are firmly back in the pre-1998 era of financing deals by using dividend flows and share price appreciation. That was ended by the emerging-market crisis, but the current trend looks set to continue for a while. Today’s boom is, ironically, driven in part by positive sentiment on emerging markets. Long may that continue.
The other issue the deal raises is whether empowerment partners are where activity and prospects are at their best. It painstakingly isolates South African operations, to limit the empowerment partner’s bene-fits to local operations. Only Old Mutual structured its deal to give empowerment partners a direct holding in the London listing of 1,5%.
In the case of De Beers, being ring-fenced to local operations may not be the best option. Local operations produced 13,7million carats last year, roughly a third of De Beers’ production of 47million carats. But rand strength over the past two years has undermined that contribution. Long may that continue, given China’s demand for commodities.
At the beginning of this year, De Beers was running five of its seven mines at a loss. MD Jonathan Oppenheimer put in place a strategy he called “thrive at five” to make the mines profitable at an exchange rate of R5 to the dollar.
This week, he said that at the end of September the mines were running at 20% ahead of the business plan, and by next year only one mine, Cullinan, just outside Pretoria, would be running at a loss following the pending closure of the historic Kimberley mine and Koffiefontein in the Free State.
Being limited to local operations also denies partners an opportunity to enjoy the upside from Botswana, Namibia and other regions. De Beers’ most exciting prospects are in places such as Angola, where they have just revived operations, and the Democratic Republic of Congo.
Locally, the members of Ponahalo, who will be deployed to the board and executive committee, will face a number of risky projects. One of these is the C‒Cut project, whose initial idea was to develop a mine at Cullinan for between R6billion and R10billion.
Other local projects include mining off the West Coast and the development of an open cast in the Free State, but rand strength may render these unviable at present. Asked for proof that DBCM’s local prospects are equally or more exciting than prospects outside South Africa, Magubane merely reiterated the group’s confidence regarding their local operations.
De Beers take its slogan from a Bond movie, Diamonds Are Forever. The empowerment partners might tweak another Bond title and tell De Beers: “The world [you have given us] is not enough.”