Ruan Kemp: Exxaro – To hold or not to hold?

By Ruan Kemp

Current consensus view amongst analysts is that Exxaro is a ‘Hold’, this despite the fact that Exxaro is struggling to hold onto its place in the FTSE/JSE Top 40 Index. In the quarter September to December 2014 Exxaro has shed ZAR 10 billion in market capitalization, and dropped nine places to number 43 in the index, with a market cap under ZAR 40 billion.

One reason for such dismal share price performance is of course the demonstrably depressed commodities outlook. Some analysts are of the opinion that investors are especially concerned about Exxaro’s exposure to iron ore, the price of which has dropped almost 50% in 2014 to its lowest level in more than five years.

But, while there is reason for concern – Exxaro is dependent on dividends from Sishen Iron Ore Company for more than half its Earnings Before Interest and Tax – one must remember that investors do not necessarily hold Exxaro shares for exposure to iron ore in the first place. Such exposure could be directly held through Kumba Iron Ore, at a lower price to earnings ratio for more than double the dividend yield.

So why hold Exxaro shares?

THE EXXARO PORTFOLIO

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EXXARO THE MINER

In terms of assets, Exxaro is first and foremost a coal miner, with the coal operations comprising half of total assets, but in terms of income, Exxaro could perhaps be better described as an investor:

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While multi-commodity exposure can spread risk and allow cross-subsidisation between business units, Exxaro the miner only has a single commodity on the operational level. The graph below is first and foremost an illustration of falling margins, as operating cash costs outpace revenue, but may also be interpreted as Exxaro’s movement from a multi-commodity miner to a coal miner. In the period depicted below Exxaro has stopped mining mineral sands, zinc and lead.

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Operating cash cost is the difference between revenue and cash generated by operations after taking into account interest, tax, and capital to sustain operations. The gap between the blue and red line thus represents free cash flow to equity, or lack thereof, as illustrated for FY2013. Exxaro closed this gap by reporting the Eskom Shortfall as ‘Other Income’. Let us call it the ‘Medupi Effect.’

THE MEDUPI EFFECT

In their 2H2014 pre-close statement Exxaro indicated that going forward the Eskom penalties received because of the Medupi construction delays will be recorded as Revenue. To date the penalties received have been recorded as Other Income, which somewhat befuddles an understanding of operating costs:

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The graph to the left is a theoretical presentation of cash costs per average tonne had no shortfall funding agreement been entered into with Eskom. The graph to the right represents cash costs per average tonne as can be estimated from the financial statements.

Actual cash cost of production (green) is derived by subtracting cash generated from revenue received. Interest and tax paid (purple) are not stipulated in the segmental report; instead it is assumed that the commercial coal mines contribute to actual net finances paid in proportion to their contribution to total cash generated by all cash generating units. The gap between the purple and the black line (revenue) thus represents operating cash flow. While sustaining capital (blue) is capitalised, it remains a cash charge, and the gap (if any) between the blue and the black line thus represents free cash flow.

From the comparison above it is evident that Exxaro’s commercial coal mines would have a shortage of cash in the absence of Eskom shortfall funding. Two arguments can be raised to counter this claim. Firstly, the purpose of the coal sales agreement with Eskom is for Exxaro to remain value neutral, id est: in the absence of the agreed upon off-take from Eskom, Exxaro should be rewarded as if delivery of coal had taken place.

In terms of the agreement, or at least to the extent that it is public knowledge, Exxaro was to supply Eskom with 6Mtpa from 2013, and 6.2Mtpa from 2014, and Exxaro has been rewarded, as if they did.

But they didn’t supply it, and they didn’t mine it:

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The first counterargument therefore does not hold; the penalty received holds no relation to production costs incurred, which in turn holds no relation to actual production.

While it is not entirely clear whether and to what extent Exxaro will in future have to deliver on the undelivered already-paid-for coal, the effect of ‘value neutral’ agreement makes it clear that Exxaro expects that, going forward, it will be able to fund sustaining capital with cash from operations.

But, and this is the second counterargument to the claim that Exarro’s commercial coal business has a shortage of cash: Exxaro finances sustaining capital not from cash flows of operating activities, but through dividend income from equity accounted investments. Be it as weird as it may, let’s remove sustaining capital from the equation, and instead add dividends paid, which Exxaro do claim to fund with cash flows from operating activities.

It is assumed that the commercial coal business unit contributes to dividends paid in proportion to its contribution to total cash generated by all cash generating units. Then:

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It is apparent that Exxaro funds dividends with Eskom penalties, and sustains operations through dividends received. Having established that Exxaro’s commercial coal business unit is not self-sustaining, and does not contribute free cash flow to equity, we may assume that investors do not hold Exxaro shares because of Exxaro’s proficiency as a miner.

EXXARO THE INVESTOR

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THE GREEN LINE: The steady increase in net tangible asset value relates not to share price appreciation of equity accounted investments, but to capital expenditure on expanding operations. The sudden kink from FY2013 to 1H2014 relates to the impairment of the Mayoko Iron Ore Project in the Republic of Congo, which was written down from ZAR 5.1 billion to ZAR 62 million.

Exxaro reported the full historical cost of ZAR 5.8 billion as a pre-tax impairment loss, which includes ZAR 1.2 billion for locomotives, wagons, processing plant, and other equipment with a resale value.

This is what is called “big bath” accounting. If fully written down, why then forecast ZAR 300 million of costs for 2H2014, capital expenditure of ZAR 89 million up to FY2016, and subsequently extend the Mining Convention by a further two years? Going forward, expect a reversal, or pure profit.

THE BLUE LINE: Exxaro looks to be approaching a “Bargain” rating, as the blue line seems to be on its way to cross the green line. But the true story is written between the lines. For Exxaro to achieve its strategic goal of a USD 20 billion Market Capitalization by 2020, the blue line should be positively correlated with the green line, and that is only possible through concomitant earnings growth. Perhaps better expressed as:

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This is not a good investment track record. The Cash Flow statement tells the same story, but provides different insights:

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The cash shortfall is debt funded and going forward let us not expect cash balance after investing activities back in the black over the medium term. Downward pressure will be experienced by less generous dividends from Sishen Iron Ore Company, as well as the Eskom Penalties that will need to be supported by increments in actual production. These are givens.

What remains to be seen is whether Exxaro will be able to:

Generate Free Cash Flow from Operations, which it is currently unable to do.

Pay dividends it can afford, which it can from investment income, but not from operations.

Reign in capital expenditure on expansions, investments, and acquisitions.

In terms of the last point, Exxaro has communicated that it does not intend to partake in further funding on the Vedanta Black Mountain mines expansion, a move towards the conclusion of their so called ‘strategic divestment’ from base metals, which started with the shut-down of Zincor, South Africa’s only zinc smelter, and the sale of the Rosh Pinah mine.

The company has also been warned that further investment in Tronox may be value destructive, but Exxaro is yet to communicate an investment decision. Exxaro’s portion of equity finance for the Cennergi wind farms, currently under construction, is estimated at ZAR 900 million, and company guidance on expansion capital for coal projects through to FY2016 is given as ZAR 7.3 billion.

Current undrawn debt facilities are ZAR 9.4 billion, of which ZAR 5.4 billion has been ring-fenced for its latest acquisition.

THE TOTAL COAL ACQUISITION

Exxaro announced a purchase consideration of USD 386.5 million (ZAR 4,135 million at time of announcement) for the issued share capital of Total Coal SA, and USD 85.5 million (ZAR 915m) on outstanding loan claims. This buys them a 74% interest (Mmakau Mining holds the remainder) in the Dorstfontein and Forzando mines near Witbank, for 1.5 billion tonnes of coal in situ, for a 395Mt ROM Resource, thermal coal production capacity (mostly export) of circa 5Mtpa, as well as additional Richards Bay Coal Terminal allocation of 4Mtpa.

Total Coal SA made a loss of ZAR 55 million for the year 2013, but if we adjust stated EBITDA of ZAR 347 million for once-off rehabilitation costs of ZAR 270 million, and assume 7% interest on existing debt, indicative earnings are ZAR 398 million. Exxaro will therefore be paying approximately a 12x multiple on earnings.

TCSA’s Net Asset Value at year end 2013 was ZAR 2.4 billion, which means Exxaro will be paying a 72% premium to book value. The terms of the acquisition provide that all risk and reward inherent in TCSA will transfer to Exxaro from 1 January 2014 but the transaction is only expected to be concluded 1H2015.

RATIONALE FOR THE ACQUISITION

On 28 July 2014 Exxaro communicated to the market that a rationale for the acquisition is the fact that: “Exxaro currently leases entitlement from other operators in the industry in order to meet its export requirements. The Acquisition will allow Exxaro to utilise Exxaro controlled entitlement to meet its export requirements in future.”

Whether this statement is the result of negligence, or intended to obfuscate is difficult to discern. ‘Export requirements’ are not defined, but it is certain that Exxaro are not meeting their export entitlement from export thermal production from Grootegeluk alone, its only operation producing export thermal after the cessation of activities on New Clydesdale Colliery. Thermal export buy-ins for 1H2014 amounted to 1,033kt.

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Exxaro’s current allocation at Richards Bay Coal Terminal is 7% of port capacity of 91Mt, for 6Mtpa coal exports. However, given Transnet Freight Rail capacity to the port, Exxaro’s export entitlement is in the region of 4Mtpa (actual RBCT allocation as a result of the TFR bottleneck is not made public). After the Total Coal SA acquisition, Exxaro’s allocation of port capacity will be 11.5% for about 10Mtpa, but given TFR maximum capacity of 74Mtpa, be entitled to about 7Mtpa.

Assuming the Total Coal SA assets are able to at least fill its own export entitlement, Exxaro will be in no different position post acquisition. High volume buy-ins erode average margins, even more so at low export prices, but not being able to utilise export entitlement may lead to penalties, which Transnet has threatened to impose in the form of take-or-pay agreements after a multi-billion Rand investment to expand its capacity to port.

It is clear then that Exxaro’s acquisition of Total Coal SA has nothing to do with export entitlement, but everything to do with product mix:

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Cash Margin on Average Tonne is the actual margin achieved per average tonne based on Exxaro’s current product mix. Cash Margins on Thermal Exports are illustrative, and takes into account theoretical rail costs, cash cost of production per average tonne, and actual prices received for thermal exports.

It makes sense then to add Total Coal’s circa 4.5Mtpa of Export Thermal to the mix, for the simple reason that Witbank is much closer to port.Bar any potential hiccups, not explored here, the Total Coal acquisition may be Exxaro’s best strategic investment decision yet.