Things have been moving rather fast in South Africa. When Mark Ingham and I spoke on Thursday, Finance Minister Pravin Gordhan had been recalled from London and his firing was still a rumour. But the advice offered by this leading independent investment analyst holds true – beware of interest rate sensitive stocks and steer clear of SA bonds. The meat of this interview focuses on Sasol. Mark has recently returned from a visit to the company-transforming investment the group is making in Louisiana. The $11bn project, touted at the time as the biggest foreign industrial investment into the US, has had its fair share of problems. Now, for the first time since it was announced with such fanfare, there is some light at the end of this particular tunnel. And it’s not an express train heading towards investors. – Alec Hogg
Mark, you’re just back from the US where you have been having a look at the huge Sasol project at Lake Charles, but before we get into that, you came back home on Monday to find the world had changed…..
Yes, Alec. I was on the taxiway at OR Tambo. I looked at my phone and the exchange rate and saw that it had gone vertical and I guessed that there had been a political disturbance because these market movements that are that sharp tend to coincide with political turbulence that we’ve become accustomed to, not least, since Nenegate and sure enough, the calling back of Mr Gordhan was, to say the least perplexing, Alec.
The Rand’s went from R12.45 on Friday to R13.12 on Monday. What are you advising to people who have money invested in the stock market as a result of this kind of volatility?
I’ve been saying to people, particularly since Nenegate late 2015, that you should really be quite cautious of exposure to interest rate sensitive stocks, not least banks. Alec, and I think you and I have had a chat about this previously. The sensitivity of the valuation to where long bonds are is such that when you do get political disturbances of this nature which has in fact, real economic consequences ultimately, means that you can have share prices move quite sharply very quickly. If you’re in a geared position such as contract for difference for example, you can lose a lot of money quite quickly. I think it’s different if you’re in a long only fund and you take a particular asset allocation decision insofar as financials go, you’ll probably ride through that, but insofar as any short-term positioning is concerned, I’ve been particularly cautious about banks and I’ve felt for a while that there’s been this unseemly calm and I’ve been waiting for some disturbance to break that calm.
I think it was only a matter of time and we certainly have that on Monday. So, just reiterating caution on exposure to the interest rate sensitives and we saw that certainly Monday where the long bonds bite, not quite as much as we saw with Nenegate. I think that was quite a shock event. To a certain extent, markets have been pricing in the anticipation of yet further shenanigans on the political front and so it isn’t over yet. We still don’t know what’s going to happen and there could be further shocks in the system.
It does look like there’s going to be a new Minister of Finance. When the announcement is made, is it likely that the currency and interest rate sensitive shocks would react or are they already discounting that.
I think the scope for further shocks, depending on the outcome and Alec, I think you’ve written some very useful insightful pieces on this topic, so as things stand, we don’t know the granular detail around what’s going to emerge and so with that in mind, we need to see how the political landscape evolves in the coming days and then markets will settle accordingly, but I think we should prepare for a rocky ride in the short-term.
It’s not just South Africa where geopolitics are playing a big role. All over the world now we’ve seen the Trump play as they call it in the United States running out of steam eventually, but you’ve just come back from Trump Land indeed, from having a look at the biggest foreign investment, that’s the way it was billed anyway, in that country and it’s from a South African business, Sasol and it is a chemicals plant that they’re putting together at Lake Charles. Now, just to go back a little bit, so far, the news out of this chemical plant has been pretty disappointing, cost overruns, it was also questionable whether the timing was right etc. How are you reading it?
I first was there a couple of years back, almost exactly two years ago, and I saw over 2 000 acres of empty land which was in the process of being cleared and what you have now is a very impressive project, a mega project by any standards, almost like a second Secunda, if we can put it in South African contextual terms. So, the engineering work, the construction work is truly impressive. There’s a very large team on site of workmen in various experts, so this colossus rising from what was vacant land only two years ago,. There have been delays, Alec, weather related and various other things, as you correctly mention, there’s been cost overruns to the extent of 25% in Dollars, which means that the project is going to be $11bn now excluding working capital. However, we should see the project coming on stream in about 2018 with the first contribution to earnings in round about 2019 and then ramping up to optimal profitability in round about 2023/2024.
What is the Sasol market capitalisation today, how much is the whole company worth?
The market cap at the moment depends, it’s a bit of a moving target at the moment, but if we take the current rate, it’s probably about R225bn, so depending on where the currency is at a point in time, we’re looking at $17bn market capitalisation. That puts Sasol in the smaller league, let’s put it that way. If you had to compare it with some of the oil majors like Excon for instance, but I think what was quite interesting to me at the [inaudible] Alec, was the degree of interest by US based fund managers and US analysts in the project. I think it’s really crystallising now, it’s right on their doorstep.
I think the differentiated product offering that Sasol is going to be having and therefore, the higher value added that will emanate from this chemical plant, I think is certainly raising interest in the United States. That I think is a positive development insofar as your market cap comment is concerned, my sense is that Sasol is undervalued to a large degree. Possibly as time goes by, we may see a benefit of the doubt premium coming in with at least some portion of the earnings and value being reflected in the share price, even before the project comes on stream fully.
Where I’m going with this is you have an $11bn project for a company that has a $17bn market cap, so it is huge in the Sasol context, on top of which, it’s outside of the country, which is not always that easy to manage. What’s the impact likely to be though, if you look five years down the line when this project is steady state and delivering all the chemicals that everybody hopes it will all, rather what it’s been planned to do? What I mean here is that Sasol’s always been vulnerable to the Rand price of oil, so it’s got a Rand exchange rate and the oil price and those determine the profit. How much of a difference is it going to make once this plant comes on stream?
Okay, Alec, that’s a very important point because the gearing is going to rise as time goes by. Certainly, by 2019 or so, we’re going to be looking at peak gearing, probably about 44% or 45%, it depends on the assumptions which you make, but that’s my kind of number.
So, lots of borrowings all of a sudden on the Sasol balance sheet at that point?
Yes, correct and it’d going to be ramping up to quite a large degree over that period and you’ll see particularly, Alec, this year onwards, that debt level is going to increase quite sharply. I think net debt’s going to peak, probably about the R100bn number in 2019 and as a consequence, Alec, you’ll also see the interest expense and the depreciation charge rising sharply, but although peaks are what seems to be quite a high number, particularly in relation to that market cap figure that I’ve just shared with you. It starts to de-gear pretty quickly after that because these projects tend to be fairly cash generating once they get cracking literally and this a cracker.
So, once they push the button on beneficial operation, you’ll start to see this as pretty cash generating and therefore, we would anticipate the gearing level coming back sharply. I think South African investors, Alec, don’t need to concern themselves too much. Bear in mind that this is offshore debt, it’s Dollar debt that’s been secured offshore at relatively good interest rates. It is backed by US Dollar cash flows revenue and so it’s largely ring sends to the project, so there is no foreign exchange or indeed, balance sheet concerns insofar as the domestic operations go.
When it comes on stream, how much is this plant going to be able to diversify Sasol’s earnings away from that vulnerability to the Rand oil price/
It[s going to be quite a lot Alec. As you correctly point out, historically, Sasol has been priced in the stock market, very much in line with where Brent crude is and the Rand/Dollar exchange rate and I have charts going back over a number of years that show this relationship fairly well. The share price typically tends to move in a ratio of 50%-60% of the movement in the Rand price of a barrel of oil and there is a close relationship too between the Rand price of an oil barrel and the earnings. It’s roughly a five times multiple, so the relationships are established, they are intact. What this project does, is threat it diversifies Sasol away from, it’s a sort of traditional revenue stream and business model.
It makes it more of an added value manufacturing company with a growing chemical sort of aspect to it and it certainly means that the Dollar income that will be derived will increase sharply from where we are at the moment. So, I’m of the view and again, it depends on the various assumptions that you make, that this project could lower the oil price sensitivity by at least 15%, it could lower the currency at some sensitivity by approximately 25%. That’s a function of the fact that the non-South African earnings will increase and therefore, I think that should bring a degree of stability to the share price that we haven’t always seen because of these two key outside variables.
Oil is still important or the crude oil price because Sasol sells its petrol based on the oil price. What do they internally believe the oil price is going to do?
They’ve been making some assumptions, Alec. You have to make assumptions when you go into a decision of this magnitude and the sort of assumptions that they’ve been making is that oil probably would be closer to $80. I think that’s probably on the high side, I think it’s probably more likely that $50-$60 is likely. There was a conference, in fact, coinciding with this recent visit and the general view was that oil’s going to be lower for longer and that certainly, when it comes to shale, the price at which break-even, brings new rigs out in terms of the market, is close to the $40 mark now.
Mark, does Sasol still have shale interests?
Yes, they’ve written off those assets that they were exploiting, Alec. So, shale is not going to really be featuring in their life to any great extent or on the future group strategy going forward.
However, the reality is the other shale operators, as soon as the oil price goes up above $50 a barrel, they’re back in business again, un-mothballing their operations and that would presume that it puts a cap on the upside of the oil price.
Yes, that’s right Alec. With various leading energy consultants looking at break-even price for shale now, it’s about the 42 level and probably even falling. The US is going to have a plentiful supply of low-cost gas to the various consultants are targeting somewhere around the 400 cents per BTU level for a number of years. There’s as positive view on the Olefin market – particularly ethylene. I’ve been doing the modelling insofar as the feet stock is concerned for this plat that’s gas at around 450 cents per million British thermal units, so the current pricing at [?] is round about 300, Alec and insofar as the Sasol assumptions go, I’d be fairly comfortable with those assumptions. I think they’re looking at about 300 cents.
I think that’s a fairly realistic number and it actually underpins the economics of the Lake Charles Project going forward, but as I say, I think their assumptions for oil are probably a little on the rich side. Again, we can’t be entirely sure as to where oil pans out, but I think given the changing energy dynamics in the United States, the chances of oil getting back to say 100 or more where we were not too many years ago is probably slim, Alec.
Having gone there now and looked around, kicked the tyres, as it were, at Lake Charles, those cost overruns that Sasol had to take on the nose some months ago, are they behind now, are we far enough into the project to know the number they say it’s going to cost, i.e. the $11bn is the right number?
Yes, that was a question I think that has been on many analyst’s minds, Alec and you know, we’re looking into the whites of the eyes of management and getting them to justify as to whether or not these are robust figures and in fact, the word ‘robust’ was used more times than I can care to recall and there has been a number of aspects that have caused it. Just to take one example, they’d had to buy 1 300 or 1 400 railroad cars and that’s been a sizeable expense.
Therefore, once you add all this up and they’ve been quite detailed as to where they started and where the cost overruns originated from and I think one can be fairly comfortable that if we take sites and civil costs, if we take the increase in ECPM, contractor costs, the increase in labour costs, those are the main component pieces that have taken the number, Alec, from $8.9bn to $11bn. I think if we stack those up, it’s fairly clear to us now that the number is pretty sound. It does mean that the cost of capital – the return that they will get – is probably going to be about 8%. That’s an internal rate of return, Alec. They talk about in excess of [unclear 0:19:13.8] which is 8%. I think it’s probably more likely to be at 8% or less, but that also depends on the pricing of ethane and various other energy component pieces as well.
Yes, so you can start getting really complex when you go into those things, but Mark, overall when you now look at the Sasol share price at around about the R350 a share level, is it offering value?
Yes, it is. I Think the stock has been under-priced for quite some time. I’m on record as saying that any price down to R350.00 or so is offering real value for money and in fact, we’ve seen, as I’m talking to you at the moment, the share price is up to R387.00 and you know, I’ve had a fair value on the stock of at least R400.00. If you start to build in, even a relatively modest future outlook on Lake Charles and the earnings contribution, the geographic diversity that it’ll bring and various other aspects, you could easily justify up to R500.00 and that’s with the Rand at these sort of levels with the oil at these sort of levels, so certainly, anything below R400.00 offers real value, Alec and then there is that blue sky element that I think is starting to become less blue sky now.
I wrote a note back in 2015 about whether Sasol was betting the farm and at that stage we didn’t even know that there’d be cost overruns to the extent of $2.1bn and so I think there was that concern and hence, the farm analogy, but I think as time has gone on and we can start to get a better sense of the reality on the ground and the fact we’ve got to take it as given that that $11bn is effectively spent. However, I think you know, as time goes by and we see this with all megaprojects they tend to have overruns, but in time people forget the capital cost as the cash starts rolling and so I think in a few years’ time once the cash is coming in and it’s going to be fairly meaningful.
You know, you’re looking at incremental EBITDA of at least R120bn depending on the exchange rate that you use in 2019/2020 and that’s going to go up and I’m talking incremental EBITDA here. That’s going to be, probably about 20 in 2021/2022, somewhere in that region. So as you move forward you know, this is going to be a $20bn additional EBITDA business to the groove, which is substantial in relation to the group at the moment, just as a reminder to the listeners Alec, EBITDA in 20016 was $40bn, so we’re talking a project over here that incrementally is going to add to Sasol’s earnings materially as time goes by.
So, Sasol shareholders can sit back, not worry about it, Mark Ingham has been off to the United states to Louisiana to see whether they are wasting money and they certainly aren’t and you’d be happy to put them in a bottom drawer and hold.
I think so, we’ve reached a point, certainly the price getting down to the R350’s where you really are bottom fishing, Alec. There are risks, but you can look at scenarios and I’m giving you here, I think what is a realistic scenario and I see it adding at least R10 earnings to share per share in the early years, roughly a R10 earnings per share. Again, to put that in context, the business this year is probably going to be generating an EPS of R34 per share, so the additional EPS is certainly going to be there. The degree to which it’s going to be there is dependent on a number of variables, but I think the factors that are within management control and this is always very important when one assesses a business, what’s within management control and are they able to do that well? I feel very comfortable.
There’s an absolutely top team in place there including some great South African expats who are doing a really great job on the ground, working closely with their US colleagues. This is a project of immense scale, of incredible intricate complexity and so yes, we can talk to the numbers, the engineering, I think is certainly robust, the technology is proven. Quite a bit of the technology is very much own Sasol technology as well, so I think from a shareholder point of view, yes there may be short-term concerns, but I think if you take a longer run view, this is a stock you would want to own.
- Mark Ingham is an Independent Investment Analyst and this special podcast was brought to you by Easy Equities.
