Interactive Investor

Stockwatch: Ugly duckling gold miner becoming a swan

13th March 2020 11:18

Edmond Jackson from interactive investor

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Broadly positive about gold on a medium-term view? Then this share is an attractive means to play it.

“Dr Doom” has had a good week. Nouriel Roubini, the New York University economics professor who shot to fame as one of few who predicted the 2008 crisis, warned on Sunday that coronavirus would send stocks and oil into freefall. A one-two punch including an oil price war represents “a perfect risk-off storm and a true signal of upcoming global recession.”  Buy gold and low-risk bonds.

His gold tip has yet to show prowess, getting hit at times in the general mayhem. It’s quite a repeat of the 2008 crisis where, in a major sell-off, all asset prices tend to get hit, including precious metals, as traders are forced into liquidations. But I suspect he is broadly right for the medium term if panic leads to recession and a search for alternative assets.

Gold’s rise from a $1,373/ounce low last December to about $1,570 currently will be broadly sustained and of use to those miners, having just completed a wave of capital investment and poised to ramp up output.

Finally, a re-birth with strong growth prospects

Petropavlovsk (LSE:POG) is a prime example. I’ve followed this now £640 million Russian gold miner listed and headquartered in London, its operations in Far Eastern Russia, for nearly two decades: its trials and tribulations.

The shares are nowadays just 16p, albeit with just over 3.3 billion shares issued as a result of a 157 for 10 highly dilutive rights issue five years ago. Yes, there’s a chequered past but the underlying company has moved substantially on – being well-positioned to capitalise on higher gold prices.

Price was actually down near 8p last springtime, and a run that started in the autumn appears broadly to align with gold’s rebound. Analysts at Peel Hunt just recently raised their target from 16p to 22p which mirrored the stock’s performance up to 5 March, since when it has dropped back to 16p.

But I suspect this is yet another example of brokers having their finger in the wind, and there’s another more interesting rationale for longer-term investors.

Source: TradingView Past performance is not a guide to future performance

Petropavlovsk has completed an extensive period of investment, culminating in a high-capacity Pressure Oxidation (POX) hub becoming operational from end-2018. This is a game changer because Russia has substantial quantities of “refractory ore” i.e. with fine gold particles disseminated throughout that’s resistant to standard extraction and constitutes around 60% of Petropavlovsk’s resource base.

Stake-building underlines a technological edge

Two Russian gold industry operators have bought in: last October, a 4.6% stake by Fortiana Holdings, Russia’s fifth-largest gold producer; then in early February the Uzhuralzoloto Group picked up an assertive 28.34%, close to what would trigger a mandatory offer to the rest of shareholders under London listing rules. This is another of Russia’s top five producers with substantial refractory gold ore assets, as if there’s a game plan to run them through Petropavlovsk’s POX hub.  

A 10 February regulatory news update on Uzhuralzoloto’s stake proclaimed: “a strong endorsement of our strategy and operational success…(and) our ongoing focus on delivering shareholder value by maximising cashflow…optimising capacity at our POX hub…we look forward to exploring the potential for future cooperation to ensure the continued strong growth of  Petrovavlovsk’s share in Russian gold mining…”

A second key factor in the bull case is this operational advance coinciding with gold price hedges coming off at the end of 2019, enabling Petropavlovsk to capture full benefits of a higher gold price environment. So, if one’s broadly positive about gold on a medium-term view, this share is an attractive means to play it (than say, an Exchange Traded Fund exposed to the mineral).

Possibly, Uzhuralzoloto is taking a pragmatic line with this minority stake, seeing exactly what benefits accrue. Yet it’s a substantial commitment, potentially as a springboard for a takeover if things go well, reducing its average cost with a sub-20p/share entry for just over a quarter of the company. Notwithstanding inherent uncertainties of mining, I regard this stake as key intrinsic support versus near-term gold price fluctuations.

It follows Petropavlovsk’s Russian CEO buying 17.4 million shares at 13p representing 0.53% of the company. I’m surprised to read that this is his total holding – i.e. a maiden purchase – but, if so, then it looks like he’s astutely caught the bottom, also in terms of shares becoming available. Institutions have churned holdings albeit with VTB Bank (Europe) accumulating 9.06%. 

Petropavlovsk - financial summary            
year end 31 Dec            
reporting in US$ 2013 2014 2015 2016 2017 2018
             
Turnover ($ million) 1,200 865 600 541 587 500
Operating margin (%) -39.0 6.0 -13.4 14.2 17.1 24.7
Operating profit ($m) -468 51.7 -80.1 77.0 100 123
Net profit ($m) -513 -261 -239 33.7 37.0 24.5
Reported earnings/share ($) -0.93 -0.34 -0.07 0.01 0.01 -0.01
Normalised earnings/share ($) 0.21 -0.30 -0.06 0.01 -0.01 0.01
Operating cashflow/share ($) 0.38 0.31 0.03 0.01 0.04 0.07
Capex/share ($) 0.64 0.36 0.03 0.01 0.03 0.04
Free cashflow/share ($) -0.26 -0.05 0.00 0.00 0.01 0.03
Cash ($m) 171 48.1 28.2 12.6 11.4 26.2
Net debt ($m) 948 930 610 599 585 568
Net asset value ($m) 860 549 493 554 556 590
Net assets per share ($) 1.57 1.00 0.15 0.17 0.18 0.18
             
Source: historic Company REFS and company accounts            

A basis for debt and credit ratings to improve

Debt has in past years been a millstone around this company’s neck, and the end-June 2019 balance sheet showed financial gearing towards 100% - $100 million near-term debt and $500 million longer-term versus $39 million cash, on a balance sheet with $603 million net assets. Net gearing had reduced from 105% to 93% over 12 months; not much, albeit before the POX technology and higher gold prices (minus hedges) are able to kick in for cash generation. As of the first half of 2019, interest charges took 65% of cash generated from operations.

In passing, I would also note from the last balance sheet that intangible exploration/evaluation assets were just $48 million versus $1.1 billion property/plant equipment, i.e. there is no big whack of dubious intangibles able to get written off.

Admittedly, the current ratio (of current assets to current liabilities, for near-term liquidity) was 0.9 due to trade payables being 2.6x receivables and $30 million derivatives also weighing. The derivatives entry (note 16 in the statement) relates to hedging, so should disappear. It is not unusual for payables to skew, but this looks like a sign that cash flow has lagged amid other priorities.

Nevertheless, in the second half of 2019 credit ratings agencies upgraded Petropavlovsk to Positive and a B- rating – based on progress made towards stronger operating performance, improved liquidity, stronger governance and potential to reduce leverage meaningfully from 2020.

Given such agencies are prone to be somewhat “rear view mirror”, requiring firm proof of change, I suggest ratings will improve further with the cash flow position poised to re-rate.  Operational cash flow was a chunky $283 million for 2018 overall, versus £50 million in the first half of 2019, albeit substantially due to an increase in trade debtors.

30% increase in gold sales guided for 2020

A sales and production report for the fourth quarter of 2019 and full financial year, cited a 39% increase in 2019 gold sales to 514,000 ounces, helped by the first year of operations at the POX hub, of which 92% was self-mined and achieving an average realised gold price of $1,395/oz.  

Guidance for 2020 was up from 620,000oz to 720,000oz, including third party concentrates - a median 30% increase. Capital expenditure was guided at $65 million to $75 million which, admittedly, isn’t dropping as yet.

The 2019 results (they were published on 24 April last year) may therefore re-assert a story of net-positive dynamics unfolding: an improving financial risk/reward profile. Petropavlovsk has in the recent past traded on derisory price/earnings (PE) multiples in low single figures, and there is no dividend, although eyes will likely be on this scope for free cash flow growth to keep cutting debt.

Another positive technical factor is inclusion in the FTSE 250 index from 23 March, on the basis of £674 million market value as of 3 March. Index funds’ buying won’t be unhelpful.

Residual country risk to bear in mind

It’s still Russia though, so while Petropavlovsk’s market value is a deep discount to other gold miners, comparing production scope, some investors will be cautious. Since the 2014 downing of Malaysian flight 17 over Ukraine and the 2018 Salisbury poisonings, alleged Russian antics have either quelled or morphed into claims of disrupting democracies with fake news.

Country risk appears to have reduced but, say if the oil price war with Saudi Arabia entrenches, who knows what next? Just be aware some extent of discount is likely.

Despite financial markets looking extremely uncertain I believe on a strategic view the stance is: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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