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Lonmin plc Q3 update: does this valuation still make sense?

Lonmin plc Q3 update: does this valuation still make sense?
Lonmin underground mine (copyright Lonmin)

Lonmin underground mine (copyright Lonmin)

Disclosure: At the time of publication, I own shares in Lonmin.

Lonmin shares have tripled in value in just seven months.

I’ve become increasingly aware that unlike the other big miners, Lonmin’s share price recovery is not backed by rising profits and substantial balance sheet improvements.

After such rapid gains, I thought it was worth taking a fresh look at the stock following yesterday’s Q3 update. I’m concerned that Lonmin’s financial progress may be slowing.

The company warned that full-year costs are now likely to be between R10,400 and R10,700 per PGM ounce, up from guidance of R10,400 per ounce previously. The rand also appears to be gaining strength relative to the US dollar.

In this article I’ll ask whether Lonmin’s market cap still makes sense. Is the risk/reward balance still favourable for equity investors?

How to value Lonmin?

Profits? Lonmin’s lack of profits makes valuation more difficult. Looking back at the group’s historical performance isn’t hugely helpful either. Between 2010 and 2014, Lonmin generated an average post-tax profit of -$9.4m. During this period, platinum prices were mostly higher than they are today.

The picture that emerges is one of unpredictable profitability driven by platinum prices, the USD/ZAR exchange rate and poor cost control and labour relations.

Book value? How about the value investor’s favourite metric, book value? Lonmin’s last reported book value was about 510p per share. The stock currently trades at a discount of more than 50% to this valuation.

However, as with the UK’s banks, a distinct lack of profits could mean that Lonmin trades below book value for a long time yet. A P/E of 20 — not unreasonable for a recovering cyclical business — would imply a net profit of $95m.

On the same basis, the current share price of about 230p implies a net profit of about $43m. Yet consensus forecasts suggest a loss of $17.9m this year and a profit of just $1.4m next year.

I fear that there’s a big gap between the performance implied by Lonmin’s current valuation and the reality.

PGM prices vs. exchange rates

Lonmin’s profits could rise sharply if the price of platinum continues to recover. This could well happen, as the white metal remains well below levels seen in the past:

IG Index 5yr platinum chart

Platinum prices over the last five years (source: IG)

However, recent gains in platinum — which has risen from $1,009/oz to $1166/oz since the start of July — have not resulted in rising forecasts. In fact, the consensus view has edged slightly lower, with the Reuters consensus forecast loss per share dropping from $0.15 to $0.19 at the start of August.

One reason for this may be the USD/ZAR exchange rate, which now appears to be moving against Lonmin:

IG USD/ZAR price chart

1yr USD/ZAR price chart (source: IG)

Exchange rates are at least as important as PGM prices for Lonmin. Yesterday’s update confirmed this view. Consider these figures, which represents 2016 and 2015:

Average prices $ basket incl. by-product revenue $/oz 796 907
R basket incl. by-product revenue ZAR/oz 11,864 10,861
Exchange rate Average rate for period ZAR/$ 14.99 12.08
Unit costs Cost of production per PGM ounce ZAR/oz 10,596 10,839

Data from Lonmin Q3 2016 Production Report

The USD PGM basket price has fallen by 12% over the last year, while the same basket priced in rand has risen by 9%.

This kind of swing is one of the reasons Lonmin’s historical profits have been so volatile. As a matter of policy, Lonmin’s doesn’t hedge commodity price exposure. Nor does the group have businesses in other countries which act as natural hedges.

Thus long-term survival is dependent on having low cost assets and building up a big cash pile when times are good. I’m not sure Lonmin’s track record of three rights issues since 2009 supports such a confident outlook for equity investors.

What about cash flow?

Ultimately, a business is only viable if it can generate positive cash flow.

Last year’s $407m rights issue left Lonmin with net cash of $69m. At the end of Q3, that figure had risen to $91m, suggesting positive cash flow of $22m so far this year. This figure may have been distorted by working capital and forex movements, so I’ve done my own sums.

Using Lonmin’s published figures from H1 and Q3, I estimate that the firm has generated operating cash flow of around $40m so far this year. After three quarters, Lonmin appears to be some way short of covering this year’s planned capex of $105m — which is the bare minimum necessary to maintain and improve current operations only.

Lonmin expects the fourth quarter to be the strongest, but warned in yesterday’s updates of a number of factors which “have the potential to interfere with production” during this period. These include local government elections and wage negotiations.

My verdict

Lonmin has clearly made a lot of progress since its rights issue. Chief executive Ben Magara appears to be doing a good job of transforming and maximising the potential of the business.

I believe Lonmin does have the potential to become free cash flow positive and profitable. But I can’t avoid the conclusion that this outcome is heavily dependent on unpredictable PGM prices and the USD/ZAR exchange rate. There’s also the risk that costs will creep up again. Lonmin appears to be at the mercy of factors it cannot control to a greater extent than some other miners.

A second concern is that Lonmin’s valuation appears to price in a return to levels of profit that are an order of magnitude above current forecasts. I suspect further share price gains will be as much down to good fortune as good management execution.

On that basis, I’m going to sell my shares in Lonmin.

Update 1/9/16: Perhaps this is another reason to sell.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.