A tunnel in a deep mine

Is Lonmin becoming a contrarian buy?

A tunnel in a deep mineDisclosure: At the time of writing,I do not own shares in Lonmin.

So the dust has settled and Lonmin shares now trade at just over half their theoretical ex-rights value of 1.2p, or 120p after taking into account this week’s 100:1 share consolidation.

I promised to take another look at the stock after the rights issue was completed, so here goes.

Book value trap

It’s tempting to say that because Lonmin now trades on a price/book ratio of about 0.2 and has very little debt, it must be a bargain.

The problem is that the book value of the firm’s mines and platinum reserves is dependent on their commercial viability. If Lonmin can’t find a way of making money from its mines (or persuade someone else to buy them) then they are potentially worthless.

Thus the firm’s massive discount to book value, while relevant, is not a standalone reason to invest, in my opinion.

What I’ve done instead is to consider what’s changed since the last time Lonmin reported a profit, which was in 2013. In that year the firm reported a post-tax profit of $166m. At today’s share price, this would equate to a P/E of 1.2! I’d argue that a sustainable profit of even one-tenth this amount would be enough to justify the current share price.

Can Lonmin make a profit again?

Leaving aside the strike-related disruption Lonmin has experienced since 2013, there are three main variables which govern the firm’s profitability (or that of any mining firm, come to that):

  • Foreign exchange rates — commodities are generally sold in USD but production costs are paid in local currencies, in this case ZAR (South African Rand);
  • Commodity prices — the price of platinum group metals;
  • Operating costs, principally labour and energy. Labour costs are paid in local currency, but energy may be either or a mixture. For the purposes of this discussion, I’ve included factors such as ore grades within operating costs — after all, the cost of producing metal tends to rise and fall with ore grades.

Currency effects

Emerging market currencies have tended to weaken against the US dollar over the last few years. The South African rand is no exception and the exchange rate has changed significantly (figures taken from Lonmin’s reported full-year averages for y/e 30 September):

  • 2013: ZAR/USD = 9.24:1
  • 2014: ZAR/USD = 10.55:1
  • 2015: ZAR/USD = 12.0:1
  • Today: ZAR/USD is currently c.15:1

In other words, $1,000 of platinum sales in 2013 generated ZAR9,240.

Today, it would only require $616 of platinum to generate revenue of ZAR9,240.

Platinum price

Platinum isn’t mined in isolation — miners such as Lonmin typically produce platinum group metals (PGM). These are platinum, palladium and rhodium. Lonmin typically focuses on the PGM basket price in its reporting, rather than simply the price of platinum.

Here’s how the PGM basket price has changed over the last three years:

  • 2013: $1,100/oz
  • 2014: $1,013/oz
  • 2015: $849/oz

However, when the effect of the ZAR/USD exchange rate is included, the average PGM basket price has remained much more stable:

  • 2013: ZAR10,614/oz
  • 2014: ZAR10,687/oz
  • 2015: ZAR10,188/oz

The improving exchange rate wasn’t enough to offset falling PGM prices in 2015. But whereas the USD PGM basket price fell by 16% in 2015, the ZAR value of the PGM basket only fell by 5%.

But here’s the interesting bit…

In late December 2015, the USD prices of platinum and palladium are about 20% lower than the averages reported by Lonmin for last year. If we assume that the group is working with a PGM basket value around 20% lower than last year, this works out at about $680/PGM oz.

However, the exchange rate has also changed. As I write, the rate is about 15.1:1. This gives a PGM basket price of about ZAR10,200. In other words, exactly the same as last year.

What about costs?

The final factor in our trio of variables is costs. Lonmin’s old, deep platinum mines are notoriously labour-intensive and costly (and dangerous) to mine. As a result of the industrial unrest over the last couple of years, Lonmin has, like most other South African deep miners, increased pay rates for mine workers. (Deservedly, in my view).

However, the firm has also reduced the workforce and announced plans to shut various shafts to focus production on the lowest-cost areas of its mines.

The most sensible way of viewing costs is probably to consider Lonmin’s reported production costs for the 2015 financial year, which were ZAR10,339 per PGM ounce. At the current exchange rate, that’s $684 per PGM ounce.

This suggests to me that the price of PGM metals would only have to improve by a small amount to enable Lonmin to breakeven at an operating cash flow level.

Unit costs are expected to be relatively flat at c.ZAR10,400 until 2018. However, the firm also that it is targeting workforce and overhead reductions of ZAR700m in 2016 and of ZAR1,600m in 2017, which could help achieve breakeven.

What could go wrong?

This article is getting quite long, so I’ve condensed this section into a list. These are all known unknowns, in my view — risks that investors have little way of quantifying:

  • The exchange rate could move against Lonmin
  • Further industrial unrest
  • What is the state of global PGM stockpiles?
  • How healthy is platinum/PGM demand?
  • How will PGM prices move from here?

Clearly there are risks, but it seems to me that Lonmin has a reasonable chance of getting into a situation where it can breakeven and generate a modest profit. In my opinion, such proof of the firm’s viability might be enough to trigger a substantial rise in the share price.

Although I think Lonmin remains risky, I also think the platinum sector may be moving into contrarian territory. I am considering a small buy.

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.

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