From Icarus to Phoenix - The Tale of A Gold Miner

| About: DRDGOLD Limited (DRD)
This article is now exclusive for PRO subscribers.

Daedalus fashioned two pairs of wings out of wax and feathers for himself and his son. Daedalus tried his wings first, but before taking off from the island, warned his son not to fly too close to the sun, nor too close to the sea, but to follow his path of flight. Overcome by the giddiness that flying lent him, Icarus soared through the sky curiously, but in the process he came too close to the sun, which melted the wax. Icarus kept flapping his wings but soon realized that he had no feathers left and that he was only flapping his bare arms, and so Icarus fell into the sea. (Source: Wikipedia.)

This classic tale of over-ambition leading to a painful and sometimes deadly fall quite often plays out in the business world. In the gold mining business, a former darling of the gold bugs stands as a monument to this cautionary tale. Luckily, there is sometimes a transition to a better future: the fall need not be fatal and new managers with a vision not clouded by a sentimental attachment to the ambitions of the past can turn things around. Then one can experience a Phoenix-like rebirth.

As Publius Ovidius Naso wrote about the Phoenix:

Most beings spring from other individuals; but there is a certain kind which reproduces itself. The Assyrians call it the Phoenix. It does not live on fruit or flowers, but on frankincense and odoriferous gums. When it has lived five hundred years, it builds itself a nest in the branches of an oak, or on the top of a palm tree. In this it collects cinnamon, and spikenard, and myrrh, and of these materials builds a pile on which it deposits itself, and dying, breathes out its last breath amidst odors. From the body of the parent bird, a young Phoenix issues forth, destined to live as long a life as its predecessor. (Source: Wikipedia.)

The company we are referring to was of course not 500 years old when it nearly expired; but, similar to the Phoenix, it has made a surprising comeback. We are talking about DRDGold (NYSE:DRD), formerly known as Durban Roodeport Deep.

A Checkered History

The company was almost ruined by two megalomaniac CEO's that managed the firm in the late 90's to the mid 2000d's. First there was South African mining magnate Brett Kebble, who actually ran quite a few gold mining businesses into the ground in his time. Kebble is better known today for the role he played in destroying Johannesburg Consolidated Investments and Randgold (not to be confused with Randgold Resources, which was a Randgold spin-off), but he was the CEO of Durban Deep as well. Kebble was a big fan of financial engineering, and he saddled the company with an enormous hedge book just as the gold price was approaching a major secular bear market low. The hedge might well have bankrupted DRD if nothing had been done.

Shareholders initially breathed a sigh of relief when Kebble was deposed and replaced by Mark Wellesley-Wood (MWW), who was imported from the UK. MWW appeared to have a vision more closely aligned with the ideas held dear by gold bugs: he believed that a bull market in gold was beginning. And so he was not only forgiven for diluting shareholders in order to close out the hedge book, he was actually feted for the decision – and rightly so.

Unfortunately, things began to go downhill from there. DRD owned a number of aging deep level mines on the East Rand near Johannesburg, such as Buffelsfontein, Hartebeesfontein, Blyvooruitzigt and East Rand Proprietary Mines (ERPM). The original Durban Roodeport Deep mine near Dobsonville had ceased operations in 1993 already. On the side, DRD was running the Crown surface gold reclamation business that re-treated the gold sands left behind by long closed mining operations on the East Rand.

The fact that these old deep level mines were all marginal high cost producers was what actually attracted investors and traders to the stock. The idea was that even a small rally in the gold price would lead to outsized increases in earnings, as the high fixed cost threshold was exceeded.

Let us illustrate this by way of a simple example. Say a miner was producing a million ounces per year at a cost of $300/oz. back in 1999. At a gold price of $300/oz., it would break even. At a price of $310/oz., it would make a $10 million profit per year. At a price of $400 oz., this profit would increase 10-fold, to $100 million. In short, a roughly 30 percent increase in the gold price would translate into a 900 percent increase in earning.

MWW and DRD's shareholders believed that the new gold bull market would turn the company's marginal operations around and help them to become highly profitable. However, before this promise could ever be fulfilled, a lot of unforeseen problems suddenly emerged. First the South African Rand did something it had not done since the late 1970s: it stopped falling and actually began to rise.

As a result, the gold price in terms of Rand stagnated in spite of the increase in the dollar gold price – but cost input inflation continued. Then the company's flagship operation – the Buffelsfontein/Hartebeesfontein mine (the two operations had been consolidated into a single mine) – suffered severe damage due to a major seismic event and it turned out that it was not economically feasible to reopen the mine. The operation was eventually sold for the symbolic amount of one Rand.

MWW's ambitions were however not deterred by the troubles of the South African mines. In order to mitigate the influence of the strengthening Rand, he decided on a flight forward – and began an ill-fated expansion of the company by investing in mines in the Australasia region: he bought a 20% stake in the Porgera mine in Papua New Guinea and the Vatukoula mine on the Fiji islands. DRD already ran a small epithermal gold mine in the Pacific Rim that had highly variable results and under Kebble's leadership had made an investment into an Indonesian mine, Rawas, which never made a profit and later turned out to have been a fraud.

Almost immediately after these investments were made, the mines DRD had bought ran into trouble. A landslide made the Porgera pit unusable for several months and Vatukoula suffered a skip accident. In the end, MWW had to resign and the new interim CEO John Sayers sold all the Pacific Rim investments (which had been consolidated under Emperor Mines). A decision was made to concentrate on the remaining businesses in South Africa: the Blyvooruitzigt underground mine and the surface tailings treatment operations. The ERPM mine's operations had also been suspended as the mine failed to make a profit.

Shareholders had gone through hell for several years:

Click to enlarge images.

DRDGold's share price over the past 10 years: shortly after Mark Wellesley-Wood took over as CEO, the share price exploded in the wake of the hedge book buyback and the initial rally in the gold price. Then things began to go wrong. The attempt to shield the company from the strengthening Rand by expanding into the Pacific Rim turned out to be an expensive failure.

Rebirth from the Ashes – Getting Out of Deep Level Mining

When new CEO Niel Pretorius came aboard, DRD was a much diminished company, but it had at least managed to survive the megalomania that marked MWW's reign, something that was for a time in doubt. For a while, the new management continued to pursue the plan put into place by Sayers; the surface treatment operation would provide a fairly safe positive cash flow, while the marginal Blyvoor underground operation would contribute an 'optionality' factor. Blyvoor was so to speak the embedded call option on a rising Rand gold price.

However, as often happens with old marginal deep level mines, Blyvoor soon turned into a major recurring headache as well. In the meantime, the company had begun to invest into a major expansion of its surface tailings treatment operations, which offered a much higher, and more importantly, much safer profit margin.

Eventually Pretorius had enough of the risk the underground operation posed. Why should the company continue to subsidize this risky and often loss-making operation when it could concentrate on the much more profitable surface treatment?

And so it was decided to sell Blyvoor, which was finally taken over by Village Main Reef this year, the company nowadays led by former Harmony CEO Bernard Swanepoel. Taking over marginal underground mines and leading them back to profitability is Swanepoel's specialty. This was how he transformed Harmony from a one-mine operation close to bankruptcy into one of the biggest gold mining companies in the world.

Apparently he is trying to reprise this feat with Village Main Reef, which was a small antimony producer at the time of his arrival. DRD has received payment in the form of Village Main Reef shares, which means it actually retains some of the underground 'optionality',while no longer having to deal with the headaches deep level mining invariably entails.

The end result is that DRD is now one of the world's leading surface gold tailings re-treatment companies – in fact, it is no longer a traditional gold mining company at all, although it retains the ERPM assets (ERPM extensions 1 and 2, a 21 million ounce fairly high grade underground gold resource; this operation may one day be listed separately) and is JV partner in a gold exploration company in Zimbabwe. A recent presentation describing the company's current business in detail can be downloaded here (pdf), the most recent earnings report is available here (pdf).

Profitability Restored

Not surprisingly, investor interest in DRD has dwindled as the company went downhill under MWW's leadership. The stock's triumphs and travails were once much talked about – it used to have a big fan base, which has basically disappeared these days. And yet, it is today that DRD is finally making good on its promises. It has been profitable for the past few years and even pays a respectable dividend.

Not only that, it is actually buying back its shares. This is a big change from the old days, when dilution of existing shareholders by issuing more and more shares for expansion and 'general business purposes' recurred with unwavering regularity.

Granted, the buybacks are small and only slightly exceed the issuance of shares used for share-based compensation of executives, but still, the share count is these days decreasing a little bit every quarter. It should also be pointed out that the buybacks make business sense, as the stock has been trading well below its net asset value for quite some time.

A Few Technical Observations

After having underperformed the rest of the gold sector by a huge margin between 2002 to 2008, DRD's share price has lately begun to outperform the sector noticeably. Slowly but surely the market seems to be waking up to the fact that the stock is quite a different investment proposition today compared to its past incarnation.

DRD's share price over the past three years (weekly candlesticks):

DRD relative to the HUI index – since August of 2011, it has begun to strongly outperform the gold sector at large:

Looking at DRD's share price perfomance relative to the HUI, we have noticed that the stock tends to move with a lag relative to moves in the Rand gold price. The effect can be seen on the chart below:

The DRD-HUI ratio and the Rand gold price. Rallies in the Rand gold price are bracketed by the vertical blue dotted lines, the subsequent rallies in DRD relative to the HUI are bracketed by the red dotted lines. As can be seen, DRD tends to rally with a lag following increases in the Rand PoG.

There can of course be no guarantee of a repeat performance, but it is nonetheless something one should be aware of. In fact, we have observed that the stocks of other South African gold mining companies also exhibit this lag relative to movements in the Rand gold price. This isn't something that has just begun to happen over the past two years; as it were, we first noticed the effect in 2001-2002.

A Unique Business

Here is an extensive interview with Niel Pretorius, in which he talks to Alec Hogg of Moneyweb about the company's overhaul and reemergence as a surface tailings retreatment operation. An interesting point he makes is that it would not be easy to replicate the capital investment to create a similar operation elsewhere – in a way, the company got very lucky as it was able to buy the ERGO plant cheaply from Anglogold. Also interesting is the fact that already treated tailing dumps can be retreated again, as long as they contain more than a quarter gram of gold per ton. The cut-off grade for DRD's ERGO plant is as low as 0.22 grams/ton these days. A brief excerpt from the interview follows below:

Neil Pretorius: […] It's very much a factory process, it's no longer really mining, it's all about maintenance or rather mechanised processing. You've got very little in the way of maintenance capital because all your capital is spent upfront when you build your plant and so forth. With the gold price where it currently is at and with the technology improvement that we hope to be implementing over the next 18 months or so, our cutoff drops down to 0.22, so that's a quarter of a gram per ton in order to breakeven at where the gold price currently is at.

Alec Hogg: How many gold dumps are around that have higher than a quarter of a gram per ton left in them?

Pretorius: Most of them, most of them are, the dumps that we just came off or the tailings dams that we just finished creating, so to speak, through Crown, we had four plants in and around Johannesburg of which two are being decommissioned. Now, those two plants moved 250m tons of material over the last 30 years. Those dumps that we created all contain more than a quarter of a gram of gold.

Hogg: The dumps you created?

Pretorius: The dumps that we created through our previous process of retreating dumps.

Hogg: So you can retreat you own dumps then?

Pretorius: Correct. Eventually you could retreat those old dumps again.

Hogg: And in the rest of the country, the rest of the Witwatersrand?

Pretorius: It's very limited because in order to be successful as a recycling entity you need a very large plant, you need to be able to connect all your various tailings dams, your reclamation sites with that plant and you also need a very large deposition site. Now we did a bit of a back of an envelope calculation a while back and if we had to recreate the current infrastructure that we have at our disposal, the plant, the tailings dam, etc, we were going to need probably two to three times our current market cap. So it's only because we've been in the business for a long time and we bought this plant from Anglo and they build a phenomenal plant and then we had to do very little to refurbish it back to where we needed to take it to process our tailings. They're done processing their tailings that belong to them. It's only because we had that advantage that we could really now treat these tailings at a profit. (emphasis added)

In other words, this is quite a unique business. The ERGO plant expansion and refurbishment is now in its last phase, which well be finalized in mid 2013. The final stage is designed to improve gold recoveries further.

Eventually, the plant may be expanded to also retrieve uranium oxide from the tailings. Once these final major capital expenditure programs are out of the way, the operation will begin to return quite a bit of of money to shareholders. Provided the gold price stays reasonably firm, shareholders can probably look forward to higher dividends and more share buybacks.

DRD's surface gold tailings operation on the East Rand. The dumps contain about 11 million ounces of gold, which at a planned production rate of 150,000 ounces per year makes for quite a long "mine life":

Naturally, DRD still faces a number of risks. South Africa has recently been in the headlines again, as wildcat strikes spread like a wildfire from a single platinum mine to eventually encompass almost the entire mining as well as the transportation sector. The strike has in the meantime ended, and DRD was not even affected by it (had it still owned Blyvoor, that may have been different). Still, it underscores the fact that political risk is somewhat higher in South Africa than elsewhere, as the ANC government has to date failed to fulfill the aspirations of the masses. This may well lead to the adoption of economically harmful policies down the road, as politicians often look for shortcuts.

However, South Africa remains the best developed country in Africa and these concerns are after all reflected to a large degree in stock prices already. If DRD were located in Canada, its market cap would likely be five times higher than it actually is. Another risk is of course the gold price, but contrary to many of the deep level underground mines in South Africa, DRD now has a considerable margin of safety due to the more predictable nature and higher profit margins of the reclamation operation.

This write-up should not be misconstrued as an investment recommendation – everyone will have to do his or her own due diligence. Gold mining shares are risky and very volatile and therefore not everybody's cup of tea. However, we though that the recent transformation of DRD is an interesting story, and the stock probably deserves more attention than it is getting nowadays. Finally, let us hope that we have not jinxed it by writing this.

Charts from BigCharts, StockCharts, and DRDGold.