ARM earnings encumbered by coal assets

The coal assets of Johannesburg-listed African Rainbow Minerals (ARM) could become "a permanent drag" on the earnings performance of the black-controlled company unless it is able to renegotiate lending terms with its joint venture partner, Glencore.

"Without some drastic change to this ownership structure and the associated debt and interest charges, the coal assets in ARM will likely end up as a permanent drag - or at least adding very little to the bottom line," said Leon Esterhuizen and Arnold van Graan, analysts for Nedbank Securities which also said a "change of guard" was needed in ARM's assets which had under-performed.

ARM's coal division, ARMCoal, was formed in July 2006 in partnership with Xstrata Coal South Africa, a subset of Xstrata Plc which was taken over by Glencore in 2013. The joint venture includes an economic interest of 20.2% in Glencore's coal operations in South Africa and a 26% attributable interest in the Goedgevonden (GGV) mine held in ARM's Participating CoalBusiness (PCB).

ARM is owned by Patrice Motsepe, one of South Africa's richest businessmen. He was feted in Forbes magazine for becoming Africa's first black billionaire. He has current net worth of US$1.75bn, according to the publication.

The two interests in Glencore's coal assets were 'vendorfinanced', in which Glencore financed the acquisition on commercial terms. This was done in order to satisfy South Africa's black economic empowerment regulations, which call for, among other demands, a 26% black ownership. The terms of this loan, however, are hurting ARM's financial performance, especially when the coal price is weak as it barely generates enough cash flow to pay more than interest on the loan.

"The biggest issue in the coal division remains the servicing costs of the coal partner loans," said Esterhuizen and Van Graan. "The debt levels have continued to increase as interest was rolled up. As a result, the serving cost of the loans continues to rise, to the point where most of ARM's attributable free cash flow goes towards debt servicing.

"ARM is thus seeing no real cash flow benefits from these assets. ARM and Glencore are in discussions around the possible restructuring of these loans in order to improve ARM's share of the cash flows," they said.

Glencore spokesman Charles Watenphul confirmed discussions were underway to potentially restructure the loan.

"However, it's too early to speculate on how that is going to work out," he said. ARM had not responded to a South African Coal Report query at the time of writing.

ARMCoal headline earnings were ZAR82m (US$5.82m) in the year ended June 2017, an improvement over the previous year's headline loss of ZAR297m (US$21m). The improvement was mainly due to PCB while Goedgevonden continued to be loss-making. It's this loss-making asset, and the heavy combined loss in the previous year which is damaging to ARMCoal's balance sheet.

"In the end, the ARM coal exposure essentially boils down to the ability (or otherwise) to pay off the substantial vendor-financed debt," said the Nedbank Securities analysts.

"The majority of 'underwater' BEE deals in a number of mining sectors over the past ten years have all tended to be renegotiated, with big chunks of the debt often written off. We believe ARM will likely be able to negotiate something similar," they said.

PCB produced 16.6 mt of saleable thermal coal on a 100% basis during ARM's 2017 financial year, a 13% year-on-year increase.

Of this, 13.4 mt was exported, some 9% lower than in the previous period. However, the average export price was 49% higher at some US$61.89/t.

As for Goedgevonden, production was 6.47 mt on a 100% basis, a 1% year-on-year decline. But exports were 19% lower at 3.18 mt. The export price FOB averaged US$62.07/t for the mine, a 51% increase.

"With our outlook for coal prices to be subdued, operations that are not low cost will be hard pressed to survive in our view. In the case of ARM's coal exposure, it will be critically dependent on cost increases not outstripping the benefit that would likely be gained from a weaker operating currency," said Esterhuizen and Van Graan in their report.

"In the past this has simply not been possible, with cost increases outpacing the benefits of significant currency weakness. Coal is certainly not one of the core profit generators for ARM, but we believe it will likely be even less so in future," they said.

Glencore said year to date coal production from its South African assets totaled 21.6 mt which was "in line" with the comparable period as "stronger operating performances at Tweefontein and Goedgevonden were offset by planned smaller mine closures.

Commenting in its third quarter update, the Swiss headquartered group said year-to-date thermal coal exports were at 14.1 mt, a 9% increase on the 12.9 mt produced at the same period in its 2016 financial year. Domestic production was down 17% to 7.5 mt year-to-date.

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David McKay is a journalist covering the South African coal market at IHS Markit. This article originally was published as part of the South African Coal Report.
Posted 3 November 2017

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.