Durban Under Fire
Adam Hamilton November 3, 2000 4073 Words
As the markets opened on Friday November 3, the sounds of war seemed to echo ethereally from a little-watched back alley of world trading. The century plus old South African gold miner, Durban Roodepoort Deep, was under heavy fire. Artillery rained down from all quarters, and sell orders flew through the air like lethal shrapnel. Durban, a major ally of the free-market guerillas fighting the bitter six year old campaign against the anti-gold forces, saw even longtime friends suddenly turn hostile in the frenetic trenches. Contrarian goldbugs, nerves frazzled from years of unrealized losses, snapped under the pressure. As hostile shells exploded just over the lip of the pro-gold trenches, goldbug capitulation sellers turned their assault rifles on Durban. The venerable miner was riddled with untold bleeding bullet holes, like the ancient Chinese “death by a thousand cuts” torture. In the melee, 2.8m shares of Durban traded hands in the States alone, or a staggering 2.3% of all the common shares in existence. At one point, with growing pools of blood staining the trench floor, Durban traded at a mere US$0.65 per share. As the battle wore on throughout the day, the besieged company managed to claw its way back to US$0.78 when the gunfire and artillery strikes waned. As after any battle, the silence was deafening. Both participants and observers were left dazed, wondering what had just transpired…
What happened? What was the spark that ignited the inferno? Did Durban announce it had invaded the sovereign nation of Botswana? Had a United Nations tribunal found Durban guilty of slaughtering baby seals in the arctic? Did the company announce bankruptcy? One would think that something fundamentally HUGE must have occurred to precipitate the slaughter… When the smoke begin to drift away from the battlefield, two apparent reasons for the melee became clear. The CEO of Durban had resigned and the company had released its latest operating results. In this essay we will examine the management changes and the latest quarterly operating results. Was the carnage justified?
Before we begin, some crucial disclosures must be made. Investing is an inherently risky activity. To the surprise of the NASDAQ bulls who were multiplying like rabbits only six months ago, markets can move up AND down. Amazingly, the stock markets are not a 50% a year risk-free CD. This essay is NOT investment advice. I am NOT and do not purport to be a personal investment advisor. As ALL the global capital markets are fraught with peril, it is absolutely critical that you consult professionals whom you know personally and trust for personal investment advice suited to your peculiar situation. Talk to your attorney, your accountant, your certified financial planner, your broker, and your barber/hairdresser before making any investment decisions. I DO have a vested interest in seeing Durban thrive, as I am a Durban shareholder and have a lot of capital invested in the company. I have no relationship with Durban management whatsoever and have never spoken to nor corresponded with any members of management. My opinion is just that … opinion … and is worth no more or no less than anyone else’s thoughts. Like anything you read on the Internet, please take this essay with a grain of salt and do your own due diligence. Enough already you say?
The whole fracas began on November 2nd, when stories started swirling on business wires that Durban CEO Mike Prinsloo was leaving the company. After one of the worst years in the august mine’s modern history, a scandal developed regarding a highly anticipated Australian expansion project that turned into a disaster. Almost immediately after taking title to the Hargraves mine in Australia, an underground water source was struck that rapidly flooded the mine and rendered it unsalvageable. The entire property had to be written-off due to the deluge. As if that was not enough, the Managing Director of Durban’s Australasia division was caught siphoning off corporate money, touching off yet another scandal. The pain was further multiplied by the last twelve months yielding the lowest real gold prices in 28 years. Needless to say, the stock price of Durban has dropped substantially in 2000 as the bad news broke and the gold price continued to languish. With shareholder ire waxing ominous, Mr. Prinsloo packed his bags and exited stage left.
On the heels of the resignation, another announcement emerged from Durban indicating the Chairman of the Board of Directors Mark Wellesley-Wood would act as the interim CEO, while former Durban Chairman of the Board Roger Kebble would be reappointed to the Board of Directors to act as a deputy chairman on an interim basis.
All-in-all, it was a highly visible shuffling of top Durban management. How will it affect shareholders? I don’t know, but I SUSPECT not very much. My experience and strength lie in analyzing rock-solid fundamental realities. As I have never met or had any communication with these gentlemen, I can offer no opinion pro or con on the management restructuring. We will leave those comments to the psychologists who claim to understand human behavior and the nutty psychics who claim to read people’s minds. From a cold and unemotional speculation standpoint, who cares who is running the company? As long as the gold is recovered from the earth at a reasonable cost and sold in the global markets for a profit, the personalities take a back seat to the corporate entity itself. One of the most wonderful attributes of a corporation is it supersedes any one personality. Managers come and managers go, but the underlying corporation will live on and thrive, as it has for over a hundred years. It is not surprising to see selling on a management shuffling, as it happens all the time in equity markets. Investors are generally emotional creatures who are rendered uncomfortable by uncertainty. Any change in the linear status quo leads to welling doubts and fears as to future direction. It will be most interesting to observe whether or not the management change affects operations downstream, but it certainly does not change any of the fundamentals underlying Durban today. I have had the privilege of meeting fellow Durban shareholders from all over the world, and not a single one has told me, “Adam, I am excited to own Durban because Mr. X works there.” They ALL have told me that they are excited to own Durban because they believe the fundamentals for the gold market are extraordinarily bullish, and Durban was historically and continues to be one of the most leveraged gold mining operations to the price of gold in the entire world. Management IS important, and we shareholders are very grateful for the excellent work they have done and continue to do in a BRUTAL gold price environment. The bottom-line on the management shuffling, however, is it does not alter the key fundamentals undergirding Durban in any way.
Phew! Now that we are done with this touchy feely soft stuff, my cold black speculator’s heart leaps at the opportunity to do some REAL analysis. After the June quarter, management set several expectations for future results. The most important two from my perspective were that management would continue to maintain an explicitly anti-hedging bias and whittle away at the hedgebook when market situations permitted, and that cash operating costs would continue to fall to push up all-important operating cashflow. We will address these two issues in light of current quarterly results, and also a thorny third one. Internet pundits in recent weeks have been floating rumors that Durban is near bankruptcy. That is a serious allegation, and obviously of tremendous import. With shareholders holding Durban waiting for the coming gold mega-bull, a critical question becomes whether or not the company will survive until gold begins its inevitable march northward. We will address that all-important question as well.
First, did Durban management deliver on their promise to maintain an anti-hedging bias? Did they whittle away at hedges where the market opportunity arose? Before we analyze the current quarter’s results, please review last quarter’s. This table was lifted directly from an essay we published on August 4 called Roodepoort Rocket. At the time, Durban was trading at US$0.95 per share while gold was barely treading water at US$274 per ounce. The essay was widely read, originally appearing on the finest gold Internet site on the planet, Gold-Eagle, and later making a cameo appearance in the legendary Gold Newsletter. A detailed explanation of “good” and “bad” hedges to have in a gold bull was outlined in Roodepoort Rocket, and I encourage you to check that essay out in order to understand the following table.
As of June 30, the consolidated Durban group had a net bad hedge exposure of 8.5%. The percentage of production hedged peaked in FY2002, and dwindled to immaterial levels a couple years later. How did the most recent quarter stack up to the results presented in Roodepoort Rocket?
Everything considered, pretty darn well! The average net “bad” hedge exposure for Durban grew from 8.5% over five years to 8.8% over five years, or around a 2.25% increase in the absolute net bad ounces hedged. Some hedges appear to be shifted from FY2002 to FY2001 relative to the previous quarter, reducing the net bad hedge exposure next fiscal year (begins July 2001) and increasing the net bad hedge exposure in this current fiscal year. In light of the worst whole quarter of real gold prices in US dollar terms since the early 1970s, this small increase in the average net bad hedge exposure is actually quite an accomplishment. Hedge shedding is best accomplished under favorable gold market price movements, which last quarter certainly lacked. On an absolute basis, the slight increase in net bad hedges occurred due to good hedges being closed out. Absolute bad hedges shrunk in the quarter.
Although no gold bull is particularly fond of hedges, some level of hedging IS prudent in a marginal mine such as Durban. With relatively high cash costs per ounce compared to the current cratering gold price, it is critically important to Durban shareholders that the company is able to pay its expenses as long as gold languishes at these levels. And why would anyone invest in Durban if they were not a gold bull? The hard reality to keep in mind is hedging of this magnitude does not materially compromise Durban’s extraordinary leverage. The utterly extraordinary leverage of Durban presented in Roodepoort Rocket remains unaltered, and those projections already accounted for an 8.5% average bad hedge exposure, so the current 8.8% represents an immaterial increase. These hedges are miniscule compared to the majority of gold mining companies in the world. There are a few companies that are virtually unhedged, but due to their unique operating and price dynamics their ultimate leverage to the price of gold is substantially lower than Durban’s. In the coming months, as the gold price bottoms and begins to rally, I have confidence that Durban management will be closing hedges into the market whenever possible, and that the hedgebook will shrink in future quarters as the gold price improves.
With the changes in the hedgebook last quarter being immaterial, the question of cash operating costs arises. We all realize that world spot gold prices are set by the intersection of the global physical gold supply and physical gold demand. When more gold is supplied to the market than is demanded, prices fall. We have observed the abnormal situation for many years now where global gold demand greatly exceeds global mined supply, yet prices continue to fall. The gold supplied to market each year by mines has been temporarily artificially augmented by sales of central bank gold hoards, causing prices to continue their slow downward burn. At some point in the near future, one of two catalytic events will occur. Either some financial or political crisis will cause global gold demand to soar, and the price of gold will follow, or the anti-gold forces will run out of easily available gold to dump on the market, and prices will soar. In either scenario, Durban has a relatively trivial influence on the price of gold, as it only supplies around 37 tons (assuming 1.2m ounces annual production) to the market each year compared to 3,500 tons plus demanded globally. Wielding virtually zero influence on gold prices, cash operating profits BEFORE the coming gold bull can only be obtained through relentless cost control by Durban management.
In the June quarter, cash costs per ounce of gold were successfully reduced to US$239 per ounce. In the most recent September quarter, cash costs rose to US$245 an ounce. Per the Letter to Shareholders posted on the Durban website at www.Durbans.com, the immaterial increase is largely the result of planned annual wage and salary increases to mine employees. Obviously management and shareholders want to see costs continue to trend lower, and management has reaffirmed its goal of cash costs under US$220 in the near future. In other operating results, production decreased slightly by 2% quarter over quarter, but this is once again immaterial.
So far, the assault on Durban appears to be a tempest in a teapot. We have mused on the management changes, analyzed the immaterial change in the hedge position, briefly discussed the immaterial change in cash costs per ounce of gold produced, and mentioned the immaterial change in production this quarter? Where is the bad news? The quarterly changes in hedging, cash costs per ounce, and production are all slightly in undesired directions, but the magnitude is totally trivial. Statistically, changes of a few percent in an incredibly dynamic mining environment can usually be attributable to random noise. Everything we have discussed thus far does NOT alter Durban’s stellar fundamentals a smidgen.
So what is all the fuss about? Maybe a look at the all-important financial statements will shed some light on the Durban siege of November 3rd. Is the company really going bankrupt, as so many anonymous Internet sages boldly assert?
We will begin with a gander at Durban’s newest quarterly income statement. The income statement provides a running summary of all the business activity of the quarter. The latest quarter ended September 30 is the first column in the table below, while the June 30 quarter is presented next. Both of these columns are in millions of US dollars. The third column shows the percentage change between the two quarters. The final column shows the September 2000 quarterly results per common share, in US dollars per share…
The top line, Gold Revenue, declined by 3.6% quarter over quarter, which is not at all surprising. Any chart of gold will show that the spot price of gold was lower between July to September than it was between April and June. The September quarter only saw an average gold price of $276.57, while the earlier June quarter had a slightly higher average price at $280.30. An almost US$4/oz lower gold price in the latest quarter multiplied by 288k ounces produced can explain $1075k of the $2800k decrease in Gold Revenue. The remainder is the result of the 2% decrease in production mentioned above. The second line, total Cash Operating Costs, only increased by 1%, which is a great achievement by management in light of annual salary increases. The third line, Cash Operating Profit, had a dramatic drop of 48%. This is an excellent example of the fabled leverage of Durban, however. With relatively high cash costs per ounce for recovering gold, any small change in the price of gold has a huge leveraged effect on Durban’s cash operating profits. With a mere US$4 decrease in the average spot gold price and an immaterial 2% decline in production cleaving cash operating profits in twain, imagine what the cash operating profit number will look like as gold climbs US$10, US$100, or US$1000+ per ounce! Leverage IS a double-edged sword, and as investors and speculators patiently waiting for the coming gold rally we have to accept the risk of leverage to win the reward.
The ultimate worth of any investment is only measured by how much cashflow it can eventually spin off for its owners. For investors, Cash Operating Profit and the Net Cash Operating Profit on line 8 of the table are THE most important numbers to watch. The positive gross Cash Operating Profit of $3.8m (line 3) is very encouraging. It is great to know that management still achieved an operating profit even in these drawn out gold doldrums. The Net Cash Operating loss on line 8 narrowed tremendously from last quarter, coming in at only $300k, an awesome 88% improvement.
Another critical expense item to monitor is Interest Expense on line 5. Largely due to a debt restructuring agreement (fundamentally no different than changing the terms on the mortgage on your house), interest expense declined by 42%. This is a fantastic development, and is great to see. The narrow $300k net operating loss coupled with the greatly reduced $2.1m quarterly interest payment on debt should instantly slay rumors of Durban’s imminent demise. Bankruptcy is technically the condition when a business is no longer able to pay its creditors. Even AFTER the interest payments, Durban had a cash burn rate of only $300k last quarter! So is there a risk of bankruptcy? It depends on the current cash balance, which is discussed in detail below…
Before we check out the balance sheet, however, a couple more quick comments about the income statement are in order. Everything below the Net Cash Operating Profit line 8 (except taxes) is irrelevant to investors. The ultimate fundamental reality of any investment is the cashflow the company can generate for shareholders. The non-cash charges, such as depreciation, represent the accounting ghosts of capital expenditures past, and are an accounting fiction with zero relevance from an investor cashflow standpoint. Non-cash charges are ignored by every form of investment valuation. One final note, EVERY single major expense category, except the previously discussed Cash Operating Costs, declined dramatically quarter over quarter, which is a good omen.
Now for the balance sheet, which represents a snapshot of Durban’s financial position as of September 30. Is the company heading for a cashflow disaster like a dot com du jour?
As we discussed above, Durban burned US$300k of cash last quarter. How much was left when all was said and done? Only US$14,700k! Yikes! At this rate, Durban will burn through all its remaining cash in ONLY 49 quarters, or 12 YEARS. The sky is falling! The sky is falling! (dripping with sarcasm) The cash balance decreased 2% from the previous quarter, which is not bad at all. The previous quarter number IS interesting, as it is restated upward dramatically from the US$6,000k originally reported on Durban’s website (and mentioned in Roodepoort Rocket) prior to the release of the audited results. There is likely some good accounting reason for the restatement of the cash position on June 30, but I was unable to find any explanation on the website.
At any rate, the bottom line is Durban has almost US$15m in cash, and an apparent $300k burn rate, EVEN AT THESE ABYSMAL gold price levels. The purveyors of the bankruptcy rumors on the Internet ought to buy that bright yellow “Accounting for Dummies” book, as they apparently have zero experience working with financial statements!
One final thought on bankruptcy. As a publicly traded company, Durban is required to have its books audited annually by a major public accounting firm. I am Certified Public Accountant and begin my career as an auditor (auditing mining companies, of all things!) working for one of the Big Six (now Big Five) public accounting firms. These five companies are the most prestigious and respected accounting firms on the planet, and they take their business VERY seriously. All audits by CPAs (or Chartered Accountants in other countries) are required to have the professional auditors assess whether or not the company being audited is viable as a going concern. That means that if the auditors have ANY doubts at all as to whether the company will survive another year, they are required to put a “going concern” clause in the Auditor’s Report. In Durban’s latest annual report which is posted at its website, Deloitte and Touche (one of the elite Big Five international public accounting firms) gave Durban an UNQUALIFIED opinion, meaning the financial statements fairly present Durban’s financial situation in ALL material respects. The public accounting companies all have very deep pockets, and shareholders all over the world make sport out of suing them over any mistakes or oversights. The liability of Deloitte and Touche is VAST if they drop the ball and blow an opinion, so the fact that they did NOT raise any going concern questions should hammer the final nail in the coffin of the malicious bankruptcy rumors.
Back to the rest of the balance sheet, which does not look too bad. Some assets declined in value, which is to be expected and is not necessarily a good or a bad thing. ALL liability categories declined, which is an excellent sign. Durban is paying down debt even in this low gold price environment. Shareholder equity DID decline by 15% in the quarter, which is a substantial amount. That brings the “book value” of Durban down to US$0.46 per share. It is never fun to watch equity dwindle, but it is not surprising due to the current low price of gold. The equity number is another largely accounting concept, and should not be confused with share valuation. The market price of Durban and every other stock is totally independent of its accounting equity number. Even the few gold companies actually making accounting profits (accounting profits lead to increases in shareholder equity) in the current environment have seen their share prices eviscerated. Like gold, a share price is determined by the intersection of supply and demand for that particular stock. If more folks are selling than are buying, the share price drops. Interestingly, Durban’s price decline over the last three months in response to heavy goldbug capitulation selling, the low price of gold, and the general mainstream antipathy for the yellow metal was smaller than many other gold mines’ respective hemorrhages.
The bottom line? I was encouraged to see the solid quarterly operating results for Durban, and totally amazed that the market was willing to push the stock down to $0.65 intraday! I suspect we saw a lot of exasperated goldbugs throwing their hands up in despair and hammering the sell button. The really tragic part of the whole day was the large number of very small blocks of Durban shares traded. Many of the sellers appeared to be smaller holders of Durban, no doubt caught up in the emotions of the moment. The fact that the stock clawed back to a 4% loss by the closing bell on November 3rd indicates that there were large buyers more than happy to snatch up Durban stock at this unheard of price.
Emotions are a priceless part of our collective human experience, but they are absolutely LETHAL from an investing and speculation standpoint. Investment decisions should be made on fundamentals alone. What are the fundamentals?
Markets are cyclical. Equity markets are OVERvalued. Gold is UNDERvalued. All investments ultimately regress to their true value. Gold is due for a moonshot from a vast multitude of key fundamental and technical perspectives, as growing legions of analysts and investors realize. Durban Roodepoort Deep is one of the most leveraged gold mines to the price of gold on the entire planet. Nothing FUNDAMENTAL has changed.
As mentioned in opening, I would never presume to offer personal investment advice in this essay, but I remain proud to be a Durban shareholder myself. I sleep soundly at night with my capital at risk in Durban, and I have many wonderful dreams about the rapidly approaching gold mega-bull. Right or wrong, after years of intense study, I believe the world gold markets are presently offering the contrarian opportunity of a lifetime. I patiently sit upon the chariot Durban, which is harnessed to the mighty gold bull that will wake and begin to stir soon. When that bull begins to snort and bellow, and the Durban chariot sallies forth, the ride will be wild, and the profits and memories will probably last a lifetime.
“The time to buy is when blood is running in the streets.” - Baron Nathan Rothschild, 1815
Adam Hamilton, CPA November 3, 2000