SIF Folio: Gold miner Centamin gives me little choice

Last week’s decision to sell pawnbroker H&T Group and gold mining services provider Capital means that my SIF folio has no exposure to gold. In a world of zero interest rates and macro uncertainty, that may not be ideal. 

I have to fess up to another problem with the portfolio this week, too. The 16 stocks in SIF are concentrated in just four top-level sectors:

In my defence, this isn’t specifically a breach of my rules. But it’s not necessarily ideal. Adding a gold miner would provide exposure to a commodity that tends to perform well in difficult times. It would also add a fifth sector - Basic Materials - to my portfolio.

Although I’m concerned about the risk that the gold market will peak, I accept that we may not be at that point yet. As far as I can see, there’s not much sign of the froth that has marked the high water level of previous commodity booms. Gold equities don’t look obviously mispriced to me.

In any case, my rules are designed to prevent me taking macro positions and instead focus on selecting companies with attractive characteristics. The SIF screen is not currently identifying many opportunities in the UK market:

Of these, Wynnstay and Morgan Sindall are already in SIF. 

Highland Gold Mining is in a bid situation. 

TP ICAP would be a possibility, but I already have several financial stocks. This share also  has the lowest StockRank in the screen results.

My rules specify that my screening results should be ranked by StockRank, which means that FTSE 250 gold miner Centamin is the only possible choice this week. 

Centamin (LON: CEY)

I’ve followed Centamin’s fortunes for a number of years. On the whole, I think this Egypt-based firm is a good business. It’s profitable and cash-generative, with a strong balance sheet and track record of attractive dividends.

Stockopedia’s algorithms like the shares too:

However, long-term followers of this mid-cap miner will know that it’s not always been a smooth ride. Although the shares have delivered an impressive 2,500% gain since Centamin’s 2001 listing, keeping the faith has been challenging at times:

Political risk: Leaving aside the gyrations of the gold price, the other factor that’s had a big impact on the performance of Centamin stock is political risk. During the Arab Spring period in 2011-2013, Centamin’s mining concession was challenged in a court case. The firm was also forced to start paying higher international prices for diesel fuel, rather than the subsidised local rate. 

My feeling is that these events were politically driven. Since 2013, they’ve faded into the background, but investors should note that both cases are still ongoing. Management are confident that they will reach a favourable conclusion, but of course there’s no guarantee of this. 

Personally, I would argue that the diesel case is not a concern, since Centamin has been paying international rates for diesel since 2012. Clearly the business is still viable. 

However, I think the case relating to the firm’s mining concession could still cause problems. If you’re interested, you can find fuller details in footnote 5.1 of the 2019 results. 

With that disclosure out of the way, let’s get back to the numbers.

Value: not so great

Centamin’s ValueRank of 57 does not appear to suggest that the shares are a bargain. It’s not too hard to see why. The shares trade on 28 times 2019 earnings and at 2.5 times their book value. 

The only numbers which do look cheap are my favourite measures, price/free cash flow and earnings yield (EBIT/EV):

• P/FCF: 11.3

• Earnings yield: 10.5>#/p###

However, these figures carry a big caveat. The profit and free cash flow they imply isn’t all available to shareholders, thanks to a very material profit-sharing arrangement. 

Profit sharing: Centamin’s sole production asset is the Sukari gold mine in Egypt. This is owned in a 50:50 partnership with the Egyptian Mineral Resources Authority (EMRA). Although Centamin’s mining licence appears to give the company full operating control of the mine, this partnership does mean that Centamin is currently paying roughly 50% of its profits to EMRA, in addition to a 3% revenue royalty to the Egyptian government.

In 2019 Centamin paid $19.7m in royalties and a profit share payment of $87.1m to EMRA, from revenue of $658m.  Although pre-tax profit was $173m, net profit attributable to shareholders was just $87.5m. 

This profit-sharing agreement explains a few apparent quirks in the StockReport data for this share:

The screenshot above highlights how Centamin’s operating profit has been roughly two times the group’s net profit since the current profit sharing agreement kicked in in 2017. 

Fortunately, the firm’s earnings per share reflect the net profit attributable to shareholders. So the P/E ratings shown in the StockReport are accurate, as far as I can see.

However, my sums indicate that the free cash flow per share shown in the StockReport includes the profit share payout. Accounting profits don’t always map directly onto free cash flow, but in this case I think a fair approximation is that c.50% of free cash flow should be available to shareholders. 

This suggests that dividends have exceeded the free cash flow available to equity in recent years, with the balance being funded by Centamin’s sizeable net cash balance:

I don’t see this as a problem, given the group’s lack of debt. Indeed, if the gold price remains high this year it seems likely to me that net cash will stabilise.

My view: The structure of Centamin’s mining agreement leaves it somewhat vulnerable to hostile political action. And from a purely financial perspective, the shares don’t seem especially cheap to me. But the numbers all seem to stack up okay. I don’t have any concerns about the company’s accounting or its dividend policy.

Quality: profitability shared

Centamin’s QualityRank of 99 suggests a very strong set of profitability metrics. For the most part, I agree. 

In 2019, cash costs of production were $699/oz. The all-in sustaining cost of production (AISC) - a more inclusive measure which includes a mine’s lifecycle costs - was $943/oz. These low costs underpin the group’s strong cash generation. If the gold price stays close to $2,000/oz, 2020 should be a bumper year.

Centamin also scores well on standard financial quality metrics. 

The group’s strong balance sheet, cash generation and improving profitability is reflected in its Piotroski F-Score of 9/9 (Ben published an excellent piece on the predictive power of the F-Score last week - see here).

However, Centamin’s profitability metrics need to be viewed in the context of its profit-sharing arrangement. In the screenshot below, we can see that return on capital employed (ROCE) is roughly twice return on equity (ROE):

Given Centamin’s lack of debt, I’d normally expect ROCE to be more closely matched to ROE. Capital employed would closely approximate equity, while operating profit (used in ROCE) and net profit (used in ROE) would only be separated by tax payments. 

The reason for the larger difference between ROCE and ROE is that Centamin pays roughly half its pre-tax profit to its state partner. This reduces return on equity to fairly average levels, despite impressive returns on capital. The effect is as if Centamin pays 50% tax.

My view: How should we reflect this unusual situation in our analysis of Centamin? 

In this case I’m willing to give Centamin a pass, due to its debt-free balance sheet, strong underlying profitability and solid track record of shareholder returns. But if the business didn’t have such strong fundamentals, I’d take a much more cautious view.

Momentum: fingers crossed

No one knows how the gold market will perform over the next 18 months. Centamin also faces a number of company-specific risks. I mentioned some earlier. More immediately, management have also warned that if COVID travel restrictions extend beyond Q3, operations could be disrupted. 

The company’s dependence on a single production asset also carries risks. The Sukari mine is currently undergoing a life-of-asset review. In a worst-case scenario, the mine’s remaining reserves could be downgraded. Future ore grades could be lower, increasing costs.

However, these risks apply to most miners, to some degree. I’m not here to make speculative judgements on what might happen. 

What we do know is that Centamin’s technical momentum metrics are currently strong:

Earnings forecasts have been rising steadily, too. Analysts expect 2020 profits to be sustained in 2021, if not increased:

My view: Centamin shares have strong technical and earnings momentum. At the time of writing, the stock trades on 16 times rolling forecast earnings, with a prospective yield of 4.9%. 

Overall, I’d say this is an attractive picture. The obvious caveat is that it’s heavily dependent on the future gold price and on mine-specific factors. 

My decision

I have little choice here. Centamin passes all my screening rules and would add welcome diversity to the SIF folio. My contrarian nature makes me reluctant to jump on a bandwagon so late in the day. But the whole point of SIF is to prevent this kind of mental bias and follow the factors.

I will add Centamin to the SIF folio and to my own holdings this week, after this article has been published. As always, I’d very much welcome your views on gold and gold miners in the comments.

Disclosure: Roland owns shares of Wynnstay and Morgan Sindall.