Sylvania Platinum - cash rich, growing and cheap

In prevailing market conditions, where participants are fixated on downside risk, looking for quality, growing companies with safe balance sheets and margins of safety is more important than ever. Sylvania Platinum (LON:SLP) might be one of those companies - if you believe the current prices of palladium and rhodium can be maintained.

Sylvania is a low-cost South African producer and developer of platinum, palladium and rhodium. Surging platinum group metals (PGM) prices have propelled the group’s shares ever higher in recent weeks. Barring a one day drop last Friday, it has also held up relatively well in the recent risk-off market conditions.

That is probably due to an attractive combination of rocketing profitability, stacks of cash on the balance sheet, and a shareholder-friendly use of prodigious amounts of free cash flow. The group’s shares currently trade on just 2.8 times forecast earnings and brokers have been busy more than doubling their EPS estimates for FY20 and FY21.

Sylvania has a market cap of £135m, but it also has $33m of cash, virtually no debt, and there is every indication the company will have added to this cash pile by the year end. The group also holds untapped mining assets with option value.

So what’s going on? Am I late to the party here or will the market at some point wake up and aggressively rerate this cash-rich South African miner’s shares?

Not without risk…

While the PGM metals Sylvania produces are in demand from auto industries for their pollution-reducing properties, it is worth remembering the Sylvania, as a low-cost operator, is operationally geared. That means profits that seemingly materialise out of nowhere can likely evaporate just as fast.

It is impossible to look at stocks without considering the Coronavirus at the moment, and I believe Sylvania could have some exposure to the economic disruption that has occurred so far. It is hard to quantify anything at this stage, but a lot of demand for PGMs comes from China’s automobile market. Assuming that spot prices for these metals can be maintained is central to the thesis that Sylvania shares are cheap.

The group itself flags other risks. In its FY19 results, it notes:

There are clouds on the horizon in automotive markets – China trade wars, Brexit, and such mean that we will remain with our conservative views of metals prices and revenue generation potential. What goes up (palladium and rhodium prices) can also come down as fast!

The group has also flagged and is managing persistent operational issues - namely water shortages, power outages, the possibility of strike action, and disgruntled communities.

Nevertheless, Sylvania’s relative valuation metrics are, frankly, remarkable. Despite strong relative momentum, the shares trade on c3 times forecast earnings and 2.5 times forecast EBITDA. If it can keep up cash generation, by the end of the financial year it could have as much as a third of its current market cap in cash on the balance sheet.

A valuable foothold in the world’s premier PGM complex

Sylvania has two distinct lines of business: the re-treatment of PGM-rich chrome tailings material from mines and the development of shallow mining operations and processing methods for low-cost PGM extraction.

All of the Group's assets are situated in various locations across South Africa's Bushveld Igneous Complex (BIC), which is the world's richest source of PGMs. The entire intrusion stretches over roughly 66,000km² and has three distinct outcrops known as the eastern, western and northern limbs.

Sylvania has operations and projects on each of these limbs (more below).

Some 80% of the world’s economically viable platinum-bearing deposits are located in the BIC. The balance is largely in Zimbabwe (the Great Dyke deposit), Russia, and North America. Southern Africa is the only primary source of platinum, with platinum in Russia and North America mined as a by-product of other metals (mainly nickel and palladium, respectively).

It is estimated that about 38.1 kilotons of platinum metal in mineral reserves and resources reside in the Bushveld. Sylvania Platinum currently targets annual production currently of 74,000 - 76,000 ounces per year.

Operations

The group’s assets are split into two groups: Sylvania Dump Operations (SDO) and Northern Limb Projects.

The SDO are seven active PGM recovery plants that treat chrome tailings from surrounding chrome mines across the western and eastern limbs of the Bushveld Igneous Complex. On the western limb of the BIC there is:

• Millsell - This site started operating in 2008 and has a PGM split of 59% platinum, 24% palladium, 16.5% rhodium, and 0.5% gold.
• Mooinooi ROM - PGM split of 64.3% platinum, 25.1% palladium, 10.2% rhodium, and 0.3% gold. It began operations in 2012.

On the eastern limb, there is:

• Lannex - Lannex ramped up to full production in 2011 and has a PGM split of 58% platinum, 25.5% palladium, and 16.5% rhodium.
• Doornbosch - PGM split is 60% platinum, 29% palladium, and 10.5% rhodium. Operating since 2011.
• Tweefontein - 64% Platinum, 22% palladium, 13.4% rhodium, and 0.15% gold. Began operations in 2012.

Meanwhile, the Volspruit project covers two adjacent ore bodies that will be mined for PGMs and other base metals, such as copper and nickel, via two open-cast pits. Sylvania is also the holder of prospecting rights to some additional Northern Limb Projects in the BIC which are thought to hold platinum, palladium, nickel, and copper deposits.

Each of these could become a new mine. However, developing these assets appears to be a bit of a slog, with company representatives continuing to prompt the South African authorities into action.

From the FY19 annual report:

Volspruit Platinum Exploration - The Department of Mineral Resources has still not communicated any progress in the appeal lodged by interested and affected parties in June 2017 against the decision to grant a mining right application to the Company. The Company’s environmental consultants continue to make enquiries.

Northern Limb Projects - There has been no further development of the Northern Limb Projects during the last financial year, apart from that which is necessary to maintain compliance with the mining right and to defend title.

These assets give Sylvania useful options though - whether that be to sell them or embark on joint ventures. And any difficulties Sylvania has in developing them are presumably shared by other would-be operators looking to take share.

Financially healthy, cash generative, growing and cheap

The scarcity of PGMs is good news for SLP as an investment - particularly as palladium and rhodium are in increasing demand from the auto industry. Prices for those metals are rocketing, but again, management’s warning comes to mind: “what goes up can come down”. Given the group’s operational gearing, profits might evaporate as quickly as they materialise.

For now, trends are encouraging. Any hit to prices from Coronavirus-related disruption has yet to declare itself, and the company has a strong balance sheet with few liabilities and virtually no debt. Profitability has been compounded by margin expansion - Sylvania’s profit margin nearly trebled from FY16 (9.45%) to FY19 (25.81%).

We can see, however, that the group has reported a net loss in four of the past 12 years.

Cyclicality must be expected with mining stocks. Two of the key attractions of Sylvania as a small cap miner are its balance sheet strength and its positioning as a very low cost operator. No pension fund in sight and a negligible amount of debt ($616k) that is absolutely swamped by a rapidly growing $33.8m cash pile. The group’s value is supported by $53.5m of exploration and evaluation assets and another $37.8m property, plant and equipment.

As of HY20, the group’s average basket price was $1,830 per ounce versus a cash cost of just $554. This insulates Sylvania from at least a degree of price falls. The group also has exceptionally strong liquidity ratios, with a current ratio of nearly eight times.

Sylvania is increasingly cash generative and is using free cash flow to buy back shares, pay dividends, and invest in growth projects.

In the group’s HY19 presentation, it forecasts a more than doubling of EBITDA to around $70m for the full year, which would put the company’s shares on just 2.48 times forecast EBITDA.

HY20 results show a step-change in profitability

Some key financial highlights from SLP’s recent HY 2020 interim results:

Operational

• A new half year record of 40,003 ounces, up some 17.5% from last half year’s 34,045 ounces.
• The Gross basket price for PGMs was $1,830/ounce compared to $1,201/ounce for the period ended 31 December 2018. Judging from price charts post-period end, I believe this basket price has continued to rise.
• Cash costs per ounce for the Group were ZAR8,140/ounce, or $554, compared to ZAR8,194/ounce in the previous corresponding period.
• The challenges mentioned in the 2019 annual report remain. SLP is building more boreholes in order to meet its water demands.
• Power cuts due to maintenance and power interruptions led to additional operational disruption - for example Project Echo completion data has been pushed back by one year to FY22.

Financial

• Revenue +84% to $59m
• Gross profit +239% to $34m
• Operating profit +266% to $33m
• Profit after tax +244% to $24m
• Diluted earnings per share +241% to 8.22 cents

Cash

• Net cash +54% to $33.8m. It should be noted that the Group holds a large portion of cash in ZAR and a strengthening ZAR:USD exchange rate will have a favourable impact on the Group cash balance, but a weakening of the ZAR against the USD will have the opposite impact.
• Net cash from operating activities +66% to $20m (including an outflow of $10.9 million for working capital changes due to timing, and $6.8 million paid in provisional income tax).
• The Company spent $3.0 million on capital expenditure comprising $1.7 million of growth capex and $1.3 million on maintenance capex.
• Free cash flow +105% to $17m.
• $2.9 million was paid to Shareholders as a dividend and $2.2 million was spent on share buybacks.

All in all, these are sterling growth figures for a company on such a cheap valuation.

PGM prices in 2020

The increase of Platinum, Palladium and Rhodium had the largest impact on the basket price. The average prices for the half year were:

• The average Platinum price increased 12% from $817 to $915/oz,
• Palladium increased 78% from $1,040 to $1,847/oz, and
• Rhodium increased 138% from $2,394 to $5,702/oz from 31 December 2018 to 31 December 2019.

Prices have continued to rise since, which bodes well for full year results. Today’s spot prices are:

• $871 for platinum,
• $2,420 for palladium, and
• $12,050 for Rhodium

PGM prospects

Sylvania is confident of producing between 74,000 to 76,000 ounces this financial year, which would be another record. Operational disruption continues to be a risk, however.

Perhaps the most important driver of share price performance will be the group’s basket price of PGM metals. The rand price of a typical South African PGM basket surged higher during 2019 to a new all-time high:

Source: Johnson Matthey February 2020 PGM Market Report

Sylvania’s management give some useful guidance on PGM market dynamics:

While platinum is forecast to make a modest recovery on the back of a rise in investor activity, autocatalyst consumption recovery and legislative changes in China and India, power supply issues and industrial activity have a major impact on a potential outcome and thus, once again, we are at the mercy of elements outside of our control. Palladium, however, is again expected to rise as a result of an increase in automotive consumption although rhodium prices may expect a moderate rise as market fundamentals stabilise following a release from pipeline inventories.

Johnson Matthey (which, as a provider of catalysts and catalyst systems to reduce emissions from vehicles and industry, is a big buyer of PGMs) released a PGM market report in February. Some brief notes below.

Platinum

Demand for platinum increased in 2019. This general improvement in platinum market sentiment over the past year has also been reflected in the futures market.

The Matthey report notes that the platinum market could well move back into surplus in 2020 and “demand is more likely to fall than to rise”. It’s worth noting that the price of platinum has slid along with the rest of the world over the past week or so, presumably on Coronavirus fears.

Palladium

All-time highs were seen in the palladium price as the market moved over a million ounces into deficit in 2019.

Tightening emissions legislation and stricter vehicle testing regimes are driving up the PGM content of threeway catalysts in most major vehicle markets, with a 14% rise in global average palladium loadings on gasoline cars and double-digit growth in both Europe and China.

Palladium extended last year’s rally in the second part of February. It has risen more than 40%. The white metal continues to benefit from worries of a further supply shortage in 2020, as rapidly rising demand from automakers pushed the global palladium market last year to its biggest deficit in five years.

The palladium deficit is likely to deepen in 2020, as an increasing number of Chinese and European vehicles rush to meet environmental legislation. While the market remains in significant deficit, prices are likely to remain strong.

Rhodium

Rhodium prices jumped past $11,000 an ounce in February, with surging demand from the auto industry alongside with tighter supplies pushed prices up 90% since the beginning of 2020. Since then it has pushed on to $12,050.

Rhodium moved into a modest deficit in 2019 and Matthey expects a deeper deficit in 2020, “as [the] automotive demand is likely to post further gains”. It seems likely that the market stocks of rhodium will need to be drawn down again in order to meet consumer demand.

What is undeniable is that a significant amount of demand for these metals comes from China’s automotive industry...

Risks

Coronavirus - what has become obvious from reading matthey’s PGM report is that Sylvania is not immune from the evolving Coronavirus situation. A material amount of demand for its PGMs comes from China’s car market. Car sales in China tumbled in February and car production has presumably also been disrupted. Whether there will be any long term impacts on China’s car manufacturing remains to be seen. Either way, Sylvania’s exposure to this market should be considered.

Given Sylvania’s balance sheet strength and global trends towards environmental sustainability, I am cautiously optimistic given longer term trends (although if there’s anything we’ve been reminded of over the past week, it’s that things can change quickly).

Water availability is rapidly becoming a strategic issue for the SDO. There are capital implications, which will be factored into future capital expenditure for FY2020 and onwards.

The costs of tailings deposition facilities are furthermore increasing significantly due to legislative changes, but the Company is taking note of new technologies with a view to further water-saving opportunities.

Power utility infrastructure and supply issues are another concern along with power costs up 13%, driven by infrastructure constraints. A new power infrastructure is being developed at Tweefontein, which once completed, will enable the Company to begin construction of the last budgeted Project Echo MF2 module.

I would also draw attention to management’s FY19 commentary:

“Mostly due to matters outside of our control, Q2 and Q3 were challenging and resulted in lower production volumes and efficiencies. In particular, the water shortages at our Western operations, and power infrastructure and supply disruptions at our Eastern operations, as well as community disruptions associated with social unhappiness, culminated in unexpected and unplanned disruptions and downtime, impacting negatively on production.”

The company adds:

“Management continues to focus on improving communication and to engage with mandated and recognised forums from neighbouring communities in order to identify potential commercial opportunities and to manage expectations regarding employment and procurement spend. The relationship with these forums is critical, especially when assistance is needed to manage community members that threaten to interrupt operations, as various neighbouring mines have experienced.”

These are encouraging actions. Additionally, from the Matthey report:

“A research study in 2016 by eunomix showed that Rustenburg... accommodations and housing are lacking and have seen little to no effort from the mining companies to improve them. However, recently (2013–2016), the platinum companies have contributed more than ZAR 370 million into the city; funding local infrastructure, water supply and treatment centres, sporting programmes, tourism, public road expansions, sewage treatment plants, cultural activities.”

Conclusion

At the time of writing, Sylvania’s share price is rebounding strongly after last Friday’s fall

To summarise my stance:

Pros

• As long as palladium and rhodium spot prices can be maintained, Sylvania Platinum shares are cheap;
• Given long term market trends regarding more environmentally friendly automobiles, I believe there is a fair chance of this happening;
• On current forecasts, the group is cheap at c3 times forecast earnings;
• Shares trade on a modest premium to net tangible asset value but, assuming another successful year of operations, cash on balance sheet should increase materially;
• It is a low cost operator and is operationally geared to rising (and falling) prices;
• It has a strong balance sheet, lots of cash, and assets with option value. It can hopefully ride out periods of disruption;
• Sylvania is generating copious amounts of free cash flow and is deploying this in shareholder-friendly ways (dividends, buybacks and growth opportunities);
• When earnings growth and share price reratings happen in tandem, gains are material for shareholders.

Cons

• As a PGM miner whose commodity prices are in part driven by demand from China’s auto manufacturing industry, Sylvania is exposed, to some degree, to the economic disruption caused by the Coronavirus;
• The group has flagged persistent operational issues to shareholders - namely water shortages, power outages, the possibility of strike action, and disgruntled communities;
• Sylvania’s extraordinary increase in revenue and profitability is driven by low costs, operational gearing, and surging rhodium and palladium prices. What goes up can come down.

A note on recent events

While a lot of uncertainty remains around the nature and impact of the Coronavirus, what is more certain is the economic disruption it has caused as a result of quarantine measures. Given that China is the world economy’s engine, we must accept that there has presumably been material supply chain disruption. There has been a clear rotation out of risk-on assets as a result.

The situation is still uncertain but I am hopeful that the world economy can recover from recent events and that said disruption is one-off in nature (rather than having a permanent impact on trend rate of growth). Of course, opinions are cheap and subject to revision. I have no informational edge, no additional insight to give, and I will adjust my views accordingly as new facts come to light.

In the meantime, I am fundamentally optimistic regarding long term global development and what can be achieved and overcome through humanity’s innate sense of industry. It’s a part of the reason I invest in stocks.

Time horizons are important here. To the investor with a 1-5 year investment horizon, the impacts of Coronavirus are much more serious if they are forced to crystallise losses. Those with longer horizons are better positioned to ride out these types of shocks. While we cannot yet quantify the impact of the Coronavirus, I think on balance it is more likely that the global economy will recover from this than that it will be permanently damaged.

However, it is prudent to acknowledge a range of probabilities. COVID-19 and its impact on the world may well be long-lasting and substantial.

At the moment, I am operating under the assumption of a sizable but temporary economic impact this year, followed by a recovery. Of course, I don’t know any better than the next person.

Facing this unknowable future, I think the answer to insulating yourself from exogenous shocks remains relatively common-sense and constant:

• Buy great companies at good prices, with good structural growth opportunities in large markets,
• Look for strong balance sheets, profitability, and cash generation,
• If you are hunting for value, make sure of a rock solid margin of safety and be wary of debt,
• If possible, find moats and high long term returns on capital that can be defended over multiple years

You can’t predict the future, but you can build a strong, robust portfolio with good growth prospects. Sylvania is a promising candidate in this regard, given its balance sheet strength and low operating costs. Although exposure to China’s auto market is a concern in the short term and may cause volatility, I think longer term trends can win out and support spot prices. As ever, alternative views are welcome.