HLM – A bet with fantastic upside or a risk not worth taking?

Coal-NEW

Hulamin (HLM) is a business that has been in existence for 80 years, forms a mainstay of the KZN economy, employs just over 2000 people and has grown to become the largest semi-fabricator of aluminium in the world. The company takes molten aluminium from the Hillside and Bayside smelters in Richard’s Bay and converts this basic aluminium into saleable products at its facilities in Pietermaritzburg and Midrand. The products include packaging such as cans and rigid aluminium foil containers as used by caterers and in take away packaging; extrusion products such as windows and door frames, which are sold to the construction industry and developers such as Balwin; and rolled products such as sheets, coil and plates sold to the auto industry and exported to industrial customers globally.

The company has faced severe headwinds recently, which has seen its market cap reduced to R600m, with the share price of R1.80/share near 5-year lows, having been trading at almost R10 half a decade ago.

Hulamin sells products on every continent, with 59% exported, 25% of sales go North America, mostly the USA. With increasing protectionism in the USA, South Africa has been reclassified as a developed country by the US Department of Trade, leading to additional tariffs on SA products and putting Hulamin’s exports to this destination at risk.

Generally speaking, this is not a great business for the following reasons:

  • Over 50% of aluminium fabrication capacity is located in China, from where dumping to international markets occurs. The group is therefore constantly working against anti-dumping tariffs in its export destinations (see the USA example currently playing out above) and has to lobby its home government to forestall dumping at home.
  • Fabricated aluminium is a commodity and they are price takers in a bigger market. Margins are very low at 4% and ROE is 7%. This is with the scale affects of being the largest company in the business and extreme proximity to the smelters. The group has little control over these metrics.
  • The business is both directly energy intensive and is fully exposed to a single supplier, South32’s smelters, who is even more exposed to the price of electricity. In an environment of rising energy prices and ongoing load shedding in the medium term, this does not bode well for the group.

However, given the very depressed share price, these poor fundamentals may be priced into the business and the share may present an incredible value play at this level. In fact, this is exactly what Investec’s John Biccard believes and he is putting his money where his mouth is. The various funds that he manages have upped their stake in the business to 11%. In addition, he purchased almost 7% (or R50m) of the company in his personal capacity. Hulamin directors agree and the company has also repurchased 3% of its shares in the last few months, at an average price that is 30% higher than the current share price.

The thesis is that the company will return to historic profitability. Revenue of R11bn in the 2017 and 2018 financial years produced, HEPS of 95c and 91c in respectively. Free cash flow was R300m in 2017 and still R90m in 2018. Even with a poor 4% margin, operating profits on R11bn revenues could be R440m, almost 70% of the current market cap. Despite an impairment of R1.1bn in 2018 the group paid an 18c dividend and reported record sales and revenue.

The thesis changes though when looking at the interim results for H1 2019 where the group reported a loss of 23c. The loss included once off costs such as right sizing and retrenchments costs and losses incurred due to metal price lag, which will reverse in the long run. The price lag is likely to continue this year as the aluminium price has fallen further, but will eventually taper off. More worryingly, is a drop off in sales, in particular in North America. This led to a R400m build up of inventories, which are now R2.6bn and make up half of assets. We are likely to see more poor sales in H2, with the coronavirus annihilating Asian demand.

The build up of inventory has led to negative operating cash flow of R170m and suggests a scrapping of the dividend is on the cards, in fact it is surprising that the group strained cash resources with a share repurchase programme.

Management concludes the poor H1 2019 results with:

“Hulamin expects the turnaround actions to gain momentum in the second half, and these are forecast to start yielding ongoing benefits from 2020. “

This is precisely the bet made by Biccard. If earnings revert to R1/share, then shares could easily increase 5 fold for an exit PE multiple of 9. This is premised on a long term vision that an increased focus on recycling and the move away from plastics will underpin aluminium fundamentals. The business is also trading at less than 20% of NAV. The bet, however, needs two key outcomes:

  1. The group remains liquid with sufficient working capital whilst the US protectionism, coronavirus and Chinese dumping reduce sales and right sizing and further price lag increase costs. This will play out in the next 12-18 months.
  2. The Bayside and Hillside smelters remain in business. They are currently running on the last years of their notoriously beneficial supply contract with Eskom. Whether South32 (or a new owner) will be able to negotiate a power supply agreement that can keep an old fleet of smelters operating on expensive and dirty electricity remains to be observed in the next 3-5 years. The Industrial Development Corporation is a 30% shareholder in Hulamin and may target the preservation of jobs by getting directly involved in these smelters in the future.

If these two trends play out, they will certainly generate significant value for people willing to take a bet at these prices. However, I chose to pass on this bet because:

  • As per my Investment Philosophy, I don’t trade or bet, but choose to invest in long term, boring, cash generative businesses. This Hulamin bet is simply not boring enough.
  • Aluminium has strong fundamentals and prospects, but I am unconvinced that South Africa is the right location to process it. Iceland, Canada, Norway have abundant geothermal and hydro-electric energy sources and should be global sites for aluminium smelting, while Guinea and Australia are hosts to excellent bauxite deposits. Dirty, expensive coal power and no good local sources of bauxite make SA uniquely unattractive for this business.
  • I find I have a better play into South African packaging through boring old Bowcalf.

WSL – Tons of cash flow

Coal-NEW

The last financial year was tough for Wescoal (WSL), with disruptions to production as a result of labour unrest and poor weather conditions. Nevertheless, the group produced 5.9 Mt of coal. This compares to a production of 6.8Mt in the prior year and targeted production of 8Mt for the 2020 financial year.

Given the supply disruptions, the generally poor sentiment surrounding South African small cap stocks and the huge concerns at Wescoal’s largest offtaker, Eskom, it is not surprising that the company’s share price has been decimated. The share is hovering at approximately R1.20 or a market cap of R520m. In my opinion, these depressed levels offer an extremely cheap entry point into a business that has demonstrated its ability to act as a consolidator of smaller coal assets within the known coal districts of the country.

Keith McLachlan made an excellent case for an investment in Wescoal by pointing out that the business is trading at a free cashflow (FCF) yield of over 30%. This in a period where production was severely affected by external once-off factors. Management in their 2019 annual report goes as far as to claim a FCF yield of 74%, but this does not allow for replacement and growth capex, which are required to be reinvested into the business. The business also trades at around 50% of its NAV of R2.53/share.

In early November it was announced that Black Royalty Minerals (BRM) are acquiring the Gupta tainted Koornfontein assets for R 300 million. Resource and reserves were not clear from the announcement and media reports, but the assets consist of an open pit and two underground mines and a total capacity of approximately 3.5Mtpa.

The R300m appears to be a bargain basement price, after the preferred bidder, Lurco, failed to raise the initially agreed purchase price of R500m. At the Lurco price, Koornfontein would change hands at R142 per ton of annual production, at the bargain BRM price, the deal is at R86 per ton of annual production. Wescoal is currently trading at R65 per ton of forecast 2020 production. The trading business is included as a free extra in this assessment.

Furthermore, in February 2020 ASX-listed TerraCom made an offer for Universal Coal that values the company at R1.7bn. They forecast their production for 2020 at 8.4Mtpa, valuing Universal’s South African mines at R200/ton of annual production or roughly three times the value attributed to Wescoal’s production.

In July and August management repurchased 17m shares or 4% of the outstanding shares of the company at an average price of R1.58 per share reflecting their own conviction that the company is undervalued at current prices. With the current share price 25% below this last repurchase price and the significant cash generation, we can expect management to continue share repurchases in the foreseeable future. Management is also eating their own cooking with director Muthanyi Ramaite buying shares at current prices since December 2019.

Unfortunately, a trading statement in November 2019, showed that production problems continue into the 2020 financial year, with H1 production only at 2.7Mt. Most of these problems appear to be temporary, and a production rate of 0.65Mt per month from Elandspruit, Khanyisa and Vanggatfontein should be possible in the medium term. This lower production will result in a loss per share for the first half, but EBITDA of R140m will be maintained. This means that even in this terrible production period, the company is operating an annualised cashflow yield of around 45%.

With the reality of climate change, coal is no longer a sexy investment. In fact, investors are justifiably concerned about coal’s long term viability. In the department of energy’s latest Integrated Resource Plan (IRP) published earlier in 2019, coal is expected to continue to make up almost 60% of the country’s energy mix in 2030. Much of the coal mining capacity to support this blend still needs to be constructed. Even, if international pressure and the increasing competitive nature of renewals force an accelerated reduction of the coal mix in South Africa’s grid, the most optimistic transition is expected to take several decades. In order to keep the lights on in the interim, coal will need to be burned in Mpumalanga’s power stations and Wescoal will be able to snatch up cheap, highly cash generating assets.