Turbulence Reaching South Africa: How Will These ADRs Perform?

What's the outlook for AngloGold Ashanti, Sasol, and Harmony Gold Mining?

Feb 12, 2014 at 3:08PM

South Africa started feeling the pressure of uncertainty again this year as its currency, the South African rand, depreciated 6.3%. In 2013, it dropped 23.5%, so the outlook is not the best. As a consequence, the country's central bank hiked interest rates 50 basis points to 5.5% in the end of January to try to get investors to remain in the rand. Although this initiative has brought good results so far, it could wear off if uncertainty continues.

The country is not in its best shape, either: It grew only 0.7% in the third quarter of 2013 -- its slowest pace in more than four years. In addition, inflation started raising new concerns when it reached 5.4% in December.

How will ADRs perform?
Let's analyze three stocks, two involved in gold production and one in energy.

South African-based AngloGold Ashanti (NYSE:AU) operates mines in four continents producing gold, as well as uranium, silver, and sulfuric acid.

The company is making some improvement on a sequential basis. Gold production is up 12%, while corporate costs fell by 26% compared to last quarter. In addition, cash flow from operating activities increased 128% to $319 million.

However, the company's operations in some of its South African mines date back 100 years, so the challenges and costs of extracting deeper gold reefs have increased. Given the maturity of its mines, production in South Africa is more expensive than in other countries in the continent.

Nonetheless, the devaluation of the rand will make labor and other expenses in the country relatively cheaper in the short term. AngloGold is a company that exports most of its production, and obtaining hard currency for its produce will help it deal better with the country's above-average mining-cost inflation.

High costs
A similar high-cost scenario is affecting Harmony Gold Mining (NYSE:HMY), which explores, extracts, and smelts gold in South Africa and Papua New Guinea.

Performance in the second quarter has not been good for Harmony. Despite gold production increasing 4.9% year over year, the company recorded a net loss of $0.02 per share in the quarter. Revenue dropped roughly 24% to $402 million compared to the prior-year quarter and remained flat sequentially.

Harmony is executing a cost reduction program that dropped its all-in sustaining cost of gold production by 19% during the first quarter. However, it remains one of the highest-cost South African major producers, as lower recovery grades of ores are lowering yields.

Finally, let's see what's up with Sasol (NYSE:SSL), which uses coal-to-liquid (CTL) and gas-to-liquid (GTL) technology to convert low-cost coal and natural-gas feedstock into higher-value liquid fuels and petrochemicals.

The company has some good fundamentals, as it has access to low-cost feedstock for the production of fuel and chemicals. In fact, Sasol's operating margins have averaged 22% over the last five years. The company mines about 40 million tons of coal per year, and it uses 95% of it internally for production, reducing input costs.

However, Sasol faces some threats from petrochemical facilities in the Middle East and Asia, as well as from the surge of low-cost natural-gas production in North America and growing interest for GTL plans in the U.S. Gulf Coast. If these nations increase their production, the oversupply will erase the long-term cost advantage that the company currently enjoys.

Bottom line
These three companies will benefit from the current conditions in South Africa in the short term, increasing their profitability thanks to a weaker rand. However, inflation will probably pick up sooner than later, erasing this hike in competitiveness. What will determine their outlook, then, is the mid- and long-term price of commodities. The CBOE Gold Index is up almost 14% year to date, but it dropped 53% last year alone. Some analysts think gold has reached its bottom price, but volatility is not over yet.

The case for AngloGold and Harmony is tricky, as weak gold prices have been hitting these companies. In addition, labor demands in the country are no joke. In late January, trade unions were pushing for a doubling of pay for miners, leading to strike-related disruptions in production. In September of last year, an 80,000-people strike -- that's two-thirds of the country's mine workers -- almost paralyzed the industry, and these two companies had to raise employee pay substantially.

Sasol remains solid, and it can profit from the spread between lower-cost hydrocarbons and higher-value fuels and petrochemicals. The weaker rand is also a positive factor, as more than 56% of the company's turnover is generated in the country. Nonetheless, the price of oil and gas will ultimately drive the company's future profitability.

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