On the positive side of the ledger, Aflease has two of the 10 most promising gold exploration projects in the world at this time. This is the opinion of Neal Froneman, the new CEO at Aflease. On the negative side, the company’s financial results for the first 2 quarters of 2003 will be poor, a situation that will be remedied once the new CIL plant is fully commissioned and loaded up, which is expected within months.

Before dealing with the changes that have taken place at Aflease since my report 6 months ago, I would like to put what is happening at Aflease into perspective. This necessitates a brief look at the current state of the world gold mining industry.

In a recent presentation, Alex Davidson the VP for exploration at Barrick, said that the gold mining industry has invested so little in exploration that current reserves could be depleted in 10 years. Non-South African producers appear to be more acutely affected since they cannot rely on deep reserves being activated by higher gold prices.

According to Davidson the industry is not funding exploration at a level sufficient to replace reserves and he claims that only two 5 million ounce deposits have been discovered since 1999.

This theme was echoed by Dr Mark Bristow, the CEO of Randgold Resources, who is recently reported to have said:

“The consolidation of the global gold mining industry has masked its stagnation over the past five years and it now urgently needs to make new discoveries. The industry’s combined exploration expenditure peaked in 1997 and since then has dropped off sharply to less than a third of that level.  Over the same period, the number of active gold mining companies has shrunk by some 15%.  The new gold supply has grown by a mere 1.5% year on year since 1991, before making any deductions for hedging,

“There has in effect been a steady decline in production, which has been masked by the frenzy of consolidation in the industry over the past few years.  However, while consolidation can preserve or unlock existing value, the only way to create new value is through exploration, development and innovation.  Quite simply, as an industry, we need to find more new viable gold mines.”

Aflease is very busy with drilling programs on two of its properties and it is expected that the company will prove up two new deposits, one of at least 10 million ounces and a second of at least 5 million ounces, within the next couple of years. This is discussed in greater detail later in this report.

John Embry, who managed one of the top performing gold funds last year and is now with Sprott Asset Management in Toronto, was recently interviewed by Miningweb and was asked the following question: “In your fund you invest in small to mid cap companies. Is that where you believe the leverage is going to be, as opposed to the bigger companies?”

Embry replied:  “I think that the big boys will work; you can make good money in the big stocks because they have lots of ounces in their reserves. But the real leverage will come in the smaller ones because they have growth capacity – the capacity to dramatically increase their reserve bases and increase their production. They tend to be more cheaply valued to begin with. If you can find the combination of a reasonably valued mid-cap or small-cap company with an interesting ore body that is in a growth phase, you are going to make an enormous amount on your money.”

The discussion that follows shows that Aflease meets Embry’s criteria precisely. 

Changes at Aflease.

There is no disguising the fact that results for the past 3 quarters were extremely disappointing. These poor results were incurred during the tenure of Peter Skeat as CEO and Executive Chairman. While the buck stops with him, there were a number of mitigating factors as Skeat was busy achieving several good things for Aflease. He recognised the significance of the Bonanza reefs and instituted a drilling program to explore them. He negotiated with Japanese gold investment company Jipangu, to raise funds via a share placement. He commenced construction of a CIL plant, in preparation for the start of underground mining. He recognised the possibilities inherent in the New Kleinfontein (NKM) acquisition. With all this action it is perhaps not surprising that he temporarily took his eye off the ball.

The alacrity of Peter Skeat’s recent resignation from the Aflease Board suggests that there was a degree of conflict on the Board. A number of corporate governance issues were apparently the cause of his departure but Aflease was Skeat’s “baby” and he probably found it difficult to give up his role as Chief Executive.

The Board has since been totally reconstituted. Only Jean Nortier remains and he becomes the Non-executive Chairman. The new appointments are:

Neal Froneman (Chief Executive Officer), Bruce Jones (Chief Operating Officer), Marais Steyn (Chief Financial Officer). New non-executive directors are Ferdinand Lips, Ken Dicks and John Sibley.

Froneman and his team have a very good reputation in South Africa. I also like the new non-executive directors. Ferdinand Lips is well-known and liked in banking and mining circles. Ken Dicks recently retired from Anglo American where he had a reputation for being a top underground production man. He was previously a consultant to Aflease with responsibility for the Bonanza section. John Sibley is a Canadian lawyer and represents Jipangu’s interest in Aflease.

I feel comfortable with the new management and confident that they will deliver on the huge promise inherent in the Aflease properties.

The new discoveries.

The two most exciting aspects of Aflease are the exploration being conducted on both the Bonanza reefs at the Aflease section, and on the Black Reef at the NKM acquisition on the East Rand. Both can now be classified as new discoveries. The geologist that I retain to advise me on mining matters in South Africa has been steadfast in his expectation that the company will eventually prove up at least 10m ounces on each of these sites.

My geologist did extensive investigative work on the NKM section some years ago when it was owned by Harmony. The latter failed to follow up on his recommendations and eventually sold the property. Through their drilling Aflease have discovered major extensions to the Black Reef at Modder East. The company’s resource inventory at NKM is already up to 3.2m ounces but drilling will continue for at least another 6 months. The company’s exploration target of proving up at least 5.0m ounces on the NKM section is, I believe, a realistic expectation. Although this is on a property that was previously mined, it now deserves to be regarded as a new discovery. Drilling results suggest an average in situ grade of 7.7g/t on the Black Reef and correspond with the values realized at neighbouring Grootvlei.

The Bonanza reefs are an equally exciting discovery. Aflease believes that it has identified what could be a 400 metre wide channel in the north west of this deposit and mining will commence when the new CIL plant is commissioned at the end of May. A surface incline shaft has been opened up and a 60,000 tons per month conveyor is being installed. Initial production of 15,000 tpm is planned but extensive development is taking place to allow this figure to be raised initially to 30,000 tpm.

Despite this activity the company has gone to great pains to describe the Bonanza project as an “exploration target” with potential to contain around 10m ounces. It is believed that the first channel so far identified extends over 16 km (10 miles) but the company needs to do extensive drilling before the new deposit can be transferred to the category of ‘Inferred and Probable Resources.’ CEO Neal Froneman described the expectation of 10m oz on the Bonanza West reefs as “defendable”. The inferred total tonnage at Bonanza West is set at 70m tons. Core values disclosed in the recently published quarterly results average out at 8,75g/t over an average width of 72cms.  These grades suggest that the deposit could possibly contain much more than 10m oz.

A second Bonanza Reef pay channel has been identified in the north-eastern sector of the property and drilling will also be focused on this area. This supports the belief that the potential of the Bonanza reefs will eventually be much greater than 10m oz.

The Profit Potential.

The need to replace reserves by the gold mining industry will inevitably drive up the value of ounces in the ground, especially those ounces that are easily accessible and highly profitable to mine. The time horizon is also important to the valuation. The sooner these ounces can be mined, the higher their net present value. Most exploration is currently being carried out in remote regions of the world and discoveries are often in areas lacking infrastructure. It can take years to bring such deposits to account.

The Aflease discoveries have several advantages. They are shallow, the Black Reef at NKM being only 300m deep while the Bonanza reefs run from surface where they outcrop, dipping down at 9 degrees, to a maximum depth of 1,700m. Furthermore they are located in areas where mining is easy and infrastructure is readily available. The Bonanza reefs can be accessed rapidly, are of relatively high grade and are potentially very profitable. (See calculations that follow).

My guess is that the value of these resources will be in the region of at least $35 per ounce. To achieve this valuation the company needs to build up detailed knowledge of the Bonanza and NKM deposits to the point where reliable resource numbers can be established and proper mining plans prepared - a process that will take both time and money. Drilling at Bonanza West is being accelerated and an additional budget of R28m has been allocated for this purpose. Once these deposits reach the Probable Resource stage, they could be valued as follows:

Valuation of Resources:

Bonanza Reefs – 10m oz at $35 per oz                    $350m

NKM deposit – 5m oz at $35 per oz                           $175m

Lower grade resources – 5m oz at $15                     $  75m

Total Valuation:                                                           $600m

Current market capitalisation of the company is about $113m (188m shares at $US 60c). This gives one some indication of the extent to which Aflease shares could appreciate once management can give credibility to the reserves and resources believed to be contained in these new discoveries.

A Possible Takeover?

The huge potential implicit in these twin deposits could easily attract predators and a takeover bid for Aflease is not without the bounds of possibility. By way of example I direct your attention to the Jipangu Inc. web site: www.jipangu.co.jp. It will come up in Japanese but the “English” button in the top right corner brings up the translation. Click on “Basic Strategies and Management Vision”, then “Focus on the Second Phase” where there is a section specifically on Afrikander Lease.

Jipangu openly states that their plan “is to ultimately incorporate Afrikander Lease as a subsidiary” by continuing to increase their stake in the company. A “subsidiary” means a holding in excess of 50% of Aflease. In South Africa, when a company acquires in excess of 35% of another, in terms of JSE Regulations it is required to make an offer for 100% of the shares in the target company at a price not less than the highest price paid prior to the bid. A full offer by Jipangu at some point in the future seems to be a distinct possibility.

There is no time scale forecast for this event, but if an offer is made before all the above deposits have been fully drilled and evaluated it is possible that the bid which materializes will be below what major shareholders believe the company is worth. If this turns out to be the case, most will refuse to accept and Aflease will continue to be quoted in Johannesburg and on Nasdaq where, incidentally, it is expected a level 2 ADR listing will shortly be granted.

The South African Rand – US Dollar Exchange Rate.

Any discussion of the potential profitability of a South African gold mine must commence with a consideration of the US$ / Rand exchange rate. This fact has been forcibly brought home to gold share investors over the past seven months. During this period the London afternoon fixing appreciated by 6.1%. This table shows what happened to the gold price expressed in Rand over that same period:

Date                ZAR/US$         $Gold oz        ZAR oz            ZAR kg

1/10/02            10.50               $321.7             R3,378                        R108,600

1/05/03              7.25               $341.2             R2,474                        R  79,500

                        +30.9%            +6.1%              - 26.8%            - 26.8%

This rapid rate of appreciation by the ZAR against the USD is unsustainable, which is just as well because the decline in the proceeds received by South African mines has placed operating margins under severe pressure. I have prepared a matrix to show how ZAR proceeds received by mines can vary according to movements in the ZAR/USD exchange rate:

GOLD PRICES IN SOUTH AFRICAN RAND

The ZAR has been depreciating against the USD for many years. This particular graph depicts only the movements since late1997, when the exchange rate was ZAR4.6 to USD1.0. I have drawn in 2 trend lines, a shallower longer-term one, and a shorter, steeper trend starting in January 2000.

What is interesting is that in the second half of 2001, the USD went parabolic against the ZAR, rising from ZAR8.0 to ZAR13.5 in 6 months. In so doing it moved a long way above both trend lines. The combination of a parabolic move, combined with it being a great distance above trend, virtually guaranteed not only a sharp reversal back to trend, but also a move below trend. In other words, as in most markets, the move is from extreme under-valuation to extreme over-valuation. This is what happened and should be corrected by a reversal back up to the trend line.

The situation we presently have is complicated by the fact that the shallower trend line has also been broken. This raises the possibility of a significant change of trend with the ZAR continuing to strengthen against the US dollar over the longer term. Despite this happening, the over bought condition of the ZAR suggests that a near term correction is likely, probably back to the base of the shallower trend line, at about ZAR8.5 or even ZAR9.0

The exceptional strength of the ZAR in recent months may have been partly due to the huge interest rate differential existing between ZAR rates (11% pa available on call) and those ruling in Europe and the USA where rates range between 1% and 3%. ZAR interest rates are unlikely to remain at double-digit levels for much longer. When they eventually fall there could be a short-term stampede out of the ZAR.

At the current low level of ZAR versus the USD, many South African mines will be forced to close marginal operations and lay off staff. Tax revenues will also diminish. It is possible that the South African balance of payments could move into deficit. A combination of these factors could eventually put pressure on Government to take action to cause the ZAR to weaken somewhat. My expectation is therefore that in due course a gold price in the region of R100,000 per kilogram is sustainable.

Potential Profitability of Afrikander Lease.

I have prepared estimates of working profits for 3 different mining strategies for each of the Aflease and NKM sections and used a range of gold prices to illustrate the impact of these price changes on each production strategy in turn. At the Aflease section the critical variable is the rate at which production from the higher grade Bonanza Reefs can be increased. The various assumptions are set out below.

The working costs per kilogram for the open pit have been estimated at R75,000 per kilogram, while costs at Bonanza West should be of the order of R35,000 per kilogram. The substantial difference demonstrates why it will be important to escalate production at Bonanza West as rapidly as possible.  Working costs at the NKM section should be of the order of R48,000 per kilogram, ensuring a very good profit margin once this new acquisition commences production.

Case 3 for the Aflease section assumes 120,000 tons per month from Bonanza West at a recovered grade of 5g/t, producing 231,000 ounces of gold per annum. Actual grade could be slightly higher than this judging by the latest drilling results. If a minimum 10m ounce ‘Resource’ is proved up on the Bonanza West reefs, one would expect this rate of production to be increased to at least 500,000 ounces a year, giving the deposit a prospective 20 year life. 

These figures are forecasts for cash working profits only and make no allowance for corporate overheads, amortisation, interest, exploration costs or taxation.

WORKING PROFIT ESTIMATES FOR AFRIKANDER LEASE GROUP

AFLEASE SECTION

Assumptions:

Case 1. CIL throughput 200k tons per month plus 60k tpm free dig on leach pads.

              Bonanza 15k, underground 25k and open pit 160k tpm.

Case 2. CIL throughput 300k tons per month plus 60k tpm free dig on leach pads.

              Bonanza 30k, underground 50k and open pit 220k tpm.

Case 3. CIL throughput 300k tons per month plus 60k tpm free dig on leach pads.

              Bonanza 120k, underground 50k and open pit 130k tpm.

Recovered grades in all cases: Bonanza 5.0g/t, Underground 3.0g/t, Open pit 1.0g/t and free dig 0.6g/t.

Working costs R150 per ton underground and R50 per ton open pit. Free dig R30 p/t.

Processing costs R25 per ton.

Production:                            Pit       Bnza   Ugnd   F’dig   Total

Case 1.  TPM  (000)                160      15        25        60        260

               TPA (m)                   1.92     0.18     0.30     0.72     3.12

            Grade g/t                     1.0       5.0       3.0       0.6       1.6

            Kg produced               1,920   900      900      430      4,150

            Oz produced (000)     61.7     28.9     28.9     13.9     133.4  

Case 2.  TPM  (000)                220      30        50        60        360

               TPA (m)                   2.64     0.36     0.60     0.72     4.32

            Grade g/t                     1.0       5.0       3.0       0.6       1.6

            Kg produced               2,640   1,800   1,800   430      6,670

            Oz produced (000)     84.9     57.8     57.8     13.9     214.4

Case 3. TPM (000)                 130      120      50        60        360

              TPA (m)                    1.56     1.44     0.60     0.72     4.32

            Grade g/t                     1.0       5.0       3.0       0.6       2.8

            Kg produced               1,560   7,200   1,800   430      10,990

            Oz produced (000)     50.1     231.5   57.8     13.9     353.3

Working Costs:

Case 1.  Tons p/a (m)                        1.92     0.18     0.30     0.72     3.12

Working + Processing p/t       R75     R175   R175   R30

Total working costs (Rm)       144      32        53        22        250

Case 2. Tons p/a (m)             2.64     0.36     0.60     0.72     4.32

Working + processing p/t       R75     R175   R175   R30

Total working costs (Rm)       198      63        105      22        388

Case 3. Tons p/a (m)             1.56     1.44     0.60     0.72     4.32

Working + processing p/t       R75     R175   R175   R30

Total working costs (Rm)       117      252      105      22        496

Cost per kg produced             R75k    R35k    R58k    R51k    R45.1

Aflease Section Working Profits:

Revenue per Kg                   R60k   R75k   R100k R125k R150k

Case 1.

4,150kg/133,400oz (Rm)        249      311      415      518      623

Less working costs (Rm)       250      250      250      250      250

Working Profit (Rm)                (-1)        61      165      268      373

Case 2.

6,670kg/214,400oz (Rm)        400      500      667      834      999

Less working costs (Rm)       388      388      388      388      388

Working profit (Rm)                  12      112      279      446      611

Case 3.

10,990kg/353,300oz (Rm)      659      824      1,099   1,373   1,648

Less working costs (Rm)       500      500      500      500      500

Working profit (Rm)                159      324      599      873      1,148

NKM SECTION

Assumptions:

Case 1. Production 60,000 tons per month and a recovered grade of 5.0g/t

Annual production: 3,600kg (115,000oz)

Case 2. Production 60,000 tons per month and a recovered grade of 7.0g/t

Annual production 5,040kg (162,000oz)

Case 3. Production 120,000 tons per month with recovered grade 5.0g/t

Annual production 7,200kg (230,000oz)

Working costs in all cases R210 per ton and processing costs R30 p/t.

NKM Section Working Profits:

Revenue per kilogram:                    R60k   R75k   R100k R125k R150k

Case 1.

3,600kg/115,000oz  (Rm)                   216      270      360      450      540

Less working costs (Rm)                   173      173      173      173      173

Working profit (Rm)                              43        97      187      277      367

Case 2.

5,040kg/162,000oz (Rm)                    300      378      504      630      756

Less working costs (Rm)                   173      173      173      173      173

Working profits (Rm)                          127      205      331      457      583

Case 3.

7,200kg/230,000oz                             432      540      720      900      1,080

Less working costs (Rm)                   346      346      346      346      346

Working profits (Rm)                            86      194      374      554      734

COMBINED WORKING PROFITS FOR THE AFRIKANDER LEASE GROUP.

Revenue per kilogram:                    R60k   R75k   R100k R125k R150k

Case 1.

Aflease section (Rm)                            (-1)      61      165      268      373

NKM section (Rm)                                 43       97      187      277      367

Working Profits  (Rm)                            42     158      352      545      740

Case 2.

Aflease section (Rm)                            12      112      279      446      611

NKM section (Rm)                              127      205      331      457      583

Working profits (Rm)                          139      317      610      903      1194

Case 3.

Aflease section (Rm)                          159      324      599      873      1148

NKM section (Rm)                                86      194      374      554      734

Working profits (Rm)                          245      518      973      1427    1882

NOTES:

1. These figures are cash working profits and do not make allowance for corporate overheads, amortisation, interest, exploration costs or taxation. The purpose of preparing these figures is to demonstrate the sensitivity of group profits both to different operating strategies and to fluctuations in the gold price expressed in Rand.
2. The present market capitalisation of the company is 188m shares at R4.50 each, a total of R846m (US$115m at R7.3 to the dollar). It is interesting to observe that in certain circumstances the company’s working profits in one year could exceed the company’s current market capitalisation.
3. The losses currently being incurred during the start up of the new CIL plant, together with the cost of the ongoing drilling program, may require the company to make use of short-term bank finance. Further capital may be needed to increase the CIL plant capacity from 200,000 tons per month to 300,000 tpm and also to establish the new NKM mine.
4. The Aflease share price has been weak due to a number of factors. These include the recent and sudden resignation of Peter Skeat, poor short-term results, the strength of the Rand, the recent decline in the gold price from $388 to $319 and general uncertainty caused by the latest Board changes. All are short-term factors of limited significance. Together they provide an attractive opportunity for long-term investors to make acquisitions in Aflease at relatively low prices.
5. Aflease is a small to mid-cap company with two very interesting deposits that have the potential to increase the company’s reserves, production and profits dramatically – the very parameters set out by John Embry in his search for maximum profit.
6. The company trades in Johannesburg under the code AFL and on Nasdaq in New York as AFKDY.

Alf Field

14 May 2003

Comments to: ajfield@attglobal.net

Disclosure Statement: The author is a long-term investor in AFL/AFKDY and this stock is the author’s largest gold share holding. The author has not been paid to write this article nor has he received any other inducement to do so. The author will benefit from any appreciation in the market prices of AFL/AFKDY.

Disclaimer: The author’s objective in writing this article is to invoke an interest on the part of potential investors in this company to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell these securities. Investors are recommended to obtain the advice of a qualified investment advisor before entering into transactions in these securities.

-- Posted Thursday, 15 May 2003 | Digg This Article