Why I think EM should be trading at discount (2)

Acacia Mining PLC (ACA LN): a waiting game.

If you think you have hedged against the current uncertain market situation by buying gold mining stocks, you should not be too excited first.

At least that is what some Acacia Mining PLC (ACA LN) investors feel.

Indeed, in the past, ACA LN share price movement is very similar to the movement of gold prices:

In fact, the correlation of both reached 0.944 over the last 5 years.

However, the harmonious relationship between the price of gold and ACA LN shares was destroyed at about the end of May17 (see the green arrow in the graph below).

Instead of getting a hedge, ACA LN investors get an additional risk: political and legal uncertainty risk.

ACA LN is primarily engaged in the business of mining, processing and sale of gold, copper and silver in Tanzania. Tanzania is an East African country known for its vast wilderness areas.

I find it difficult to find the Tanzanian category in the investment world, but I believe the status of Tanzania is closer to the frontier market rather than emerging market. Which means that structurally, Tanzanian is even more risky when compared to other emerging market countries.

ACA LN is actually a foreign company operating in Tanzania. The majority owner is Canada based Barrick Gold, a largest gold mining company in the world.

The company has 3 operating mines located in Tanzania. The company’s segments are North Mara, Bulyanhulu and Buzwagi gold mines.

The North Mara gold deposits are situated in the Mara Musoma greenstone belt. It is a combined open pit and underground operation from two deposits, Gokona (underground) and Nyabirama (open pit).

The Bulyanhulu is a narrow-vein gold mine containing gold, silver and copper mineralization in sulfides.
The Buzwagi is a shear-hosted quartz-veined deposit, hosted in porphyritic granite. The Buzwagi mine is a low grade bulk deposit with a single large open pit. It also has a portfolio of exploration projects located across Africa.

ACA LN’ overall reserve and resource base of 27.5 mio ounces is one of the largest asset bases in Africa. Although ACA LN has reserves of gold, copper and silver, but until now the production and sales of ACA LN consists of only gold.

While the company’s revenue depends on the price of gold, but in terms of production, which in fact is a factor that is more controlled by the company, the ACA LN shows stability.

With a cash cost of USD 600/oz, ACA LN is one of the most efficient gold producers.

However, all of sudden, the president of Tanzania, John Magufuli banned the export of unprocessed ores in Mar17 as part of a plan to promote the development of domestic smelting. Tanzania also accused ACA LN of operating illegally. As a result, ACA LN was served with USD 190 bio bill unpaid taxes, penalties and interest accumulated over the past 17 years.

ACA has denied the charges. ACA LN claims to have invested more than USD 4 bio in Tanzania over the past 20 years and operates 3 mines in the country.

In essence, Mr. Magufuli’ action is a form of asset nationalization movement.

In my view, there are several reasons why a country would take such repressive action:

• The country wants to regain their assets fully.
• The government wants to replace their business partner.
• The government wants to get more profit sharing either in the form of taxes, investments or the absorption of more local labor.

For the first reason, it could happen but the chances are small. There is no advantage of expelling foreign money. Tanzania can learn from North Korea, how it feels the country has no business cooperation with others. Furthermore, I doubt Tanzanian government and its private companies have sufficient funds and expertise needed to manage their assets independently.

For the second reasons, it may happen. But if you think further, which investors are willing to invest after the government slaughter ACA LN?

Of the three, the last reason is the most plausible. Which means the Tanzanian government and ACA LN must sit together to discuss the issue.

Regardless of the government’s angry reaction, the Tanzanian government’s demands are far-fetched.

To put things into perspective, USD 190 bio bill is equal to 190x ACA LN’ revenue in 2016 or 100x ACA LN market cap. Even Barrick Gold’ market cap – which is the parent of ACA and the world’s largest gold company – is just USD 18.62 bio or about 10% of the total bill being put on hold.

Therefore, the request of the Tanzanian government is clearly unreasonable.

But, absurd as it may sound, the damage is already happening.

This turmoil has resulted in ACA LN losing 67% of market cap from its highest point last year. While in the same period, the price of gold rose 8%.

At a price of GBp 181.80, ACA LN is trading at 0.5x BV whereas in the past ACA LN was on average trading in the range of 1x BV and the median of similar companies is 1.35x.

ACA’ financial condition is also very healthy, with total liabilities only USD 629 mio while cash and equity of USD 176 mio and USD 1,891 mio respectively. However, I predict the cash portion will decrease rapidly due to this scandal.

Investors who had thought of getting cheap stock now can only bite their fingers. By buying these shares, they are not investing, but hoping. They hope the president of Magufuli is just joking.
The future of the ACA LN relies heavily on the outcome of the company’s negotiations with the Tanzanian government, which in fact is not known when it will finish.

This case should open the eyes of investors to the political and law uncertainty risks that can occur in developing countries like Tanzania.
At 0.5x BV, the risk-reward ratio is not attractive enough. If investors should demand a higher margin-of-safety on firms in emerging markets, investors should instead insist on huge margin-of-safety for companies in or who have exposure to frontier markets. 

Disclaimer: This article is not a recommendation to conduct transactions on the intended securities. Any consequences arising from this writing are beyond the responsibility of the author.