The case of investment in Harmony Gold

Nouriel Roubini, the man famous for predicting the 2008 financial crash, doesn't believe in gold as an investment.

"Gold can go up for only two reasons," he wrote towards the end of last year. "[One is] inflation, and we are in a world where there are massive amounts of deflation because of a glut of capacity... There's no inflation, and there's not going to be for the time being. The only other case in which gold can go higher with deflation is if you have Armageddon, if you have another depression. But we've avoided that tail risk as well."

There is, however, strong counter opinion to this view. Firstly, many analysts believe that inflation is inevitable, given the way that governments created money to stave off doomsday. Secondly, gold is a finite resource and global production is flat at best. With central banks less prepared to sell their gold reserves on the open market, the deficit between supply and demand may continue rising.

Since Roubini penned the above, the gold price has already increased by around 20%. Taking a slightly longer-term view, the price of the metal has more than tripled since 2005, having traded at under $500 an ounce for 20 years before that.

There is a strong view in the market that what is occurring is a natural re-pricing of gold. The suggestion is that the price is set to continue to rise to a level where supply and demand offset one another, thereby eliminating a shortage.

Those who buy into that assumption may view an investment in South Africa's gold stocks as a means to benefit from this correction. These are companies with strong asset bases and relatively assured production over the medium term.

Harmony is the smallest of the three top tier local players. While its resource base does not match those of AngloGold Ashanti or Gold Fields, it does boast an enormously impressive record of growth over the last 15 years and fascinating prospects through its projects in Papua New Guinea.

History

Harmony Gold was incorporated and listed on the JSE in 1950. At the time, it operated a single gold mine in the Free State that soon fell under the management of Randgold & Exploration.

In 1995, Harmony was re-established as an independent entity when the management agreement with Randgold & Exploration was cancelled. The Harmony mine was close to closure at this point, being mature and only marginally profitable.

However, through a series of acquisitions from 1997 onwards, Harmony dramatically reversed its fortunes. By taking ownership of a number of mines on the Witwatersrand, as well as in the Free State, North West and Mpumalanga, the group grew into the third largest gold miner in the country and one of the biggest in the world.

Harmony merged with ARMGold in 2003, and the following year made a failed hostile bid for Gold Fields.

In 2007 it acquired the royalty rights for Hidden Valley in Papua New Guinea from Rio Tinto, thus launching its operations in that country.

Dividends

Harmony paid a dividend of 50c for the last financial year, matching the dividend it paid in 2009. However, the last dividend it declared before that was in 2004.

The group's dividend yield is currently around 0.6%.

Which funds hold this stock?

Harmony does not enjoy a strong presence amongst South Africa's leading unit trust funds. Of the five leading general-equity funds over the last three to five years, only the Allan Gray Equity Fund has exposure to the counter. It assigns a little over 3% of its funds to Harmony. (In total, Allan Gray currently holds a little under 14% of the company.)

The top five mining and resources funds do not have much exposure to the stock either. Harmony is only held by the RMB Resources Fund - at around 4.4% of the fund - and the Investec Commodity Fund - which assigns it 3.6%. Both of these funds have bought into the stock over the last six months.

To see which funds are buying and selling the counter, visit Moneyweb's Unit Trust Portfolio Tool.

Why would an individual consider investing in this company?

The story of Harmony's growth from a single, struggling mine to one of the world's largest producers of gold says something for the quality of the group's senior management. The true test will be however, whether Harmony can translate its success beyond South Africa's borders.

The group is also uniquely positioned in the mining sector in the diversity of its operations.

"Harmony has a balanced portfolio of assets, with quality assets, growth assets and leveraged assets," a recent analysis by Frost & Sullivan explains. "Quality assets are those that form the basis of Harmony's operations; growth assets represent the future of the group's operations; and leveraged assets are older, low grade assets that are capable of providing a significant upside in the event of an increase in the gold price."

The sale earlier this year of its mothballed Mount Magnet project in Australia, and the recent closure of a number of shafts in South Africa, is however a demonstration of Harmony's commitment to streamlining its operations and focusing on its quality assets. Increasingly these will be in Papua New Guinea, but it still has a number of excellent mines in South Africa.

What risks does this company face?

Increasing energy and labour costs in South Africa are a significant challenge for Harmony, as 95% of its gold is produced locally. The added demands of deep level mining, including the need for more steel and concrete to support shafts, also push up costs. The government's heavy-handed approach to safety issues also has the potential to have a major influence on output.

"Safety-related production stoppages are likely to continue having an adverse impact on the country's gold production," Frost & Sullivan notes. "In addition, electricity shortages, skills shortages, and other operational constraints are likely to continue affecting capacity."

A strong local currency has adverse effects on Harmony too, as its costs are paid in rands, while it earns dollars for its ore. A lower rand price for gold therefore translates into smaller margins for the group.

Harmony also faces the threat of old mines and declining ore grades that are below the industry average. During the last year it closed seven shafts that it felt had reached the end of their economic life. The group's ability to successfully clean up its asset base while at the same time commissioning new mines and expansion projects to address this issue will be vital for its future success.

Where does this company's growth potential lie?

Harmony has begun to establish a base in one of the world's most promising gold regions, Papua New Guinea. The Wafi-Golpu copper-gold project, which is part of a 50/50 joint venture with Australia's Newcrest, is probably the most promising new resource on the planet. It will be a major boost to Harmony's production when the mine comes into operation. The group has also acquired extensive exploration rights nearby.

Harmony has indicated that it has aggressive plans to expand outside of its current South African base, to mitigate against the risks in the local mining environment. The group expects to produce 40% to 45% of its gold in other countries by 2017. Most of this will come from its projects in Papua New Guinea.

The group's increased exploration activities are not, however, solely geared towards improving its geographic diversity. It is also looking for opportunities to extend its mines within South Africa.

"The company has commissioned a number of growth projects within its existing mining operations in South Africa, as well as its open pit operations in Papua New Guinea," notes Frost & Sullivan. "Harmony has also increased its exploration spending in order to open up new mines, extend the life of existing mines and increase production."

In addition, Harmony owns 40% of unlisted Rand Uranium, which has the rights to produce uranium from the highly rich Cooke Tailings Dam near Randfontein, amongst other assets. While construction of the Rand Uranium plant has been delayed due to the current low uranium price, some analysts suggest that supply shortages could translate into a jump in the uranium price within the next couple of years that could make this project profitable.

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