Draft Money Bill. Principle of the Royalties

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1 Equity Research South Africa Bulletin Comment Deutsche Member of the Deutsche Bank Group South Africa 24 March 2003 Draft Money Bill Hard Hitting Andrew Jackson (+27 11) Brenton Saunders (+27 11) Johan Rode (+27 11) Monique Mathys (+27 11) The draft Money Bill was released on 20 March The proposed royalties are higher than we expected ranging between 1% and 8% of revenue, split by commodity type and in line with international norms. These higher than anticipated royalties are offset, to a degree, by the implication that they will only be applied once the new order rights have been awarded (within a five-year window). In spite of this, these proposed royalties pose a significant headwind to South Africa s current operations (increasing costs, cut-off grades and reducing mine lives) and even larger hindrance to the establishment of new projects and fostering empowerment deals. The Bill is now scheduled for a four-week period of consultation and submissions. This process could result in modification of the Bill, although we anticipate that the scope for significant change is limited. The proposed Money Bill generally has assigned higher royalty levels to higher margin sectors. However, this has not been universally applied, the major discrepancy being manganese and iron ore, which are reasonably high margin businesses and have the royalty set at 2% relative to gold at 3%, platinum at 4% and diamonds at 8%. While these royalties are in line with international norms, their imposition, for most operations, will occur during the course of ongoing operations resulting in these extra costs not being factored into the return expectations during the project planning and commissioning phases. This may well result in certain operations now returning sub-economic returns to shareholders and in extreme cases the write down of assets. While we believe the Bill could potentially/is likely to be modified as various stakeholders present their cases, we have included below a summary of the impacts of the Bill in its current format. Principle of the Royalties The principle behind state royalties is that the state is levying a tax on the mining companies given that they are depleting a State-owned nonrenewable resource. On this basis, we would expect these royalties only to be levied once the current old order rights have been converted to new order rights. These rights have to be converted within five years. Deutsche Securities (Pty) Ltd Deutsche Bank AG, Johannesburg 3 Exchange Square, 87 Maude Street, Sandton Clients can access our research on our web site: IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS AT THE END OF THIS REPORT Copyright Publisher: Deutsche Securities (Pty) Ltd, 3 Exchange Square, 87 Maude Street, Sandton, 2196, South Africa. Author: As referred to above. All rights reserved. When quoting, please cite Deutsche Securities Research as the source. Additional information available on request

2 Deutsche Draft Money Bill 24 March 2003 The royalties will only be levied on mining operations (ie. those utilising State-owned mineral rights) and not on beneficiation and processing operations. Given the higher royalties for high margin sectors, the South African government appears to be trying to manage margins across all commodities in the country to similar levels. This provides a disincentive for companies to operate in South Africa if their upside potential will be limited by government. Objective of the Royalties The proceeds of the planned royalty are to be allocated to providing relief for communities impacted by mining operations together with their social and infrastructural development. Structure of the Royalties The major features of the royalty structure are: 1. The Royalty Levels: These are detailed in the table below for each individual commodity grouping: Substance Classification and Royalty Rates Group Substance Royalty Rates % Salt, sand, stone, sandstone, late, gravel, clay, concrete, mortar, plastar, brick, dolorite, limestone, shale, gypsum, limestone, perlite, and phosphate rock extracted by a mineral extractor outside of the exemption described under section 12 Oil and gas: natural gas and natural gas condensate petroleum crude offshore production where the water depths are deeper than 500 metres Alumino-silicates (andalusite, sillimanite, kyanite), asbestos, ammonium sulphate, barytes, zirconium oxide, uranium oxide, kaolin, talk, magnesite, mica, silica, sulphur, sodium sulphite, mineral pigment, pyrophylite, dimension stone (granite, norite), and perlite 4 Anthracite and bituminous coal (low ash and steam) Antimony, copper, iron, manganese, lead, zinc, cobalt, nickel, silicon, tin, and vermiculite Oil and gas: natural gas and natural gas condensate petroleum crude onshore and offshore production where the water depths are shallower than 500 metres 7 Gold, silver, vanadium, chromite, and titanium dioxide (ilmenite, rutile) 3 8 Platinum group metals: platinum, palladium, rhodium, iridium, ruthenium and osmium 4 9 Amethyst, quartz (smoky quartz, citrine, rose quartz), cryptocrystalline quartz (jasper, opal), or chalcedony (blue lace agate, moss agate, onyx, rainbow chalcedony), tiger s eye, blue asbestos (crocidolite), beryl (emeralds, aquamarine, morganite, heliodor), chrysoberyl (cat s eye, alexandrite), corundum (rubies, sapphires), garnet (jade, hydrogrossular, spessartine), lolite, kyanite, sodalite, sugilite (royal lavulite or royal azel), tourmaline, verdite (serpentine) and topaz 10 Unpolished natural diamonds 8 Source: Department of Mineral and energy Affairs 2. Calculation of Revenue: Royalties will be levied on revenue calculated at prices determined at an arms length basis, which is on a commercial or fair market value excluding transportation and insurance. The South Africa Bulletin Comment

3 24 March 2003 Draft Money Bill Deutsche exclusion of transport is an important positive for the bulk materials (coal, manganese, iron ore, chrome etc) which incur significant transport costs that are included in company revenues. These royalties will be charged on FOR (Free on Rail, ie. on an on mine sales basis) rather than on an FOB (Free on Board) basis. 3. The royalties payable are tax deductible. This effectively reduces the impact of the royalties by a third in terms of net government take assuming a tax rate in the region of 30%. 4. Royalties will be payable quarterly. 5. The minister may add or amend commodity groupings to account for new discoveries. 6. A curious aspect of the new Bill is the ability to lock in a long-term (30- year) royalty rate through a policy described as fiscal stabilisation. This involves electing to increase the current royalty rate by the lesser of 2% or 50% of the existing royalty, ie. a company can elect to pay a higher royalty rate in perpetuity (30 years) in order to guarantee the royalty for the life of the project. This clause rings an alarm bell given that it implies to us that government appears quite comfortable with the fact that it is willing to adjust these rates going forward and if a company wants certainty it must be willing to pay for it. 7. Under anti-avoidance rules, the issue of producers exporting products but not immediately selling the product is confronted. The Bill makes provision for royalty payments to be levied on discrepancies between eventual sales values and quoted export values (with the ramifications for commodity trading operations) and for 50% of the royalty outstanding to be paid if the product has not been sold within six months. These clauses appear to us to be targeting predominantly De Beers that in the general course of their business export and stockpile diamonds depending on market conditions. 8. The proposed Bill makes provisions for royalty exemptions to be granted by government. These are granted when it is deemed that only low grade ore remain or the operation is of questionable economic viability. To qualify the government has to be satisfied that all operational costs have been optimised (excluding the streamlining of labour!), significant job losses are likely and the targets of the social plan, empowerment initiatives and environmental management will be compromised. There are also certain exemptions for low value commodities (salt, brick making materials, concrete, dolorite, limestone and agricultural minerals) used in the domestic economy. There are still a number of areas of uncertainty 1. The details given in the press release imply to us that companies will begin paying royalties once they have transferred their old order rights to new order rights (within five years). This is not dealt with in the Bill, however, should this be the case we believe it would be likely to retard South Africa Bulletin Comment 3

4 Deutsche Draft Money Bill 24 March 2003 the conversion process of mineral rights towards the end of the five-year conversion window. We believe companies will need to balance the positive rating impact of securing their mineral rights at an early stage with optimising the NPV by delaying the payment of royalties. 2. Section 3(3) of the Money Bill appears to exempt an operation from the new royalties if an existing royalty is payable. This would imply that even if the existing royalty is lower than the new royalty, the new rate would not be imposed on the operation. We expect this would benefit the likes of De Beers that are currently paying royalties at both Namaqualand and Finsch operations if these royalties could be extended and thus avoid the new 8% diamond royalty. Local community royalties are also protected in the Minerals and Petroleum Resources Development. 3. The levels of royalties set appear to be broadly based on a combination of international norms and the level of each sectors current margins. However, imposing royalties on the basis of a sector wide margin does not acknowledge the fact that there can be very marginal and highly profitable operations within a single commodity grouping. In spite of there being a broad alignment of royalty levels to margins this has been inconsistently applied with the iron ore and manganese operations (high margin businesses that also benefit from transport cost exclusions in the royalty calculation) getting off towards the bottom of the royalty scale. This approach also takes no cognisance of the cyclical nature of the commodity business that can result in large changes in margins through the cycle. 4. The fact that the legislation allows companies to lock in royalties does give rise to concerns that the government may be comfortable with adjusting these rates according to industry profitability. This type of potential moving target combined with the fact that government may manage margins over time creates significant medium term uncertainty. The worst possible case for a producer is one in which a marginal player in a highly profitable sector is faced with high royalty levels. These royalties only apply to mining operations in which minerals rights are held. Therefore we see the obvious exclusions as being: 1. BHP Billiton s aluminium operations. 2. Samancor ferro-alloy beneficiation operations (BHP Billiton 60%, Anglo 40%) 3. Impala s third party IRS revenues. 4. Anglo s South African forest product operations. 5. The bulk of Anglo s ferrous metals operations. 6. Kumba s zinc refining operations. 4 South Africa Bulletin Comment

5 24 March 2003 Draft Money Bill Deutsche Likely Government Revenues and Gross Costs to Shareholders Based on recent historic data we estimate that government s tax take in 2003 terms would be in the region of R6bn. Given that these (100%) levels are only likely to be reached in the discounted value of these in today s terms would be in the region of R5bn per year. Weighted Average Royalties and Gross Costs to Shareholders Looking at the gross numbers, the weighted average royalty for the South African mining industry is calculated to be 3.9% pre-tax and 2.7% on a post tax basis once all producers are paying royalties ( ). Taking the government take and adjusting it for the corporate tax benefit, assuming that the full royalties are only reached five years hence (and discounted appropriately) and applying an appropriate multiple we estimate the cost of these royalties to the entire South African mining business are in the region of R30bn. Impact on Earnings and Valuations The press release by government implies to us that the implementation of these royalties will commence once the mineral rights have been transferred to the State. This transfer has to occur within five years. We believe the fact that companies have the flexibility to delay royalty payments clearly can reduce the near-term earnings impact to zero and can reduce the DCF impact by a third. In Anglo Platinum s case, the DCF valuation is reduced from a 9% decline if the royalty is levied from today onwards down to a 6% decline if the levy is payable from 2008 onwards. Given the structure of the royalties imposed on the various sectors and accounting for the differing geographic exposures of the various counters our initial estimations of the impact on the resources sector counters are detailed in the table below. We run two scenarios, one in which we assume the royalties are levied from June 2003 and one in which we start the royalties in January Clearly in the second scenario we only include a DCF impact as there is no near term earnings impact. The most realistic valuation and earnings impact is likely to be somewhere in between these two end member scenarios: South Africa Bulletin Comment 5

6 Deutsche Draft Money Bill 24 March 2003 Stock Price EPS Impact DCF 2003 DCF 2008 SAc Rec F1 F2 F3 F4 Impact* Impact** Anglo American Buy -2.2% -4.2% -4.1% -4.1% -4.5% -3.2% BHP Billiton 4300 Buy 0.0% -1.5% -1.4% -1.3% -1.0% -0.7% Kumba 2795 Buy 0.0% -7.9% -6.3% -5.8% -5.0% -3.1% AngloGold Sell -4.6% -9.1% -8.9% -11.7% -6.1% -3.4% Gold Fields Ltd 8790 Hold 0.0% -9.4% -8.9% -8.0% -5.9% -3.9% Harmony Hold 0.0% -20.1% -19.6% -19.9% -10.6% -6.5% Avgold 885 Sell 0.0% -14.7% -11.8% -10.1% -14.8% -11.1% ARMgold 6720 Hold 0.0% -17.0% -21.3% -25.3% -8.9% -4.4% Durban Deep 2300 Sell We expect the company will apply for the marginal mine exception Anglo Platinum Buy -7.1% -10.3% -9.7% -9.5% -9.0% -6.0% Impala Buy 0.0% -6.4% -5.6% -5.5% -5.7% -3.5% Lonmin Hold 4.5% 9.7% 8.8% 8.0% -7.3% -4.8% Northam 1465 Hold 0.0% -15.3% -13.4% -13.1% -9.4% -6.2% Sasol 9200 Buy 0.0% 0.0% 0.0% 0.0% -0.6% -0.2% Iscor 1710 Buy 0.0% -3.5% -8.9% -15.6% -12.4% -3.6% * Assumed Royalty payments from June 2003 ** Assumed Royalty payments from January 2008 All impacts are expressed as a percentage change on current deutsche forecasts/estimates December year-end companies:f1= December 2003 etc June YE Companies: F1 = June 2003 etc Source: Deutsche Securities estimates Impacts on Long-Term Orebody Management We consider the impact of these royalties on the mine planning and lives of mines is significant. Royalties effectively increase an operation s cost base. An increasing cost base increases pay limits and reduces the size of the mineable resource and reduces a mine s effective life and or output. The net result is that increasing royalties are likely to result in the sterilisation of currently economic mineral resources, in our view. The South African gold industry is likely to be most affected by this phenomenon. Ancillary Impacts Other impacts of this legislation, not discussed above, include: 1. Higher project hurdle rates. We believe the combination of this legislation with the strengthening Rand is likely to undermine the viability of some of the planned expansion projects in the sector. 2. Upward pressures on cost curves PGMs (platinum group metals), diamonds and gold are the major areas of impact. 3. Kumba to Iscor cost plus contracts Kumba s cost plus operations that sell coal and iron ore to Iscor are not likely to impact Kumba s earnings as the extra costs will be passed on to Iscor. At Sishen, in which Iscor has retained a share in the mineral rights, the royalty will in all likelihood be paid directly by Iscor for its beneficial production. The unknown factor is whether the royalty on the iron ore and coal sold to Iscor on a cost plus basis will be levied at market values or on the cost 6 South Africa Bulletin Comment

7 24 March 2003 Draft Money Bill Deutsche plus sales price. Kumba will, however, carry the royalty burden for all its other mining operations. 4. Eskom electricity prices: Thermal coal producers supplying Eskom power stations (Anglo, BHP Billiton, Kumba etc) generally operate on a cost plus basis (or a derivative of the cost plus contract). Therefore, the extra "cost of the 1% revenue royalty will be passed onto Eskom and will most likely be reflected in higher electricity prices. 5. Sasol coal transfer pricing Sasol s mining division produces low value (high ash content) coal for use in the synfuels division where the transfer pricing is based on a form of cost-plus pricing. The unknown factor is again whether the royalty on the coal sold to synfuels will be levied at market values or on the cost plus transfer price. We believe that only the export portion of Sasol s sales will attract royalties at market values. 6. Companies will have to review targeted gearing ratios given the direct negative impact these royalties will have on free cash flow. We believe this Bill could also lead to a long term weakening of the South African mining operation s balance sheets. 7. The promotion and funding of empowerment deals (and the relative attractiveness of the sector for empowerment players) is likely to be compromised by royalties at these higher than expected levels. Conclusion On balance, these royalties are worse than we expected. Given the Finance Ministry s good track record, we expected a more pragmatic approach to fostering growth and empowerment in the sector. It would appear to us that the royalties are negatively biased towards Anglo given the high rates on gold, platinum and diamonds. The stocks, however, that we consider are most exposed to this legislation are the South African focused, high royalty counters. Of these we highlight Avgold, Harmony and Anglo Platinum as being potentially particularly hard hit. We also believe that we need to highlight the fact that the legislation makes provision to fix the long-term royalty rate by electing to pay a higher royalty level (+50% to a maximum of 2%). This implies, in our analysis, that government envisage further (or ongoing) changes to royalty rates. These potential moving targets serve to increase legislative uncertainty in the South African mining arena. Given that the Money Bill is still a discussion document we would envisage that the Bill is likely to moderate prior to parliamentary approval. However, we do not envisage that the moderation will be nearly as significant as that seen in the final Mineral Development Charter relative to the leaked draft. The saving grace for this legislation will be if government follows the principle of only levying royalties once the mineral rights pass into state hands as implied by government s recent press release. This will allow South Africa Bulletin Comment 7

8 Deutsche Draft Money Bill 24 March 2003 companies to mitigate the valuation impacts by retarding conversion of their minerals rights. We would anticipate that under this scenario companies would look to convert their mineral rights on a year time frame, allowing time to deal with any last minute snags in their conversion process. We believe this would reduce the near term earnings impact of royalties to close to zero and minimise the DCF impact by 25-30% of the cost of applying these royalties immediately. We estimate that under this scenario the cost of this legislation to be in the region of R20-30bn to shareholders in the major listed resource counters, the bulk of which we anticipate has already been priced into the stocks. Disclosure Checklist Listed Company Disclosure Anglo American 2,6,7,8,9 Anglo Platinum AngloGold 8,9 ARMgold Avgold 3 BHP Billiton 1,2,6,7,8,9,10 Durban Deep 2 Gold Fields Limited 2,3,6 Harmony 2,6,9 Impala 3,6,7,8,9 Iscor Kumba 6,7,8,9,11 Lonmin Northam Sasol 2,3,6,8,9 The following conflicts of interest may exist with any one or more securities recommendations in this report. For detailed disclosures pertaining to a specific recommendation or estimate made on a security mentioned in this report, please see the most recently published company report on our website at 1. Within the past year, Deutsche Bank and/or its affiliate(s) has managed or co-managed a public offering for this company, for which it received fees. 2. Deutsche Bank and/or its affiliate(s) makes a market in securities issued by this company. 3. Deutsche Bank and/or its affiliate(s) acts as a corporate broker or sponsor to this company. 4. The author of or an individual who assisted in the preparation of this report (or a member of his/her household) has a direct ownership position in securities issued by this company or derivatives thereof. 5. An employee of Deutsche Bank and/or its affiliate(s) serves on the board of directors of this company. 6. Deutsche Bank and/or its affiliate(s) owns 1% or more of any class of common equity securities of this company calculated under computational methods required by US law. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. 8. Deutsche Bank and/or its affiliate(s) expects to receive or intends to seek compensation for investment banking services from this company in the next three months. 9. Deutsche Bank and/or its affiliate(s) was a member of a syndicate which has underwritten, within the last five years, the last public offering of this company. 10. Deutsche Bank and/or its affiliate(s) holds 1% or more of the share capital of this company calculated under computational methods required by German law. 11. Where applicable, please see special disclosure for this company below. Deutsche Bank AG and/or an affliate(s) is providing investment banking services to Anglo American plc, South Africa in relation to its relationship with Kumba Resources Ltd, South Africa. 8 South Africa Bulletin Comment

9 24 March 2003 Draft Money Bill Deutsche Deutsche Bank Research Ratings Key Buy: Total return expected to appreciate 10% or more over a 12-month period. Hold: Total return expected to be between 10% to -10% over a 12-month period. Sell: Total return expected to depreciate 10% or more over a 12-month period. Deutsche Bank@ Deutsche Securities@ Member of the Deutsche Bank Group Publisher: Deutsche Securities (Pty) Ltd, 3 Exchange Square, 87 Maude Street, Sandton, 2196, South Africa. Author: As referred to on the front cover. All rights reserved. When quoting, please cite Deutsche Securities Research as the source. The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively Deutsche Bank ). The information herein is believed by Deutsche Bank to be reliable and has been obtained from public sources believed to be reliable but Deutsche Bank makes no representation as to the accuracy or completeness of such information. Important Information Regarding Our Independence. The research analysts responsible for the preparation of this report receives compensation that is based upon, among other factors, Deutsche Bank s overall investment banking revenues. In addition, Deutsche Bank: (i) may be a market maker or specialist in securities issued by companies mentioned herein, (ii) may act as an adviser, underwriter or lender to companies mentioned herein, (iii) may have received or intend to seek compensation for investment banking services from the company mentioned herein, (iv) along with its respective officers, directors and employees, may affect transactions and/or hold long or short positions in securities, derivatives thereon or other related financial products of companies mentioned herein, (v) may engage in securities transactions in a manner inconsistent with this research report, and (vi) with respect to securities covered by this report, will sell to or buy from customers on a principal basis. Certain additional details regarding these and other potential conflicts of interest, if any, are discussed at the end of the text of this report or on the Deutsche Bank website at Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. Prices and availability of financial instruments also are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and investment objectives. If a financial instrument is denominated in a currency other than an investor s currency, a change in exchange rates may adversely affect the price or value of, or the income derived from, the financial instrument and such investor effectively assumes currency risk. In addition, income from an investment may fluctuate and the price or value of financial instruments described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor s home jurisdiction. In the US this report is approved and/or distributed by Deutsche Bank Securities Inc, a member of the NYSE, the NASD and SIPC. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this report is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Registration Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. Copyright 2003 Deutsche Bank AG Additional information available upon request. South Africa Bulletin Comment 9