Kicking the (oil) can down the road

• South Africa
• Debt, Fossil fuel, Oil, Rights issue, Rights Offer, Sasol
• August 18, 2020

Sasol is up 600% since the share price collapsed in March. It’s down 11% over the past two days. This gives an idea of how nervous investors are about the company after the latest financial results were released.

Sasol is my single largest exposure in my portfolio. That’s not because I bet the farm on the stock, but because I took a risk (sadly not early enough in lockdown) and it has grown beautifully. Many have taken their gains and gone, in which case I wish them luck in their debate with SARS over whether the profits should be taxed as capital or income.

If you hold a stock for less than three years, you have to convince SARS that your intentions were to be a long-term holder rather than a trader. If Sasol can keep it together, I’m in for at least three years. Paying capital gains tax vs. income tax is material at these profit levels and I also happen to believe that Sasol will successfully navigate its immediate future.

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Importantly, I’m not buying more at these levels. My exposure is high enough for my tastes.

Let’s take a closer look at what is really going on at Sasol.

Cash war room

Sasol has released its results for the year ended 30 June 2020 (FY20). Sasol reported a loss of over R90bn vs. a profit of R6bn the year before. Many would stop reading at that point and walk away in the belief that Sasol is dead in the water.

Finance and investing isn’t that simple. There’s a lot to consider here, like operating cash flow which is only down 18% to R42bn. Many of the metrics aren’t all that bad.

The investor presentation gives a casual nod to a “cash war room” which tells you everything about the current state of play for Sasol’s management team.

They are counting every single penny because the only priority at the moment is to reduce the group’s debt. With nearly R200bn of total debt and a R7bn interest charge on the Lake Charles project debt alone, the situation is desperate.

Sasol needs to reduce debt by between $4bn and $6bn. The target is in USD so translating at current exchange rates isn’t necessarily the right thing to do, but in today’s money that is between R70bn and R100bn in round numbers. To give context to this, Sasol’s market cap is below R90bn.

We must touch on Sasol’s breach of its debt covenants. A debt covenant is a promise to a bank that there is enough security against the loan to prevent the bank losing out. It can be based on the interest charge (“I promise that I will earn x times more than my interest bill”) or on the capital value of the debt (“I promise that total debt won’t be more than x times higher than EBITDA”).

EBITDA is Earnings Before Interest, Tax, Depreciation and Amortisation and is a great proxy for operating profit.

Sasol already had to go to the banks, begging them to relax the covenants. They were successful, with a new covenant set at a maximum debt level of 4x EBITDA. Sasol’s position at 30 June was 4.3x EBITDA but this would’ve improved since then, so that isn’t a problem in and of itself.

Management isn’t just relying on the oil price

There are things within Sasol’s control (like cash cost savings and disposals of assets) and things that are totally beyond its control.

Let’s start with the most important external factor: the oil price. Sasol does have a hedging strategy in place to smooth out the impact of oil price changes, but that doesn’t save the company over an extended period. As the world has started to open up, the Brent Crude price has improved considerably to over $45 a barrel (vs. $20 a barrel at its worst in March).

That’s a 125% gain vs. a 600% gain in Sasol, which is worth remembering the next time an “expert” tells you they traded oil futures instead of Sasol because it’s “the same thing” – it absolutely isn’t.

In FY19, the Energy division (aka oil) contributed nearly R23bn of R47.6bn adjusted EBITDA. Put differently, just less than half of Sasol’s operating profits were contributed by the business that is directly exposed to the oil price. Chemicals, for example, contributed 37% of operating profit.

In FY20 the picture looks completely different because the Energy division took most of the pain. It only contributed a third of operating profit, down R11.3bn from FY19. My point is that a reasonable recovery in the oil price and consumer demand will go a long way towards solving Sasol’s immediate problems.

The management team isn’t relying solely on this outcome. The investor presentation assumes $35 – $45 per barrel for FY21, which is conservative but fair given Sasol’s debt problems.

$2bn in cash savings

Management pledged to save $1bn in cash in FY20 and they beat that goal by 20%. They have promised another $1bn in savings in FY21. Much of this will come from capex savings as the Lake Charles project requires limited further capital investment.

Importantly, management highlights that every 10c move in the USD:ZAR exchange rate hurts them by R30m in required capex spend. Sasol is a complex beast because they have to manage a web of USD and ZAR commitments.

I’m glad I don’t work at Sasol, because these kind of cost savings cannot be achieved without an impact on the workforce.

>$2.6bn in asset disposals

A critical part of the plan is the accelerated asset disposal programme.

$0.6bn of this target has either been concluded or the deals are well advanced. At least another $2bn needs to be achieved and Sasol doesn’t have much negotiating leverage.

You know those ads where people advertise a car as “urgent sale – emigrating next week”? That’s what Sasol’s Gumtree ad looks like, except they are advertising assets like Lake Charles and the price is many billions of Rands. Hopefully.

Nobody quite knows what Sasol will achieve for Lake Charles as there isn’t a deal currently on the table. The only thing we know for sure is that it will be far lower than the amount Sasol invested in that nightmare of a project. There are other assets in the Great Sasol Garage Sale, but Lake Charles is the big one.

Up to $2bn rights issue (but perhaps not…)

The rights issue (raising money from shareholders) is the last resort to reduce the debt. Whether or not it happens and at what value will depend entirely on the performance in Sasol’s business and the prices achieved for the asset disposals. The $2bn cost savings plan is helpful but they cannot beat that target by enough to negate the need for a rights issue.

This is the where the rubber hits the road in terms of the share price. If the rights issue goes ahead, the share price will probably take a knock (although much of it is priced in). If it can be avoided or materially lowered, I will have an even bigger Sasol Smile on my face.

Another potential outcome is that Sasol goes ahead with the rights offer but does so to prepare the company for Sasol 2.0 – a company that is less reliant on oil.

FY22 and beyond: avoiding becoming a fossil

Sasol isn’t exactly top of a Greenpeace “most loved companies” chart. From a climate change perspective, Sasol is a dinosaur.

To achieve any kind of long-term sustainability, Sasol needs to move into new energy sources. This is why businesses like the chemicals divisions are so important. Sasol has also pointed towards gas and renewable energy as other alternatives.

More clarity from management is expected in November. Sasol cannot possibly work towards Sasol 2.0 until Sasol 1.0 has a presentable balance sheet, but I’m genuinely feeling bullish that management can get this right, at least over my three year holding period.

A large percentage of my portfolio depends on it.