Endeavour Mining — Forecasts up; valuation up

Endeavour’s Q3 results were considerably ahead of our forecasts, despite a challenging rainy season in which more than four times as much precipitation fell than in the equivalent period in Q316. The effects of the weather were notable particularly in individual mines’ unit mining costs (as opposed to processing or G&A costs), which were flat or increased in every instance, not least as a result of additional water pumping costs being incurred. In addition, inventory adjustments added to the cost of sales at Houndé, Agbaou and Karma. However, production also rose at three of Endeavour’s four mines – the exception being Houndé, where output dropped by 6.1% quarter-on-quarter. Note that this performance followed a Q2 in which all of Endeavour’s mines also outperformed our production expectations, with the exception of Karma. Overall, group production increased by 5.5% relative to the prior quarter (NB historically, production has tended to fall in Q3 relative to Q2) and was 3.5% above our forecasts, driven by increases in both tonnes milled/processed (+3.3% q-o-q) and head grades (+6.3%), despite the selective utilisation of low-grade stockpiles, partially offset by a decline in recovery rates at all of the mines with the exception of Agbaou.

Financial results included a US$49.5m loss on financial instruments (see dedicated section on page 4) and a US$10.6m charge for deferred tax. Even so, stripping these out, earnings were US$28.0m compared with Edison’s forecast of US$10.4m – albeit almost all of the difference could be accounted for by the additional US$15.7m in revenues that were generated by Endeavour’s 6.1koz increase in production relative to our forecasts plus a further 4.5koz of sales over and above production. Net adjusted EPS of 30.2c was more than twice our forecast of 12.9c. Otherwise, operating cash flow (before working capital items) more than doubled to US$1.05/share, return on capital employed increased to 15% (on an annualised basis) and net debt (excluding IFRS 16 leases – see Financials, below) reduced by US$52m. Capex continued to fall with sustaining plus non-sustaining capex amounting to no more than US$24.3m across the company’s four mines.

From an operational perspective, the best performance during the quarter was recorded by Ity, where an increase in production of 10.9% on an ostensibly flat cost base resulted in an increase in the mine’s earnings of 85.5%, or US$15.8m, relative to the prior quarter, albeit aided by a relatively low marginal tax rate and a lower than ambient minority charge. Of note was a moderation in reagent consumption, which had previously been required to achieve higher recoveries on some ores containing high cyanide soluble copper as the blend of ores fed to the mill stabilised. By contrast, rain slowed the development of the high-grade Bouéré deposit at Houndé, which was mined at a slower rate than planned and necessitated the augmentation of the mill feed with low-grade stockpiles, which also reduced metallurgical recoveries on account of the ore blend. In addition, Houndé attracted a deferred tax charge, which resulted in an increased marginal tax rate, as well as a higher than ambient minority charge. Agbaou similarly attracted a deferred tax charge as well as a higher than ambient minority charge. Operationally however, it benefited from higher throughput and recovery (as a result of increased capacity utilisation and, consequently, lower unit processing and G&A charges) and a lower stripping ratio as mining focused on the deeper elevations of the North Pit and as it commenced in the South Pit extension, which resulted in an increase in capitalised waste, albeit less than anticipated owing to better than expected unit mining costs. Finally, at Karma, mining transitioned from the Kao Main pit to the Kao North pit early in the quarter, with the result that the stacked grade increased owing to the oxide nature of the new ore, while metallurgical recovery rates declined at the same time as tonnes stacked declined, owing to maintenance downtime related to the installation and commissioning of the tripper conveyor in addition to the heavy rains, which resulted in an increase in unit mining costs. As at Houndé and Agbaou, Karma experienced a deferred tax charge, which increased its marginal tax rate. It also recorded a sharply higher depreciation and depletion charge (although no more than in line with the increase in production). However, there was no charge for minority interests.

A detailed analysis of Endeavour’s financial and operational performance, relative to both the previous quarter and our prior expectations (as set out in our note, Endeavour Mining: Valuation US$27.58; potential 32% upside, published on 3 October 2019) is as follows:

Once again, it is notable that both the tax charge and the minority interest charge during the quarter were above those that would naturally be expected, given the realities of Endeavour’s commercial circumstances. On an underlying basis however, the marginal current income tax rate was more in line, equating to 33.8% of underlying pre-tax profits (compared to 17.5–25.0% for those of Endeavour’s individual operations), while the underlying minority charge equated to 24.1% of underlying profits after tax (compared to 10–15% for those of Endeavour’s individual operations) – albeit it is noticeable that both of these numbers have always exhibited considerable volatility, historically, on a quarterly basis.

The largest single variance between Edison’s Q319 forecasts and actual results related to losses on financial instruments. Edison had forecast a loss of US$1,445k compared to an actual figure of US$49,528k. However, whereas Edison’s forecast was based on the anticipated loss on the realisation of contracts relating to its gold revenue protection strategy during the quarter, the actual loss reflected a number of other items, which are summarised below:

In addition to the additional four items, in the third quarter, of the US$8,138k charge relating to the gold revenue protection programme, only US$1,633k related to realised losses (ie tolerably close to Edison’s forecast of US$1,445k) with the balance relating to unrealised losses for the balance of the programme:

Note that the charges relating to realised and unrealised gains/(losses) on the gold revenue protection programme relate to the short-term strategy put in place by Endeavour in order to maximise cash-flow certainty during its debt reimbursement phase. Similar to the strategy it put in place during its recent construction phases, this comprises a deferred premium collar strategy using written (sold) call options and bought put options to (effectively) create a synthetic short position. The programme began on 1 July 2019 and will end on 30 June 2020 and covers a total of 360,000oz (approximately 50% of Endeavour’s total estimated production over the period), with a floor price of US$1,358/oz and a ceiling price of US$1,500/oz. Now that the gold price has reverted below US$1,500/oz however (and is close to our forecast of US$1,474/oz for the quarter) the bought put option contracts will be ‘out of the money’ and therefore has the potential to result in reversals of these losses in future quarters (all other things being equal).

Note also that, in recognition of the change in value of the Tabakoto and Nzema receivables (Exhibit 2), we have removed an assumed cash inflow of US$10m from our cash-flow forecasts for FY19 in Exhibit 9.

Following the performance test conducted in Q219, optimisation and de-bottlenecking work commenced, which is expected to increase plant capacity by 1Mtpa, or 25%, to 5Mtpa at a cost of US$10-15m. During the third quarter, plant throughput achieved an annualised rate of 4.7Mtpa after the installation of larger motors on the primary apron feeder and vibrating grizzly at the crusher as well as increased lime addition capacity, which accounted for c US$4m of the budgeted capital expenditure. The remainder of the upgrade is on track to be completed in Q419 and will account for the remainder of the budget.

While Edison expects Ity’s Q419 performance to be broadly in line with its performance in Q319, in the longer term, the advantage of increasing plant capacity to 5Mtpa will be to bring processing capacity in line with the mining rate at Ity, thereby avoiding the build-up of large stockpiles for processing once mining operations have been concluded, as shown graphically in the Exhibit below:

Note that, for the purposes of the above analysis, Edison has simply brought forward 1Mt of production at the appropriate grade (from the 2017 optimisation study) from FY21 into FY20, 2Mt from FY22 into in FY21, 3Mt from FY23 into FY22 etc, such that exactly the same amount of gold is mined at exactly the same cost over a shorter timeframe. No other changes have been made.

All other things being equal, we estimate that this change increases the NPV10 of the Ity CIL project by US$117.7m, or 14.0%, or US$1.07 per share as at 1 January 2020 (at Edison’s updated gold prices – see below).

Historically, Endeavour has a good record of meeting its production and cost guidance targets. Moreover, historically, Q4 has always been one of Endeavour’s strongest quarters. Within this context, Ity is on track to achieve the upper end of its full-year 2019 production guidance range of 160-200koz, as it continues to mine into harder fresh ore. The challenge for management in the fourth quarter will be to successfully manage the transition from soft ore. At the same time, the lower average grade required to fill excess plant capacity beyond its nameplate design (see below) coupled with higher royalty costs is expected to result in all-in sustaining costs (AISC) finishing near the top end of the guidance range of US$525-590/oz.

To a greater or lesser extent, some of the rains experienced in Q3 continued into October, especially at Houndé, which has delayed the ramp up at the high grade Bouéré deposit. As a result, the stripping ratio at Houndé is expected to stay high in Q4 and the ramp up will only occur towards the end of the quarter and in the beginning of Q120 – albeit this will be partially offset by the fact that the grade of the ore mined there is expected to reach c 3g/t (cf a blended head grade of 1.85g/t processed in Q319).

In the light of these expectations and its mines’ performances to date, Endeavour has slightly adjusted its guidance for the full-year to the following, which are similarly compared with Edison’s updated forecasts (see also Exhibit 6):

Aside from the changes to production and cost estimates noted in Exhibit 5 above, Edison’s forecasts for FY19 continue to reflect Endeavour’s sustaining and non-sustaining capital cost guidance for each of its mines for the remainder of the year, with the result that our financial and operational forecasts for Endeavour for Q419 and FY19 are now as follows:

We note that forecasting on a quarterly basis is prone to large variations between actual and forecast numbers (as demonstrated, not least, by the variances observed between Q319 actual figures and Q319 estimates in Exhibit 1, above). To this end, it is worth noting that the top end of Endeavour’s production guidance is 44.5koz gold above our updated forecast for the year, which is worth a material US$62.0m in additional revenue to the company (net of royalties) and therefore has the ability to increase Endeavour’s full year profit before tax by 89.1% relative to our forecasts above (all other things being equal). As such, the exhibit above should be regarded as more indicative than prescriptive with respect to the individual quarters.

In addition to our short-term FY19 forecast adjustments, we have also adjusted our longer-term gold price assumptions to those set out in our recent report, Portents of economic weakness: Gold – doves in the ascendant, as follows:

Endeavour is a multi-asset company that has shown a willingness and desire to trade assets to maintain production, reduce costs and maximise returns to shareholders (eg the sale of Youga in FY16, Nzema in FY17 and Tabakoto in FY18). Rather than our customary method of discounting maximum potential dividends over the life of operations back to FY19, therefore, we have opted to discount potential cash flows back over four years from FY19 and then to apply an ex-growth terminal multiple of 10x (consistent with using a standardised discount rate of 10%) to forecast cash flows in that year (ie FY22). In the normal course of events, exploration expenditure would be excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, we have included it in our estimate of FY22 cash flows on the grounds that it may be a critical component of ongoing business performance in its ability to continually expand and extend the lives of the company’s assets.

Since our last note, we have updated our life of operations financial model for Endeavour to reflect our updated gold price forecasts (see Exhibit 7 and Portents of economic weakness: Gold – doves in the ascendant) as well as Ity’s expansion of its process plant throughput rate from 4Mtpa to 5Mtpa. As a result, our estimate of Endeavour’s cash flow in FY22 has increased materially to US$4.20 per share (cf US$3.23/share previously), on which basis our terminal valuation of the company at end-FY22 is US$41.99/share (cf US$32.33/share previously), which (in conjunction with forecast intervening cash flows) discounts back to a value of US$32.30/share at FY19 (cf US$27.58/share previously).

Endeavour had US$615.1m in net debt (including IFRS 16 leases) on its balance sheet at end-Q319 (vs US$653.2m at end-Q219, US$615.3m at end-Q119 and US$517.5m at end-Q418), after US$32.8m in net capex during the quarter (vs US$66.1m in Q219, US$103.9m in Q119, US$87.1m in Q418 and US$110.8m in Q318). This level of net debt equates to a gearing (net debt/equity) ratio of 74.4% (vs 76.5% at end Q219, 72.4% at end Q119, 60.3% at end-Q418 and 52.1% at end-Q318) and leverage (net debt/[net debt + equity]) ratio of 42.7% (vs 43.3% at end-Q219, 42.0% at end-Q119, 37.6% at end-Q418 and 34.3% at end-Q318). Note that US$615.1m accords with Endeavour’s Q319 balance sheet; it differs from the figure of US$608.5m quoted in some of the company’s other materials on account of the fact that it includes US$9.3m in IFRS 16 leases (albeit mitigated by the fact that future cash flows associated with certain debt instruments are discounted back to present value rather than being presented on an undiscounted basis).

With capital expenditure relating to the Ity CIL project now having been, to all intents and purposes, completed, Endeavour has no major capex commitments in the future until the development of Kalana and/or Fetekro. In the new gold price environment, we calculate that cash flows will be strongly positive in Q419, such that we are forecasting that the company will have net debt of c US$526.8m as at end-FY19 (cf US$523.3m previously), which will equate to a gearing ratio of 62.2% (cf 57.4% previously) and a leverage ratio of 38.4% (cf 36.4% previously). Note however, that this forecast is dependent on trade and payables reverting to something close to their normal historical relationship with operating expenses and attaining a level of c US$190.4m at end-FY19 compared to a level of US$134.3m at end-Q319 and US$177.3 at end-FY18. Thereafter, net debt should decline rapidly such that we estimate the company will be net debt-free in late FY21 (cf early FY22 previously) notwithstanding any capex related to the Kalana project, at which point it will potentially be able to make dividend distributions to shareholders.