Hello from Hanoi

Alkane Resources 14 April 2016 Update

Alkane Resources

Hello from Hanoi

Critical rare earth agreement

Metals & mining

14 April 2016

Price

A$0.22

Market cap

A$91m

US$/A$0.76

Net cash (A$m) at 31 December 2015

14.8

Shares in issue

414.2m

Free float

74%

Code

ALK

Primary exchange

ASX

Secondary exchange

OTCQX

Share price performance

%

1m

3m

12m

Abs

(4.3)

(2.2)

(20.0)

Rel (local)

(2.5)

(3.9)

(7.5)

52-week high/low

A$0.3

A$0.2

Business description

Alkane Resources is a multi-commodity explorer and developer, with projects in the central west region of New South Wales in Australia. It owns the Tomingley Gold Operation and DZP rare metal and rare earths projects (both 100%). TGO entered production in January 2014 and DZP is currently planned for first production during FY18.

Next events

Finalised zirconium sales agreement

End June 2016

Analysts

Tom Hayes

+44 (0)20 3077 5725

Charles Gibson

+44 (0)20 3077 5724

Alkane Resources is a research client of Edison Investment Research Limited

Alkane Resources (AZL), via its wholly owned subsidiary Australia Zirconia (AZL), has signed a letter of intent with a private Vietnamese specialty metals refiner and trader relating to the toll treatment of DZP rare earth (RE) output. The agreement, although early stage, removes a degree of uncertainty over the future sale of a significant portion of the DZP’s annual production. We also see the agreement as de-risking project financing. We continue to maintain our view that the DZP, through its diversified product suite and very advanced stage of engineering and product offtake arrangements, remains the strongest non-Chinese contender for exposure to the strategically important REE (and other speciality metals) space.

Year end

Revenue (A$m)

PBT*
(A$m)

EPS*
(c)

DPS
(c)

P/E
(x)

Yield
(%)

06/14

35.5

3.4

(0.4)

0.0

N/A

N/A

06/15

101.8

0.1

1.0

0.0

22.0

N/A

06/16e

100.7

(6.6)

(1.6)

0.0

N/A

N/A

06/17e

113.4

(5.5)

(0.5)

0.0

N/A

N/A

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Agreement positions for longer-term engagement

The letter of intent (LOI) has been signed with Vietnam Rare Earth JSC (VTRE) to toll treat the DZP’s rare earth concentrate into separated rare earth products (both RE alloys and oxides). VTRE has its own rare earth and specialty metals processing plant in Vietnam, a facility that would likely cost four times as much to develop if it were in Australia. The LOI also details a joint marketing company to be formed between AZL and VTRE to market the latter’s currently produced RE and associated downstream products. This marketing company should provide AZL with a window of opportunity to broaden its footprint in the downstream RE marketplace.

Financing – many moving parts to align

The VTRE agreement replaces the previous Shin-Etsu agreement, which lapsed at end 2014. While only an LOI at present, a commercial agreement that can be used for financing purposes is to be finalised on completion of due diligence and toll treatment, and marketing terms and conditions. This, with a zirconium sales agreement, should be completed by end June 2016, at which point all necessary data will be at a bankable standard, allowing for DZP financing to be completed.

Smaller hafnium output and A$ strength hurt value

A significant 8% strengthening of the A$ versus the US$, along with a 50% reduction in planned long-term (ie post-2025) hafnium output, albeit with a 60% increase in the long-term hafnium price used, drives our fully diluted valuation down 17% from A$1.09 to A$0.90 per share. All other valuation assumptions remain unchanged (including very conservative DZP prices) from our update note published in February 2016, and we use a 10% discount rate to reflect general equity risk. Volatility in the A$/US$ forex rate provides the most significant near-term risk/opportunity to our base valuation.

Almost there…

Finalising commercial agreements for all the DZP’s products is critical to guaranteeing future revenues and project financing. The history of the DZP has seen a varied set of circumstances provide the backdrop to its development, first experiencing the unsustainable rare earth bubble of 2011, through the subsequent downturn, a crash in the gold price (which effectively marked an end to the previous decade-long commodities boom in April 2013) and then the marked slowdown in Chinese economic growth and the protectionist changes in its domestic rare earth production and export policies. All these factors have served to oppose development; however, through dogged persistence, a strong portfolio of geologically rich land holdings and a realistic and cautious approach (demonstrated through frugal cash management and taking on no debt to build the TGO), Alkane is now cash flow generative through its gold mine and, due to years of technical de-risking, well positioned to bring the DZP online with a gradually improving macroeconomic backdrop.

Further, in 2016 the mining industry appears to be servicing a far more differentiated commodity market, the likes of which will probably look to support more projects bearing specialty, minor and rare metals – those elements that are used pervasively, however diffusely, throughout technology and clean-tech applications. The nascent, though high-growth energy storage subsector will also serve as a separate catalyst from the natural growth rates seen in established technology applications. This will occur not only through direct consumption of specialty metals, but also through the myriad and varied set of applications, which will plug into the increasingly electrified energy infrastructure that will result.

Status of DZP product agreements and end-markets

A key risk of the DZP is securing commercial offtake partner agreements for its different products. Securing such agreements is critical to Alkane’s ability to generate revenue from its suite of products that have no open market on which to be sold. The following table summarises the current agreements that Alkane has in place for its DZP products.

Exhibit 1: Summary of DZP product agreements

Product

Status of product agreements

Date agreement signed

Expiry date

Company

Zirconium products

MoU to market zirconium products in Europe and North America.

15 August 2012

31 December2014

European trading and manufacturing company – moving to agreement

Refined REE output

LOI with Vietnam Rare Earth JSC to toll process AZL’s rare earths concentrate into separated rare earth products.

March 2016

2027 with option to extend

Vietnam Rare Earth JSC

Niobium concentrate

Framework agreement whereby TIAG and AZL jointly process DZP niobium into FeNb ready for subsequent sale.

17 July 2013

N/A

Treibacher Industrie AG

Source: Alkane corporate announcements

With only one agreement in place with Treibacher Industrie (TIAG) over the DZP’s future production, Alkane intends to finalise agreements on its zirconium and rare earth output over the remainder of CY16. It has marketed extensively through Europe and the US over the last few years and has been stepping up its efforts in 2015 and ytd. Although TIAG and VTRE have allowed their names to be disclosed, this is not a standard practice and disclosure of the company name supporting zirconium offtake may not be announced. Regardless, Alkane will need to notify the market of finalised commercial offtake agreements in the coming months, such that it can maintain its development timeline and first production occurs in 2018.

Alkane’s projected group revenue split and DZP products are shown in Exhibit 2 below.

Exhibit 2: Group revenue split for FY20e

Source: Edison Investment Research

The chart above correlates to the following amounts being produced in 2018:

16,374t of high-purity zirconia products;

6,664t of rare earth chemical concentrate;

1,967t of niobium as ferro-niobium;

50t of hafnium as HfO2; and

approximately 65,000oz Au from the TGO.

We provide a summary of the DZP’s product suite below.

Zirconium – commercial terms being finalised

The sale of zirconium-based products, in the form of zirconium basic sulphate and chemical zirconia, constitutes the largest revenue stream (31%) at group level for Alkane. The zircon market in all its forms has remained flat during recent years and, with zircon used in its most widespread form in building construction applications, demand is closely linked to infrastructure spending, especially out of China. Alkane has guided to a Q2 CY16 timeframe for commercialisation of its zirconium-based sales agreements.

Niobium – Treibacher Industrie

Subject to the effects of the oligopoly in this market, niobium prices remain flat at US$40-45/kg. Commercialisation of Alkane’s framework agreement with TIAG (Exhibit 1) is also being converted into a commercial offtake agreement by end 2016.

Rare Earths – Vietnam Rare Earth JSC

The LOI signed with VTRE is valid for 12 months, during which time Alkane will complete due diligence on VTRE to make sure it can deliver the quality of product at forecast cost levels to end-users. After this 12-month period, Alkane will also have the option to purchase equity in VTRE (details of this potential purchase are not available). VTRE has been separating rare earth concentrates into separated rare earth metals since 2012 and, according to Alkane’s management, achieves this at cost levels similar to that of the rare earth processors in China. If true, it has a major competitive edge over those western rare earth developers looking to refine in house.

Hafnium – output revisions mirror industry needs

Management has guided us to a reduction in future hafnium output based on its ongoing discussions with potential customers, primarily in the aerospace and industrial gas turbine industries, and its current understanding for the potential scale of this market once the DZP is in production. We previously forecast 200t produced and US$100m in revenue pa from the DZP. We now reduce hafnium production to 50tpa from start-up through to 2025, at which point we raise output to 100tpa from 2025, resulting in annual revenues of A$80m pa. Alkane’s management has stated that hafnium output could increase beyond 100tpa as the world market for this metal grows and accepts the DZP as an established long-term stable producer. Refined hafnium metal currently trades at US$1,200/kg, and we forecast that US$1,100/kg will be realised during the DZP’s ramp-up period 2018-20, followed by a flat US$500/kg over the remainder of the mine’s life. We retain our estimate for hafnium prices during the ramp-up phase and, based on management’s guidance (no other firm price data are available for hafnium, which trades largely by private contract between supplier and customer), forecast US$800/kg flat at steady-state production rates until 2036 – the end of the DZP’s mine life under our assumptions (the DZP resource base, however, can support a mine life of 35 years at a mining rate of 1Mtpa).

Valuation: Down due to hafnium output reduction

This valuation section should be read in conjunction with our February update note Gold production on target, costs within budget, as the note contains details on the newly finalised underground mining phase at the TGO. We move our valuation forward one year to FY17 and adjust for the aforementioned revised guidance relating to the future output of hafnium metal from the DZP (page 3 of this note). We retain our forecasts regarding TGO production (ie 65koz of gold produced by end FY16) and reduce (due to A$/US$ strengthening) our average FY16 A$ gold price from A$1,725/oz to A$1,600/oz. We also increase our A$/US$ forex rate by 8%, from 0.70 to 0.76. On this basis, our SOTP valuation is shown in Exhibit 3 below.

Exhibit 3: Edison SOTP valuations, January 2016 and April 2016

Asset

January 2016 (A$/share)

April 2016 (A$/share)

TGP

0.15

0.15

DZP

0.90

0.71

Cash

0.04

0.04

Total

1.09

0.90

Source: Edison Investment Research

Our valuation is based on a dividend discount approach and therefore discounts all free cash from operations in the form of theoretical dividend payments using a 10% discount rate to reflect general equity risk. Our DDF-based model includes Alkane’s current financing strategy for the DZP (see our October 2015 update note), as well as debt funding for the TGO UG phase and a new DZP working capital facility totalling A$4m (see Financials section below for our treatment of these items). Note that the above valuation is post-dilution. If the DZP is not successfully developed and we remove all financing assumptions and dilution for this project, Alkane’s shares, based on gold production from the TGO only at a spot price of US$1,250/oz (A$1,664/oz at a US$/A$0.76 forex rate), are worth A$0.53 each.

Financials

Alkane’s cash position at end H116 was A$14.8m. We expect gold production to come in at 65koz of gold production for FY16 and we forecast AISC costs to be at the upper end of guidance at A$1,296/oz. As mentioned above, in our model, we have adjusted the gold price to A$1,600/oz and A$/US$ forex rate to 0.76 (cf 0.70 previously). These factors drive our revenue estimates to A$113.4m (cf A$101.5m previously) for FY17, while cost of sales remains at A$63.1m for FY17 as these costs are A$ denominated. We forecast total FY16 exploration expenditure (which includes DZP development expenditures) of A$8.0m (H116: A$4.0m) and include A$3.7m in land purchases and a A$4m working capital facility (treated as debt, repaid over five years starting in FY19, bearing 10%) relating to the DZP. We also budget A$8m in exploration expenses for FY18, where previously we recorded none. We have also included A$20m in UG development capex for the TGO and assume this is met by debt repaid over five years bearing 10%, starting in FY19 as UG production is firmly bedded down. On this basis and including our valuation adjustments, we estimate that Alkane will finish FY16 with cash of A$21.8m.

Exhibit 4: Financial summary

A$'000s

2014

2015

2016e

2017e

Year end 30 June

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

35,474

101,813

100,664

113,398

Cost of Sales

(25,692)

(74,809)

(80,307)

(63,131)

Gross Profit

9,782

27,004

20,357

50,267

EBITDA

 

 

3,890

26,478

20,135

50,089

Operating Profit (before GW and except.)

3,890

(79)

(6,795)

(5,652)

Intangible Amortisation

0

0

0

0

Exceptionals/discontinued

(4,798)

(8,211)

0

100,000

Other

0

0

0

0

Operating Profit

(908)

(8,290)

(6,795)

94,348

Net Interest

(471)

153

223

177

Profit Before Tax (norm)

 

 

3,419

74

(6,573)

(5,474)

Profit Before Tax (FRS 3)

 

 

(1,379)

(8,137)

(6,573)

94,526

Tax

(4,893)

4,051

0

0

Profit After Tax (norm)

(1,372)

4,125

(6,573)

(5,474)

Profit After Tax (FRS 3)

(6,272)

(4,086)

(6,573)

94,526

Average Number of Shares Outstanding (m)

373.7

413.4

414.2

1,061.6

EPS - normalised (c)

 

 

(0.4)

1.0

(1.6)

(0.5)

EPS - FRS 3 (c)

 

 

(1.7)

(1.0)

(1.6)

8.9

Dividend per share (c)

0.0

0.0

0.0

0.0

Gross Margin (%)

27.6

26.5

20.2

44.3

EBITDA Margin (%)

N/A

N/A

N/A

N/A

Operating Margin (before GW and except.) (%)

N/A

N/A

N/A

N/A

BALANCE SHEET

Fixed Assets

 

 

160,174

162,624

148,113

911,100

Intangible Assets

53,406

65,251

73,251

81,251

Tangible Assets

100,032

89,787

67,276

822,263

Investments

6,736

7,586

7,586

7,586

Current Assets

 

 

40,811

28,394

37,207

17,378

Stocks

15,391

11,505

8,370

9,435

Debtors

4,906

1,988

7,047

7,943

Cash

15,569

14,901

21,790

0

Other available for sale financial assets

4,945

0

0

0

Current Liabilities

 

 

(14,726)

(11,251)

(8,126)

(453,259)

Creditors

(13,755)

(9,726)

(6,601)

(5,189)

Short term borrowings

0

0

0

(446,545)

Other

(971)

(1,525)

(1,525)

(1,525)

Long Term Liabilities

 

 

(12,039)

(9,265)

(9,265)

(9,265)

Long term borrowings

0

0

0

0

Other long term liabilities

(12,039)

(9,265)

(9,265)

(9,265)

Net Assets

 

 

174,220

170,502

167,929

465,955

CASH FLOW

Operating Cash Flow

 

 

(3,508)

28,454

15,085

46,716

Net Interest

(369)

153

223

177

Tax

0

0

0

0

Capex

(95,281)

(32,588)

(12,419)

(818,728)

Acquisitions/disposals

40,534

3,151

0

100,000

Financing

9,800

214

4,000

203,500

Dividends

0

0

0

0

Net Cash Flow

(48,824)

(616)

6,889

(468,335)

Opening net debt/(cash)

 

 

(64,294)

(15,569)

(14,901)

(21,790)

HP finance leases initiated

0

0

0

0

Other

99

(52)

(0)

0

Closing net debt/(cash)

 

 

(15,569)

(14,901)

(21,790)

446,545

Source: Company accounts, Edison Investment Research. Note: We forecast DZP financing capex starting in FY17 including the planned sale of 10% of the DZP for A$100m recorded on the P&L. Assumes capital raise of A$194m via issue of 647m shares at A$0.30 each.

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