Endeavour Mining — Valuation US$27.58; potential 32% upside

Following the end of Q3, we have revised our earnings forecasts for Endeavour to reflect a higher gold price (a quarterly average of US$1,474/oz cf previous forecast US$1,416/oz), a slightly more disruptive rainy season (at Houndé in particular) than expected and the estimated impact of the company’s gold revenue protection strategy that was put in place on 1 July.

Edison’s Q3 gold price forecast of US$1,416/oz was made in the aftermath of Endeavour’s Q2 results (which were released on 1 August) and reflected the price of gold at the time of writing, albeit erring to the side of the relatively conservative. In the event, the gold price began to rise relatively strongly from 2 August and remained around the US$1,500/oz level from 7 August until almost the end of the quarter such that, for Q319, it averaged approximately US$1,474/oz, or 4.0% above our original number.

Although we had was already forecast it at the time of our last note (see Endeavour Mining, Tipping point, published on 9 August 2019), the higher gold price nevertheless triggered higher government royalty rates for Enedavour’s mines relative to the first two quarters of the year, as follows:

Operations at Houndé in H2 have continued to benefit from access to high-grade ore from the Bouéré deposit, where pre-stripping was completed in Q219 and from which ore began to be processed early in Q319. However, we believe that milling operations will have been slightly disrupted by the more inclement rainy season than anticipated.

Operations at Karma have similarly benefit from the stacking of higher-grade oxide ore from the Kao North pit, which started in Q219. In this case, however, we expect the weather will have affected the mining, rather than the processing, operation.

Readers are cautioned that forecasting results on a quarterly basis is prone to large variations between actual and forecast numbers. Nevertheless, the consequences of all of the above effects are shown in the table below, relative to our prior forecasts:

In addition to the immediate effects of the above considerations, on 1 July 2019 Endeavour entered into a short-term Gold Revenue Protection Strategy 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 option and bought put option contracts to (effectively) create a synthetic short position. The programme began on 1 July 2019 and will end on 30 June 2020 and will cover 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. The total premium payable for entering into these transactions was US$9.2m, which has been deferred and is settled as monthly contracts mature.

As a result of the programme, we estimate that Endeavour will not have fully benefitted from the gold price being above US$1,500/oz over the past quarter and that the written calls over an estimated 90,000oz (a quarter of the total programme) will have been exercised at US$1,500/oz, resulting in a paper contract loss of US$16.05/oz, or US$1,445k in total, which we have included in our forecast for ‘Loss on financial instruments’ in Exhibit 3, above.

Historically, Endeavour has a good record of meeting its production and cost guidance targets. In the light of the above changes, we have revised our forecasts for FY19 as follows for each of its mines for the year:

To date, we have given no credit to Endeavour’s plan to increase the Ity CIL plant nameplate capacity by 1Mtpa to 5Mtpa (which is expected to be completed in Q419). These plant upgrades are expected to be completed during scheduled maintenance shut-downs over the next two months. However, if the process is completed by the end of Q3, then we estimate it would have the potential to increase quarterly Ity CIL production from 55.3koz to 69.1koz in Q4 and group adjusted net earnings attributable (see Exhibit 3, above) from 36.5c per share to 45.1c per share (all other things being equal) in Q419 and from 52.7c/share to 61.4c/share for FY19.

Within this context, it is worth noting that the top end of Endeavour’s production guidance is 39.0koz gold above our updated forecast for the year, which is worth a material US$54.3m in additional revenue to the company (at US$1,474/oz) net of royalties and therefore has the ability to increase Endeavour’s full year profit before tax by 42.4% (post-royalties) relative to our forecasts (all other things being equal).

In addition to its forthcoming Q3 financial results, on 3 September Endeavour announced it had increased its indicated resources at the Lafigué target at Fetekro in Côte d’Ivoire by 141%, to 1.19Moz.

The initial resource at Lafigué was based on 312 reverse circulation (RC) and diamond (DD) holes, totalling 32,000m, or 22.5oz per metre drilled. Owing to the high quality of the initial exploration results, an additional 201 additional RC and DD holes were drilled between Q318 and the end of Q219, totalling 35,000m (equating to 15.2oz per metre drilled) and resulting in the following updated resource:

The Lafigué resource now encompasses a mineralised area of 1.32km2 (equating to 947koz per square kilometre) and remains open at depth and towards the southeast and, as such, is comparable in size and grade to Endeavour’s Agbaou mine (currently 711koz at 2.15g/t) when it started production in 2014. At least 30,000m of additional drilling is therefore scheduled to begin in Q419 with the intention of publishing an updated resource in Q220.

More than 90% of the drill holes intersected at least 2m of mineralisation at grades in excess of 0.5g/t. Moreover, since the mineralisation starts at surface, the deposit will be amenable to open pit mining, while preliminary metallurgical results suggest high gold recovery rates above 95%, with a ‘significant portion’ recoverable by gravity.

Exploration investment in the project to date has been approximately US$10m, or c US$9 per indicated ounce delineated. Of particular note is the increase in the resource grade since December 2018 and the fact that the resource is relatively invariant with respect to the gold price (indicating that the gold mineralisation exists within discrete geological structures).

Endeavour’s exploration success comes within the context of its programme to spend c US$45m per year to discover an additional c 10–15Moz of indicated resources over five years at a discovery cost of c US$15/oz. To date, it has delineated resources at Fetekro, Le Plaque and Kari-Pump and aims to publish maiden resource and reserve estimates for both Kari West and Kari Center in Q419:

As such, Endeavour has delineated a little over a quarter of its target resource in approximately a quarter of its stipulated timeframe (ie a little over a year). Once maiden resources and reserves have been published at Kari West and Kari Center, an updated mine plan and technical report, integrating Kari Pump, Kari Center and Kari West, is also expected to be released.

Fetekro’s 531koz resource increase equates to 3.3% of Endeavour’s prior, global resource (on a 100% basis, including the Le Plaque upgrade), or 2.5% on an attributable basis. However, the indicated category increase equates to a rather more significant 4.6–7.0% of Endeavour’s 10.0–15.0Moz exploration target over five years.

Immediately prior to the Fekero resource upgrade, Endeavour’s enterprise value (EV) equated to a resource multiple of US$202.56 per attributable resource oz. On this basis, Fetekro’s 1.25Moz resource immediately after the upgrade would be valued at US$253.2m (or US$1.50/share, attributable for EDV’s 65% interest). Given that almost all of Endeavour’s other resources relate to assets in which development (as well as exploration) capital has already been sunk, however, such an estimate is likely to be an over-estimation, except in the event that ore derived from the resource could be transported to other, nearby processing facilities. Within this context, investors should note that Endeavour’s balance sheet value of its ‘Mining interests’ as at 31 December 2018 (a measure of Endeavour’s investment into its resources in order to achieve their US$202.56/oz valuation) equated to US$97.77 per resource ounce on a 100% basis, which suggests a pre-investment valuation of Endeavour’s resources of US$104.79/oz (being 202.56 – 97.77 = 104.79), on which basis Fetekro would be worth US$131.0m (or US$0.77/share). Adopting a similar methodology, its 531koz resource upgrade would be likely to be worth in the order of US$55.7m, or US$0.33/share (attributable).

Alternatively, in our report, Gold stars and black holes, published in January 2019, we calculated average values for pure in situ resources, differentiated both by the markets in which they were listed and also by category of resources (as well as on a blended average basis). The results of this process for London- and Canada-listed companies (as well as the global average) plus their implications for the valuation of Fetekro are provided in Exhibit 7, below.

On the basis of this analysis, a minimum value for the Fetekro maiden resource is US$10.8m (third last column, 10.3 + 0.5 = 10.8), or US$8.64/oz, or US$0.06/share (attributable), derived from applying London resource multiples differentiated by category. A maximum value for the Fetekro maiden resource (valued purely as an in situ resource) may otherwise be seen to be US$18.7m (or US$0.11/share, attributable), derived by applying a geometric, global mean rating of US$14.95/oz to the resource in its entirety. Note that these US dollar per resource ounce valuations accord closely with the reported investment in the drilling programme to define the resource, but may understate Fetekro’s valuation to Endeavour in that the benchmarks used to calculate the valuation are derived from pre-production junior mining companies. As such, these valuations may be more appropriate to Fetekro in the event that it were to be spun off into a separately quoted vehicle (excluding cash), rather than being retained within the Endeavour portfolio.

In valuing Endeavour, we have opted to discount potential cash flows back over four years from FY19 then apply an ex-growth terminal multiple of 10x (consistent with using a standardised discount rate of 10%) to the forecast cash flow per share in that year (ie FY22) to reflect the fact that Endeavour is a multi-asset company that has shown a willingness and desire to trade assets, maintain production, reduce costs and maximise returns to shareholders (eg the sales of Tabakoto in FY18, Nzema in FY17 and Youga in FY16). Note that, given exploration success at Houndé and its increasing reserve and resource profile, management has confirmed that a review of the plant will be conducted during Q319 with a view to increasing its capacity. Nevertheless, in recognition of the fact that exploration expenditure may be required to maintain cash flows at their FY22 level, we have also opted to include this investment in our cash flow analysis on the grounds that it may be a critical component of ongoing business performance in its ability to continually extend the lives of the company’s assets, instead of excluding it (as would be our normal practice).

After our gold price etc adjustments above, our estimate of Endeavour’s cash flow remains broadly unchanged at US$3.23 per share in FY22 (cf US$3.24/sh previously), on which basis our terminal valuation of the company at end-FY22 is US$32.33/share. In conjunction with forecast intervening cash flows, this discounts back to a value of US$27.58/share at the start of FY19 (cf US$27.66/sh previously). Note that, over the past three months, Endeavour’s share price has risen from c C$21/share during H119, when the gold price averaged US$1,304/oz, to c C$26.50/share now that it is c US$1,474/oz – ie Endeavour has risen c 26% over the same period that the gold price has risen by c 13%. At the same time, the value of the Canadian unit of currency has failed to strengthen materially against the US dollar (unusually, at a time of higher gold prices), while the value of the euro (to which Endeavour’s margins are inversely related) has fallen by approximately 3.5%.

To this may now be added our estimate of the potential range of values for the Fekekro resource upgrade of US$0.06-0.77/sh (attributable).