Alkane Resources — Update 14 April 2016

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.

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.

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.

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

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

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.

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.

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.

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).

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.

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.

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.