Alkane Resources — Update 19 December 2016

Alkane’s revised two-stage development concept underlines the continuing commitment to build out its flagship diversified rare metals and chemicals project. Recent announcements concerning the signing of Memorandums of Understanding (MoUs) (Siemens), due diligence at Vietnam Rare Earths, as well as strategic partner alliances with major engineering firm Outotec to progress development, among others, highlight a period of heightened activity and point to the likelihood of a successful conclusion to the DZP’s development.

We have always considered the DZP, with its mix of products including zirconium chemicals, heavy and light rare earth concentrates, ferro-niobium and the highly valuable hafnium output (plus TGO gold output), as a project that through its diversification should weather the worst of end-market environments. This is all in addition to the gold mine revenues occurring at the TGO, and the realisable extension to that mine’s life linked to a highly prospective package of land tenements close to existing TGO infrastructure.

The advantages put forward by Alkane for why a two-stage development concept of the DZP would benefit shareholders are:

The past 12 months have seen a number of agreements put in place to complement existing arrangements, all with a focus on getting the DZP into production. We note that no major approval or mining licences are outstanding and the project is effectively ‘shovel ready’ save for certain off-take agreements being finalised and DZP’s project financing being put in place. Over 2016 Alkane announced the following agreements and arrangements, all of which relate to the DZP:

An agreement is already in place for the DZP’s output of ferro-niobium, with a commercial off-take and JV agreement signed with Austrian firm Treibacher Industrie AG (TIAG), signed 2013. This agreement will see TIAG have sole marketing rights for DZP FeNb and it will also allow Australia Zirconia Ltd the right to use TIAG’s proprietary processing technology to produce FeNb from DZP concentrates at a new plant located either in Australia or elsewhere to be developed within a separate company. TIAG will be able to buy 50% in this new downstream processing company three years after commissioning.

To get the DZP into the construction phase Alkane needs to:

Alkane announced changes to the DZP development plan at the end of October that included the aforementioned capex reductions and the two-stage development. However, accurate cost and working capital data have yet to be finalised; the company has stated that it expects to provide details to the market in early in June quarter of 2017.

As such, we have limited the changes to our DZP valuation to the size and stage nature of development. We have adjusted our capex profile to reflect development over the five-year period from 2017 to 2023, but keep operating costs as per our original valuation and as per the company’s published definitive feasibility and front end engineering design (FEED) studies for the DZP.

We have made the following changes to our financing assumptions for the DZP:

To reflect the impact of the recent high-level of rainfall experienced over the TGO in Q117, we have revised our production model down to 62koz, which is c 10% below the lower end of its current gold production guidance of 65-72koz for FY17. With only 10.4koz produced in Q1, a further 54.6koz to 61.6koz needs to be mined out over the remaining three quarters of FY17. This amounts to an average 18.2koz to 20.5koz per quarter.

The plant at the TGO has capacity of 1.0Mtpa on the basis of a 350-day operating year (including scheduled maintenance shut-downs). To achieve c 18koz of production the following mining needs to occur:

We have also revised down our gold price forecasts. The model we use to forecast the gold price implicitly assumes a relationship between the total US monetary base, inflation and the gold price. In 2015 there was an (extremely rare) decline in the total US monetary base and (arguably conservative) absence of inflationary pressures. These combined to reduce the base for our longer-term analysis and, therefore, our longer-term numbers.

For further detail on the above method, please refer to page 48 of our October 2016 sector report Mining overview: Gold and other metals.

Ahead of a comprehensive revised set of cost input data to be released in a bankable feasibility study for the DZP’s two-stage development concept (due around April 2017), we take the view that cost assumptions remain as per the original DZP 1Mtpa single development phase Front End Engineering Design results announced August 2015, and which amended the company’s previous DFS published April 2013.

Our DZP and TGO long-term (ie post-FY17) cost assumptions can be seen here. DZP production output will be half the amounts stated in our previous note, reflecting the new two-stage plan – see Exhibit 6.

We consider the two-stage development approach as being positive in that it will reduce start-up costs and lower working capital. In terms of operating costs, the implication of the revised development approach is less clear. The economies of scale that occur at the 1Mtpa level should be greater than at an initial production size of 0.5Mtpa.

Our valuation of the DZP is therefore based on a revised ramp-up to the 1Mtpa production rate. A comparison of our old and new ramp-up to 1Mtpa is given in Exhibits 3 and 4 below.

The following exhibit is based on the two-stage development concept for the DZP. It also includes our value for the TGO, though we highlight that the future revenues and profits occurring from the DZP (starting in FY18 under our assumptions) dwarf the relatively small cash generation levels that result from gold mining.

As can be seen above, earnings are depressed through to FY22 as production from the DZP ramps up and the project’s capital expenditure dominates. Even though maximum gold production of 73koz from the TGO occurs (as per our assumptions) in FY18e, earnings are depressed as a result of the A$20m in capex required to develop an underground mining phase at Wyoming. A slight rise in earnings is seen over FY19 and FY20 as first DZP profits materialise, but reduce again as stage 2 capex is spent over FY21. The following year (FY22) sees the first full year of mining at the maximum 1Mtpa ore throughput rate.

Breakdowns of discounted earning valuations for the following periods of our valuation horizon are given in the following bullet points:

Mining companies, once they are firmly into profitable stable production are usually awarded valuations at a multiple to their NPV. Simply put, once the DZP reaches steady-state stable production and its products are sold into a stable price environment, if we assume that Alkane pays out all its free cash in the form of dividends, we can impute a share price valuation. If we assume a 5% dividend yield (a relatively conservative assumption of long-term mining stock yield levels), Alkane’s maiden theoretical dividend of A$0.19 in FY24 (the first year we estimate the dividend could be paid) could imply a potential A$3.80 Alkane share price.

Other than commodity prices, the most notable effect on our valuation stems from our assumption for the price at which Alkane raises capital, which we have adjusted to A$0.40 per share. Exhibit 7 provides our total valuation (TGO+DZP) given a range of share prices that an equity portion of the DZP’s financing might be raised at:

The DZP’s set of products are all traded using bi-lateral contracts between the supplier (Alkane) and the customer, and also via a third-party marketing agent. As a result, Alkane has had to market the DZP products in advance of the mine opening and production starting. The following is a summary of Alkane’s marketing efforts and the types of agreement currently in place:

Zirconium chemicals

Alkane signed a marketing agreement in 2016 with UK chemicals firm Minchem over the marketing and sale of its zircon-based production.

DZP zircon-based products, including zirconium basic carbonate (45% ZrO2) and chemical zirconium (>99.5% ZrO2), are targeted for the growing and higher value chemical zirconia, zirconia and ceramics end-markets. Further, the success Alkane has had in removing hafnium from its zirconium-based concentrates makes DZP zircon-based output suitable for the production of refined zirconium metal, used in nuclear reactors.

Hafnium

Hafnia (hafnium oxide) samples were sent to customers for testing, a condition precedent to these customers agreeing to future DZP hafnium products. The samples were generated during the August to September 2016 pilot plant run. Alkane’s demonstration pilot plant (DPP) as it is officially known is located at the Australian Nuclear Science and Technology Organisation (ANSTO).

Industry feedback has been especially positive for DZP hafnium output as it is not tied to the vagaries of the nuclear industry. This is because growth in the extremely small (c 50tpa) hafnium market is to be largely linked to high-tech material usage, such as alloys used in the aerospace and industrial gas turbine industries. Current hafnium production is linked to production of neutron transparent zirconium metals used in nuclear fuel-rod casings (hafnium absorbs c 600x the amount of neutrons zircon does and therefore needs to be refined out of zirconium metal – a process Alkane has successfully completed). As such, with the level of depressed activity currently in the nuclear industry and uncertainty persisting on from the Fukishima disaster of 2011, plus the increasing growth in the renewable energy economy, stable hafnium output from nuclear industry sources cannot be depended upon. Further, hafnium production volumes from the nuclear industry are unlikely to meet demand from other industrial sectors.

Rare Earths: VRE due diligence underway

Alkane has a letter of intent in place with private Vietnamese firm Vietnam Rare Earths (VRE JSC). The agreement was announced April 2016. The agreement is to toll process DZP rare earth concentrates into certified quality rare earth end products. VRE has two plants in operation:

Alkane is currently completing technical due diligence on VRE plants and is looking to complete this during Q1 CY17.

Alkane’s market commentary on rare earths is a good guide to this extremely opaque and Chinese-centric market. The long-held view of Chinese supply dominance persists (it supplies roughly 90% of global rare earths), as does the illegal mining of these metals (which is reportedly still as high as 40% of annual Chinese rare earth production). Alkane also highlights the very healthy demand for rare earth permanent magnets. The uses of these types of magnets are wide-ranging, and the increasing roll of the electric vehicle is a key driver behind this sector’s growth.

Rare earth permanent magnets, specifically neodymium-iron-boron, which will support Alkane’s neodymium (Nb) production and commercial off-take signed with German company Treibacher Industrie, are enjoying high rates of growth. Chinese annual production of sintered neodymium-iron-boron alloys in 2015 was 140kt and y-o-y growth reported at 16%, against rest-of-world growth at 12%. China produced 88% of the global supply of sintered NeFeB magnets during 2015.

A sintered magnet is manufactured from grinding a suitable composition into a powder, then compacted and heated to cause densification. Iron-neodymium-boron magnets are all made this way.

Zirconium and lanthanum could improve Li-ion battery performance

An interesting note is made in Alkane’s quarterly activities report concerning research currently being undertaken by Michigan University into the use of solid electrolytes in lithium-ion batteries. The research involves the use of a film made of lithium-lanthanum-zirconate, using proportions of lithium hydroxide (20%), lanthanum oxide (53%) and zirconia (27%). The rise of the electric vehicle, either hybrid-electric or pure-electric, would greatly benefit from this battery technology being commercialised as it allows li-ion batteries to operate at higher temperatures as well as having a greater energy density. This would allow for batteries to be made lighter with the potential positive impact on vehicle range – a key anxiety of electric vehicle customers.

Alkane had A$22.5m in cash at 20 September 2016, and currently has c A$6m in debt outstanding (to be used to develop TGO underground development).

We estimate that Alkane will finish with net cash of A$24.5m at end FY17 (June year-end), which reflects the strength of the gold price over H117 which averaged YTD US$1,266/oz (A$1,679/oz at a A$/US$ exchange rate of 0.75), and our in-house gold price assumption of US$1,275/oz (A$1,688/oz) over the remainder of FY17.

Note: Alkane has a hedge book with MacQuarie bank. At the beginning of FY17 this book had a starting balance of 63,900oz Au. We assume 34,650oz are paid into this book over FY17, fetching a minimum (floor) price of A$1,690/oz. We have factored these sales and revenues into our cash flow forecasts for the TGO. The remaining 29,250/oz are to be paid over FY18.

Our model also now includes 21.7m shares which is the shortfall of the entitlement offer announced in April 2016 (placed at A$0.20 and raising A$4.1m) and 8.3m incentive shares given to Alkane’s employees as announced in September 2016.