Caledonia Mining — Doing everything you want a gold miner to do

Caledonia’s FY16 results show the company continues to run a tight ship at its 49%-owned Blanket gold mine in Zimbabwe. Effective control of its mining practices and increased underground mining flexibility are evident on the bottom line, with y-o-y EPS growth of 79%, simultaneously driven by the marked y-o-y increase in gold production to 50.4koz – a slight beat on Caledonia’s guidance of 50koz for 2016.

The year ahead should continue the positive trend of 2016, with production up, costs down and positive cash generation comfortably covering capital outflow. Management targets 2017 production of 60koz, which in our view puts it well on track for its targeted 80koz in 2021.

C1 equivalent on-mine cash operating costs fell for the second consecutive year, supporting the company’s ability to implement significant capital expansion plans at Blanket. Cash operating costs were 9.3% lower y-o-y in 2016 and a further 3% drop is expected in 2017 as production ramps up to 60koz.

We note from the company’s MD&A that in Q416, on-mine costs were actually at our forecast for FY17 at US$614/oz. Although quarterly production is relatively variable (as with all mines), this early sign that costs are coming down as planned is further support to management’s ability to implement the Investment Plan.

With two elements of Caledonia’s Investment Plan completed on schedule during 2016 (ie the No. 6 Winze and Tramming Loop), the company’s main development focus is the sinking of the 1,080m planned Central Shaft. So far, this shaft has been excavated to a depth of 633m and is therefore roughly two thirds complete. The main phase of capital investment has now passed, with US$36m expended over the course of 2015 and 2016, and the last major capital investment of US$18m due over 2017. Most of this will be used to finish excavation and fit-out the Central Shaft ready for operation in mid-2018, as planned. Pre-development works underground, using the newly completed No. 6 Winze, have been completed and will ensure that once the Central Shaft is completed, first gold production can occur shortly thereafter.

Caledonia stated in its FY16 MD&A that the main impediment to the central shaft’s development has been some intermittent loss of electricity to its shaft sinking equipment as a result of electricity supply difficulties from the Zimbabwean national grid. As a result, extra diesel-powered generators were installed in 2016 to provide additional power to the Central Shaft development as and when required.

Caledonia has decided to tweak the internal structure to Blanket’s haulage ways, beyond those originally provided by the Investment Plan. This is only a slight modification to the Investment Plan, incurring minor incremental costs, but should result in even greater flexibility as the mine establishes itself for long-term growth below the 750m Level.

These other projects are:

To address the issue of lower-confidence resource ounces being present below the 750m Level, Caledonia materially stepped up resource delineation and exploration drilling over 2016. The company drilled 22,172m of drilling over 2016, 55% up on the year. This, backed by information generated from digitising historical production and exploration data has resulted in an increase in resources and reserves. Highlights of these programmes are:

As Caledonia formalises its digital models using old paper mine plans, we expect it to markedly increase its geological understanding of Blanket’s numerous orebodies. Although orebodies can be relatively easily followed by miners underground, understanding the subtleties of orebody shapes and the nuanced interactions they can have with each other and various geological structures around them, can yield surprisingly positive results. We expect the company to continue to develop its own internal geological systems and for the results of these improvements to be borne out in a net positive gain for resources and reserves at year-end. New resource to reserve estimates are currently being compiled and will replace the old published ones released in 2014.

There is also the potential, however uncertain at present, that the digitising process could open up fresh lines of thought into Blanket’s orebody genesis and provide new drill targeting techniques with the obvious potential positive impact it could have on gold resource and reserve levels.

Additionally, increased knowledge of the orebodies underground will allow tighter mine planning by engineers to take place, and potentially small improvements to grade control practices through optimised orebody wireframe modelling, in particular around production headings.

The following paragraphs highlight the key changes and main assumptions we use to value Caledonia’s shares. For an extensive overview of the company’s Investment Plan please read our January 2015 outlook note, Future-proofing Blanket.

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 a (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.

We base our valuation of Caledonia’s shares using the following gold price deck and apply it to our production forecasts which include the targeted 60koz in 2017.

The Zimbabwean government reduced the royalty rate paid on incremental gold production in 2016 from 5% to 3%. For Caledonia, this meant that for the additional 7,196ozs of gold it produced in 2016 compared to 2015, it saved a modest US$181k which will be offset against royalty payments due in 2017. We assume this continues into 2017 and 2018, which covers off the main phase of development at Blanket, but resist applying this royalty reduction longer term due to potential changes in its structure.

Using our gold price assumptions (see Exhibit 2) and the estimated annual gold production amounts as outlined in the IP for 2017 and 2018 results in the following small royalty savings:

In May 2016, the Zimbabwean government announced an export incentive scheme designed to promote increased gold mining and therefore increase the amount of gold the country can export. The export incentive provided to Blanket was 2.5% of the sale proceeds from the gold sold to the Fidelity refinery in Harare. Caledonia recorded the majority of this incentive in Q417, which was the reason all-in sustaining costs were much lower than in previous periods. The total amount under the export incentive scheme received by Caledonia was US$1.1m.

We note from management that the scheme has recently increased the rebate on sales from 2.5% to 3.5%. In terms of adjusting our forecasts for this rebate, we increase our gold revenues by 3.5% of total sales across our valuation period 2017 to 2026 as shown in Exhibit 4.

Caledonia invested US$19m over 2016 and after all mine and head office costs, finished the year with a net cash position of US$14.3m, a 33% y-o-y increase. Note that with production expected to reach 60koz for 2017 and costs expected to decrease as fixed costs (which at Blanket account for approximately 60% of total mine costs) are spread over more ounces, we expect a further 6% increase in cash to US$15.3m. This assumes US$18m in capex spent in 2017, as well as a gold price of US$1,275/oz.

Looking further ahead, as capex drops off markedly in 2018 (only US$8.2m is forecast for 2018) and production increases from 60koz to 67koz, cash build should accelerate considerably with a doubling of cash to US$29.4m at end 2018, we estimate.

Caledonia guides that its recently increased 5.5c annual dividend paid in 1.375 cent amounts, will be maintained and is covered three times by cash. For reference, the FTSE Mining Index average cash cover is only 1.1x, making Caledonia appear a far lower risk investment in terms of dividend sustainability. We include this dividend in our model for both 2017 and 2018.

As a result of adjusting our model for FY16 results, royalty and rebate adjustments and using our gold price assumptions and maintaining our US$/£ forex rate at 1.25, our combined dividend discount flow (of Blanket’s free cash flow of production post-IP implementation) and DCF of vendor facilitation loan repayments increases by 2.0% from 146p to 149p per share. This is at a 10% discount rate to reflect general equity risk. Forcing our model’s valuation of Caledonia’s shares to its current share price (113p as of 12 April 2017) requires using a discount rate of 15.6% (in our Q317 note this was 16.3%). This relatively low hurdle rate represents, in our view, a marked reduction in the country-risk factor applied to Caledonia’s shares, as well as a significantly more positive view on the company’s ability to deliver its IP on time and on budget, which is now two years completed.