Caledonia Mining — Expansion on track, a gold mine with purpose

A comparison of Caledonia’s Q4 results with our estimates is given in Exhibit 1 below. Revenue and royalty payments rose in line with improving gold production during the quarter (see Exhibit 3 for tonnes milled, gold grade, recovery and gold production data), with revenues received and royalties paid exceeding our estimates by 10% and 18% respectively. Note that CMCL’s revenue line includes refining costs and a revised 10% export incentive credit reimbursement (tax deductible, for 2018 only, reverting to our long-term 3.5% assumption for each year thereafter) paid by the Zimbabwean government, which could be viewed as a means of stimulating gold production in-country. On 4 April, Caledonia announced that it had been granted the ECI uplift to 10% by the Zimbabwean government. We do not yet consider this marked increase in the ECI as sustainable in the long term and so only assume it lasts for 2018, and will adjust future years ECI on a rolling basis. It could be viewed as a short-term measure to try and force artisanal gold miners in-country to formalise their operations and sell gold through the Zimbabwean reserve bank, rather than receiving informal/unregulated, paper-based monetary payments from these small artisanal gold mines. We see the export incentive credit scheme as growing in importance as the Zimbabwean government seeks to regain entry to global capital markets, potentially re-instate the Zimbabwean dollar (surely a prerequisite to obtaining debt on international markets) and as a means of alleviating the crippling effects of a domestic shortage of US dollars, to which its currency is pegged.

Operating costs came in a fraction lower than our forecasts, resulting in a 6% increase in gross profit over our Q417 forecast, alongside the improvement in revenue during the quarter. Although mine-site operating costs were stable quarter-on-quarter, the effects of a strengthening South African rand during Q417 on Caledonia’s wage payments resulted in an increase in G&A to US$1.4m, 16% above our forecast of US$1.2m. However, FY17 G&A came in at US$5.9m, a y-o-y reduction of 18.2%, resulting from lower advisory and consultancy fees. Caledonia attempted an acquisition which fell through and resulted in elevated advisory and consultancy costs of US$7.9m in FY16.

As reported in Caledonia’s 10 November 2017 announcement titled ‘Extension of Central Shaft Project’, the company has had to make a significant near term adjustment to its gold production estimates. The main change is an 11koz reduction in estimated gold production for FY19, with 61koz now estimated, as opposed to previous guidance of 72koz. A further 10koz in 2020 gold production has also been made by Caledonia (see Exhibit 2 below). These meaningful shortfalls are due to ongoing constraints at the No. 4 Shaft, which handles the vast majority of material handling and transport of ore and waste to surface. We have previously commented (please refer to our September 2017 update note) that the underground tramming loop’s completion served to alleviate material handling bottlenecks underground. However, Caledonia in the aforementioned 10 November 2017 announcement states that its tramming loop, along with the deepening of the Central Shaft to allow for an extended Blanket mine life to greater depths, forced it to pare back short-term production targets. The following table details the changes in Caledonia’s short-term production compared to our previous production schedule and how gold production of 80koz (we estimate 80,688ozs Au) is still maintained for 2021:

Exhibit 2 above provides detail over the adjustment we have made to our model and the amount of gold produced per annum by the Blanket gold mine. Note that FY18 (2018) EPS is up 14.8% compared to our Q317 results note published January 2018, whilst production has decreased 7.5%. This is explained through the increased export incentive credit scheme, from 3.5% (in our January 2018 note) to 10% as announced by Caledonia 4 April 2018. We only apply the 10% ECI rate to our FY18 forecasts, with it kept constant at 3.5% thereafter. Whilst gold production remains unchanged from 2021, underlying tonnes have increased by c 11% per annum which we consider implies a commensurate c 8% reduction in forecast gold grade long-term (ie 2021 to 2026) from 4.0g/t Au to 3.7g/t Au.

Previously (in our Q317 results note, published January 2018) we maintained production as per Caledonia’s investment plan ending 2026. The company’s recent decision to extend the Central Shaft accommodates a further five years of production, according to Caledonia, with production as per the revised production schedule given in the 10 November 2017 announcement ending 2031 (as opposed to 2026 previously). However, with our aforementioned grade and tonnage adjustments through to 2026, and noting that the entirety of the additional gold production from 2027 to 2031 being sourced from inferred mineral resources, we consider it prudent to omit this production (from 2027 to 2031) until further geological confidence over the grade and quantum of these inferred resources is established. Our valuation horizon is therefore maintained until 2026, with upside clearly linked to the inferred resources being upgrade in confidence. We expect Caledonia to be able to furnish the market with this information post-Central shaft completion and achieving 80koz gold production by 2021, which should then free up drilling locations along the 22 Level.

Caledonia’s FY17 overall effective taxation charge reflects its ongoing high level of capital expenditure and a revised treatment by the Zimbabwean tax authority of CMCL’s management fee.

Caledonia’s overall effective tax rate in FY17 was 42.2% (FY16: 41.0%), and its income tax rate was 18.3% (vs the headline rate of 25.75%), reflecting the deductibility of its high capital expenditure associated with the implementation of its investment plan. We note that withholding tax increased by a significant 142%, from US$503k to US$1,222k. Caledonia states that this was due to a change in the tax treatment of its management fee. Previously, Caledonia’s management fee, paid from the Blanket mine to Caledonia Mining South Africa (CSMA) was taxed as income, however, we now understand that it is taxed as a dividend, thereby incrementally increasing withholding tax.

Note that the export credit incentive scheme is 100% tax deductible, and our tax calculations do not include any ECI payments to the Blanket gold mine.

A core reason for investment in Blanket is to fully realise the high level of operational gearing available due to the high level of fixed costs. As fixed costs remain flat, the more gold ounces a company produces, the lower its unit costs become. This is most clearly evidenced through the on-mine unit costs, as detailed in the following exhibit:

With gold production forecast at around 57koz for 2018 (under our assumptions), unit costs should remain relatively flat moving only slightly from US$633/oz for FY17, to US$634/oz for FY18. However we do note that there is an indication Caledonia is operating at levels below this with on-mine costs per ounce reported for Q417 at US$556/oz.

The Blanket gold mine demonstrated improved performance resulting from additional measures put in place over the year to help alleviate haulage bottlenecks and improve waste haulage capacity. Tonnes milled increased 6.0% y-o-y from 142,169t to 150,755t, and 10% q-o-q, from 136,064t to 150,755t. This pattern of improved operational performance (clearly visible in the trend of increasing tonnes milled and quarterly gold production, LHS in Exhibit 4 below) continues in line with Caledonia’s ramp-up in production at Blanket to 80koz in 2021.

The Central Shaft is the name given to the capital project most critical to a successful implementation of the IP launched in 2014, and which has been subsequently revised. Originally planned to a depth of 1,080m below surface, the current depth of the shaft is 990m below surface, corresponding to 30 level in Blanket’s mine layout. The Central Shaft has been designed to become the main access and egress route for personnel at Blanket, and the main haulage route to transport ore and waste to surface. Its completion will alleviate a considerable burden on the existing and smaller capacity No 4 Shaft, allowing for considerable future growth potential to be realised below the 750m level. The 750m depth has been the historic ‘floor’ or depth limit to pushing Blanket’s production downwards into what is currently understood to be higher-grade gold deposits.

Central Shaft development will now be completed to a depth of 1,330m below surface to provide additional scope for these extracting deeper and potentially higher-grade resources. The additional cost of this extension is already included in our financial model.

A further revision to the original Central Shaft development is the construction of a ‘mid-shaft loading’ system. This additional construction project was commenced during December 2017 at the 26 level, 870m below surface. It will serve to alleviate ore handling constraints on the 22 level haulage, and free up haulage capacity at the base of the Central Shaft development so as to be able to complete this development without compromising the projected ramp-up from c 57koz Au by end 2018 to 80koz Au by 2020.

We have adjusted our model for Q417 and FY17 results. We have also revised our production schedule as per the company’s 10 November 2017 announcement (see page 3 for details) and a revised schedule of capital expenditures as per its March 2018 corporate presentation (Exhibit 5). Caledonia’s net cash position at end FY17 was US$11.3m. We note end-year payables grew to US$12.7m largely due to a c US$6m payment to ZESA not being paid during Q417. This was not due to a lack of funds on Caledonia’s part and will be settled during H118, bringing payables down to a more normal level. We see net cash increasing to US$14.9m in 2018 (net of dividend payments totalling US$2.9m), before we see a material shift in FCF generation in 2020 driven by lower IP development capex, when we forecast net cash increasing 45% to US$21.6m. With capex peaking in FY18, our DCF valuation reflects this strong FCF generation resulting from a successful IP build-out. This drives our DCF up 4.8% from 869p (FY17) to 911p on an FY18 basis. This valuation also reflects a 1.0% weakening in the US$/£ exchange rate from 1.41 to 1.395.

Our earnings projections are given in the following exhibit. The trend of rising earnings extends through to 2021 when Caledonia expects to produce 80koz pa gold at cash costs of US$501/oz. Our FY17 normalised EPS of 79c grows 115% to 170c in FY18e, and again by 31% to 223c in FY19e. Capital expenditures of US$21m in FY18 stay level through FY19 before decreasing markedly (by c 33%) to US$14m in 2020, demonstrating a considerable freeing up of cash resources.

On a P/E basis, the company’s successful execution of its IP at Blanket will drive the company’s forward-looking P/E multiples lower. Caledonia’s FY17 P/E of 12.1x matches the FTSE Mining Index average of 11.3x (as of 19 April 2018) very closely. However, looking forward, earnings generation shows Caledonia undervalued on a P/E multiple of 4.3x FY19e EPS.

Caledonia’s year-end net cash position decreased by 14.7% from US$13.0m to US$11.3m, reflecting the company’s increased capital expenditures (including the additional capex required to develop the Central Shaft to 1,330m). We note Caledonia’s payables increased to US$12.6m by end FY17, but also that management states this is largely down to a delay in a c US$6m payment to the Zimbabwean electricity company, ZESA, which should be made sometime in H118. This was not due to a lack of funds on Caledonia’s/Blanket’s side. Our projection of Caledonia’s working capital position, as well its end-year net cash position, is given in the following exhibit:

Our view is that Caledonia’s creditor days normalise to a more conventional 30-day turnaround by 2020. We will continue to monitor and adjust the number of creditor days as and when Caledonia’s financial results are released.

As long as the company’s working capital situation reverts to a more historical pattern, we estimate that it will generate the following net cash flow:

Exhibit 8 above includes all operational, central costs, FY18 dividend payment and capital expenditures, as per our 12 January 2018 note Record production and 14% increase in grade.

Caledonia states that its dividend of US$2.9m paid quarterly will be maintained in FY18. We have included this for FY18 and await further guidance to forecast this payment beyond the current year.

President Mnangagwa assumed leadership of Zanu-PF and became president of Zimbabwe in late 2017. He quickly stated his intention to relax the country’s indigenisation policy concerning gold miners. Caledonia’s statement on this change is given below. Until formal confirmation of this change and the rights issue are complete (see below), we maintain our model of the indigenisation structure with all indigenous party loan accounts modelled through cash flow.

‘’These pronouncements have now passed into law and accordingly, the boards of Caledonia and Blanket have agreed to implement a rights issue at Blanket to raise approximately $4 million which will be underwritten by Caledonia's Zimbabwean subsidiary. Blanket will use the proceeds of the rights issue to advance work on certain of its satellite properties. Assuming that Blanket's indigenous shareholders do not subscribe for shares in accordance with their rights, it is expected that, subject to the terms of the rights issue, Caledonia's shareholding in Blanket will increase from 49 per cent to slightly over 50 per cent.

"Caledonia will also evaluate the potential to buy the shareholdings in Blanket that are currently held by certain indigenous shareholders. However, it is our intention to retain the shareholders representing employees and the local community (both of which currently hold 10 per cent each) as long term shareholders of Blanket. Any transactions would reflect the value of the indigenous shareholders' holdings in Blanket after deducting the value of their outstanding facilitation loans and would be subject to a mutually agreed valuation of the holdings in Blanket.’’