Galaxy Resources — Update 17 October 2016

GXY is a lithium-focused company listed on the ASX. It has exposure to both hard rock lithium assets through its Mt Cattlin 160,000tpa spodumene project in Western Australia and its James Bay spodumene project in Quebec, Canada and lithium brine assets through its Sal de Vida lithium and potash brine project in Argentina. GXY is expecting to begin commissioning of Sal de Vida in 2019 with a nameplate lithium carbonate capacity of 25,000tpa. The balance sheet has been considerably strengthened by a series of financial restructuring initiatives, including the 2015 sale of its 100%-owned Jiangsu lithium plant. Mt Cattlin has already generated first cash flows through offtake prepayments. GXY expects the first shipment of concentrate to occur during December 2016. On 30 May 2016, GXY and GMM entered into a definitive takeover bid implementation agreement to merge. Compulsory acquisition of remaining shares was completed on 29 September 2016.

We have valued GXY using NPV10 methods for Mt Cattlin and Sal de Vida under a base case (conservative) and two scenarios, Case1 and Case 2 (more bullish). With resource similarities between the Mt Cattlin operation and the James Bay project, we have also determined an indicative valuation for James Bay. Based on 1,807m issued shares after the GMM acquisition, our valuation for GXY’s assets is A$0.51/share (base), A$0.56/share (Case 1) and A$0.68 (Case 2). Exploration potential at both Mt Cattlin and James Bay could lift the valuation – a three-year extension at both properties would lift the valuation to A$0.58/share (base), A$0.63/share (Case 1) and A$0.76/share (Case 2). The valuation is sensitive to the long-term lithium carbonate equivalent (LCE) price – the base case valuation would change by c A$250m or A$0.14/share for every US$1,000/t change in the assumed price. Valuations will increase with time as capital is spent and projects developed.

GXY has low net debt, with the majority relating to the refinancing of outstanding convertible bonds. After the takeover of GMM, GXY has 1,806.8m shares on issue. The balance sheet will be strengthened with the receipt of cash flow from the Mt Cattlin project.

Drawdowns of debt to fund 60% of capital expenditure for the Sal de Vida project are incorporated in our projections. We have not incorporated any further equity raisings into our projections, but additional equity is a possible further funding mechanism for Sal de Vida.

Sensitivities: LCE prices and demand

Lithium has a number of unique properties and a broad range of applications. While its use in batteries has gained prominence because of the high growth in lithium-ion batteries (LIB), only about 40% of lithium produced is currently used in batteries, with around 60% of production used in glass making, ceramics, lubricating greases, continuous casting powders, aluminium smelting and medical uses. However, we forecast that batteries will account for over 50% of demand by 2020. We estimate global demand for lithium (lithium carbonate equivalent or LCE basis) in 2016 at approximately 210,000 tonnes.

Lithium used in batteries is processed from brine or lithium ore such as spodumene to produce lithium carbonate or hydroxide. Lithium carbonate and lithium hydroxide contain 18.8% Li and 29.0% Li respectively. These are then converted to cathode and other lithium battery component materials used in the manufacture of batteries. These are higher value-add products.

Lithium is an industrial mineral rather than a commodity. There is no terminal market – prices are often set between producer and customer.

The key drivers of LCE demand growth are electric vehicles (EVs) and grid scale batteries, the latter off a lower base. Estimates of demand growth vary widely. For the purposes of our model, we assume both EVs and grid scale batteries experience annual demand growth of 25% over the period to 2020. Given the disruptive and far reaching demand potential of lithium-ion batteries, this could prove to be conservative. EVs also include buses and trucks, which can use six and 10 times the weight of lithium of a conventional car respectively. The take-up of grid scale batteries could be far greater than we assume given the pace of change in global power generation.

After taking into account an assumed 3.5% GDP/industrial production (IP) growth rate for most non-battery applications and much slower growth rates for PCs, tablets (c 2.5% pa), cell phones and cameras (c 5% pa), we generate an average weighted compound LCE growth rate over the period to 2020 of around 16% for LIB applications and around 9% overall if industrial applications are included (Exhibit 1). This implies additional demand of just over 100kt LCE to 2020 bringing total demand to around 300kt LCE.

For the period 2020-25, we have considered two cases:

Lithium is mainly produced from lithium brines as lithium carbonate or from hard rock as a spodumene (LiAlSi2O6) concentrate. Brine projects tend to have longer lead times, are more capital intensive but have lower operating costs. Hard rock projects can generally be brought into production more quickly at a lower capital cost but have higher operating costs. Spodumene is mainly shipped to converters in China that produce lithium carbonate or hydroxide. Approximately 8 tonnes of spodumene concentrate are required to produce 1 tonne of lithium carbonate.

Given our projected demand scenario relative to new production scheduled to be delivered, we envisage a tight lithium market between 2016 and 2020. Most of the increasing demand is being met from hard rock projects because of shorter lead times. Some projects have been delayed which has exacerbated supply tightness.

Over this period, there are a number of definite lithium projects or expansions. These include GXY’s Mt Cattlin mine (20ktpa LCE equivalent), Neometals Mt Marion project (27ktpa LCE equivalent), Albemarle’s La Negra expansion in Chile (20ktpa LCE equivalent) and Lithium America’s Cauchari Olaroz (20ktpa LCE equivalent). GXY aims to start commissioning its Sal de Vida project in 2019. The DFS for this project has just been updated. There are a number of other potential sources of production. Most of these do not have a definite schedule, will need financing and will also be subject to the normal project lead times such as permitting, construction and commissioning.

Beyond 2020, the supply/demand tightness could ease, as in our Case 1 scenario. In the stronger demand scenario of Case 2, the demand increment over the five years to 2025 is 255kt and it may be difficult for supply to keep up, implying an extended period of supply/demand tightness.

Spot lithium carbonate prices, generally for small volumes, of up to US$20,000/t have been reported in China with up to US$14,000/t in Japan. Some industry commentators are suggesting a price range of US$11,000-13,000/t for the period to 2020. However, contract prices may be lower with reports of prices of around US$10,000/t. In reality there is little or no visible exchange or spot trading, and there are only a small number of counterparties. Further, the current nascent electric vehicle sector limits the accuracy of future lithium demand and makes price forecasting difficult.

To give a framework to our valuation, we have developed price scenarios for lithium carbonate and spodumene for the base case and Case 1 demand and Case 2 demand (Exhibit 2). Spodumene prices are derived from lithium carbonate prices after taking into account lithium content, conversion charges and transport charges.

There are strong reasons why lithium is achieving the market penetration it is enjoying and why its market share of a growing market may be unchallenged for some time

The Sal de Vida lithium and potash brine development is located between the Salta and Catamarca provinces in Argentina in an area known as the Lithium Triangle (Exhibit 1). GXY controls 100% of brine mineral rights over 385 square kilometres for production wells and surface evaporation. The project encompasses the northern and eastern sub-basins of the Salar del Hombre Muerto, one of several lithium-rich brines in the Altiplano of Argentina, Chile and Bolivia.

The project is adjacent to the El Fenix lithium brine operations, owned by Minera del Altiplano, a subsidiary of FMC Corporation (FMC.NYSE), a diversified global chemical company. These operations are located on the western half of the Salar del Hombre Muerto. El Fenix commenced production in 1997 and is understood to have a mine life of 75 years. Current production is around 23,000 tonnes pa lithium carbonate.

GXY acquired its interest in the Sal de Vida project in July 2012 as a result of its merger with Lithium One.

The JORC 2012 guidelines do not address lithium brines specifically in the guidance documents. Consultants Montgomery & Associates (M&A) followed the NI43 43-101 guidelines for lithium brines of the Canadian Institute of Mining, Metallurgy and Petroleum (CIM 2012). M&A considers these comply with the intent of the JORC 2012 guidelines.

The Sal de Vida resource has been updated (Exhibit 4). The total resource is unchanged. However, the update incorporates a partial upgrade of inferred resources to the indicated category.

There has been no change to the mineral reserve estimate (Exhibit 5). This is based on the southwest and east well fields only. The reserves account for anticipated leakage and process losses of lithium and potassium. A continuous average brine extraction rate of 30,000 m3/day is assumed.

Sal de Vida brine has favourable grades and chemistry. It has a high lithium grade, a high potassium grade (potassium is a saleable by-product) and low Mg:Li and SO4:Li ratios by industry standards. The advantage of a low Mg:Li ratio is lower cost – high magnesium can increase lithium carbonate production costs. A high SO4:Li ratio indicates additional chemical treatment.

We have compared Sal de Vida with the adjacent El Fenix resource and other salar deposits (see Exhibit 6). The results are indicative as resource characteristics may vary in each deposit.

In broad terms, the Sal de Vida deposit appears to have very similar characteristics to the adjacent El Fenix project, which has successfully operated since 1997.

When compared to other salar deposits in our sample, Sal de Vida ranks highly:

Parameters of the revised DFS include:

The main production stages will be:

There is expected to be a focus on the south-west field (20 wells) and eastern field (30 wells) due to brine quality, extent of the aquifer and ability to pump the brine at a sufficient rate to keep the evaporation ponds at the required level.

The DFS investigated the hydrogeological conditions for the project area. The basin aquifer system was modelled on both the conceptual hydrogeological model and the numerical ground water flow model.

The production rate is dependent on the evaporation rate. The evaporation rate in summer can be twice winter rates. Additional wells can be brought on line in summer.

Halite (NaCl) ponds and muriate (KCl) evaporation ponds are used sequentially to concentrate the lithium and separate the KCl.

The DFS assumes a purification technology similar to the successful process previously adopted at GXY’s now sold Jiangsu plant in China. This purification technology was developed and patented by GXY in 2010. It produces a high-quality, battery-grade lithium carbonate with a purity of 99.5% or higher. GXY’s strategy is to focus on the production of high-quality material that can be used directly by battery material producers in manufacturing cathode and electrolyte for lithium-ion batteries.

Concentrated brine at a minimum 2% weight per weight (w/w) Li content from the final muriate pond is pumped via a surge pond to the lithium carbonate (LiCO3) plant. There are a number of process stages:

The harvested muriate contains approximately 71% NaCl and 25% KCl. The KCl is extracted and purified in the potash plant to a grade of 97% for sale as a potash fertiliser. This is sold as MOP (muriate of potash) fertiliser. The global market for MOP is approximately 55Mtpa.

GXY does not produce SOP (sulphate of potash, K2SO4) fertiliser. SOP has a smaller, more specialised global market of around 5.5Mtpa and has historically traded at a price premium of 30-60% to MOP.

The Mt Cattlin hard rock spodumene lithium tantalum project comprises a mine and processing facility. It is located near Ravensthorpe, approximately 430km south-east of Perth, WA.

The Mt Cattlin operation was originally integrated with GXY’s now divested Jiangsu downstream lithium plant in China. Delays at Jiangsu created an imbalance between spodumene supply from Mt Cattlin and processing rates at Jiangsu. In early 2013, Mt Cattlin was put on care and maintenance.

Mining and processing operations were restarted in March 2016 by GMM as part of the JV agreement. They were subsequently halted for construction/refurbishment to expand the nameplate capacity to 1.6Mtpa and enhance operational efficiencies. In early September, 2016, GXY announced that the refurbishment and upgrade had passed 80% completion. After the plant modifications and following delays during the refurbishment, wet commissioning commenced and achieved certain milestones ahead of the completion schedule. GXY expects final commissioning and first production during November 2016, with the first shipment in December 2016.

GXY forecasts an increase in the total capital cost to reopen the Mt Cattlin operation to A$22.4m (previously A$15m) resulting from the throughput capacity upgrades and other plant modifications.

The Mt Cattlin mine is an open pit. The pit design incorporates existing measured and indicated resources. The flat lying pegmatite orebody allows mining at a constant strip ratio. Mining is carried out using excavators and trucks with delivery to the three-stage crushing circuit.

With the recommencement of operations at Mt Cattlin, material for processing is being initially sourced from previously blasted ore in the Dowling pit and the recovery of fines material from the tailings storage facility (TSF).

The reopening of the Mt Cattlin operation has provided the opportunity to redesign aspects of the processing plant. To the extent that any cash shortfall is forecast after utilisation of existing cash resources, including the prepayments received from the Chinese customers, some directors of the company have indicated their willingness to assist in arranging the necessary working capital from their own resources until such time as significant cash flow is achieved in 2017.

Outcomes from the redesign include:

The range of initiatives and improvements include:

GXY expects the first shipment of spodumene concentrate to be made through the Port of Esperance during December 2016.

Mitsubishi Corporation is the project’s agent, responsible for logistics and settlement. Major Chinese customers have been established for spodumene offtake. Spodumene is the preferred feedstock for lithium converters.

The Mt Cattlin project is not controlled by a downstream lithium converter or a trader. Therefore it is positioned to take advantage of market opportunities that may present in the current tight market, provided the project can achieve its production targets.

Mt Cattlin resources are tabulated in Exhibit 7:

Mt Cattlin reserves are tabulated in Exhibit 8:

A deep diamond drilling programme commenced in February 2016. The programme is designed to provide a greater understanding of the Mt Cattlin orebody. It will follow up exploration drilling activities in 2008 in which intersections of spodumene bearing pegmatite were recovered.

Initial drill results have been received. They include assays for pegmatite samples within the first four of six holes drilled during 2016. They confirm a new deep mineralised zone 500m wide and at least 150m long. This is open in all directions but in particular to the east, where it appears to be increasing in thickness. GXY believes significant potential exists for finding additional repetitions in upthrust faulted positions closer to surface which may be open-pittable.

Planning for the next drilling programme is currently underway, with a focus on lateral extensions to existing mineral resources and an increase in drill density within inferred resources. A formal update to Mt Cattlin mineral resources and ore reserves is underway.

James Bay is a hard rock lithium project containing a spodumene pegmatite deposit. It is located 1,000km north-west of Montreal, Quebec, Canada. The project is located in a mining friendly jurisdiction with the availability of low cost energy and is adjacent to key infrastructure including roads and readily accessible water.

The project comprises resources as in Exhibit 9, where they are compared with the resources at Mt Cattlin. James Bay has a similar resource base to Mt Cattlin in the measured and indicated category on both a tonnes and Li2O grade basis. At the inferred category, James Bay resources tonnes and Li2O grades are higher.

Tantalum grades have not been disclosed for James Bay.

A further drilling programme is planned at James Bay to expand resources, and drilling is expected in the September quarter 2016.

Development work at James Bay will involve a continuation of the previously started DFS. Given the similarity in deposit type and size, GXY intends to take advantage of the experience at Mt Cattlin to fast-track the DFS process. GXY expects to recommence DFS work in Q117. It is possible that process plant design could be similar to that at Mt Cattlin.

The James Bay deposit occurs at surface and resource modelling has indicated it can be mined by open-pit methods. The mineral resource at the 0.75% Li2O cut-off was derived from the material inside conceptual open-pit shells with an overall pit slope of 45 degrees.

GXY believes there is excellent potential to increase resources through additional delineation of the pegmatite dykes along strike and at depth. It also believes there is potential to increase grades through infill drilling.

Geological investigations to date have revealed that the pegmatite dykes at James Bay are almost always spodumene bearing. Spodumene crystals at James Bay are relatively coarse and are usually more than 50mm in length and sometimes exceed 1m.

The project is strategically located to be a potential supplier to the growing North American market.

Valuations, earnings and cash flow are sensitive to a range of parameters including:

Our valuations have been updated for the revised Sal de Vida DFS (August 2016) and the Mt Cattlin update (September 2016).

Valuations (Exhibit 10) are presented for a base case (conservative) and two scenarios, Case 1 and Case 2 for GXY using price scenarios from Exhibit 2. Case 1 represents a lower demand scenario than Case 2 with prices falling after 2020. Case 2 represents a high demand scenario with higher prices sustained to 2025. Demand assumptions are shown in Exhibit 1.

Our valuation assumptions include:

We have assessed the sensitivity of the GXY valuation to the long-term LCE price and increased mine lives from exploration success:

GXY has calculated its own internal valuation for the Sal de Vida project. This was released as part of the announcement of 22 August 2016 outlining the revised DFS for Sal de Vida.

The GXY valuation reflects the company’s internal opinion of the outlook for lithium and potash prices. Its pricing scenarios assume a Li2CO3 price range of US$11,000 to US$13,911/t and a KCl price of US$220/t flat throughout the life of the project for battery-grade lithium carbonate and potash. GXY has determined an after-tax NPV10 valuation of US$1,043m under this price scenario. This is higher than the comparable Edison valuation.

There are a broad range of market views on the outlook for lithium prices. Our view is that lithium prices are likely to revert to a lower, sustainable ‘long-term’ price when supply and demand come into balance. With regard to potash, GXY is using what appears to be a bottom of the cycle KCl price of US$220/t. We are using a potash price of US$300/t, which we believe is a more sustainable long-term price.

During a period of substantial financial restructuring in 2015, GXY entered into agreements with General Mining Corporation (GMM) such that GMM would manage and develop the Mt Cattlin mine. An earn-in agreement for the James Bay project was also negotiated.

The broad intention of the agreements was to enable GXY to focus on the Sal de Vida project and derive a cash flow stream from Mt Cattlin, which hitherto had been a dormant asset.

In February 2015, GXY announced an agreement with GMM for Mt Cattlin that would generate annual cash flow for GXY through a lease fee and a production royalty with an option to purchase.

In June 2015, terms for the Mt Cattlin transaction were amended with GMM to acquire a direct 50% interest for a total consideration of A$25m.

GXY executed a Mount Cattlin Definitive Agreement with GMM on 7 September 2015 involving:

GMM also had the right to earn a 50% stake in GXY’s James Bay lithium project by spending US$5m over a three-year period.

On 30 May 2016, GXY and GMM entered into a definitive takeover bid implementation agreement to merge.

Prior to the takeover offer by GXY, GMM achieved the recommencement of production at Mt Cattlin on 31 March 2016. This mainly involved the extraction and processing of fines material, containing spodumene, from the tailings dam. This triggered the entitlement to 14% equity in the Mt Cattlin assets. Capital expenditure of A$7m by GMM was also confirmed. At this date, 50% of the net assets of Mt Cattlin were treated as sold.

At the GXY share price of A$0.48 assumed in the bidder’s statement, the purchase consideration in shares and unlisted options was A$262.5m.

The difference between the purchase consideration and the net assets was allocated to property plant and equipment, viz:

The Mt Cattlin project was established to provide spodumene concentrate to GXY’s then new Jiangsu lithium carbonate plant in China. A long and difficult commissioning period at the Jiangsu plant led to the mothballing of the Mt Cattlin plant and a build-up in debt. This forced GXY, under a new management team, to initiate a programme of strategic initiatives and financial restructuring, which included the sale of the Jiangsu plant and a future focus on the Sal de Vida brine project.

Ultimately, the Jiangsu plant was sold to Tianqi in April 2015 for an effective consideration of US$71.7m and assumption of GXY’s outstanding US$101.5m loan. At the 30 June 2015 balance date, GXY had A$42.9m cash off set by A$64.5m debt, mainly comprising A$60m convertible notes.

The purpose of GXY’s agreements with GMM was to generate a source of cash flow from the mothballed Mt Cattlin assets. GMM was able to provide funding and processing expertise to reopen and upgrade the Mt Cattlin project. GXY put in place agreements to sell a 50% stake in Mt Cattlin to GMM in 2015. This stake was treated as sold in March 2016. GXY also provided an agreement where GMM had the right to earn a 50% stake in the James Bay lithium project.

At the time, GXY was undergoing a restructuring of its debt and was not well positioned to investigate the possibility of reopening Mt Cattlin.

Remaining debt and a component of the convertible notes were later repaid. A three-year A$31m secured debt facility with OCP was negotiated and subsequently drawn down in November 2015 for the principal purpose of repaying the balance of outstanding convertible notes. GXY stated that it regarded the debt refinancing as a major milestone and marked the final stage of the company’s balance sheet restructuring.

The May 2016 definitive takeover bid to merge with GMM means that GXY is effectively buying back the 50% stake in Mt Cattlin it had sold and unwinding GMM’s earn-in agreement for James Bay. First sales from Mt Cattlin are expected during December 2016.

The share purchase consideration allocated A$269.2m to property plant and equipment. This consideration is supported by our valuation of A$209m for 50% of the Mt Cattlin and James Bay projects and the benefits to GXY of a cash-generating project during a period of strong prices that will assist in the funding of its next project, Sal de Vida.

In our earnings, cash flow and balance sheet forecasts (Exhibit 12), we incorporate 100% of GMM, following the compulsory acquisition of the remaining shares in GMM on 29 September 2016. Our forecasts include Mt Cattlin and the development of Sal de Vida, which we assume commences production in 2019. The James Bay project has no firm development schedule and is not included in our forecasts.

GXY has already received prepayments for Mt Cattlin concentrate. It expects concentrate shipments to start during December 2016. The company expects to commission Sal de Vida in 2019, but the schedule could vary. The timing of James Bay is uncertain and a DFS is still required. Given the level of development activity during the period to 2019, we do not forecast a dividend in this time frame.

GXY’s estimate of the capital cost to complete construction and commissioning of the Mt Cattlin project until first revenue has increased from A$15m to A$22.4m. To the extent that any cash shortfall is forecast after utilisation of GXY’s cash resources, some directors of the company have indicated their willingness to assist in arranging the necessary working capital from their own resources prior to the achievement of significant free cash flow. This is expected in 2017 when the Mt Cattlin operation reaches full capacity. The amount that could be received by GXY after exercise of options held by directors is approximately A$2.4m. Given possible legal requirements, options exercise has not been incorporated in the financial forecasts in Exhibit 12.

Cash flows from Mt Cattlin will benefit from unused tax losses of approximately A$207m as at 30 June 2016. At our price assumptions, we forecast that GXY is unlikely to pay any tax until 2019.

The Sal de Vida project has a capital cost of US$376m and this will need to be funded. Preliminary analysis carried out by Edison has indicated GXY could retain around 60% of Sal de Vida if the project was debt funded and perhaps a larger stake if further equity was raised. We believe it is likely GXY will divest part of the Sal de Vida project to assist funding and diversify risk. GXY is in discussions with potential strategic partners at the project level. Our financial forecasts assume GXY retains 60% of Sal de Vida.

GXY has low net debt, with the majority of debt relating to the refinancing of outstanding convertible bonds. Following the acquisition of GMM, there are 1,806.8m shares on issue. The balance sheet will be strengthened with the receipt of cash flow from the Mt Cattlin project.

Drawdowns of debt to fund 60% of capital expenditure for the Sal de Vida project are incorporated in our projections. We have not incorporated any further equity raisings into our projections, but additional equity is a possible further funding mechanism for Sal de Vida