Alkane Resources — Getting back on track at the TGO

The longstanding investment case for Alkane Resources is tied to the development of the Dubbo Project (DP), a strategic project in that it carries a multitude of key speciality metals outside of the dominant supplier, China. These metals feed not only into a wide range of green technologies and electric vehicles, but also into defence technologies that do not wish to be subjected to Chinese export controls, in whatever form they take. Alongside the DP, the ongoing mining of gold at the TGO has seen a rebound in gold production after an H117 affected by rain.

We have valued Alkane’s shares on the basis of its revised DP project scope (see our December note Staged DZP plan de-risks financing and off-take), as well as our interpretation for mining the TGO until FY24. The TGO valuation uses our in-house gold price deck, and the DP uses prices as per its Front End Engineering Design (FEED) study announced in August 2015. The latter, in general, reflect current REE pricing levels, with zirconium product pricing rebounding from multi-year lows. Hafnium prices could rise as supply disruption results from Toshiba’s Westinghouse bankruptcy and ferro-niobium prices remain stable, as ever, due to the oligopoly present over supply. Our base case valuation, fully diluted for our DP financing assumptions, is A$0.84/share using a 10% discount rate.

Alkane had A$20.8m cash at end March 2017 and we now estimate net cash of A$9.4m at end FY17, which factors in an earlier repayment of its debt, than under our previous assumptions. To this could be added A$8.2m for the company’s gold held as bullion on hand.

We consider that Alkane’s share price over the course of 2016, and ytd, reflects both newsflow concerning the DP, as well as the market’s assessment of the TGO’s profitability and performance. Sensitivities to Alkane’s valuation therefore range from operational performance at a working gold mine to the pre-development catalysts involved with developing the multi-commodity speciality metal DP project into a working mine. The performance of the TGO was only affected in H117 due to heavy rainfall of roughly four times the average for the time of year. Third-quarter gold production, which came in at 18.7koz, or c75koz on an annualised basis, indicates that Alkane is more than able to generate the gold ounces required to meet its annual production targets. The main sensitivity to the DP is that of finalising offtake agreements to secure revenue, a finalisation of bankable studies on the phased two-stage development plan and DP financing.

As Alkane continues to progress its flagship DP, with financing to follow a finalisation of bankable studies into the project’s revised modular design (by its consultant Outotec, due later in 2017), exploration has become a focus for the TGO. This is not only to replenish depleted reserves, but also to gain greater confidence in planning for building out a UG mining phase at Wyoming and possibly also either at Caloma or Caloma Two. Caloma Two is situated only c 0.5km laterally from Wyoming One, making lateral UG development from one to the other very possible. The following overview of exploration activities continues to demonstrate the highly prospective (for gold and copper, in particular) land packages Alkane maintains in New South Wales, Australia. We also provide a brief summary of the current level of DP product prices. These include the rare earth group of elements, chemical zirconia and zirconium basic carbonate, as well as hafnium and ferro-niobium. All but a few of the rare earths are being sold, and there have been material price increases in rare earths used in magnets.

Exploration activities during Q317 have focused on areas surrounding the existing TGO mining operation, in particular the area underneath the Wyoming One and Caloma open pits. This focus will allow Alkane to form stringent underground mining plans for these orebodies. We already value an UG mining phase at the TGO, and have done so since the company first suggested it had plans for an UG phase at Tomingley when the surface operations and mine schedules were being devised as part of the DFS back in 2013. Whereas Alkane has guided that its underground mining inventory may reduce on removal by its engineers of an ore-grade crown pillar at the base of the Wyoming One pit accounting for c 20koz, we understand from management that this will in fact be extracted, but likely towards the end of the mine’s life. This could occur when deeper-level workings cease and a retreat through the upper levels allows for the removal of certain ore-grade rock left in place for structural support.

Coupled with exploration at the TGO, the company continues to explore the areas surrounding the mine. The geology of the TGO, as well as that of the surrounding area, is that of a 60km-long trend of complexly folded and faulted Ordovician-aged volcanics, intrusives and sediments. Alkane states that much of the belt is covered by younger, transported sand and clay sediments, which mask basement geology and mineralisation – the term for such hidden mineralisation is ‘blind’.

Drilling undertaken during H117 adjacent to or below the Wyoming One and Caloma open pits was designed to prove greater continuity between known ore-grade drill intercepts. For a very good and thorough overview of these results, the company’s 20 January 2017 announcement is well worth reading. The following two views of drill hole traces below the Wyoming One pit are taken from this announcement and clearly indicate the typical vein hosted at the TGO (as shown by the pale green areas in Exhibit 2 below).

The exploration targets drilled by Alkane in the surrounding areas to the TGO have so far returned gold and copper grades that encourage further investigation. 16,277m of air core drilling to the top of fresh rock have been completed so far, broadly spaced and testing an area just south of the TGO to the Cemetery exploration target located just north of Alkane’s past-producing gold heap leach operation, approximately 12km away. Air core drilling is used as a cheaper, early-stage drilling method, and is commonly used to screen exploration targets devised either from field reconnaissance works or desk top studies using remote sensing data. It is usually not included in resource estimation calculations due to the lack of sample support it provides. Side-wall contamination of the returned air core cuttings can take place which can arterially extend or reduce the area of influence of a particular assay data point.

The following chart displays all grade and tonnage data, by quarter, for the TGO mine from start of mining in Q214 to the current quarter. While H117 was adversely affected in terms of ore tonnes milled and grade mined (due to the above average heavy rainfall across the period), the third and fourth quarters tend to experience relatively high levels of waste tonnes mined, along with a commensurate decrease of ore tonnes moved due to finite haulage capacity. This pattern now appears to be roughly consistent should be noted in terms of earnings potential from the mine.

This seasonality in TGO’s operational data suggests that as the Australian autumn sets in, so it also favours a return of more stable mining conditions during the latter half of the financial year, followed by a final quarter of production that is guided by the company’s requirement to meet its stated production target. Such management can include the processing of existing lower-grade stockpiles, blended with higher-grade ore (if appropriate) or the amount of gold held as bullion on hand.

In terms of unit costs over the course of FY17, the following trends are seen, as represented by Exhibits 5 and 6. Despite the unseasonal weather experienced through H117, in fact on a unit cost basis the main costs incurred from mining were all steadily decreasing through FY17.

Following discussions with management, we are now more positive on the company’s cost performance and expect costs to stay at the same level as Q3 to support a FY17 AISC cost level below A$1,500/oz. Actual gold production was obviously affected, but the strength of Q3 gold production as the TGO mine recovered shows that, importantly, the actual operational performance of mining and processing equipment was relatively unaffected by the adverse weather conditions in H117.

Alkane’s longstanding flagship project is now called the Dubbo Project (DP). Previously, it was known as the Dubbo Zirconium Project (DZP). The new simplified name omits zirconium which, although forming a major component of future DP revenue streams, does not describe the multi-commodity nature of the project. The DP will extract and sell 12 of the 15 lanthanide group elements. Lanthanum and cerium will not be sold due to current oversupply/low prices, and will, instead be stockpiled. Also, thulium will not be sold. The DP will also produce a highly pure form of chemical zirconia (free of the element hafnium, which itself will form a distinct revenue stream to service the growth in demand seen particularly in the aerospace sector) and zirconium basic carbonate, as it is the preferred feedstock material for use in a range of downstream industrial applications. The DP will also produce ferro-niobium, with this output already subject to a binding offtake agreement with German company, Treibacher Industrie.

Alkane’s initial scope for the DP has changed materially over the course of our coverage of the company (which dates back to 2010). Putting the recent material change of project scope to one side (see our December 2016 note Staged DP plan de-risks financing and off-take , which should be read in conjunction with this note and carries a complete review of our DP + TGO valuation), the company’s R&D into DP products has been assessing and meeting potential end-user requirements since 2008. Indeed, Alkane’s continued use of its pilot plant facility at ANSTO, just outside central Sydney, NSW, has provided the company with a crucial tool to tailor the DP’s products to meet the ever changing landscape of specialist metal applications alongside the development of the DP’s front-end design. The use of the ANSTO pilot plant facility has allowed Alkane to develop its product suite at minimal cost. Alkane spent A$2.5m on building the plant in 2007 and has spent c A$30m operating it. This compares very favourably to works being undertaken elsewhere in the sector. For example, Northern Minerals’ recent announcement (8 April 2017) states that it intends to build a A$56m plant to recover only 148 tonnes of neodymium over a three-year period, and from this work to prove a working flow sheet design. Note that Alkane has been refining its proven flow sheet design for over seven years to recover 15 speciality metals, including 12 of 15 lanthanide metals. In addition, its long use of the ANSTO facility is not due to any abnormal difficulties in processing DP ore material. Rare earth development is notoriously difficult and to develop a working process flow sheet is a long-winded process.

The level of attention paid to the lithium space over the course of 2016, intimately linked to the electric vehicle space, brought about a considerable increase in the value of this market over 2016. However, the metals used in the production of electric vehicles and the myriad of other green technologies go far beyond just that of lithium and graphite. Of the various metals used in electric vehicles, the following are the key technology metals required in the manufacturing processes behind renewable energy storage and generation in particular:

Based on DP Phase 1 product output tonnages at 500ktpa ore throughput, and applying our assumption of product prices in 2020 (as guided by Alkane and its consultants due to the opaque nature of these product markets), we generate 2020 revenue estimates as shown in the following exhibit. Note that the DP is enriched with the aforementioned ‘magnet’ metals, with all of the main three (Nd+Pr+Dy) accounting for 73% of DP REE revenues (excluding Hf), and 22% of total DP revenues (including hafnium, zirconium basic carbonate, chemical zirconia and ferro-niobium).

Alkane stated in its Q317 quarterly report that the rare earths that go into making magnets are undergoing material price increases, of 5-7% since the start of 2017. Indeed, this is supported by our view of SteelHome prices recorded over the same period (source: SteelHome/Bloomberg), as shown in the following six exhibits. These indicate only neodymium, in particular, experiencing a meaningful price increase of 11% ytd. This rare earth element is the most important in terms of volumes mined (Nd represents 34% of traded DP rare earth element tonnes produced, and 10% of Phase 1 DP revenues based on a US$47.5/kg price assumption). Phase 1 dysprosium production is 87% lower than the tonnes of neodymium produced. Based on the 2020 assumption for dysprosium given in Exhibit 8, of US$285/g, it accounts for 8% of estimated 2020 DP revenues. The current SteelHome dysprosium price is US$234/kg, 18% below the 2020 forecast price we use to value the DP. Due to the bilateral nature of trading REEs, SteelHome prices may not truly reflect the prices fetched in the overall global REE market.

When comparing these six REE prices to our DP pricing assumptions given in Exhibit 8 above (estimated levels expected in 2020, the year of first steady-state production for Phase 1 at the DP under our assumptions), the majority are at the price level used in the DP’s August 2015 FEED study.

We include three other rare earth price charts for europium, terbium and ytterbium for reference and note that these six prices are the only available for the lanthanide group of elements on the Bloomberg platform.

A surge in demand for zircon based products in 2011 resulted from concerns about supply shortfalls, creating an almost bubble-like demand situation that carried through into 2012. The result of this intense period of buying led to the creation of vast stockpiles which, when coupled with decreasing Chinese demand through the downturn years of 2012-16, depressed zirconium prices to multi-year lows (one major market driver was the construction industry as zircon is used in the manufacture of tiles, which are a major type of floor surfacing and wall finishing in Asia). As these stockpiles have now dissipated into the marketplace and along with increased Chinese demand experienced over 2016 and ytd, the commodity is now experiencing price increases across its various product types (ie ZOC, ZBS and the Dubbo Project’s own ZBC), which Alkane states are similar to the 5-7% increases seen in the REE group.

The marketing of the DP’s zirconia-based output has been plagued in recent years by the aforementioned depressed nature of the zircon market, which now appears to be recovering. Potentially as a result of this recovery, Alkane’s marketing agent, Minchem, has secured six non-binding letters of intent (LOIs) covering 60% of planned Phase 1 output from the DP (ie 8,150tpa, or 8,178tpa under our assumptions, with the difference due to rounding during the calculation of finished product tonnages from raw ore at the grades and recovery numbers given in the DP’s DFS).

Hafnium is an important, although relatively recent addition to the DP’s product suite. Hafnium is constrained by supply; and its ability to enhance the physical properties of alloys has led to increased R&D and demand in the high-growth civil aerospace industry. One important recent development that may affect the supply of this metal is the bankruptcy of Toshiba’s Westinghouse atomic unit. The closure of this business, due in large part to cost overruns in reactor construction and increased health and safety regulation post-Fukushima, may well constrain upstream supply of speciality metals produced by Westinghouse used in the nuclear industry, of which hafnium and hafnium-free zirconia are two such materials.

Industry feedback has been especially positive for DP 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 that zircon absorbs and therefore needs to be refined out of zirconium metal – a process Alkane has successfully completed). As such, the depressed levels of activity in the nuclear industry currently, coupled with the Westinghouse bankruptcy, and uncertainty persisting from the Fukushima disaster of 2011, plus the increasing growth in the renewable energy economy, mean that stable hafnium output from nuclear industry sources cannot be depended on. Further, hafnium production volumes from the nuclear industry are unlikely to meet demand from other industrial sectors.

The following exhibit is based on the two-stage development concept for the DP. It also includes our value for the TGO, although we highlight that the potential future revenues and profits occurring from the DP (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 DP ramps up and the project’s capital expenditure dominates. Even though maximum gold production of 68koz from the TGO occurs (as per our assumptions) in FY19e, earnings are depressed as a result of the A$7m in capex required to develop an underground mining phase at Wyoming, with an additional A$13m in TGO UG capex capitalised as the reserve base is expected to grow as mining commences. A slight rise in earnings is seen over FY20 and FY21 as first DP profits materialise, but reduces again as stage 2 capex is spent over FY22. The following year (FY23) sees the first full year of mining at the maximum 1Mtpa ore throughput rate.

Note that our current UG mining assumptions for the TGO may change as the company finalises new resource estimates and these are subsequently used to potentially revise the mine schedule.

Breakdowns of discounted earning valuations for the following periods of our valuation horizon are given in Exhibit 16 below.

Other than commodity prices, the most notable effect on our valuation stems from our assumption for the price at which Alkane raises capital. Following Edison’s practice we apply the current share price to future potential equity issuance. However, we note that likely positive upcoming DP catalysts will alter this calculation as good news feeds into the share price. Exhibit 17 provides our total valuation (TGO+DP) given a range of share prices at which an equity portion of the DP’s financing might be raised:

Mining companies, once they are firmly into profitable stable production, are usually awarded valuations at a multiple to their NPV. Simply put, once the DP 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$0.11 in FY24 (the first year we estimate that the dividend could be paid) could imply a potential A$2.20/share Alkane valuation.

Alkane had A$20.8m cash at end March 2017 and we estimate that Alkane will finish with net cash of A$9.4m at end FY17. To this should be added A$8.2m for the company’s gold held in inventory as bullion on hand.

Our end FY17 net cash figure is after a cash outflow of A$46.1m relating largely to TGO expenditures, and net financing inflows of 3.6m. From our discussions with management we do not expect bullion-on-hand to increase further from its end H117 amount. Our estimate includes an earlier repayment of the company’s bank debt. Previously we had repayment of Alkane’s working capital loan facility equally over four years, from FY18 through to FY22. From Alkane’s Q3 cash flow report, debt repayments ytd total A$6.7m. We now assume that all debt is repaid by end FY17, amounting to a small debt repayment of A$0.9m in Q417.

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 have factored these sales and revenues into our cash flow forecasts for the TGO. The remaining 31,000/oz are to be paid in full by end FY18, unless the book is replenished by agreement with Macquarie bank.

Alkane’s financing team (led by Sumitomo Mitsui Banking Corporation) is pursuing the US$0.5bn initial capex required to bring the DP into Phase 1 production. Alkane’s plan is to sell a small stake in its wholly owned subsidiary containing the DP. Alkane is also pursuing Export Credit Agency (ECA) funding, which may provide hundreds of millions of Australian dollars in the form of loans at very low interest rates. These two financing routes would be joined with more conventional debt and equity financing to satisfy the requirement.

The exact financing structure of the DP has not been finalised. However, we understand from discussions with management that the financing structure for the total US$0.84bn (A$1.1bn) required to develop the DP could be secured by:

In the above scenario, we calculate that this would leave Alkane with a maximum required net debt position in FY18 of A$327m to fund Phase 1, which equates to a gearing (debt/equity) ratio of 78% and a leverage (debt/debt+equity) ratio of 44%. Alkane is looking to cover this requirement using ECA loans incurring very favourable interest rates, as well as conventional project financing routes, potentially incurring higher interest rates.

Phase 2 development depends on the success of Phase 1 and prevailing commodity prices. However, if the same funding scenario is applied to raising 35% of Phase 2 capex; 639m new shares would be issued in FY21, giving rise to a net debt position in this year of A$78m, equating to gearing and leverage ratios of 11% and 13% respectively.