KEFI Minerals — Update 30 September 2015

With collaboration from Senet, Golders, Epoch and Snowden, KEFI completed an updated definitive feasibility study (DFS) on the Tulu Kapi project in July 2015. The DFS reflected both a complete overhaul, and an independent validation, of the Tulu Kapi geological resources and reserves, whereby KEFI inserted significant additional data and “wireframed” each individual ore lode in the system as part of a concerted programme of works to put behind it the issues raised by the intended bankers about the previous project plans under past ownership. Capex for the project in the DFS was estimated to be US$176m. However, the study was completed as if Tulu Kapi would be owner-operated. In consideration of the need to minimise initial capital expenditure, as well as the more exacting technical requirements of the selective mining campaign, KEFI instead decided to pursue a contract mining business plan, with the result that estimates for development capex initially reduced to US$141.2m (including working capital and relocation costs), which formed the basis of our initiation note, published in August 2015.

The development plan for Tulu Kapi has continued to evolve since then and, on 7 September, KEFI announced revised operational parameters for the project, based on an increased plant throughput rate. The expansion was based on the company’s ongoing discussions with potential project contractors. However, whereas the processing rate will increase, the mine plan will remain unchanged, as the original plan envisaged building up a stockpile, which would then be processed in years 11 to 14 of the project. The updated plan, by contrast, assumes a closer relationship between mining and processing rates, such that both are completed in year 11 of the project. However, based on the bids received to date, KEFI does not expect the expanded plant to increase the assumed level of funding required to develop the mine. A summary of the new processing plan and cost schedule is shown in Exhibit 1 below.

This may be compared to the assumptions used in our initiation note, which are reproduced in Exhibit 2 below.

As previously, additional costs include the 7% mining royalty, US$8.5m in life-of-mine offsite costs and an US$11.9m provision for closure costs. On-site general and administrative costs are forecast to be US$7.1m pa during full mining and processing operations and US$3.6m pa while reprocessing stockpiles (for the final nine months of operations only). Head office costs are assumed to amount to £2.0m pa. A carried-forward tax loss of US$60m has also been applied to future pre-tax profits before tax is payable.

The principal differences between the two plans may be summarised as follows:

A summary of these changes is provided in the table below in the units in which each of these parameters is reported.

Overall, unit working costs decline 3.1% under the updated processing schedule (from US$40.77/t processed to US$39.50/t). By contrast, total unit cash costs of production, which include unchanged offsite and royalty cost assumptions, decline 2.7%, from US$761/oz to US$740/oz.

In addition to the revised plant throughput schedule, KEFI is in the process of revising and optimising its capital expenditure estimates. Updated capital cost estimates, including their evolution since the release of the original BFS in July, and projected savings are provided in Exhibit 4 below.

Note that the US$10.4m reduction in the retainer payable to KEFI’s EPC contractor is presumed to be a deferral only, ie it is assumed that a payment for the same amount will occur, but later in the life of the mine’s operations, such that it will not be a part of initial capital expenditure and will therefore be payable out of cash flows, rather than adding to KEFI’s initial funding requirement.

On the basis of these updated estimates, overall, pre-production capex equates to US$1,203 per annual oz of average gold production at full capacity (vs US$1,396 previously), or US$83.67/t of ore processed (vs 112.6/t previously).

KEFI has recently announced that it intends to source US$20m in funding for the project “as minority equity investment in the project subsidiary” and that this will “be priced at a valuation reflecting Tulu Kapi’s net present value of c US$100m at current gold prices.” On this basis, a US$20m investment in the project subsidiary would confer a 16.7% interest in the project on the investor and KEFI has confirmed that the government of Ethiopia is now planning to proceed with such an arrangement, which is self-evidently a positive development.

Whereas previously funding had been assumed to be in the form of a US$100m streaming agreement and a US$10m equity raise, it is now assumed to be in the form of streaming (US$45m), equity in the project (US$20m) and equity in the parent (US$5m), with the balance to be provided in the form of conventional debt.

On the basis of the above assumptions alone and converting at the prevailing foreign exchange rate of US$1.5231/£ (vs 1.55/£ previously), we calculate that KEFI is capable of generating average after-tax earnings of c £25m pa for eight years, from 2018 to 2025 (vs £20m pa previously) and free cash flow of £34m pa (vs £32m previously) on a 100% basis. Without taking into account the anticipated streaming deal and using a 10% discount rate, our updated estimate of the project’s NPV is £78.8m (vs £68.0m previously), or 4.5p per existing share (4.3p attributable). The project’s internal rate of return increases from 26.1% to 29.5%.

Over the period since our initiation note, KEFI’s share price has fallen from 0.78p to 0.53p. However, to the extent that this implies a proportionate increase in dilution (although the amount of equity to be raised is now lower), this is more than offset by the fact that dividends will be paid out over a shorter, earlier timespan (notwithstanding the increased minority interest), with the result that investors in KEFI’s shares may expect maximum potential dividends in the order of 0.69p/share pa (vs 0.46p/share previously). Therefore, whereas the net present value of this dividend stream was 1.93p/share previously (when discounted at 10% pa), it is now 2.59p – an increase of 34.2%. This valuation then rises to 3.79p/share (vs 2.82p/share previously) in FY19, being the year of the first (potential) substantive dividend payment. As a result, an investment in KEFI shares at a price of 0.53p per share will therefore generate a return to investors of 38.6% in sterling terms over 12 years (vs 25.9% over 17 years previously).

Quantitatively, our DDF valuation of 2.59p is most sensitive to the gold price, cash costs and the discount rate, as shown in Exhibits 6 and 7 below.

A 10% change in the gold price from our long-term forecasts therefore results in a c 0.94p per share change in our KEFI valuation, whereas a 10% change in cash costs (excluding royalty and offsite costs) results in a 0.62p per share change.

KEFI’s financial results for the half year to 30 June 2015 were consistent both with what investors should expect from a junior mining company and our forecasts. As at 30 June, the company had cash of £1.0m on its balance sheet (cf £0.6m on 31 December 2014) after a cash burn of £3.6m
(cf £3.8m in H114 and £6.3m in FY14). For the purposes of our valuation (and in line with company guidance), we have assumed one further equity raise of US$5m in FY15 via the issue of an additional 619.4m shares (vs 859.4m previously) at a price of 0.53p/share.

On the basis of these assumptions, we estimate that KEFI will have a maximum funding requirement (likely to be satisfied predominantly by debt) of £40.0m (excluding streaming) in FY17 (see Exhibit 8).

Streaming will create an additional contingent liability in KEFI’s accounts, which we estimate in the order of £28.1m at its maximum extent in FY17 (see above and also Exhibit 8). However, streaming is associated with less risk than debt (and is not considered as debt by the lending banks), as it has neither debt-service covenants nor a fixed repayment schedule.