Orosur Mining Inc — Update 5 December 2016

The San Gregorio mining complex contains 20 discrete orebodies that have been mined since 1997, producing over 1.4Moz of gold from 23.1Mt of ore grading an average 1.89g/t Au. The mainstay of Orosur’s current mining activity is the Arenal Deeps underground mine, with mining here due to end during the current quarter (Q217).

Concurrent with mining at Arenal Deeps, a smaller open pit operation called Veta Rey was started in April CY16 (Q415) and was completed at end Q117. Production from Veta Rey allowed the transfer of underground equipment to start development works at the company’s next major underground project, San Gregorio West Deeps. This careful mine planning removed the need for any additional funding required for new/second-hand mining equipment to operate two underground projects concurrently and demonstrates the company’s astuteness in adding production while being non-dilutive to shareholders.

Development of the SG West Deeps project started with a first development blast on 12 May 2016. This development is occurring below the historic San Gregorio open pit (which produced over 534koz Au), and will cost US$7.9m in capex, funded solely from cash flows, phased over FY17 and FY18.

SG West Reserves are 33koz Au at a grade of 2.2g/t, being roughly one year’s worth of production at current mining rates of 35koz to 40koz. It is worth noting that the company has over 200koz of total reserves on its books at San Gregorio and recent exploration work appears positive on upgrading these (see following section). Supplemental production will need to occur alongside SG West Deeps, and we expect this to come from either of the company’s two other UG projects, SG UG Central or SG UG East.

Operational gold mines can and do operate for very long lifespans, with a rolling three- to four-year reserve base. Market valuations of such companies are based on code-compliant resources with a premium applied relative to the company’s ability to regularly replenish depleted reserves, while managing costs and meeting production guidance. This is usually most relevant to smaller, sometimes older, underground narrow-veined gold mines or where numerous small open-pit gold occurrences are present – such as Orosur’s San Gregorio mining complex.

Orosur did pare back its exploration activities during the recent low gold prices, post the April 2013 gold price ‘crash’, which lasted until the start of 2016.

The above mineral resources are spread over several locations as shown in Exhibit 2. The highly distributed nature of these mineral resources over the San Gregorio mining complex demonstrates the highly fertile nature of this gold field. Obviously, certain of the resources are small and on a standalone basis may not be able to provide the scale of resource required to reinitiate mining at these brownfield sites. However, it is important to note that many of the small-scale operations were not fully explored using systematic and modern exploration techniques; instead many were mined based on largely indicative and rudimentary analysis and drill testing before Orosur’s current management and board team took control of operations in 2013. However, with the gold price crash occurring in April of that year, a complete re-evaluation of past operating areas of the San Gregorio mining complex was not undertaken due to the need to manage cash flows at low gold prices. Under its current management, Orosur has proved itself as capable of extracting value from these assets economically and efficiently, as evidenced by replenishing depleted reserves and maintaining a reserve base capable of providing consistent production of between 50koz and 60koz pa from 2010 to 2015.

The following sections provide detail over each of the three deposit areas and the drill results released by the company to market.

The location of these three areas, plus the deeper, largely untested San Gregorio West (SGW) UG Deep Extension zone, is given in the following exhibit:

This area of focus is contiguous at depth and east of the SGW UG mining area. The following are preliminary assay results from five diamond drill holes. Gold grades here are a little lower on average than the 1.5g/t Au mined currently and we anticipate further drilling being undertaken to prove the viability of any estimated resource.

This area is located immediately below the SGW UF sector, and is not currently in the mine plans for SGW UG. Deeper drill holes targeting this area are positive and show, at least from the two holes released to market, the presence of gold grades much higher than the typical 1.5g/t Au mined. .

The two drill holes released by Orosur to market are:

This Central Area is situated between the SG West UG and SG East UG reserves bases. Orosur has drilled seven exploratory diamond-drill holes into this area, the results of which are given in the following exhibit:

Orosur is the only listed company operating a gold mine in Uruguay. It has a good relationship with the government, proven by the government’s grant of a royalty exemption in support of the company maintaining itself as a going concern by undertaking a broad restructuring of its business over the course of 2014 and 2015. This restructuring included some necessary reductions in the workforce. The company’s wider opportunity to grow the scale of its gold mining business in Uruguay is to explore along the Isla Cristalina trend and in particular certain of its exploration licences (which are held in good standing with the government).

The three areas that have been drilled underground have provided sufficient drill data and reserves (SG West Deeps and SG East) to warrant a revision to our assumption on San Gregorio’s mine life. We have previously assumed a short valuation window of FY17 to FY20 inclusive (ie four years), with gold production of 35koz in FY17 rising to 40koz every year after.

In recognition of the company’s overall production and cost control performance over the past three quarters (we also note annual production guidance has been met for the past two years) we adjust our FY17 production forecast, which was bottom of the range for its stated 35koz to 40koz production guidance, up moderately, to 37.5koz of gold produced and sold. We expect Orosur to deliver this at cash operating costs of US$858/oz, mid-range of its stated US$800/oz to US$900/oz cost guidance for FY17. However, we note from our discussions with management that Q217 will see costs increase due to development works at San Gregorio (eg SG West and East UG projects), accompanied by moderating production due to the transition of mining equipment from Arenal to SG underground). As these works complete, H217 will see a pick-up in production and an associated reduction in unit costs as operations predominantly focus on mining activities once again.

We view the company’s 12 October 2016 exploration and development update announcement as highly supportive of an upgrade to its 31 May 2016 proven and probable reserve base of 127koz.

The two main reasons for this are:

Therefore we now assume that the company entirely mines out its existing 127koz reserve base (this figure excludes SG West and East UG reserves) and converts 60% (a conservative view of converting resources to reserves for gold deposits) of its measured and indicated resource base of 508koz Au into reserves. While the measured, indicated resources are not all within a similar situation to the three zones highlighted above, we expect that the company can and will successfully convert these to reserves. A 60% conversion of the 508koz measured and indicated resource base translates to an Edison assumed reserve of 229koz, or a further three to four years at a 35koz to 40koz production rate.

On this basis, we assume that the company can mine at a rate of 40kozpa comfortably until FY23. To support this we include a US$3m exploration budget every year, as well as US$4m in capex. This exploration budget is the same amount as currently being spent over FY17 on a 3,000m drilling campaign and which has provided the positive exploration results assessed in this note. We forecast US$7m in capex in FY17 based on management’s guidance, falling to US$5m in FY18, and then US$4m every year through to FY22.

We have largely kept our operating mine model unchanged from our last note published August 2016. Orosur’s Q117 (ending 31 August) results are in line with expectations and at this stage we see no reason to adjust any of our production or capex assumptions. However, we have adjusted our FY17 depreciation charge from US$11.3m down to US$7.1m based on management’s guidance.

We have also accounted for the 5% decrease in the value of the pound against the US dollar since our last note, bringing the exchange rate down from US$1.30/£ to US$1.24/£.

We have also revised down our gold price forecasts. 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 an (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.

On the basis that Orosur provides the level of gold production we envisage in Exhibit 8, maintains its operational and cost-management performance and provides a sufficiently positive set of resource and reserve upgrades (though de-risked significantly, this is probably still the core risk to our valuation), we value Orosur’s shares at C$0.57/£0.34 (cf C$0.42/£0.31 at our old higher gold prices), as shown in the following exhibit (presented in US dollar terms).

Based on the above assumptions and gold prices, we consider Orosur capable of delivering earnings of 3.9c per share, a year-on-year increase of 325%, followed in FY18 by a further 170% increase, from 3.9c to 10.5c per share. The stark increase over the next two years highlights the high leverage to fixed production costs gold mines experience. Note, our estimate for production in FY17 is 37.5koz, climbing 7% to 40koz for FY18.

Earnings of 3.9c equate to a current P/E of 4.3x, reducing to 1.6x in FY18 as earnings increase by c 2.5x, to 10.5c.

Our valuation at a range of gold prices, discount rates and percentage change in mine costs (as a proxy for Uruguayan inflation) are given in the following sensitivity tables.

Reflecting the company’s short mine life, a US$100/oz (ie 10%) change in the US dollar gold price has a material effect on our base case valuation of anywhere between 90% at the lower end of the range, to 24% at the upper bound value of US$1,500/oz.

According to World Bank data, inflation for the last reported full year (2015) was 8.66%. Since the start of the year, it appears that inflation in Uruguay has stabilised and is currently running at an annualised 8.45% (taken from an end October 2016 reading of Uruguay’s CPI measure of inflation). This is, however, still above the government’s ceiling for inflation of 7% pa.

As a proxy for the effects of Uruguayan inflation, we provide a sensitivity analysis based on a percentage change in mine site costs to our base case valuation:

A 5% decrease in costs results in a 21% increase in our base case valuation, whereas a 5% increase in operating costs results in a 17% decrease in our valuation.

The Colombian Anza gold and zinc project was acquired via the takeover of Waymar Resources in 2014. Orosur has sole ownership of the project, which has a small working gypsum mine situated within the project’s boundary. An operating permit is already in place for the gypsum operation, and this permit also allows for the extraction of precious and base metals. The only permits required are related to the processing of metalliferous ores (ie use of cyanide and tailings dumps), as well as the overall expansion of the gypsum operation and the tonnages mined.

Since its acquisition, exploration activities were not undertaken due to cash conservation by Orosur. However, towards the end of FY16 the company did start metallurgical and density testing on historical drill core taken from the project’s core yard. These initial studies are prudent and will at least provide an early, cheap way of assessing certain key processing characteristics, to help validate/invalidate historical drill core information. The first results of these tests were released in the company’s wider exploration announcement of 12 October 2016 and provided the first indication of a metallurgical recovery factor. The drill core analysed produced a recovery factor of 95.9% to 96.1% gold recovery, via a gravity separation, flotation and cyanidation process route – typical for such a deposit type. Although testing of the wider orebody will be needed before a meaningful resource estimate can be performed, we would highlight that a greater understanding of the proportion of gold recovered via gravity separation would positively benefit the project’s future processing costs. Gravity separation is basically the cheapest method of separating gold from waste rock. If a meaningful fraction of the rocks’ total contained gold content can be liberated using gravity techniques, it can provide a project that sits in the lowest quartile of cash operating costs.

Management states that since January 2016, it has been working on scoping studies for a future metals operation at Anza, as well as preparing for environmental and security requirements. Orosur plans to be ready for mining at Anza as early as January/February 2017.

Orosur stated cash flow from operations of US$4.8m in Q117 (cf US$0.2m for Q116), net profit after tax of US$2.8m (cf a US$1.7m loss in Q116), driven by a rising gold price and stable mining and overall operating costs. After deductions for capex (Q117: US$1.9m) and exploration expenditures (Q117: US$0.9m), it finished the first quarter with cash of US$5.0m (US$4.7m net of debt).

On the basis that it achieves our mid-range FY17 production target of 37.5koz of gold produced and sold at our average FY17 gold price estimate of US$1,271/oz, and keeps operating costs mid-range of its target (US$800-900/oz), we expect Orosur to strongly build its cash position to US$7.6m (US$7.3m net) by end-year.