Alkane Resources — Poised for the next stage

The future of the TGO’s mine life (mining commenced Q2 FY14 with current open pit operations due to end Q1 FY19) will shortly be announced. There are two options: ALK either announces a positive investment decision to take the mine underground below the Wyoming pit, or looks to pare operations back significantly, potentially processing the c 1Mt of low grade stockpiles containing c 31koz Au and increasing its exploration activities with a view to feeding new ore streams into the TGO’s existing plant. New ore streams could include the deeper sulphidic gold ores left behind at Peak Hill upon its closure in 2005. These would require either development of a standalone process facility close to the source of these ores, or modifying the existing TGO processing facility. To this end the biological oxidation (BIOX) method has been previously proven to be viable at Peak Hill.

The TGO produced 18,635oz of gold in the third quarter, in line with management’s forecast. Year to date (YTD) gold production is 59,398oz, making the company’s production target of between 75,000oz Au and 80,000oz look eminently achievable. Costs have also come down to the planned life-of-mine average of c A$1,000/oz on a AISC basis, and are in stark contrast to the Q1 to Q3 period in FY17, when extreme levels of rainfall affected operations and drove AISC as high as A$2,139/oz (Q117). As open pit operations are nearing the end of their planned lives at Caloma One and Wyoming, we do not expect any further large tonnages of waste to be mined and we expect operational data through Q417 and Q119 to mirror that of Q318. Our expectations for Q418 are presented in Exhibit 1, below.

The following exhibit details the TGO’s quarterly production since mining commenced in Q2 FY14.

ALK has been revising its underground gold resource and reserve estimations with a view to publishing the reserve estimate in May 2018. The result of this revised reserve estimation will allow the company to decide whether the quantum of economic gold available for mining will be the best use of its cash, or whether a better financial return would be achieved from developing either a greenfield exploration asset or brownfield development. We await the company’s guidance on this matter.

We believe one brownfield opportunity that is worthy of further investigation is the primary sulphide gold resource left behind at the Peak Hill gold mine. This was previously mined by ALK for its oxide gold cap between 1996 and 2005.

The existing Peak Hill resource estimate was undertaken using JORC 2004 guidelines, which have since been superseded by JORC 2012.

As shown above there is the potential for roughly 0.5Moz of gold resource (at the lower 0.5g/t COG). While the above resource cannot be used as it is based on old JORC guidelines, it presents a clear opportunity for further investigation. We understand from management that the BIOX process method has historically been proven as viable for treatment of proprietary sulphidic ores. Further assessment would be required to confirm this is in line with JORC 2012 guidelines. However, previous investigations are worthy of recognition and provide some de-risking for the potential development of the brownfields proprietary deposit.

ALK is also converting its old Peak Hill database into a format that can be used in more modern mining software. Along with some further confirmatory drilling, this will allow the company to publish a JORC 2012-compliant resource estimate in the September 2018 quarter.

Aside from the DP’s potential development, ALK has control over large exploration tenements in the Dubbo region of New South Wales, Australia. Of these exploration tenements, over the past 20-plus years two have yielded operational mines (Peak Hill and the current TGO), a large gold-copper porphyry resource (McPhillamys) sold for an attributable A$73.5m in 2012 to ASX listed Regus Resources, and the DP. ALK’s exploration tenements and land holdings appear to be fertile ground and could potentially yield further economic mining opportunities for ALK.

Included amongst ALK’s numerous exploration results (see the company’s Q3 quarterly activities report for the full set of results) is a series of three prospects that lie directly to the south of the TGO’s operations. These have been drilled to varying degrees and have all yielded drill assay results of >1.0g/t Au. The three prospects are McLeans, San Antonio and El Paso. In our opinion, San Antonio provides the highest and shallowest gold grades (as opposed to high gold grades at El Paso, which start at a depth of c 340m below surface). So far, the grades in drill hole TO228 are:

This southerly corridor runs parallel to the Newell Highway, which bisects the TGO mine site. Mineralisation is found along this north-south trend due to rheological differences between the brittle rhyolitic porphyry to the east and the relatively ductile sediments to the west.

The DP has been Alkane’s flagship project for at least a decade. Over this time management has run a pilot plant at the Australian Nuclear Science and Technology Organisation facilities outside of Sydney to determine a viable and proven flowsheet design to process the rare metal containing eudialyte ores into the following saleable products:

With a technical flowsheet design completed and product samples generated and supplied to potential customers over the pilot plant’s 10 years of operation, the DP stands alone in the mining industry as the only viable rare metal project. Further, it is the only project that will have bankable level data with which to source financing of the roughly US$500m per 0.5Mtpa throughput module. Previous iterations of the DP’s design contemplated a US$$1bn single-phase build-out. However, this approach is cumbersome in terms of marrying demand to supply and is difficult to finance.

As such, ALK’s modular design execution plan, which it is due to release in May 2018, will detail the exact operating cost structures and capital expenditure profile required to build out the project in stages.

Alkane has long held the view that financing the DP will involve conventional debt, export credit agency debt, equity (potentially at the DP level) and involvement of a strategic partner(s). The view we maintain, until the exact financing structure is announced, is as follows.

ALK’s financing team (including debt advisers Sumitomo Mitsui Banking Corporation) is pursuing the US$0.5bn (A$0.63bn) initial capex required to bring the DP into Phase 1 production. ALK’s plan includes selling a small stake in its wholly owned subsidiary containing the DP. ALK 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 total US$0.84bn (US$1.1bn, A$1.8bn) required to develop the DP over two stages could be secured by a series of staged transactions. An example is:

In the above scenario, we calculate that this would leave ALK with a maximum required net debt position in FY19 of A$317m to fund Phase 1, which equates to a gearing (debt/equity) ratio of 82% and a leverage (debt/debt+equity) ratio of 45%. ALK 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. It would be expected that ALK would be rerated in the market before commencing Phase 2 capital expenditure, and therefore achieve much of the second phase on debt.

The DP’s products feed into four broad end markets:

Our valuation for the TGO is suspended until we gain clear insight into the company’s future direction for this asset. Including net cash flows for the remainder of its official open pit operations (ending Q119) only adds 1 cent to our base case valuation. We will look to revisit, remodel and re-value the TGO and ALK’s wider gold-centric development plans as details emerge, first in May with the outcome of the TGO UG study and in the September quarter with the publication of a revised Peak Hill Proprietary deposit resource estimate.

As such, our base case valuation of ALK’s shares is pinned to just the DP for now. This asset’s value has always dwarfed that of the TGO, and will continue to unless ALK decides not to go ahead with the project’s development. However, we can only see this occurring through a lack of financing being made available.

On a standalone basis we value the DP at A$0.90 per share on a FY19 basis (previously A$0.79 on an FY18 basis).

For a full explanation behind our valuation methodology for the DP please refer to our December 2016 update note Staged DZP plan de-risks financing and off-take.

ALK’s appendix 3B to end Q318 details YTD revenues from the TGO of A$95.9m and total cash outflows from operations of A$72.2m. Costs comprise all G&A (mine site [A$2.0m] and central costs [A$3.5m]), production (A$48.5m) and development (A$7.4m) operating costs and exploration and evaluation costs (A$8.4m). With Q418 costs likely to mirror Q318 and no significant amount of waste requiring extraction as the open pits near completion, we have assumed these cost levels carry through to year end.

ALK reported YTD capex of only A$1.0m, which we consider mirrors the company’s intention to hold its cash until all its internal studies are completed.

Cash at end Q318 was A$60.6m, a q-o-q increase of 35% (Q218: A$44.8m) driven by solid performance at the TGO, with costs driven lower against a relatively flat Australian dollar gold price. To this could be added A$8.4m in bullion-on-hand, for total liquid assets of A$69m or A$0.13 per ALK share.

Factoring the company’s Q3 results into our model and assuming it sells 78koz of gold at an average price of A$1,653/oz (our US$1,275/oz gold price assumption adjusted for YTD monthly gold prices and a US$/A$ exchange rate of 0.75), we forecast Alkane will finish FY18 with cash of A$63.3m, a modest –q-o-q increase of 4.5% over Q3, with bullion-on-hand valued at A$8.4m, for total liquid assets of A$71.7m.