Endeavour Mining — Q419 and FY19 results ahead of expectations

Endeavour is an intermediate gold producer, with four mines in Côte d’Ivoire (Agbaou and Ity) and Burkina Faso (Houndé, Karma) and two major development projects (Fetekro and Kalana) in the highly prospective West African Birimian greenstone belt. Although not restricted to a particular geography or mode of operation, Endeavour has a preference for operating in francophone West Africa and for owner-operated (rather than contractor) mining. Its target is for all of its mines to have operational lives (on average) in excess of 10 years at an AISC below US$850/oz.

In valuing the company, we have opted to discount potential cash flows back over three years from end-FY19 and then to apply an ex-growth, ad infinitum terminal multiple of 10x (consistent with using a standardised discount rate of 10%) to forecast cash flows in that year (FY22). In the normal course of events, exploration expenditure would be excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, we have included it in our estimate of FY22 cash flows on the grounds that it may be a critical component of ongoing business performance in its ability to continually extend the lives of the company’s assets. Our estimate of Endeavour’s potential cash flow is US$3.96 per share in FY22, in which case our terminal valuation of the company at end-FY22 is US$39.62/share, which (in conjunction with forecast intervening cash flows to shareholders) discounts back to a value of US$32.74/share at the start of FY20 (cf US$32.30/share in FY19 previously).

In qualitative terms, the principal risks to which Endeavour’s projects are immediately exposed are geographical/sovereign, geological, metallurgical, engineering, financing and management risk. For its mines that are successfully in production, most of these technical risks will be perceived to have been mitigated and others, such as commercial, commodity price and global economic risks will have taken their place. For its projects that have yet to enter production (Kalana and Fetekro), the whole suite of risks may be summarised as execution risk, ie management’s ability to bring the projects to account within their geographical jurisdictions and the required technical parameters. However, these risks are also mitigated by management’s proven track record in successfully bringing mines into production on time and on budget (eg Ity CIL). In the meantime, while ‘gains/(losses) from financial instruments’ are excluded from our forecasts, at the current gold price, we estimate Endeavour’s gold price protection programme to June 2020 potentially represents up to a c US$19.215m (US$0.175/share gross of tax) risk to our FY20 earnings forecasts (see Exhibit 8).

Endeavour had US$216.8m in net debt at end FY17 and US$535.9m at end FY19, after having embarked on a major capital expenditure throughout FY18 and H119 relating to the development of the Ity CIL project, which saw net debt peak at US$653.2m at end-Q219. The current level of net debt equates to a gearing (net debt/equity) ratio of 74.7% and a leverage (net debt/[net debt + equity]) ratio of 42.7%. With capital expenditure relating to the Ity CIL project having now been completed, Endeavour has no major capex commitments in the future until the development of either Kalana or Fetekro. Cash flows were strongly positive in Q419 and we expect them to remain so into the foreseeable future, such that we are forecasting that the company will have net debt of c US$447.2m as at end-FY20 and be net debt-free in mid-FY22 (notwithstanding any capex related to Kalana and/or Fetekro), at which point it will potentially be able to make dividend distributions to shareholders.

Note that a net debt figure of US$535.9m reconciles with Endeavour’s Q419 balance sheet; it differs from the figure of US$528.2m quoted in some of the company’s other materials on account of the fact that the latter is calculated on the basis of the value of the minimum equipment finance obligations discounted back to present value, whereas the former is presented on an undiscounted basis.

Fourth quarter adjusted EPS at Endeavour of US$0.336 (bottom line of Exhibit 1) was ahead of both our (US$0.188) and consensus (US$0.21–0.27) forecasts. Production (which was already known via the company’s preliminary results statement of 23 January) was exactly in line with our prior expectations, albeit it was better at its Houndé and Agbaou mines and worse at Karma, in particular (see Exhibit 1). All-in sustaining costs (AISC) of US$819/oz for the quarter were similarly lower than both our forecasts (US$884/oz) and also consensus (US$869/oz), although total cash costs were higher (see Exhibit 1), as all four mines were affected to a greater or lesser extent by the continuation of the disruption of the rainy season in Q3 into Q4, which necessitated them continuing to process ore from low-grade stockpiles – the divergence between AISC and total cash costs being accounted for by a more than halving of sustaining capital expenditure in Q4 versus Q3, especially at Houndé and Agbaou. The continuation of the rains into Q4 affected operations at Houndé in particular, where the ramp up at the high-grade Bouéré deposit was delayed until late Q4/early Q1 and the stripping ratio therefore remained high.

Financial results were distorted by the inclusion of a US$127.4m impairment charge relating to Endeavour’s Karma asset in Q4 (and its related deferred tax liability written off). Note that these have been excluded in the two columns marked ‘Underlying’ in Exhibit 1, below. Other ostensibly one-off adverse effects on earnings included US$12.2m in ‘Other expenses’ and US$4.6m in ‘Acquisition etc costs’, which both reflect (effectively) exceptional legal costs relating to Endeavour’s merger/takeover approach to Centamin in December 2019 until January 2020. However, these are anyway excluded in the company’s calculation of adjusted net earnings attributable (the penultimate row of Exhibit 1). In addition, the marginal tax rate remained high at all of Endeavour’s operations with the exception of Ity.

Other highlights of the period were:

A detailed analysis of Endeavour’s financial and operational performance, relative to both the previous quarter and our prior expectations (as set out in our note, Endeavour Mining: Forecasts up; valuation up, published on 11 November 2019) is shown in Exhibit 1, overleaf:

Items included in the reconciliation between adjusted net earnings attributable and total net and comprehensive earnings are losses from discontinued operations, deferred income tax effects, gains/losses on financial instruments, other expenses, share-based compensation and acquisition costs (all shown independently in the table above), plus the tax impact of adjusting items, non-cash and other adjustments and the minority interest attributable to the adjusting items (not shown independently). A full reconciliation of adjusted net earnings from continuing operations with total net and comprehensive earnings/(loss) is provided in Table 26 on page 32 of Endeavour’s Management Discussion & Analysis (MD&A) report for the three and 12 months ended 31 December 2019 and 2018.

While the minority interest charge during the quarter of US$4.5m may appear high within the context of the company’s consolidated group accounts’ US$7.4m total net loss, it equates to a much more credible 7.4% of aggregate post-tax earnings from mine operations (ie excluding all centralised expenses) and 15.2% of aggregate post-tax earnings from mine operations if deferred tax effects are excluded. Nevertheless, it is worth noting that this number has always exhibited significant volatility, historically, on a quarterly basis.

Historically, Endeavour has a good record of meeting its production and cost guidance targets and FY19 was the seventh year in succession in which the company achieved its production and AISC cost targets.

In general, the first half of FY20 in particular is anticipated to be an extension of circumstances in Q419. Ity will continue to mine into harder fresh ore at Daapleu, which will restrain recoveries before a degree of improvement in H220. However, its CIL plant should naturally be less affected by the uncertainties of the Q3 rainy season than its historical heap leach operation. In addition, the second lift of its tailings storage facility is reported to be progressing well and management believes that the mine, which is located in an area of acknowledged high rainfall, is now better prepared for the FY20 wet season than in previous years. Performance at Houndé will depend largely on its ability to mine Kari Pump in H220, for which a permit is expected to be received in Q2/Q3. In the meantime, it will continue to mine predominantly hard ore at a relatively high stripping ratio in H120, although this will be somewhat mitigated by its plant continuing to operate at or above nameplate capacity throughout the year. Readers should note that the difference between Edison’s cost and production forecasts for FY20 and company guidance may be explained by the timing of operations at Kari Pump. Whereas management expects a contribution from Kari Pump’s materially higher grade ore in H220, Edison’s forecasts assume that there is no such contribution until FY21, with the result that our cost forecasts in particular are slightly above the top of the guidance range for FY20 (and are therefore inherently conservative). At Agbaou, harder ore is expected to be mined, while the overall stripping ratio is anticipated to decrease slightly and throughput and recovery rates to decrease marginally owing to the harder ore blend. In the meantime, tonnes stacked at Karma are projected to increase as a result of the installation of the new stacker system and grades and recoveries to remain consistent with Q419 (albeit to improve upon FY19, which was adversely affected by maintenance downtime related to the installation and commissioning of the tripper conveyor in addition to the heavy rains, which resulted in an increase in unit mining costs, among other things).

With due regard for the above factors and considerations, Endeavour’s production and cost guidance for FY20, compared with Edison’s forecasts, is as follows:

On the basis of the above guidance and forecasts, Edison’s financial and operational forecasts for Endeavour for FY20, by quarter, are as follows:

We note that forecasting on a quarterly basis is prone to large variations between actual and forecast numbers (as demonstrated, not least, by the variances observed between Q419 actual figures and Q419 estimates in Exhibit 1, above). To this end, it is worth noting that the top end of Endeavour’s production guidance is 37.4koz gold (5.3%) above our forecast for the year, which is worth a material US$52.3m in additional revenue to the company (net of royalties) and therefore has the ability to increase our estimate of Endeavour’s FY20 profit before tax by 28.1% (all other things being equal). As such, the exhibit above should be regarded as indicative, rather than prescriptive, particularly with respect to individual quarters. Within that context a comparison between Edison’s FY20 adjusted net EPS from continuing operations estimates and consensus estimates, by quarter, is as follows:

Endeavour is a multi-asset company that has shown a willingness and desire to trade assets to maintain production, reduce costs and maximise returns to shareholders (eg the sale of Youga in FY16, Nzema in FY17 and Tabakoto in FY18). Rather than our customary method of discounting maximum potential dividends over the life of operations back to FY20, therefore, we have opted to discount potential cash flows back over three years from FY20 and then to apply an ex-growth terminal multiple of 10x (consistent with using a standardised discount rate of 10%) to forecast cash flows in that year (ie FY22). In the normal course of events, exploration expenditure would be excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, we have included it in our estimate of FY22 cash flows on the grounds that it may be a critical component of ongoing business performance in its ability to continually expand and extend the lives of the company’s assets.

Compared with our last note, our estimate of Endeavour’s cash flow in FY22 has reduced by a modest 5.7% to US$3.96 per share (cf US$4.20/share previously), which should be credible in the context of its having generated US$1.10/share in cash flow from operations in Q419 alone. On this basis, our terminal valuation of the company at end-FY22 is US$39.62/share (cf US$41.99/share previously), which (in conjunction with forecast intervening cash flows) discounts back to a value of US$32.74/share at the start of FY20 (cf US$32.30/share at the start of FY19 previously).

Endeavour’s valuation on a series of commonly used measures, relative to a selection of gold mining majors and international peers, is as follows:

Of note is the fact that Endeavour’s valuation is materially cheaper than the averages of the majors on 100% of measures, regardless of whether Edison or consensus forecasts are used. On an individual basis, it is cheaper than the majors on at least 83% (30 out of 36) of valuation measures. Relative to its peers, it is cheaper on at least 39% (40 out of 102) of valuation measures.

Endeavour had US$535.9m in net debt on its balance sheet at end-Q419 (vs US$615.1 at end-Q319, US$653.2m at end-Q219, US$615.3m at end-Q119 and US$517.5m at end-Q418), after US$40.2m in net capex during the quarter (vs US$32.8m in Q319, US$66.1m in Q219, US$103.9m in Q119, US$87.1m in Q418 and US$110.8m in Q318). This level of net debt equates to a gearing (net debt/equity) ratio of 74.7% (vs 74.4% at end Q319, 76.5% at end Q219, 72.4% at end Q119, 60.3% at end-Q418 and 52.1% at end-Q318) and leverage (net debt/[net debt + equity]) ratio of 42.7% (vs 42.7% at end-Q319, 43.3% at end-Q219, 42.0% at end-Q119, 37.6% at end-Q418 and 34.3% at end-Q318). Note that US$535.9m reconciles with Endeavour’s Q419 balance sheet; it differs from the figure of US$528.2m quoted in some of the company’s other materials on account of the fact that the latter is calculated on the basis of the value of the minimum equipment finance obligations discounted back to present value rather than being presented on an undiscounted basis.

With capital expenditure relating to the Ity CIL project now having been, to all intents and purposes, completed, Endeavour has no major capex commitments in the future until the development of either Kalana and/or Fetekro. In the new gold price environment, cash flows were strongly positive in Q419 and we expect them to remain strongly positive into the foreseeable future, such that we are forecasting that the company will have net debt of c US$447.2m as at end-FY20, which will equate to a gearing ratio of 53.8% and a leverage ratio of 35.0%. Thereafter, net debt should decline rapidly such that we estimate the company will be net debt-free in mid-FY22 (cf late FY21 previously) notwithstanding any capex related to the Kalana project, at which point it will potentially be able to make dividend distributions to shareholders.

During the year ended 31 December 2019, Endeavour put in place a gold revenue protection programme in order to maximise cash flow certainty during its debt reimbursement phase. Similar to the strategy it put in place during its recent construction phases, this comprises a deferred premium collar strategy using written (sold) call options and bought put options to (effectively) create a synthetic short position. The programme began on 1 July 2019 and will end on 30 June 2020 and covers a total of 360,000oz (approximately 50% of Endeavour’s total estimated production over the period), with a floor price of US$1,358/oz and a ceiling price of US$1,500/oz. As at end-Q419, 210,000oz remain outstanding under the collar derivative liability, implying that call options over 150,000oz of gold were exercised by counterparties in Q3 and Q419.

Edison’s short- to medium-term gold price forecasts are those set out in our recent report, Portents of economic weakness: Gold – doves in the ascendant, published on 14 August 2019, expressed in both nominal and real terms, below:

At US$1,479/oz at the time of writing, the gold price is currently 9.5% below Edison’s price forecast for CY20. In common with Edison’s stated practice, however, we use prevailing prices to generate our forecasts for the remainder of the current year (see Exhibit 3), followed by long-term forecasts thereafter (Exhibit 7).

While it is tempting to assume that a gold price above US$1,500/oz will automatically result in losses on Endeavour’s gold revenue protection programme, recent history would suggest that this is not a foregone conclusion. Exhibit 8, in particular, details Edison’s estimates of the (losses)/gains incurred by the programme during the past two quarters within the context of the gold price movement during the quarters and the extent of potential (losses) in Q120 and Q220, assuming that all remaining ounces covered by the revenue protection programme are exercised in Q120 and Q220:

Self-evidently, the extent of actual losses realised depends on, among other things the timing and the exact price of gold when the contracts are exercised. Nevertheless, while the extent of the potential realised losses on the gold revenue protection programme in Q120 could not be considered trivial, it is worth noting that, historically, gains (or losses) on the gold revenue protection programme have not always been the largest constituent part of total gains (or losses) on financial instruments as in Q319, as a case in point, below:

As a result of the inherent uncertainties surrounding gains (or losses) from financial instruments, they have been excluded from our forecasts in Exhibits 3 and 10. While the gold price protection strategy programme is a limited one therefore, investors should nevertheless be aware that the remaining contracts outstanding potentially represent a US$19.215m (US$0.175 gross of tax) risk to our FY20 earnings forecasts (albeit not our normalised or adjusted earnings forecasts).