Endeavour Mining — Showing its mettle as well as its metal

A full analysis of Endeavour’s Q121 results relative to our prior forecasts is provided below:

In addition to Endeavour’s actual reported Q121 results (in the ‘Actual Q121a’ column), we have also provided our best estimate regarding the equivalent pro forma results for Q121, in the event that the takeover of Teranga had occurred on 31 December 2020 and Sabodala-Massawa and Wahgnion had therefore contributed to its profit & loss account for the full three-month period, rather than merely the part-period since 10 February. To construct these notional pro forma Q121 results, we have made a number of assumptions, chief among them being that the over-sale of gold relative to production occurring in the period since 10 February also existed in the period from 1 January – that is, there was no corresponding under-sale from 1 January until 10 February. Otherwise, we assumed the unit costs that prevailed from 10 February until 31 March also prevailed during the entire period and that both sustaining capital and non-sustaining capital costs were incurred in the entire period pro rata to the costs incurred in the 10 February to 31 March one. Finally, we treated taxation independently for both Sabodala-Massawa and Wahgnion and added what we believed to have been payable in the period from 1 January to 10 February for both mines to what was otherwise disclosed as paid by the group for the three-month period. For earnings per share calculations, we assumed the quarter-end number of shares in issue of 252.6m shares prevailed over the entire period. All of this is shown in the Est Q121a pro forma column in Exhibit 1. We have also provided our prior estimates with Agbaou both fully consolidated and deconsolidated and shown as a separate line item.

In general, however, regardless of whether ‘as reported’ or ‘pro forma’ results are used, Endeavour produced c 20% more gold than our expectations in Q121 and sold c 30% more, giving rise to a positive variance in revenue of approximately 22.9–30.2%. This rise was then offset by a fractionally higher variance in operating expenses relative to our forecasts; however, it is worth noting that operating expenses, in both cases, were inflated by US$22.6m of non-cash operating expenses relating ‘to the reversal…of the fair value adjustment of inventory on hand’ at Sabodala-Massawa and Wahgnion in particular at the date of their acquisition. If these costs are excluded from the calculation, then the variance in operating expenses relative to our prior forecasts, in both cases, is less than the variance in associated revenues (note, these costs are automatically excluded in the calculation of adjusted net earnings from continuing operations attributable to shareholders). The variance in royalties, depreciation and exploration expenses was also greater than the variance in revenues and production. In the case of royalties, this reflected both higher royalty rates (in part, reflecting the gold price) as well as higher production. In the case of depreciation, this reflected both higher production (since Endeavour depreciates on a ‘units of production’ basis) and a normalisation of depreciation rates at Mana and Boungou in particular, after both were depressed in Q420 by the decision to retrospectively recognise goodwill in Endeavour’s acquisition of SEMAFO and to treat it separately from the depreciation of the underlying assets. All of the above gave rise to a positive variance of 9.2–11.3% in earnings from operations relative to our prior forecasts. Endeavour’s effective tax rate too was also higher than our prior expectations. In this case, however, much of the variance could be attributed to the inclusion of a deferred tax charge. If this too is excluded (as well as one-off, non-recurring and exceptional costs), it can be seen that the (positive) variance in adjusted net earnings attributable to shareholders relative to our prior expectations is 16.6% in the case of the ‘as reported’ numbers (ie with Sabodala-Massawa and Wahgnion included only since the date of their acquisition on 10 February) and 14.8% in the case of our estimate of Endeavour’s pro forma results (ie with Sabodala-Massawa and Wahgnion included for the full three-month period).

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). Readers are reminded that Endeavour changed its definition of cash costs in Q420 to include royalties. The decision was made so Endeavour may be more consistent in reporting within the context of its peer group. For reasons of comparability with past results, however, as well as ease of forecasting (given that royalties are reported as a discreet item distinct from the balance of operating expenses), we (at least for the moment) are continuing to show total cash costs excluding royalties unless specifically indicated otherwise (eg the ‘Actual’ Q121a column in Exhibit 1).

As well as exceeding our forecast, at US$0.503/share, actual adjusted net EPS for the quarter were well to the top end of the range of analysts’ expectations:

Full details of each mine’s operational performance and outlook are available in Endeavour’s press release. As per Exhibit 1, output from each of the company’s nine mines, exceeded our expectations, with the exception of Agbaou and (by a fraction) Sabodala-Massawa. Financially, each of them performed in line with, or outperformed, our expectations, with the exceptions of Sabodala-Massawa and Wahgnion – although both experienced material, exceptional costs in the form of ‘the reversal…of the fair value adjustment of inventory on hand’ at the date of their acquisitions. Agbaou outperformed on an underlying basis, if a US$13.5m loss on disposal is excluded from its results. While a number of factors can be invoked to explain both the operational and financial outperformance of Endeavour’s mines relative to our prior expectations, in general, it may be reduced to five main factors:

Historically, Endeavour has a good record of meeting its production and cost guidance targets and FY20 was the eighth year in succession in which the company achieved its production cost and AISC targets.

In the wake of Q121 results, Endeavour reiterated production and cost guidance for each of its mines for FY21 as shown in Exhibit 3.

Readers should note that Endeavour’s guidance includes production from Sabodala-Massawa and Wahgnion from 10 February onwards only. They should also note that, for the purposes of our forecasts (below) we have left Agbaou fully consolidated into Endeavour’s ‘pro forma’ accounts. For those who wish to deconsolidate it, Agbaou’s profit and loss for the period in which it was under Endeavour ownership in Q121 is reproduced below. All told, however, we would note that its contribution to Endeavour’s bottom line was, to all intents and purposes, immaterial during this period.

In the meantime, we understand it is not Endeavour’s intention, at least for the time being, to reflect Karma as an asset held for sale (despite it now being classified as ‘non-core’). With these provisos, our updated forecasts for Endeavour for the remainder of FY21 and in the wake of Q121 results, by quarter, on both an ‘as reported’ and ‘pro forma’ basis are as follows:

As before, 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).

Notwithstanding the detailed appearance of our forecasts, readers are cautioned that forecasting on a quarterly basis is prone to large variations between actual and forecast numbers. As such, the exhibits both above and below should be regarded as indicative, rather than prescriptive, particularly with respect to individual quarters. With this caveat, a comparison between our FY21 adjusted net EPS from continuing operations estimates and consensus estimates, by quarter, is as follows:

Self-evidently, one of the main assumptions behind Edison’s forecasts is that there are no major deleterious effects to ongoing operations as a result of the COVID-19 pandemic. To date, the effect of COVID-19 on Endeavour’s operations in West Africa has proven to be negligible and is expected to remain so. Nevertheless, Endeavour has mitigated future risks as far as possible by both setting itself up to operate under level 2 COVID-19 restrictions (see our note, New senior gold major looking to join FTSE 100, published on 17 December 2020) and also by preparing multiple different levels in its pits from which to produce, thereby affording it operational flexibility in event of disruptions.

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, Tabakoto in FY18 and Agbaou in FY20 and the acquisition of SEMAFO in FY20 and Teranga in FY21). Historically, rather than our customary method of discounting maximum potential dividends over the life of operations back to FY21, in the case of Endeavour, we have instead opted to discount six years of forecast cash flows in FY21–26 back to the start of FY21 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 FY26). In the normal course of events, exploration expenditure would have been excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, it was included on the grounds that it was a critical component of ongoing business performance in its ability to continually expand and extend the lives of its mines.

In this case, our estimate of cash flows in FY26 is US$4.00/share, giving rise to a terminal valuation of the company at end-FY26 of US$39.96/share (cf US$39.92/share previously), which (in conjunction with forecast intervening cash flows) then discounts back to a valuation of US$35.66/share (cf US$35.98/share previously) at the start of FY21, as shown in the graph below.

Given its elevation into the ranks of the world’s foremost producers of gold however, we believe that Endeavour can increasingly attract lower cost finance and, as such, a CAPM-derived WACC can also be considered (as discussed in our February 2021 initiation on Newmont Corporation). Long-term nominal equity returns have been 9% and 30-year break-evens are expecting 2.2% inflation. These two measures imply an expected real equity return of 6.7% (1.09/1.022) and applying this to our forecast cash flows would imply a terminal valuation for Endeavour of US$60.05/share (cf US$59.99/`share previously) and a current valuation of US$55.39/share (cf US$55.70/share previously). Readers should note that, given its beta of 0.66 (source: Refinitiv, 15 March 2021), even this (real) discount rate of 6.7% is likely to prove conservative.

In the meantime, Endeavour’s valuation remains at a material discount to those of its newly acquired peer group, as shown in Exhibit 8, below.

Endeavour’s valuation on a series of commonly used measures, relative to a selection of gold mining majors (the ranks of which it has now joined since its takeovers of SEMAFO and Teranga have been completed), is as follows:

Of note is the fact that Endeavour’s valuation is materially cheaper than the averages of the majors in all but one of the measures shown in Exhibit 8, regardless of whether consensus or Edison forecasts are used. On an individual basis, it is cheaper than the majors on at least 44 out of 54 (81%) of valuation measures if Edison forecasts are used or 45 out of 54 (83%) if consensus forecasts are used. Reverse engineered, the average valuation measures of its peers imply an average share price for Endeavour of US$35.12, or C$42.31 per share.

Readers should note that Edison’s forecast dividend yield in year 2 and year 3 (FY22 and FY23) is notional. When it declared its maiden dividend of US$0.37/share for FY20 in November, Endeavour announced a policy of declaring future dividends on a semi-annual basis with the aim of maintaining an approximate dividend yield of 1.6% until it has reached a targeted net cash position of c US$250m (note, in H122 according to Edison’s updated estimates). Thereupon, it will re-assess its capital allocation priorities, which may include augmenting its shareholder return programme. Endeavour’s share price is at approximately the same level that it was in November implying, all other things being equal, its FY21 dividend should also be of the same order of magnitude to maintain a yield of 1.6%. However, it could increase to the extent that its share price appreciates above US$23.13, or C$27.85 (being US$0.37/0.016). Given we have no more information than this, however, our dividend ‘forecast’ for FY22 and FY23 therefore shows the maximum that we estimate Endeavour could distribute to retain a net cash position of US$250m on its balance sheet. This we believe to be unlikely in practice. However, it does indicate that, all other things being equal, Endeavour has plenty of scope to increase dividend distributions to shareholders into the foreseeable future.

In tandem with its FY20 results, on 18 March 2021, Endeavour announced a normal course issuer bid (NCIB) or share buyback programme to supplement its policy of augmenting shareholder returns. The NCIB commenced on 22 March and will end on 21 March 2022 and will allow Endeavour to buy up to 12.2m ordinary shares, or approximately 5% of its total issued and outstanding ordinary shares at the time of the announcement, whereupon the purchased shares will be cancelled. At Endeavour’s current share price of C$28.89 (US$23.99), the NCIB is worth c US$293m and compares extremely favourably with its FY20 dividend payout of US$60.3m and its forecast US$93.5m payout in FY21. Combined, the NCIB and FY21e dividend distribution together represent c US$386.5m in aggregate returns to shareholders – equivalent to a dividend yield of 5.3% – in FY21.

Note that, owing to the inherent uncertainty surrounding whether purchases are made and at what price under the NCIB, we have not attempted to include potential future share buybacks in our financial forecasts in Exhibit 9, below, but only historical ones. To date in FY21, Endeavour has repurchased a total of 0.6m shares at an average price of C$27.42 resulting in total cash outflows of C$16.2m, or US$13.0m.

According to its Q121 balance sheet, Endeavour had net debt of US$220.2m post the acquisition of Teranga and the injection of US$200m by La Mancha. This compares with net debt of US$43.3m as at end-FY20 (pre the Teranga acquisition). This figure of US$220.2m includes lease liabilities of US$43.6m and an option premium of US$46.3m. Excluding the latter results in a net debt position of US$173.9m or just 4.3% of the company’s balance sheet equity of US$4,007.7m at end-Q121. Note that it differs slightly from the figure of US$161.8m quoted elsewhere in Endeavour’s announcements in that the latter excludes US$43.6m in lease liabilities and owing to the discounting, variously, of certain committed future payments to present value.

Note that, for the purposes of its financial modelling (see Exhibit 9, below) and for simplicity’s sake, we have assumed the consolidation of Endeavour’s and Teranga’s balance sheets took place retrospectively on 31 December 2020. In this case, we estimate that Endeavour would have consolidated c US$242.6m in net debt on its balance sheet and c US$349.2m in gross debt as a consequence of its Teranga acquisition. As such, on a pro forma basis, we estimate Endeavour would have had US$323.1m in net debt on its balance sheet at end-FY20, which we calculate would have equated to a gearing (net debt/equity) ratio of just 8.8% and a leverage (net debt/[net debt+equity]) ratio of 8.1% on the group’s enlarged equity base.