Alkane Resources — TGO shows it can, and Dubbo’s value re-emerges

Strong production performance of 17koz of gold produced across April and May led Alkane, at end June, to revise upwards its H217 production target from 31-36koz, to 43-45koz. H217 all-in sustaining costs (AISC) also came down to the range estimated by the Alkane in January 2017 of A$1,350-1,550/oz, to A$1,000-1,100/oz. This has had a marked positive effect on the company’s full year cash flow from operations, with A$32.7m realised (net of development costs), and its cash position has also grown to A$42.0m from A$24.4m in FY16.

Alkane’s strong H2 production performance at the TGO had also led the company to revise its full-year FY17 production guidance to 65-67koz Au at all-in sustaining costs of between A$1,300/oz and A$1,400/oz. This is 12% above our TGO gold production estimate for FY17 (published in May 2017) of 58koz, and slightly ahead of our AISC estimate for FY17 of A$1,469/oz.

This positive H217 production performance sees Alkane finishing FY17 with a flourish, after a difficult H117 dominated by intense periods of rainfall, which negatively affected gold mining at the TGO. Further, Alkane has guided that it expects to produce 65-70koz of gold in FY18 at an AISC of between A$1,100/oz to A$1,200/oz. We expect to revise our base case valuation for the TGO, and Alkane’s shares, pending its release of formal revised underground mine plans for the TGO, sometime towards the end of H118 (H2 of CY17). This will follow the completion of current drilling activities and a revised resource and reserve statement for the TGO.

As a direct result of improved mining conditions, operating costs reduced markedly across FY17, as detailed in Exhibit 2 below. Alkane guides to similar production and cost levels being achieved for the TGO during FY18 (notwithstanding any further disruptions due to high levels of rainfall like those experienced in H217). We therefore estimate 65koz of gold produced at an all-in sustaining cost of A$1,092/oz.

A key concern to investors about Dubbo has been the state of its respective end-product markets. Since the 2011 rare earth bubble, rare earth metal prices have consistently dropped in value, not only as the commodity boom in China ended, but also as worldwide demand slowed in general. Matters were exacerbated by development of Lynas Corporation’s Mt Weld project in Western Australia and the relatively short lived re-opening of Molycorps’s Mountain Pass project. However, both the aforementioned projects were largely light rare earth dominant and created a situation of oversupply, namely within the lanthanum and cerium markets.

Fast forward to today, and specific rare earth and specialist metal markets are seemingly changing for the better (see price charts in Exhibit 6). The metals given in Exhibit 6 are experiencing price increases mainly as a result of the growth in renewable energy production, but also due to Chinese environmental auditing and closure of illegal mine sites. The main consumers and drivers for growth in rare earths and specialty metals demand relate to, among others, the manufacture of magnets used in (wind) turbine technologies and the uses of rare earths throughout the spectrum of renewable energy technologies and the associated electronic infrastructure required to support it. A stark indication of the average growth rates in solar photovoltaic and wind turbine energy supply across a 25-year time span, as calculated by the International Energy Agency, is given in the following exhibit.

The above chart should be viewed in conjunction with the following exhibit, which details the percentage share of fuels used in energy production worldwide in 2015. While solar, wind, geothermal and tidal technologies only account for 1.5% of the fuel share in the world’s total primary energy supply, the growth rates given in the above exhibit clearly support demand for specific rare earth and specialty metals.

The following price charts are taken from Alkane’s quarterly report and detail key Chinese US dollar metal prices.

The memorandum of understanding (MoU) signed with Vietnam Rare Earth JSC (VTRE) in April 2016 was originally valid for 12 months, but has been extended to allow Alkane to complete exhaustive due diligence on VTRE to make sure it can deliver the quality of product at forecast cost levels to end-users. After this due diligence period, Alkane will also have the option to purchase equity in VTRE (details of this potential purchase are not available). VTRE has been separating rare earth concentrates into separated rare earth metals since 2012 and, according to Alkane’s management, achieves this at cost levels similar to those of the rare earth processors in China. If true, it has a major competitive edge over Western rare earth developers looking to refine in house.

During Q417 Alkane signed a toll treatment agreement with VTRE as a further development to the aforementioned MoU. Toll treatment of Dubbo rare earth concentrates is favoured by Alkane as construction and operation of a dedicated rare earth separation plant at the Dubbo site is considered to add some complexity to the project.

Alkane has therefore been in the process of undertaking considerable due diligence at Vietnam Rare Earth’s processing facility. Key to this due diligence process has been the supply by Alkane of 80 tonnes of rare earth concentrate (bought on market by Alkane’s subsidiary, ASM) to VTRE, from which 31 tonnes of refined rare earth oxides have now been produced. We are unsure of the exact quantities of rare earths contained within the concentrate shipped, or whether it had similar characteristics to the concentrate that could be produced from Dubbo. However, Alkane does state that the concentrate contains cerium and lanthanum (which are in general oversupply and due to be stockpiled and not sold once Dubbo is in production) and praseodymium and neodymium (which will be produced and sold; they are key magnet metals and will be important revenue streams to Alkane).

Alkane states that final processing will be completed in July, after which Alkane will be able to validate VTRE’s processing technology as well as the quality of the refined metals and oxides produced, commercial logistics and sales capabilities.

We feel it is worth repeating Alkane’s observation that zirconium and lanthanum could improve Li-ion battery performance. It concerns research currently being undertaken by Michigan University into the use of solid electrolytes in lithium-ion batteries. The research involves the use of a film made of lithium-lanthanum-zirconate, using proportions of lithium hydroxide (20%), lanthanum oxide (53%) and zirconia (27%). The rise of the electric vehicle, either hybrid-electric or pure-electric, would greatly benefit from this battery technology being commercialised as it allows li-ion batteries to operate at higher temperatures as well as having a greater energy density. This would allow for batteries to be made lighter with a potential positive impact on vehicle range, a key anxiety of electric vehicle customers.

A key risk of the DP is securing commercial offtake partner agreements for its different products. Securing such agreements is critical to Alkane’s ability to generate revenue from its suite of products that have no open market on which to be sold. The following table summarises the current agreements that Alkane has in place for its DP products.

With only one agreement in place with Treibacher Industrie (TIAG) over the DP’s future production, Alkane intends to finalise agreements on its zirconium and rare earth output over the remainder of CY17. It has marketed extensively through Europe and the US over the last few years and has been stepping up its efforts. Although TIAG and VTRE have allowed their names to be disclosed, this is not a standard practice and the company name supporting zirconium offtake may not be announced. Regardless, Alkane will need to notify the market of finalised commercial offtake agreements in the coming months, such that it can maintain its development timeline and progress to first production in 2019.

Edison’s projected group revenue split for DP products are shown in Exhibit 8 below.

The chart above correlates to the following amounts being produced once in steady state production in 2023 (under our assumptions):

We provide a summary of the DP’s product suite below.

The sale of zirconium-based products, in the form of zirconium chemicals and chemical zirconia, constitutes the largest revenue stream (31% at projected prices) at group level for Alkane. The zircon market in all its forms has remained flat during recent years and, with zircon used in its most widespread form in building construction applications, demand is closely linked to infrastructure spending, especially out of China. Alkane’s discussions with potential customers are ongoing for commercialisation of its zirconium-based sales agreements.

Subject to the effects of the oligopoly in this market, niobium prices remain flat at US$30-35/kg. Commercialisation of Alkane’s framework agreement with TIAG is also being converted into a commercial offtake agreement.

The DP’s future hafnium output is based on Alkane’s discussions with potential customers, primarily in the aerospace and industrial gas turbine industries, and its current understanding for the potential scale of this market once the DP is in production. Hafnium production will be 25tpa from start-up through to 2025, at which point it rises to 100tpa, resulting in annual revenues of A$80m pa at projected prices. Alkane’s management has stated that hafnium output could increase beyond 100tpa as the world market for this metal grows and accepts the DZP as an established long-term stable producer. Refined hafnium metal currently trades at US$1,200/kg, and we forecast that US$1,100/kg will be realised during the DP’s ramp-up period from 2018-20, followed by a flat US$800/kg over the remainder of the mine’s life (2036 under our assumptions).

The following exhibit is based on the two-stage development concept for the DP. It also includes our value for the TGO, although we highlight that the potential future revenues and profits occurring from the DP (starting in FY19 under our assumptions) dwarf the relatively small cash generation levels that result from gold mining.

As can be seen above, earnings are depressed until FY23 as production from the DP ramps up and the project’s capital expenditure dominates. We forecast gold production of 65koz from the TGO in FY18 (ie the lower bound of the company’s guidance announced on 27 June 2017), with earnings lowered in this coming financial year as a result of A$7m in capex required to develop an underground mining phase at Wyoming, with an additional A$13m in TGO UG capex capitalised as the reserve base is expected to grow as mining commences. A slight rise in earnings is seen over FY20 and FY21 as first DP profits materialise, but reduces again as stage 2 capex is spent over FY22. The following year (FY23) sees the first full year of mining at the maximum 1Mtpa ore throughput rate.

Note that our current underground mining assumptions for the TGO may change as the company finalises new resource estimates and these are subsequently used to potentially revise the mine schedule.

Breakdowns of discounted earning valuations for the following periods of our valuation horizon are given in Exhibit 10 below.

The exact financing structure of the DP has not been finalised. However, we understand from discussions with management that the financing structure for the total A$1.1bn required to develop the DP could be secured by:

We estimate that this would leave Alkane with a maximum net debt position for Stage 1 development in FY18 of A$322m, which equates to a gearing (debt/equity) ratio of 77% and a leverage (debt/debt+equity) ratio of 44%. Alkane is looking to cover this requirement using a combination of government (termed Export Credit Agency) loans incurring favourable interest rates and more conventional project financing routes, potentially incurring higher interest rates.

Other than commodity prices, the most notable effect on our valuation stems from our assumption for the price at which Alkane raises capital. Following Edison’s practice we apply the current share price to future potential equity issuance. However, we note that likely positive upcoming DP catalysts will alter this calculation as good news feeds into the share price. Exhibit 11 provides our total valuation (TGO+DP) given a range of share prices at which an equity portion of the DP’s financing might be raised:

Mining companies, once they are firmly into profitable stable production, are usually awarded valuations at a multiple to their NPV. Simply put, once the DP reaches steady-state stable production and its products are sold into a stable price environment, if we assume that Alkane pays out all its free cash in the form of dividends, we can impute a share price valuation. If we assume a 5% dividend yield (a relatively conservative assumption of long-term mining stock yield levels), Alkane’s maiden theoretical dividend of A$0.10 in FY24 (the first year we estimate that the dividend could be paid) could imply a potential A$2.00/share Alkane valuation.

Alkane saw its cash pile rise a massive 72% from end FY16, from A$24.5m to A$42.0m. To this can be added a further A$2.9m in gold bullion on hand.

If we take out all our financing assumptions for the DP in FY18, we see the TGO generating A$102.6m in revenue and EBITDA of A$25.9m. We estimate TGO capex of A$12m for development of an underground operation (NB this may well change) and exploration expenditure of A$4m.

On the basis of the above gold production and other cost assumptions, we forecast that, based on TGO alone, Alkane would finish FY18 with cash of A$46.0m.