Alkane Resources — The final countdown

As the Tomingley Gold Operation (TGO) continues to mine gold from open-pit sources, and management assesses the most profitable way to mine underground at the project, Alkane’s longstanding flagship the Dubbo Project (DP) is starting to take centre stage. With CY17 drawing to a close a number of objectives are being pursued and completed.

The importance of the Dubbo Project to be a sustainable western supply of strategic raw materials should not be understated. China still dominates world supply of zirconia and zirconium products, hafnium oxide, and the 17 rare metals used in a very wide range of products across the electronics spectrum. Crucially, the DP will provide a Tier 1 western supply channel of the rare-earth permanent magnet metals praseodymium, samarium and neodymium – metals that account for c 75% of the value of REE demand globally at current prices, and represent 40% of group annual revenues under our assumptions for 2020 REE and gold prices. Many of the REE price assumptions we use in our DP valuation model, as of 1 November 2017, are below Steelhome spot prices accessed via Bloomberg.

It is also worth stating that China’s reported “war on pollution” and its positive effect on commodity prices is having and will continue to have a broadly positive effect on the western mining industry. However, as with the REE bubble of 2011, and indeed instances elsewhere in the commodities complex (noting iron and nickel as examples during their respective boom periods), projects were rushed to market that were not of a high enough quality and in some instances were arguably never going or able to be used for the highest value end-uses.

The DP is the only western REE bearing development project that is fully de-risked in terms of its process flowsheet design. There is no other western project that has run its own pilot plant for 10 years or more, which is the length of time that Alkane has run its plant outside of Sydney. There are no approvals outstanding, and pending a successful conclusion to its various offtake agreements and, in turn, its financing strategy, the DP should become a major strategic western source of specialty metals and oxides separate from the vagaries of Chinese supply.

With 10 refined specialty products to be sold from the DP, plus additional concentrate sales and two stockpiled for future sales as prices recover, the project has revenue streams associated with a wide range of end-markets. Many of these are experiencing a potential paradigm shift in demand linked to a global push towards automation, electrification and ongoing digitisation. This breadth of supply of specialty metals from the DP should be an attractive characteristic compared to many strategic metals projects, many of which focus on a far narrower set of products and end-markets. These companies formed through the 2011 REE bubble and remain listed without a clear strategy, demonstrable flowsheet design, or funding to evaluate their assets to an appropriately high level of end-product quality. Alkane has addressed and continues to refine its process flowsheet (and has been running its own pilot plant outside of Sydney since 2008). Alkane will probably continue to refine the DP’s end products even as production commences, and as customers dictate changing end-product requirements. Even as the DP enters production, further minor adjustments can still be made to the DP’s back-end processing routes without any need to revise the project’s overall process plant design.

Alkane’s group revenue split under our assumptions for 2020, using prices as per Alkane’s modular development plan and our in-house gold price assumptions, is as follows:

The above pie charts reflect the following DP product tonnages, 2020e TGO gold production (likely to be revised pending the company’s revised underground mining plan due end CY17), and product prices:

Hafnium is an important, although a relatively recent addition to the DP’s product suite. Hafnium is constrained by supply (it is produced as a by-product of zirconium refining) and its ability to enhance the physical properties of alloys has led to increased R&D and demand in the high-growth civil aerospace industry (see Exhibit 2, hafnium oxide accounts for 10% of DP revenues at steady state). One important recent development that may affect the supply of this metal is the bankruptcy of Toshiba’s Westinghouse atomic unit (announced March 2017, with proceedings expected to conclude early 2018). The closure of this business, due in large part to cost overruns in reactor construction and increased health and safety regulation post-Fukushima, may well constrain upstream supply of speciality metals produced by Westinghouse used in the nuclear industry; hafnium and hafnium-free zirconia are two such materials.

Industry feedback has been especially positive for DP hafnium output as it is not tied to the vagaries of the nuclear industry. This is because growth in the extremely small (c 50tpa) hafnium market is largely linked to high-tech material usage, such as alloys used in the aerospace and industrial gas turbine industries. Current hafnium production is linked to production of neutron transparent zirconium metals used in nuclear fuel rod casings (hafnium absorbs c 600x the amount of neutrons that zirconium absorbs and therefore needs to be refined out of zirconium metal – a process Alkane has successfully completed). As such, the depressed levels of activity in the nuclear industry currently, coupled with the Westinghouse bankruptcy, and uncertainty persisting from the Fukushima disaster of 2011, plus the increasing growth in the renewable energy economy, mean that stable hafnium output from nuclear industry sources cannot be depended on. Further, hafnium production volumes from the nuclear industry are unlikely to meet demand from other industrial sectors.

An important factor in terms of the DP’s overall development design was completed by Outotec over 2016 and Alkane released the outcome to market in late 2016. Before this, the DP was to be built over one construction phase requiring all offtake agreements to cover the entirety of annual production at a throughput rate of 1Mtpa of ore. The revised scope put forward for Alkane and Outotec for the DP’s construction outlined a phased development approach, with the following benefits to shareholders:

Outotec’s detailed costings of the modular design approach are due to be completed by end 2017..

The past two years have seen a number of advances in terms of getting the DP into production. We note that no major approval or mining licences are outstanding and the project is effectively ‘shovel ready’ save for certain offtake agreements being finalised and DP’s project financing being put in place. Over 2016 and 2017 Alkane announced the following agreements, arrangements and updates, all of which relate to the DP:

An agreement is already in place for the DP’s output of ferro-niobium, with a commercial offtake and JV agreement signed with Austrian firm Treibacher Industrie AG (TIAG), in 2013. This agreement will see TIAG have sole marketing rights for DP FeNb and it will also allow Australia Strategic Materials (Alkane’s DP operating subsidiary) the right to use TIAG’s proprietary processing technology to produce FeNb from DP concentrates at a new plant located on site at the Dubbo Project. TIAG will be able to buy 50% in this new downstream processing company three years after commissioning.

To get the DP into the construction phase Alkane needs to:

We have limited the changes to our DP valuation to the size and nature of development pending release of Outotec’s detailed project costing. We have adjusted our capex profile to reflect development over the five-year period from 2017 to 2023, but kept operating costs as per our original valuation and as per the company’s published definitive feasibility and front end engineering design (FEED) studies for the DP.

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 a revision to the mine schedule.

Breakdowns of discounted earning valuations for the following periods of our valuation horizon are given in Exhibit 5 below.

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

In the above scenario, we calculate that this would leave Alkane with a maximum required net debt position in FY18 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%. Alkane 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 the company would be-rerated in the market before commencing Phase 2 capex, and therefore achieve much of the second phase on debt.

Alkane has set production guidance of 65koz to 70koz at AISC of between A$1,100/oz and A$1,200/oz for FY18. We forecast production at the lower end of guidance, 65,447oz at AISC of A$1,092/oz. The TGO experienced a torrid H117 due to extreme levels of rainfall hampering open-pit production, and the mine’s true performance can only be assessed via its H217 data.

During H117 the TGO mined a total of 3.9Mt of material, of which 0.5Mt was milled to recover 22,191oz of gold. This first half performance compares with 5.0Mt of material mined, and 0.6836Mt of ore mined (of which 63% was mined in Q417), for 47,410oz of gold produced in H217. The fourth quarter FY17 saw 27,924oz of gold produced at a grade of 2.12g/t.

Q118 saw a continuance of H217 operational performance producing 24,122ozs gold, a slight q-o-q decrease of 14%, though 131% up from the corresponding period a year before. As mentioned previously, H117 production suffered from extreme levels of rainfall.

Beyond FY18, the TGO’s growth relies on Alkane making an investment decision on the profitability and return on investment of developing an underground mining phase. With resources and reserves having been recently revised to account for, among other things, ore grade material being left out previously due to its situation in crown pillars, we await Alkane’s revised underground mine plan, anticipated before the end of FY17.

We maintain our TGO production forecasts as per our July note TGO shows it can, and Dubbo’s value re-emerges. As the first quarter of FY18 saw 37% of its lower end of production guidance (ie 65,000oz) already mined, and as in previous years the greatest risk of inclement weather hampering production occurs in the first half of the financial year, we refrain from adjusting our forecasts for 65,447oz produced at AISC of A$1,1092/oz.

Alkane finished Q118 with cash of A$46.3m, to which can be added A$7.0m in bullion-on-hand at fair value for total liquid assets of A$54.3m. This is after the addition of net cash from operating activities of A$7.8m, resulting from the sale of 21,610oz gold at an average gold price of A$1,685/oz for revenues of A$36.4m. Costs totalled A$28.6m (net of interest received of A$0.2m), and included A$16.6m in production costs (annualised this would be A$66.4m, cf our forecast of A$71.4m), exploration costs of A$3.3m and development capex of A$5.3m.