By Leo Sek, Clime Asset Management
During the financial turmoil late last year and early this year a number of mining projects were either put on hold or written off completely. This was due to two main reasons:
1) lack of funding available through debt and equity markets; and
2) falling commodity prices making the projects uneconomical.
Since March commodity prices have rallied off their lows. This has been led from returning demand from Asia and in particular China. Also during this time funding has slowly returned to the market for higher quality projects, however a number of projects previously determined economically feasible when commodity prices were trading at all time highs may never be stgeloped.
Clearly one lesson that has stayed with investors from the crisis is that there is a need to focus on high quality or ‘Tier one’ assets. These assets are low cost mines with a long mine life. Investors now appear willing to pay a premium for such assets no matter where they are located. Because of this Australian companies have looked offshore in recent times for high quality assets. One such companies is Equinox Minerals Limited (ASX:EQN) whom has had success stgeloping a world class asset in Zambia.
EQN is a copper and uranium exploration and stgelopment company with a focus on the Lumwana open cut copper project in Zambia.
The Lumwana mine began production in December 2008. Construction cost $841 million and took just over two years. The current mill on site has capacity to process 20 Mtpa of ore, which will provide output of between 160 -170k tonnes of copper per year. This will make it one of the top 20 copper producers in the world. Management estimate the cash costs of production to be between US$1.35 and $1.50 per lb and with current spot copper prices running at close to $3 per lb the mine is operating at a healthy margin.
The mine currently has resources of 6.3Mt Copper (or 13.8 billion lbs) and its production life is estimated at current rates is expected to be around 37 years.
There are two expansion options available to Equinox at Lumwana:
1) expand the existing mill to increase throughput;
2) Take advantage of a large Uranium resource at the Lumwana site.
Both of these options are likely to occur in the next two years. The existing mill can be expanded by 20% with limited additional capital requirements and could easily be funded out of free cash flow.
A full feasibility study has been completed for a Uranium plant producing 2 Mlb per year and environmental approval has been received. This is now subject to offtake agreements and financing. Current reserves suggest an eight year mine life.
With the company currently operating solely in Zambia, one has to question the political landscape and the risks that may evolve from this. Zambia is a stable multi party democracy and Equinox maintains a constructive relationship with the government and supports the local community through education, training and employment.
The importance of the mine for Zambia cannot be underestimated. Currently approximately 80% of Zambia’s GDP comes from copper production and when Equinox reaches full production they will represent around 25% of the country’s production.
Equinox will turn its first profit in the FY10 year. At current spot prices of copper and assuming the lower end of management guidance (i.e. 160k tonnes of copper at a cash cost of $1.50 per tonne) the company will have EBITDA of US$525 million. Assuming exploration costs continue at the rate of the first half FY09 (annualised US$50 million) and taking into account the Zambian corporate tax rate of 20% we arrive at a net profit of US$380 million. This gives a Return on Equity of 50%. If we assume reinvestment into exploration and further future production the ROE falls to 33% the following year. Therefore it is feasible to assume a recurring ROE of 30% fully reinvested, this gives a valuation of $5.33, well above the current share price of $3.99.
Realistically it is unlikely Equinox will reinvest all its profit, it is feasible to expect Equinox to start paying out dividends in FY10 as in comes into profit. So another way to value Equinox is to value the current Lumwana mine is like a bond. If we assume Lumwana provides profit of US$380 million for the next 37 years and discount this back at 15% we get a net present value of US$2.519 billion. Converting this the current spot rate of US$0.93/A$1 we get A$2.709 billion. This is approximately A$100 million below the current market cap. Taking into account the current debt levels of U$400 million we can see the market is placing a value of just under A$500 million on the growth options.
Equinox has established a world class mine with long term production. Given management’s proven track record in establishing the company to this position we believe there to be little risk over the expansion options and we see good value around current levels.
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