Kutessay II Pre-Feasibility Study a negative valuation catalyst…
As we mentioned in previous reports, there is a backlog of major milestone reports due from several companies in the junior rare earth mining sector over the coming months. One of these reports is the Pre-Feasibility Study on the former Kutessay II mine being re-developed by Stans Energy (OTCQX:HREEF). This report is expected to be released by the end of the first quarter of 2012. In advance of this report, we built our own discounted cash flow model of the project using the information we have collected on the deposit. The results of our research and analysis are that Kutessay II must offer higher returns to attract the necessary capital for project development.
We hereby assign a SELL rating to Stans Energy with an optimistic price target of $0.84/share. Our price target is based off our previously published "The Strategist Rare Earth Price Deck," which was in our January research piece on Molycorp (NYSE:MCP). We have reduced our heavy rare earth prices through 2015 to reflect the reduced heavy rare earth prices since the end of 2011.
Our overall macro views on the rare earth sector remain unchanged through the oxide stage of the supply chain from our January piece on Molycorp, so we will jump straight into the company specific component of this analysis.
Kutessay II Proposed Mining Plan
The proposed Kutessay II rare earth element mining project will involve producing 1,500 tonnes per annum of rare earth oxides from the ore body that once satisfied the overwhelming majority of Soviet Union rare earth demand. The mine is located northern region of the former Soviet republic of Kyrgyzstan near the Russian border.
The Kutessay II deposit is a low grade rare earth deposit, but a significant portion of the those within the deposit are heavy rare earths. Kutessay II contains 18.011 million tonnes grading 0.26% TREO with an HREO grade of 0.12% according to the JORC compliant resource estimate completed in 2011.[3/4] Please note that we combined measured, indicated, and inferred resource levels together for this analysis to extend mine life.
The current plan is to produce 1500 metric tonnes starting in 2014 of separated rare earth oxides for sale. We have used this production objective in calibrating our DCF model. The key issue with rare earth mining projects is the recovery rates; In layman terms, how much of the TREO can be extracted from the ore. The website of Stans Energy indicates that its lab tests are achieving recoveries of individual rare earths ranging from 50-72%. For the sake of this analysis, we have assumed that the company will achieve 72% recoveries of all rare earth elements across the board. Excluding rare earth oxide prices, we have found recovery rates to be the most significant driver of project net present values in our models for rare earth mining enterprises. This is because the cost of processing each tonne of ore is constant in the mining process (putting X material through the processing circuit costs Y), so the cash cost of production on a product basis declines as the amount of value extracted from each tonne of the resource increases (more product from same cost).
Our largest issue of uncertainty in our assumptions is the operating cost per tonne of mineral resource. This cost figure is typically constant in a mining operation with the recovery rates determining the variation in cost per unit of product for sale. We have looked at other rare earth mining operations to develop an estimate for the operating cost per tonne through the separated rare earth oxide stage. We lack clarity on this component of the analysis, and hope that the Pre-Feasibility Study will reduce uncertainty.
In terms of peers, Hudson Resources in its PEA for the Sarfatoq project projected an operating cost of $105/tonne to produce a rare earth carbonate concentrate.
The PEA on Quest Rare Minerals' Strange Lake B-Zone projected an operating cost of $102/tonne, however the electricity cost per tonne is on the low side in our personal opinion.
The PEA recently published on the Zandkopsdrift project owned by Frontier Rare Earths projects that operating costs through the concentration stage would be $117/tonne and $253.39/tonne through the separated rare earth oxide product stage.
Our internal model suggests Mountain Pass will have $140/tonne operating costs through the rare earth oxide stage.
The Bear Lodge PEA published in late 2010 estimated $159/tonne operating costs to develop a rare earth concentrate.
As a result of these figures, while acknowledging that no two deposits are alike in either infrastructure, labor costs, or metallurgy, we believe our $150/tonne operating cost estimate is optimistic for the Kutessay II project.
In terms of project CAPEX, we are modeling $300 million with zero in maintenance CAPEX. The reasoning behind this figure is that there is a pre-existing mine with some infrastructure, but also, this reflects what some of the juniors are expecting their CAPEX to be only through the concentrate stage. Those we have discussed Kutessay II with who have a level of expertise on the project have indicated to us that $300 million is a descent ball park estimate on the development CAPEX. Frankly, when we look at the peers only going to the rare earth mixed concentrate product phase, it seems rather low, but we will use it.
In terms of SG&A, we are assuming zero expense during life of mine in order to be conservative. As we will show later, our 2016 onward price deck results in a steady state EBIT of approximately $50 million before any SG&A cost is deducted. As a result, SG&A cost will materially impair NPV.
Also note we have modeled in a tax rate of 10%, which is the flat corporate income tax rate in Kyrgyzstan. While we have been informed that a 3% royalty applies to mining revenue from Kutessay II, we have not incorporated it into our model. Its inclusion would be negative to our valuation.
Under the assumptions we have outlined, the project has an after-tax IRR of 37.23% and a net present value of $0.70/share at a 20% discount rate. As we have explained in the past, we believe that investors will demand a 30% after-tax IRR before committing funds. The Kutessay II project achieves this objective, however we must acknowledge that Stans Energy will either have to sell a significant portion of the project in order to fund its development or sell the entire project to an entity that can fund the CAPEX internally. We based our price target on a hypothetical takeover of Stans Energy where the acquirer demands an after-tax IRR of 20% and determines its offer price accordingly. We frankly think an acquirer will demand a higher IRR than that given the country that Kutessay II is located in, the low ore grade, and the uncertainty regarding rare earth prices.
Also note that if we include annual SG&A expense of $5 million and $1 million in annual maintenance CAPEX, our price target on a 20% after-tax IRR to acquirer basis declines to $0.64/share.
We would add that at the February 28, closing price of $1.19/share, an acquirer would be accepting an after-tax IRR of 15.69% if it acquired Stans Energy at the current market price and assuming our internal price deck, zero SG&A, and zero maintenance CAPEX.
Under YE2011 domestic Chinese prices, the 2016 onward revenue distribution of the Kutessay II project would be as follows on a percentage basis for each rare earth oxide:
What we see from this revenue distribution chart is that the Kutessay II project economics live and die on dysprosium, terbium, and yttrium. The FOB spot price for these specific rare earth oxides in mid-February were 63%, 71%, 309% above YE2011 domestic Chinese prices. If, like us, you subscribe to the view that any long-term rare earth oxide price forecast should be built on domestic Chinese prices rather than the FOB spot prices, then it is difficult to argue that Stans Energy is undervalued, or even fairly valued.
At this juncture in our analysis, we started to investigate both the takeover route and the independent operator route for the Kutessay II project. In the takeover scenarios, we modeled zero SG&A and zero maintenance CAPEX. In the independent operator scenarios, we modeled $5 million per annum SG&A expense and $1 million per annum maintenance CAPEX.
If we set our heavy rare earth price deck for 2016 onward at 20% premium (roughly what the premium used to be on a top down basis prior to the 2H2010 quotas) to YE2011 domestic Chinese prices, our 20% after-tax IRR hurdle rate for an acquirer suggest a price target of $1.39/share.
Under this scenario (2016 HREO prices 20% above YE2011 domestic Chinese prices), assuming Stans Energy chose to do an equity offering to fund the capital budget for Kutessay II and go the route of being an independent operator of Kutessay II, at the February 29, closing price, the post-offering NPV/share would be $1.22/share at a 17.5% discount rate.
Stans Energy's February 29, closing price of $1.19/share is pricing in heavy rare earth prices 20% above YE2011 domestic Chinese prices from 2016 onward on an independent operate basis, and 12.5% above YE2011 domestic Chinese prices from 2016 onward on a takeover target basis. Because the current share price requires long-term rare earth oxide prices above YE2011 domestic Chinese prices, our decision was to rate Stans Energy a SELL instead of a HOLD.
We have in all scenarios modeled that the existing cash balance of Stans Energy will be spent in 2012 on the Definitive Feasibility Study for Kutessay II
We want to make it very clear that we have outlined the business plan for Kutessay II as we understand it to be laid out by Stans Energy management in corporate presentations and from our own research. This analysis does not reflect our opinion on management, but purely on the valuation of the company based on the Kutessay II mining project as we see it going into publication of the Pre-Feasibility Study.
With these figures on hand, we are left to conclude that the shares of Stans Energy are not a good risk/reward in the short term going into the Pre-Feasibility Study publication and in the long term given where we expect long-term rare earth prices to be. This unfortunately is one of those situations where investors will lose money even though the rare earth sector has several existing significant opportunities.
The Counter-Argument to our Base Case
Those who disagree with us on the company have two points of contention. We will rebut them one by one.
Point #1: We are too bearish on heavy rare earth oxide price long term
The current FOB spot dynamic is as result of a supply crunch that will be resolved either through technological innovations (less dysprosium in alloys), or new supply coming online. The current FOB spot prices make several junior rare earth miners with 2016 and 2017 estimated production dates economically viable such that if they all come online, our assumption of YE2011 domestic Chinese prices as the new long-term reality for heavy rare earth oxide prices may be too optimistic.
We would also add that the Mt. Weld-Duncan deposit at 1,079 tonnes per day and 60% recovery, can produce the same amount of terbium oxide, 51% more dysprosium oxide, and 45% more yttrium oxide than Kutessay II each year. Mt.Weld-Duncan is right next door to the Central Lanthanide Deposit currently being mined by Lynas Corporation (OTCQX:LYSDY), and metallurgical tests are ongoing.
Our point is that there are other projects out there. Here is the in-situ value per tonne of mineral resource at YE2011 domestic Chinese prices of several advanced juniors.
Obviously this figure does not reflect variables in CAPEX, reagent costs (which will impact production costs), but it does give an adequate reflection of the revenue and profitability potential. We cannot help but notice that Stans Energy is in last place. It is a terrible top down point to make, but if Kutessay II is viable economically then several of these projects with higher in-situ values are also probably economic unless Stans Energy can show an incredible relative cost or capital expenditure advantage.
Point #2: Operating costs assumption is too high
We will first refer to the production cost per tonne assumptions seen from fellow junior rare earth mining companies in their economic models cited earlier in this report. The one we did not include is the operating cost per tonne used in the Kipawa PEA. At $89.2 million in operating costs per year and 1.5 million tonnes mined per annum, it suggests a production cost of $59.47/tonne through the rare earth concentrate stage. This does not include the cost of separating mixed concentrate into individual rare earth oxides.
We have used a production cost per tonne less than 10% higher than what Molycorp is projected to have upon completion of Project Phoenix. Given also that the Frontier Rare Earth's PEA on their Zandkopsdrift project involved a production cost per tonne through the separated rare earth oxide stage above $200/tonne, we are not comfortable with using a number any lower than $150/tonne, and frankly we view it as optimistic in the first place. Just to put some perspective on this, the TREO of the current measured resource at the Mt. Weld CLD deposit is 12.2%11, the planned recovery rate is 65%, assuming a 95% separation recovery rate at the LAMP facility, and the indicated production cost is $10/kg REO on a product basis, we derive a production cost for the Lynas operation of over $700/tonne mineral resource processed through the individual rare earth oxide stage. What makes that project economic is its high ore grade, something that Kutessay II does not have, and as a result, the project needs a very low production cost per tonne. But no one outside of China is suggesting rare earth oxides can be produced outside of China on a basis less than $150/tonne except for Molycorp (and the analyst community is skeptical).
What We Expect From the PFS Headline Numbers
When the Kutessay II Pre-Feasibility study is published (scheduled for by the end of 1Q2012), we expect the project to show an after-tax net present value of $261 million at a 10% discount rate as the output determined by our assumptions and price deck. The after-tax IRR headline number will be 33.33% in this scenario. If the numbers come out in this realm with a $300 million CAPEX and operating cost per tonne at $150/tonne or higher, you will find our conviction increase in our bearish view.
What to look for in the PFS
The most important figures we will be looking for in the Pre-Feasibility Study are the CAPEX numbers and the operating cost per tonne of mineral resource mined. The future rare earth oxide price decks is a macro factor out of the control of each individual company, but the operating parameters will make or break each project once a long run macro picture is established. Given our macro view of long term rare earth prices, and our confidence that our CAPEX estimate is conservative, our primary focus will be the production cost per tonne. If the production cost per tonne comes in at $134/tonne, it would suggest the February 29, closing price of $1.19/share would offer an acquirer an after-tax IRR of 20.04%, and that would suggest Stans Energy is fully valued under our after-tax IRR hurdle rate acquirer requirement.
Under our long-term view of rare earth oxide prices and our optimistic operating assumptions, we cannot make the argument that Stans Energy is even fairly valued at its current price. The company is going straight to the Pre-Feasibility Study and skipping the Preliminary Economic Assessment, which as a result forced us to use peer analysis to estimate the production cost per tonne for Kutessay II. With the Pre-Feasibility Study due out by the end of March, we will see whether or not our assumptions are optimistic as we believe.
Given all of this, we think the Pre-Feasibility Study will be a material negative catalyst for the share price. Some will question our method of valuing the company in terms of the after-tax internal rate of return we believe an acquirer will demand, but our reason for this is simple.
The alternative route is the independent mining route which involves additional costs such as SG&A needing to be incorporated into the model. Under our base scenario, using diluted shares outstanding without accounting for any dilution from an equity offering to fund the CAPEX at Kutessay II, the NPV/share at various discount rates will be the following. Please note this does not include any maintenance CAPEX or SG&A expense.
The equity offering will have to be below the post-offering NPV per share to offer investors a positive NPV opportunity.
With our belief that in general the junior rare earth miners merit a 5% higher discount rate than our Molycorp discount rate, our post-offering discount rate for Kutessay II comes in at 17.5% (and given the low in-situ value per tonne of mineral resource, and jurisdiction, we would be more inclined to use 20%, but for the sake of it, we used 17.5% here). This means the offering must be done below $0.91/share. If the offering is done at $0.84/share the post-offering NPV/share is only 2.43% above the offering price. If the offering is done at $0.775/share, then the post-offering NPV/share offers investors 4.97% upside to post-offering NPV/share. In this scenario, we think selling the whole company for $.84/share sounds more attractive.
If you reduce the post-offering discount rate to 15%, the offering price being $.84/share offers investors 11.79% upside to post-offering NPV/share. If the offering price is at $1.01/share, investors will have 5.12% upside to post-offering NPV/share. Investors also will have execution risk, which is why we think a 5% premium to our Molycorp discount rate is more likely.
But now we get to the fact that the NPV/share pre-offering table above does not account for any SG&A or maintenance CAPEX, which we need to include if we are assuming the independent operator route is chosen by Stans Energy.
The one thing that cannot be ignored in all of these scenarios is that, after incorporating SG&A ($5 million per annum) and maintenance CAPEX ($1 million per annum) we need to use a discount rate almost the same to what we are using for Molycorp in order to get an NPV/share that is equal to the current share price, and that assumes in the equity offering to raise the capital, that investors will engage in a zero NPV acquisition while taking on project execution risk.
When we include SG&A and maintenance CAPEX, our NPV/share pre-offering at various discount rates is as follows:
Note that under this scenario, the equity offering to raise the necessary capital for project development will be at a lower share price than the February 29, close whether a 15% or 17.5% discount rate is chosen. At the 17.5% discount rate, it makes more sense to put the company up for sale since an acquirer can buy it and develop Kutessay II and receive a 20% after-tax IRR. At the 15% discount rate, if the offering was done at $0.84/share, the post-offering NPV/share would be $.87/share which would offer investors in the offering less than 4% upside from the offering price, which we don't see them going for. This means that the independent operator route will result in a lower share price.
Given all of this, we think the takeover route is the most likely one for this junior rare earth company versus the route of developing and operating Kutessay II as an independent mining company. We also cannot put a together a reasonable scenario given our macro view of rare earth prices that results in us concluding that Stans Energy is fairly valued or undervalued. We thereby initiate on Stans Energy with a SELL rating and initial price target of $0.84/share, (29.4%) below the February 29, closing price.
6 Available on SEDAR, page 24-5
8 Available on SEDAR, page 18-21
9 http://www.techmetalsresearch.com/2011/11/navigating-the-rare-earth-metals-landscape/, note Gareth Hatch says Tasman $200M, Matamec $300M (PEA came out at $315M), Ucore $175M
Disclosure: I am long MCP.
Disclaimer: Those involved with this report may initiate a short position in Stans Energy in the next 72 hours, but the primary author does not currently hold a position in Stans Energy at the time of submission.The facts in this newsletter are believed by the Strategist to be accurate, but The Strategist cannot guarantee that they are. Nothing in this newsletter should be taken as a solicitation to purchase or sell securities. These are Mr. Evensen’s opinions and he may be wrong. Principals, Editors, Writers, and Associates of The Strategist may have positions in securities mentioned in this newsletter. You should take this into account before acting on any advice given in this newsletter. If this concerns you, do not listen to or consider our opinions. Investing includes certain risks including potential loss of principal. The commentary of The Strategist does not take into consideration individual investment objectives, consult your own financial adviser before making investment decisions.