Kenmare Resources: A Speculative Call On The Ilmenite Price

| About: KENMARE RESOURCES (KMRPF)
This article is now exclusive for PRO subscribers.

Summary

Kenmare Resources is well-positioned on the ilmenite-scene with its Moma project in Mozambique.

However, the company has quite a lot of debt on its balance sheet, and most of its operating margin is spent on interest payments.

An investment in Kenmare is a bet on the ilmenite price, as the company definitely needs a higher ilmenite price to be able to repay its debt.

Introduction

In this article I'll have a closer look at Kenmare Resources (OTC:KMRPF) which is currently producing ilmenite and zircon from its Moma project in Mozambique. The company is in production, but the share price has been sliding down, and I will determine in this article whether or not a position in Kenmare Resources could be warranted as the capital expenditures should drop substantially, resulting in a higher free cash flow to pay down the debt.

Source: old company presentation

As trading in Kenmare on the US exchange is very limited, I'd strongly recommend to trade in its shares through the facilities of the London Stock Exchange where the company is trading with KMR as its ticker symbol. At the current GBP/USD rate of 1.68 (used throughout this article where applicable), the current share price is $0.155. This might sound like a speculative penny stock, but don't forget there are 2.78 billion (yes, almost three billion) shares outstanding, resulting in a market capitalization of $430M.

As always, all images in this article were directly sourced from the company's website, press releases and corporate presentation.

About Mozambique and Ilmenite

As I can imagine ilmenite isn't really a mainstream investment, allow me to explain what it actually is, what it's used for and what the market price is. Ilmenite is actually iron-titanium oxide (FeO3) and usually gets upgraded to so-called 'pigment-grade titanium', and such titanium-oxide has a wide range of applications such as sun-screen and as a coloring additive for food processors as well as in paint and plastics. Even though the ilmenite price has recently dipped to below $200/t, demand for ilmenite will continue to increase and Kenmare expects a CAGR of 4.5% in its base case scenario between now and 2020 (see next image).

Source: company presentation

Should you believe a company-generated expectation? No, you shouldn't, but if you look at a chart which tries to find a correlation between the GDP of a country and its use of TiO2, you see there's a very strong indication that richer countries tend to use more of the commodity. Canada for instance uses just over 3 kilo's per capita (about 6.5 pounds), whilst poorer countries which are just starting on the development curve such as China and India are consuming just 1 kg/capita and half a pound per capita.

Source: company presentation

This means that if those countries indeed continue to develop, the demand for TiO2 should increase, and this will be an indirect boost for the demand for ilmenite, which is used to produce TiO2. Does this mean the TiO2 price will increase substantially (and thus increase the ilmenite price)? Not necessarily, but it's a good indication the world will continue to need ilmenite, and that Kenmare's low-cost asset in Mozambique will be one of the 'go-to' suppliers for the world as when the project will be in full production, it will supply in excess of 10% of the world's ilmenite production (and 8% of the total titanium feedstock demand), based on an annual production of 8-9 million tonnes per year.

Moving over to Mozambique, I think it makes sense to introduce you to the country as I can imagine not a lot of people are familiar with this African country. Mozambique used to be a Portuguese colony but gained independence in 1975. The country has some coal mines (operated by senior companies such as Vale and Rio Tinto) and I think Kenmare's Moma operation is the most recent start-up in the country. The fact that Vale and Rio Tinto have invested billions of dollars in the country should be seen as a vote of confidence in the legal system and framework of the country, and indeed, no (semi-)nationalizations have occurred. Meanwhile, the reputable magazine The Economist reported on an earlier Ernst & Young study which said that Mozambique was amongst the African countries which were getting more attractive. That being said, Mozambique still is a 'young' country and as more and more countries have started to force companies to give them a bigger share of the pie, you cannot fully exclude the geopolitical risk here, and a higher discount rate of 10% is warranted. All my calculations later on in this article will be based on this discount rate.

The Moma project will produce longer than you'll live

Kenmare has been working in Mozambique for almost three decades now, and advanced the Moma project in the early 2000's. Just last year, Kenmare increased the output of the project by 50%, and the annual production capacity for Moma now stands at 1.2 million tonnes of ilmenite per year, which results in Kenmare having a sizeable market share. The operation is quite straightforward, as you can see on the next image. Mineral sands are being mined by using dredges, where after a wet concentrate is being processed in a separation plant which results in three end-products being produced; ilmenite, zircon and rutile.

Source: company website

As the total resource estimate is in excess of 7.1 billion (!) tonnes of mineralized ore, the Moma project obviously has a long mine life which will outlive us all, as the resources are supporting a mine life of in excess of 100 years.

A dredge, source: company presentation

Moving over to the cost structure of the company, you'll immediately notice something alarming, as the cash cost per tonne of ilmenite was approximately $200/t, which would make the project unviable. However, the $200/t seems to be a bit high as the company was operating cash flow positive in 2013 to the tune of almost $26M (this excludes financing costs). As the total throughput at Moma has been increased by 50% to 1.2 million tonnes of ilmenite per year, the operating costs should decrease to, say, $180/t. Additionally, you need to deduct the revenues from the zircon which is being sold as a by-product. Assuming a zircon output of 40,000 tonnes per year at $1000/t, the cash cost per tonne of ilmenite (net of by-product revenues) could be as 'low' as $140/t when the 1.2M tonnes per year production rate could be achieved. Fortunately the capital spending seems to have reached its peak and I expect the sustaining capex to drop considerably from in excess of $80M last year to just $20M in the next few years. This should result in an AISC of $155/t ilmenite.

Keep in mind these assumptions are my own and are not an official guidance, as Kenmare hasn't provided a 'cost per tonne of ilmenite'-guidance and I had to work with my own numbers. This is a theoretical calculation and I'd actually love it if the company would become more transparent.

What's the fair value of the Moma Project?

Now I have determined some important parameters, let's see what the economics are of the Moma project. I will limit the mine life to 50 years, as the impact on the NPV of the project will be quite marginal thereafter. The discount rate is 10% which is quite high for a country which seems to behave itself, but I prefer to err on the safe side. The corporate tax rate in Mozambique is 32% and when adding a special mining tax, I end up with a total tax burden of approximately 35%. I will use a production of 1 million tonnes this year, increasing to the nameplate throughput of 1.2 million tonnes next year.

The only uncertainty now (if I keep the received zircon price constant at $1000/t (current spot price is approximately $1400/t), is the ilmenite pricing. The current ilmenite price is hovering between $185-200/t but was trading in the $200s just a year ago and in excess of $300 less than two years ago. According to the company, an ilmenite price lower than $250/t isn't sustainable for the industry. I would like to make two calculations now, one based on a received ilmenite price of $195/t and one using $230/t. In the calculation I will also deduct the interest payments on the debt using interest payments of $35M in year 1-2, $20M in year 3-4 (these are conservative estimates, as the senior debt should have a lower interest rate than the subordinated debt) where after the debt should be extinguished. As I'll explain later in this article, Kenmare was able to strike a favorable agreement with its lenders to reschedule the debt and is allowed to let the interest payments accrue onto the total debt position. However, if the AISC really is $160/t, the interest payments on the debt will be quite high, to the tune of $30/t, which means that at the current ilmenite price, the project would barely generate sufficient cash flow to service the debt despite the higher output. So a higher ilmenite price is definitely needed to make sure the company is able to repay its debt. Fortunately there's an accumulated deficit which should allow the company to reduce its tax payments in the first few years of the operation.

So let's hope the management team at Kenmare is right. Their claims seem to be backed by the Royal Bank of Canada which estimated last month the ilmenite price would average $210/t this year and next year, increasing to $240/t thereafter. That being said, RBC also expects the zircon price to increase to $1250/t, which would have an impact on the cash cost per tonne of ilmenite as high as $10/t. So in my calculation I will use the RBC assumptions on the ilmenite and zircon price.

Keep in mind these calculations are my own and as no official guidance has been given by the company I had to calculate a few parameters by myself, so this calculation should only be seen as a starting point for your own due diligence.

Cash Flow per year

Corporate tax rate (35%)

after tax

Discount rate (10% per annum)

NPV10%

0

     

0

7,500,000

0%

7,500,000.00

1.00

7,500,000

25,000,000

0%

25,000,000.00

1.10

22,727,273

65,000,000

15%

55,250,000.00

1.21

45,661,157

70,000,000

15%

59,500,000.00

1.33

44,703,231

75,000,000

15%

63,750,000.00

1.46

43,542,108

80,000,000

15%

68,000,000.00

1.61

42,222,650

85,000,000

15%

72,250,000.00

1.77

40,783,241

90,000,000

35%

58,500,000.00

1.95

30,019,750

90,000,000

35%

58,500,000.00

2.14

27,290,682

90,000,000

35%

58,500,000.00

2.36

24,809,711

90,000,000

35%

58,500,000.00

2.59

22,554,282

90,000,000

35%

58,500,000.00

2.85

20,503,893

90,000,000

35%

58,500,000.00

3.14

18,639,903

90,000,000

35%

58,500,000.00

3.45

16,945,366

90,000,000

35%

58,500,000.00

3.80

15,404,878

90,000,000

35%

58,500,000.00

4.18

14,004,435

90,000,000

35%

58,500,000.00

4.59

12,731,304

90,000,000

35%

58,500,000.00

5.05

11,573,913

90,000,000

35%

58,500,000.00

5.56

10,521,739

90,000,000

35%

58,500,000.00

6.12

9,565,217

90,000,000

35%

58,500,000.00

6.73

8,695,652

90,000,000

35%

58,500,000.00

7.40

7,905,138

90,000,000

35%

58,500,000.00

8.14

7,186,489

90,000,000

35%

58,500,000.00

8.95

6,533,172

90,000,000

35%

58,500,000.00

9.85

5,939,247

90,000,000

35%

58,500,000.00

10.83

5,399,316

90,000,000

35%

58,500,000.00

11.92

4,908,469

90,000,000

35%

58,500,000.00

13.11

4,462,245

90,000,000

35%

58,500,000.00

14.42

4,056,586

90,000,000

35%

58,500,000.00

15.86

3,687,805

90,000,000

35%

58,500,000.00

17.45

3,352,550

90,000,000

35%

58,500,000.00

19.19

3,047,773

90,000,000

35%

58,500,000.00

21.11

2,770,703

90,000,000

35%

58,500,000.00

23.23

2,518,821

90,000,000

35%

58,500,000.00

25.55

2,289,837

90,000,000

35%

58,500,000.00

28.10

2,081,670

90,000,000

35%

58,500,000.00

30.91

1,892,427

90,000,000

35%

58,500,000.00

34.00

1,720,388

90,000,000

35%

58,500,000.00

37.40

1,563,989

90,000,000

35%

58,500,000.00

41.14

1,421,809

90,000,000

35%

58,500,000.00

45.26

1,292,553

90,000,000

35%

58,500,000.00

49.79

1,175,048

90,000,000

35%

58,500,000.00

54.76

1,068,226

90,000,000

35%

58,500,000.00

60.24

971,114

90,000,000

35%

58,500,000.00

66.26

882,831

90,000,000

35%

58,500,000.00

72.89

802,574

90,000,000

35%

58,500,000.00

80.18

729,613

90,000,000

35%

58,500,000.00

88.20

663,284

90,000,000

35%

58,500,000.00

97.02

602,986

90,000,000

35%

58,500,000.00

106.72

548,169

       

571,875,221

So the sum of the present value of future cash flows (which include sustaining capex and interest payments) is $572M. As the company's net debt (defined as current assets - total liabilities) was $303M as of at the end of last year, the real current value is just $272M, which is lower than today's share price. This surely must mean that the market is expecting a much better ilmenite price and a lower cost per tonne of ilmenite. As I can indeed understand the management team will do its very best to reduce the operating expenditures, the operating cost could be brought down a bit more. Let's re-do the exercise using an AISC of $150/t and a revenue of $250/t, which the management team deems to be the minimum for a sustainable industry.

Cash Flow per year

Corporate tax rate (35%)

after tax

Discount rate (10% per annum)

NPV10%

0

     

0

60,000,000

0%

60,000,000.00

1.00

60,000,000

60,000,000

0%

60,000,000.00

1.10

54,545,455

75,000,000

15%

63,750,000.00

1.21

52,685,950

80,000,000

15%

68,000,000.00

1.33

51,089,406

80,000,000

15%

68,000,000.00

1.46

46,444,915

80,000,000

25%

60,000,000.00

1.61

37,255,279

100,000,000

35%

65,000,000.00

1.77

36,690,805

100,000,000

35%

65,000,000.00

1.95

33,355,278

100,000,000

35%

65,000,000.00

2.14

30,322,980

100,000,000

35%

65,000,000.00

2.36

27,566,345

100,000,000

35%

65,000,000.00

2.59

25,060,314

100,000,000

35%

65,000,000.00

2.85

22,782,103

100,000,000

35%

65,000,000.00

3.14

20,711,003

100,000,000

35%

65,000,000.00

3.45

18,828,185

100,000,000

35%

65,000,000.00

3.80

17,116,532

100,000,000

35%

65,000,000.00

4.18

15,560,483

100,000,000

35%

65,000,000.00

4.59

14,145,894

100,000,000

35%

65,000,000.00

5.05

12,859,903

100,000,000

35%

65,000,000.00

5.56

11,690,821

100,000,000

35%

65,000,000.00

6.12

10,628,019

100,000,000

35%

65,000,000.00

6.73

9,661,836

100,000,000

35%

65,000,000.00

7.40

8,783,487

100,000,000

35%

65,000,000.00

8.14

7,984,988

100,000,000

35%

65,000,000.00

8.95

7,259,080

100,000,000

35%

65,000,000.00

9.85

6,599,164

100,000,000

35%

65,000,000.00

10.83

5,999,240

100,000,000

35%

65,000,000.00

11.92

5,453,854

100,000,000

35%

65,000,000.00

13.11

4,958,049

100,000,000

35%

65,000,000.00

14.42

4,507,318

100,000,000

35%

65,000,000.00

15.86

4,097,562

100,000,000

35%

65,000,000.00

17.45

3,725,056

100,000,000

35%

65,000,000.00

19.19

3,386,415

100,000,000

35%

65,000,000.00

21.11

3,078,559

100,000,000

35%

65,000,000.00

23.23

2,798,690

100,000,000

35%

65,000,000.00

25.55

2,544,263

100,000,000

35%

65,000,000.00

28.10

2,312,967

100,000,000

35%

65,000,000.00

30.91

2,102,697

100,000,000

35%

65,000,000.00

34.00

1,911,543

100,000,000

35%

65,000,000.00

37.40

1,737,766

100,000,000

35%

65,000,000.00

41.14

1,579,787

100,000,000

35%

65,000,000.00

45.26

1,436,170

100,000,000

35%

65,000,000.00

49.79

1,305,609

100,000,000

35%

65,000,000.00

54.76

1,186,918

100,000,000

35%

65,000,000.00

60.24

1,079,016

100,000,000

35%

65,000,000.00

66.26

980,924

100,000,000

35%

65,000,000.00

72.89

891,749

100,000,000

35%

65,000,000.00

80.18

810,681

100,000,000

35%

65,000,000.00

88.20

736,982

100,000,000

35%

65,000,000.00

97.02

669,984

100,000,000

35%

65,000,000.00

106.72

609,076

       

699,529,102

The present value of future cash flows of the Moma project would increase to close to $700M. Basically, the Moma project is a good project based on the NPV of the future cash flows, but the problem is that the time is ticking for the company, as it needs to repay its debt and the company only seems to be able to do so with a higher ilmenite price.

Kenmare's financial situation - the reason why the share price went tumbling?

Kenmare had to borrow a sizeable amount of money, and as of at the end of 2013, its total debt stood at $342M with an average interest rate on the subordinated of just over 10%, which is quite expensive. Kenmare was able to renegotiate this debt; this resulted in a repayment holiday until halfway next year, which increases Kenmare's flexibility. If I assume the debt would not increase and the company decides to pay the interest instead of accumulating it, I estimate the company could pay off $70M which would bring the total debt down to $270M (for simplicity's sake I use the consolidated debt position). Half of it would be repayable in 9 semi-annual installments (which would be $15M/half year) and the remaining $135M would be payable at the end of those quarterly installments (which should be at the end of 2019). So the question now is whether or not the Moma project will generate sufficient cash flow to repay the debt. Let's use the more conservative scenario (using the RBC ilmenite and zircon price expectations) to see how much money the project will generate between now and the end of 2019.

Based on those assumptions, the after-tax cash flow between now and the end of 2019 will be $279M, which should be sufficient to repay the debt. However, this obviously leaves no room for error (literally none) so I would expect Kenmare to re-finance the debt sometime in 2015 or later, when it can convince its lenders it is generating sufficient cash flow to repay the debt. If Kenmare would be able to extend the balloon payment by 3 years to 2022, it will buy a lot of time which could be very important, as during those three additional years, the company will be able to build up a decent cash position. Additionally, I think a lower interest rate could be negotiated. If the interest rate would drop from 10% to 7%, the company would save approximately $7.5M per year in 2015-2018 and roughly $4-5M per year thereafter.

An additional point of attention is the fact Kenmare has to repay $38M of its senior debt in 2015, but given the current cash position of the company I'm not expecting any issues there.

Investment Thesis

Should the ilmenite price not trade higher than $240/t, Kenmare will have problems in repaying its entire debt load in time (and the situation would be quite disastrous if the ilmenite price remains under $200/t). The re-financing agreement from earlier this year was a good first move which allowed the company additional room to breathe and bought it some more time. However, I have explained the debt situation is a difficult one, as Kenmare is getting choked by the interest payments which are $35M per year, or $30/tonne of ilmenite. To put things in perspective, at an AISC of $160/t and a market price of $210/t, the interest payments (without repaying the principal) are reducing the operating margin by 60%. Even if the ilmenite price increased to $240/t, the interest payments will decrease the net operating margin by 30-35%. So while the operational side of things are going very well, it would be beneficial for Kenmare to reduce the outstanding debt as fast as possible, as the declining interest payments will have a serious positive impact on the free cash flow which will be used to pay down the principal amount.

I know and realize investors hate dilution, but should the company issue 650 million more shares at $0.14/share (for instance to a strategic investor), it would raise $90M which would reduce the interest payments by $9M per year and this could prove to be very beneficial for the company.

I like the prospects for the ilmenite and zircon price, but the problem here is that Kenmare needs the higher prices sooner rather than later and can't afford to wait for better times. This is also the main reason why I'm reluctant to invest at this point. Should the debt have been $150M instead of $350M I wouldn't be as worried as I now am as I definitely acknowledge the management team is running a very tight ship.

I might be enticed to get in should Kenmare be able to show it can produce ilmenite at an AISC of less than $160/t and/or should the ilmenite price increase to $240/250+. Don't forget ilmenite was trading at $330/t just two years ago, and at that price the Moma project would be a real cash cow. As such, Kenmare could be considered as a bet on the ilmenite price, and even though the risk is high, the reward could also be high, as at an operating margin of $170/t, the NPV of the Moma cash flows increases to $1.4B. However, I don't really like to speculate and you'll find me on the sidelines until a clearer picture about costs and the ilmenite price emerges, and 2014 will very likely be a very important year for Kenmare.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.