Canaccord's Luke Smith: Five Aussie Companies With Cash Flows, Low Costs And MOUs

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Includes: ACH, NCMGY, OROCF, TM, TSLA, TYHOF
by: The Energy Report

Summary

One aspect about gold mining is that companies can react relatively quickly to lower prices, unlike iron ore and coal companies.

From the smaller gold miners to the larger, companies are making the changes necessary to maintain margins.

We have seen all-in costs drop between $100/oz and $300/oz for most of the companies we cover.

The decrease of Indonesian nickel has already been positive for Australian nickel producers and explorers and the nickel price on the London Metals Exchange.

Now more than ever, only select mining companies are attracting investors. Luke Smith, head of mining research for Canaccord Genuity in Melbourne, argues that low costs, increasing cash flows and improved net cash positions are crucial for gold companies. Solid contracts with end-users and strong institutional support are crucial for commodities. In this interview with The Mining Report, Smith highlights two undervalued Australian gold companies and three Australian companies in graphite and lithium that have already seen explosive share growth and appear poised for even greater gains.

The Mining Report: Australian mining shares had a great July. Was that a one-off or indicative of a trend?

Luke Smith: July tends to be good because the fiscal year-end for most personal investors in Australia is June 30, so there is tax-loss selling up to that date. That said, this July was better than average. The gains slowed down at the end of the month, but we've seen a liftoff again from the middle of August. Hopefully, this trend will continue, and we'll see the revival of Australia's small-resources sector.

TMR: Asian countries such as China and Indonesia are moving toward added-value mining. What implications does that have for Australian mining?

LS: Indonesia is a large supplier globally of tin, nickel and pig iron. The decrease in tin from there is counteracted to some degree by Myanmar becoming a tin producer overnight. The decrease of Indonesian nickel has already been positive for Australian nickel producers and explorers and the nickel price on the London Metals Exchange.

TMR: Newcrest Mining Ltd. (OTCPK:NCMGY) [NCM:ASX], Australia's biggest gold miner, has suffered a lot of bad news lately, including a $2.5 billion [$2.5B] writedown and a class action suit. To what extent do its woes mirror that of Australia's gold industry as a whole?

LS: Newcrest is the big daddy of Australian mining companies. Because of its size, it is held by retail investors, as well as by institutions. Obviously, the big gold price decline last year did hurt everyone in that sector. And yet, what happened to Newcrest was very company specific.

Despite the much lower gold price, several Australian gold producers have taken that hit in their stride, moved forward and are prospering.

TMR: Newcrest released its year-end financials Aug. 18, reporting a statutory loss of $2.2B and an underlying profit of $432 million [$432M]. Did this match your expectations?

LS: Pretty much. We have seen a shake-up of management there, and I think this will continue. The company has announced it will not shelve its Lihir gold project in Papua New Guinea, neither will it put some of its assets on care and maintenance. Marginal levels of free cash flow have appeared, but there is a lot of work to do over the next 12-24 months before Newcrest restores its credibility.

TMR: Newcrest shares have recovered from a low of under $10 in June to more than $11 today. Will shares continue to rise?

LS: Newcrest shares dropped from about $40. I think the share price has stabilized around the $9-11 mark. Share recovery is going to take time.

TMR: The company's all-in sustaining cost of gold production was reported at $976/ounce [$976/oz], 24% lower than the previous year. Is this something we've seen from other Australian gold producers?

LS: Absolutely. One nice aspect about gold mining is that companies can react relatively quickly to lower prices, unlike iron ore and coal companies. Newcrest is not alone in reducing its all-in costs by raising head grades and cut-off grades. All across our coverage list, from the smaller miners to the larger, companies are making the changes necessary to maintain margins.

TMR: How difficult is it for Australian gold miners to make profits at current prices?

LS: Some are struggling, particularly in the bottom quartile. We have seen all-in costs drop between $100/oz and $300/oz for most of the companies we cover. The profitability is there. What we focus on at Canaccord Genuity are increased free cash flows and improving net-cash positions.

TMR: What do you expect from the gold price for the remainder of 2014?

LS: There will still be rises and falls of $20-30/oz on particular days, but we forecast the price trend toward the $1,300-1,350/oz range over the remainder of 2014.

TMR: Moving on to graphite, China has announced it will replace green petroleum coke with graphite in its aluminum production. How important is this?

LS: It could expand the graphite market considerably. However, commercial decisions must be made, such as, what kind of graphite will be used? Flake graphite? Medium graphite? Amorphous graphite? Chinalco [Aluminum Corporation of China Ltd.] (NYSE:ACH) and Chalieco [China Aluminum International Engineering Corporation Ltd.] [2068:HK] are leading this research.

TMR: You're bullish on graphite. How would you compare your view of this sector today to the graphite boom earlier this decade?

LS: In Australia, the boom occurred around May 2012. Some graphite companies and junior explorers really did take off. They then fell just as quickly. Two years later, Australian graphite companies have learned that success depends on end markets: knowing your customers and what kind of graphite they demand. We are still in the early stages of understanding this sector, however, because producing graphite is much more complicated than producing copper cathode or gold bars.

TMR: How much is expected growth in the graphite industry dependent upon popular adoption of the electric car?

LS: Not much, actually. Less than 10% at the moment. However, the sentiment is much stronger than that, and sentiment is what often drives share prices. Graphite company managements are keen to point out that electric vehicles will be very good for graphite. It is worth noting, however, that the evolution of lithium-ion batteries and electric vehicles is ongoing. The materials going into these batteries can and probably will change. Right now, less than 5% of graphite production goes into lithium-ion, but there is potential for that to increase considerably.

TMR: Will Elon Musk's Gigafactory for Tesla Motors Inc. (NASDAQ:TSLA) advance the graphite market appreciably?

LS: It will. The Gigafactory will require a lot of graphite and lithium, but we don't know how much. Will the new generation of lithium-ion batteries used in the Tesla require 20 kilograms [20kg] per battery or 50kg? This question affects lithium demand as well, and I don't think the market completely understands these variables. Tesla could lift graphite demand by, let's say, 5% or perhaps 15%.

TMR: Let's talk about lithium. Is it more or less important than graphite to the battery revolution?

LS: There is a lot less lithium used in a lithium-ion battery than graphite at the moment, but lithium is more important and less likely to be substituted. If you remember your high school chemistry class, lithium is the third element on the periodic table. It's one of the lightest metals out there and a fantastic conductor of electricity. It has great energy-storage and energy-density principles. What lithium can deliver in rechargeability and energy density makes it fantastically attractive for use in electric vehicles, where weight is a significant design factor.

Lithium is not so critical for residential and static energy storage, however, as weight and size there are not as important. The vanadium redox battery might become more prevalent in those sectors. As far as transportation usage goes, however, the lithium-ion battery is likely to remain at the forefront for at least a decade.

TMR: How much will lithium production increase by 2020?

LS: There has been about 8% compound annual growth since the beginning of the decade, and it's still growing. The electric vehicle lithium-ion battery portion of the lithium market remains relatively small, but it is in this sector that we have exponential growth. A wide range of estimates exists, but it would be reasonable to predict 10% annual growth to 2020 or 2025.

TMR: What's your favorite near-term lithium producer?

LS: There are not many to choose from. Lithium, unlike graphite, is much harder to find in deposits and, more important, in economic quantities. The near-term lithium producer I like is Orocobre Ltd. (OTCPK:OROCF) [ORL:TSX].

TMR: What distinguishes Orocobre?

LS: Orocobre owns 66.5% of the Olaroz lithium-brine project in Jujuy Province, Argentina. The company announced Aug. 18 that commissioning will begin by the end of the month. What brings a great deal of authority to Olaroz is that 25% is owned by Toyota Tsusho Group (OTC:TYHOF), a subsidiary of Toyota Motor Corp. (NYSE:TM), and much of the debt funding for this project has come from Japanese banks.

Olaroz should start production of lithium carbonate and battery-grade lithium carbonate in October. It has a nameplate of about 18 Ktpa lithium carbonate, about 10% of the current world market. Roskill, the industrial-commodity expert, has stated that it believes Orocobre will be the lowest-cost producer of lithium carbonate globally. It will have an exceedingly long project life.

TMR: What is Olaroz's sustaining capex?

LS: The project will produce lithium from a salar, a salt lake, and this has enabled a capex of only $230M. This is not traditional mining; there are no trucks or shovels, no crushing or grinding. The majority of the capex went into the infrastructure, which includes evaporation ponds that stretch over many hectares and a gas pipeline for the gas power station, which was built on site. The rest went into the pumping stations and the lithium-carbonate plant.

TMR: Should an Argentinean project worry investors?

LS: No. I'm quite familiar with Argentina, having traveled there many times for almost two decades. Olaroz is in Jujuy, an impoverished Andean province, and it will be a significant source of economic development and provincial revenue. To underline this, 8.5% of the project is owned by the provincial government, and it was signed off by President Christina Kirchner herself. The joint-venture entity, which legally owns the asset, is actually domiciled in Singapore, which provides stability and confidence.

TMR: Olaroz has potash and borax as well. How significant are these to profitability?

LS: The potash will be a byproduct credit, which will become more important in two to three years. The borax, of which Orocobre owns 100%, is actually quite important now. It produces cash flows, which are expanding. The company has just finished relocating the borax plant closer to the mine site, which will further increase margins.

TMR: What's your rating and target price for Orocobre?

LS: A Buy rating and a target price of $3.77. The current price is $3.30. Our price target is based solely on the discounted cash-flow valuation for the Olaroz lithium-brine project. As this moves into production, I would anticipate a revisit of the price target, and I expect the stock will be rerated by the market. This is what makes Orocobre so exciting.

TMR: In Australia, as in Canada, there has been grave concern about the amount of "zombie" companies on the national stock exchange. Has the necessary purge been completed, and is the Australian Stock Exchange [ASX] much healthier as a result?

LS: Unfortunately, no. As of the last quarter, 226 ASX-listed companies don't have enough cash to cover the next quarter of proposed cash outflows. They continue to find ways to stay afloat and listed, but I believe that further purging and consolidation will be required for the ASX to be restored to health.

TMR: Luke, thank you for your time and your insights.

This interview was conducted by Kevin Michael Grace of The Mining Report and can be read in its entirety here.

Luke Smith is head of mining research at Canaccord Genuity in Melbourne, Australia. He worked previously as an analyst and fund manager for Ord Minnett and the Lion Selection Group. He holds a Bachelor of Engineering in mining, honors, and a Master of Commerce in finance. Smith was a mining engineering consultant for several years.

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DISCLOSURE:
1) Kevin Michael Grace conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. Streetwise Reports does not accept stock in exchange for its services.
3) Luke Smith: I own, or my family owns, shares of the following companies mentioned in this interview: Orocobre Ltd. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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