Deep in the heart of Africa, unearthing treasure, Ivanhoe Mines stands apart
How a Vancouver-based exploration juggernaut came to control three of the richest mines the world has ever known. What I learned about mining and how I came to chase the reef.
Since the dawn of civilization, the quest for mineral riches has lit a fire in the heart of man. This burning desire has caused him to endure hardship, mountain fastness, sacrifice and mortal peril, all for the promise of valuable discovery and the windfall profits which ensue.
However great the prize, the odds are long. Today, the advantages of modern geological understanding and state-of-the-art technology are offset by several disadvantages. It must be noted that unlike many natural resources, mines are not renewable resources. Many of the earth's best deposits have long been mined out and depleted, and their metal products are gone forever. Today, few fine ore bodies outcrop, appearing on surface for easy recognition and exploitation. Those which remain are often deeply buried in remote or inaccessible areas, with little obvious indication of their existence. All valuable metals occur at an average concentration, or crustal abundance, far below economic grades. In order for mining to be profitable, the metal yield of a deposit must exceed the cost of mining. The higher the concentration, or grade, of a metal, expressed as a fraction that the metal represents of the mass of rock ore which must be mined and processed to produce it, the more profitable the mine. This is because the cost of mining is directly correlated with the throughput (ore mined) of an operation, while the revenue is directly correlated to the amount of metal produced from concentrating and refining the metallic ore. Apart from grade, many factors affect mining economics, such as the scale, depth, continuity, geometry and metallurgy of an ore body, input costs, availability of infrastructure, environmental protection, the cost of social benefits, taxation, and tenure of claim.
How a Mine is Created
Grass Roots Exploration
Today, economic grades of metal in ore deposits range from approximately ten- to ten thousand times crustal abundance. Mineral anomalies are concentrations of metal significantly above crustal abundance. Typically, several physical and chemical processes must occur in sequence over a long period of ancient geologic time in order to concentrate metals sufficiently to reach economic grades, so not one in ten thousand mineral anomalies becomes a producing mine. Thus, in order to find an economic ore deposit, it is necessary to gain an understanding of possible genetic processes in a target area, and to apply a variety of exploration methods such as sampling, mapping, and geophysical and geochemical analyses with the aid of sophisticated field and laboratory equipment and procedures.
Drilling and Resource Estimation
The ultimate test of the content of potentially mineralized rock is to conduct, at great cost, diamond drilling to produce two-inch diameter cylinders of rock known as drill core, and send them to a laboratory for chemical treatment and spectral analysis known as assay, to determine their mineral composition and grades, meter by meter. This information is then used in combination with statistical methods to build a block model of an ore body, a three-dimensional map of the buried rock indicating the location of one or more valuable metals present as they occur in various minerals, i.e., metallic chemical compounds, along with their estimated grades for each block or rectangular prism, and an aggregate tonnage and grade for each target metal.
Once a resource has been delineated and determined to be of a size, grade, and other characteristics such that it is thought to be potentially mineable with current technology, at current or forecast metal prices and input costs, and under current regulations, and thereby providing a sufficient return on capital, detailed engineering studies are undertaken in order to determine an appropriate mining method, whether at surface (open cast) or through a variety of underground methods, depending on the geometry of the ore body. Metallurgical testing of the core is used to determine the mineral composition of the rock, which will suggest the physical and chemical industrial processes such as gravity separation, crushing, grinding, acid leaching, froth flotation and electrolysis, required to extract the valuable metal from the rock and remove impurities. These studies also assess the requirements for power, process water and chemicals, possible modes and routes of transportation, plant and equipment, labour, inputs for environmental reclamation, marketing services, etc., as well as their availability and likely costs, before they are procured. The economic portion of a study provides, through an estimated schedule of costs and revenues in each year of a mining project's operation, an indication of its value.
Environment and Permitting
A variety of environmental impact assessments are also required in order to obtain regulatory approvals and permits, and local governments and communities are typically consulted extensively in order to reach an agreement on the plan of exploitation, employment opportunities and compensation for land use, as applicable.
Financing and Construction
Once a mine plan has been established through a sequence of progressively more detailed engineering economic studies, and the exploitation of the deposit is deemed economically (profitably) and environmentally feasible, financing is arranged, often through a variety of sources such as debt, equity, streams and royalties, and vendor finance. Then construction begins. This includes, among other things, procurement, power and water supply, open pit stripping or underground development (shafts, declines, adits and drifts), installment of a suite of processing plants, the building of tailings (waste) containment facilities, the construction of camps, and often the implementation of various programs for community benefit.
The details of each of these phases of development are far greater than those listed above, and require hundreds, if not thousands, of people with various skill sets, over a period of not years but decades, often twenty to thirty years. Usually, the exploration and early development, and the later development, engineering, financing, construction and mining, are done by different firms, since an exploration firm may sell a project to or be acquired by a mining firm. Outside contractors are retained for a variety of specialized purposes such as drilling, laboratory assays and testing, engineering, environmental and economic analyses, shaft sinking, the provision of power, water and transportation infrastructure, plant construction, and sometimes even contract mining.
The key point here is that in order to build a mine, it takes a lot of people, money and time. Thousands of people, hundreds of millions or billions of dollars, and twenty to thirty years' time.
Capital Discipline and Overcapacity
In spite of all the expertise, expense and effort over time committed to building a mine, the industry exhibits poor aggregate economics. Some studies indicate that the long-term returns of mining and exploration are near zero. That is to say that, altogether, costs exceed revenues, and in the full cycle of the business industry-wide, no profit is generated for investors. The attraction of the industry is largely that of the lottery: that the financial gains possible from an explorer's discovery or, for a producer, a cyclical upturn in the industry, are far greater than in most sectors. As a result, investors value this possibility at a premium so high as to result in systematically excessive availability of finance and a chronic oversupply of exploration and productive capacity. The financial consequence is a boon to the consumer at the direct expense of the investor in the aggregate.
Not In My Back Yard
Mining is a challenging business in a number of respects. One is that in spite of their necessity and ultimate benefit to the consumer everywhere, mines are often unwelcome neighbours, requiring great favour to ingratiate themselves with local communities, government agencies, and non-governmental organizations which may oppose their operation. Mining firms must prove to local communities and governments that environmental impact is well minimized, and that the economic benefit of jobs, supply contracts, tax revenues, and social development projects financed by the company during and before commercial production, are sufficient to offset the imposition of a major industrial operation on nearby residents.
Long Lead Times and Externalities
As in other businesses, costs and revenues, being the products of supply-demand dynamics of cost inputs and metal products, are beyond the control of mining companies. But unlike in other business operations, mines cannot easily be started, stopped or altered, except at great cost and over long time periods. Thus, mining operations are necessarily long the victim of circumstances beyond management's control or forecasting abilities.
In the mining business, the majority of costs are borne at the beginning, and the majority of revenues arise at the end. Because of the time value of money, perennially optimistic estimates of costs and time frames required can cause inevitable cost overruns and delays to decimate the net present value of a mining project.
An additional consequence of this characteristic sequence of cash flows is that local governments and communities may increase their claims on the revenue of a mine once costs are sunk. Since mines cannot be moved, their economic value may be involuntarily diminished or obliterated by this eventuality.
Mines are depleting assets. Depreciation is not an expense required to maintain a business, but a real and permanent destruction of earning power. Mineral reserves, once mined, must be replaced by restarting the costly, time-consuming and uncertain process of exploration.
Considering all the risks and uncertainties, and the altogether dismal nature of the mining business from the perspective of financial returns, why on earth would any sane person invest in a mining company?
Notwithstanding the above challenges, the mining industry has a number of features which make it uniquely attractive for investment. Indeed, it is precisely the challenges of the business which present the greatest opportunity.
Capital Intensity and the Production Lag
The fact that a significant portion of the cost associated with a mining operation is borne several years prior to the commencement of production, and that such capital costs are for the most part not salvageable, mean that commodity price as a determinant of optimal producer supply is a poor economic signal. During this time gap, prices may change, rendering prior capital expenditures either excessive or deficient. Not only is supply response to price slow or imprecise, but there is a pro-cyclical mechanism at work, which economists describe with the so-called cobweb model.
The Cobweb Model
According to this theory, any perturbation of supply or demand sets in motion a price oscillation. A shortfall in supply, say as a result of technical failure or political disruption, leads to a leftward shift in the supply curve, and an accompanying rise in price. The rise in prices leads producers expecting sustained high prices to invest for more production. When this production comes online, the supply curve undergoes a rightward shift, and prices fall. Lower prices, in turn, cause producers expecting persistent lower prices to refrain from investing in future production, which brings about another leftward shift of the supply curve. This cycle may also be triggered by price increases or decreases resulting from changes in demand.
The time lag between supply and demand decisions results in poor investment decisions not only because of poor, outdated price signals but also because of the availability of funds. When prices are high, not only are they forecast to be high but also profits are high and cash is available for investment. When prices are low, not only are they forecast to be low but also cash is not available for investment. Generally, when miners have money they spend it, and banks are ready to lend; when miners don't have money, they don't spend it and can't borrow or raise it.
Standard arguments against the cobweb model hinge upon rational expectations theory. However, long-term commodity price forecasts are notoriously difficult even for economic research firms. In addition, investor and producer attention to and capacity for long-term economic analysis is limited.
One result of this industry dynamic is that those firms which have either the foresight or fortune to avail themselves of high volumes of production at a time of acute deficit tend to enjoy especially long periods bumper profits, because the long lead times of the industry impose a barrier to entry. There can be no short-run supply response; medium-term supply response is limited to expansion projects of existing mines and reopening of shuttered mines; and supply response by greenfield mining projects is limited to the very long run. The capacity and economics of greenfield projects is a function of exploration success, which, thanks to varying efficiencies and chance, is only loosely correlated to exploration spending, whose funding has arisen from mining booms long past. The converse is true. For similar reasons, those producers with the myopia or misfortune of having a large volume of production come online at a time of acute surplus may suffer an especially long period of losses before the industry effects a supply response or demand growth closes the output gap, returning them to profitability.
The Inefficient Market Hypothesis
In addition to the cyclical nature of the underlying industry, mining equity market investors enjoy an additional benefit (or suffer an additional cost), which is the inefficiency and hyper-cyclicality of the market for mining securities. Mining asset values fluctuate with industry conditions, so that a mining project, whether at an exploration, development, or producing stage, is valued higher in a higher metal price environment, and lower in a lower metal price environment, ceteris paribus.
In theory, a rational investor ought to value a mining asset by discounting future profits based upon expected future prices and costs, at an appropriate discount rate. One may substitute a uniform long-run average commodity price and mining cost. But since no one knows what this really is, and because investors are subject to recency bias, asset values tend to follow the commodity price.
The fluctuations in asset values are greater than those of commodity prices. Part of this is explained by the operating leverage of the mining business, which is to say that profitability fluctuates more dramatically than revenues (a function of commodity prices and volumes) because cash flows are the net of revenues and costs, many of which are theoretically fixed. In practice, many costs do rise and fall with the underlying commodity tides, as land, labour, and capital availability vary inversely to price, which determines the aggregate amount of mining activity, including production, development and exploration.
Even after accounting for commodity price and operating leverage, the equity market demonstrates additional cyclicality in higher quality issues. (Lower quality projects are worthless at low commodity prices.) Part of this is explained by the financial leverage of indebted, usually producing, firms, as equity is the net of asset values and fixed liabilities. But there is an additional pro-cyclical factor. Not only do projected cash flows rise and fall with metal price but also equity discount rates often expand in a recession and contract in a recovery. Regarded another way, at a fixed discount rate, equity values often trade at greater discounts (or lesser premia) to net present values during depressed markets, and at lesser discounts (or greater premia) to NPV during elevated markets. This may be attributed to sentiment, fluctuations in sector interest, or momentum trading strategies.
In parallel to the phenomenon of asset and equity values generally fluctuating in sympathy with fundamentals, shares in mining firms tend to exhibit cyclicality, albeit with greater amplitude than those observable in corporate or private market transactions. That is, the value of mining projects implied by the stock exchange undergoes more extreme fluctuation than that evidenced by acquisitions and divestitures of mining companies. This is partly because frequent quotations capture the absolute extremes of the industry cycle, but also owes to the fact that mining firms engaged in asset transactions, mergers and acquisitions tend to be more sophisticated, and, although often far from rational, more rational than the average participant in the equity market. Thus, while mines may be purchased at a bargain price during a bust and sold at a pretty price during a boom, industry contractions witness yet more extreme share price discounts, and industry expansions witness yet more extreme share price premia.
The combination of the deep cyclicality of commodity markets owing to exceptionally long lead times, that of the mining business resulting from this as well as operating and financial leverage, the exaggeration thereof witnessed by share market valuations, and the occasional fortuitous discovery, results in some of the most extraordinary capital gains and losses seen in finance. It is common for mining share prices to increase or decrease by a factor of ten over a cycle of a few years, and not uncommon for some shares to appreciate by a factor of one hundred to one, or fall to nothing. Therein lies the attraction for the thrill-seeking risk taker and the astute speculator. As a sector of the capital markets shunned by many rational fundamentally-oriented investors, it is all the more attractive to the few who dare invest.
Ivanhoe Mines Ltd.
TSX: IVN, OTC: [[IVPAF]]
12 January 2018
TSX Price: CAD $4.04/share
OTC Price: USD $3.23/share
Shares Outstanding: 787 million
Market Capitalisation: USD $2.55 billion
Net-Net Cash Plus Receivables: USD $200 million
Enterprise Value: USD $2.35 billion
Ivanhoe Mines presents a rare opportunity to participate in the development of three of the highest-grade, world-scale, long-lived mineral deposits known on planet earth, each of which should be highly profitable in any conceivable metal price environment. Management and technical team are widely recognised as leaders in the industry, having made some of the most valuable mineral discoveries of the century and brought them into production. Due to a secular low in mining equity valuations, the company's shares are available at a fraction of their intrinsic value.
Ivanhoe Mines Ltd. is a Canadian-domiciled development-stage mining exploration company with three mineral deposits in Africa. Kamoa-Kakula (K&K) is a copper project situated in the Democratic Republic of Congo (DRC), in which the company holds a 40% interest. Kipushi is a zinc-copper project, with by-product germanium, also located in the DRC, in which the company holds a 68% interest. Platreef is a platinum-palladium project, with by-products of rhodium, gold, nickel and copper, situated in South Africa, in which the company holds a 64% interest.
Mines are generally valued according to the dividend discount model (DDM), via a discounted cash flow (DCF) analysis. Mines are depleting assets, having not only finite lives, but also production volume and head grade (and hence profit margin) profiles skewed higher towards their earlier years, for purposes of maximising the present value of cash flows. As such, they have non-constant economic characteristics and are unsustainable businesses. Therefore, a valuation based on a multiple of earnings, (free) cash flows, or EBITDA, etc., is not the most sound approach. Rather, according to the DDM, a standard industry metric for valuing mineral resources and (geologically higher confidence) mineral reserves is the net present value (NPV) of future cash flows. In the case of Ivanhoe, these are estimated by detailed economic studies audited by independent engineers, and published according to the strict reporting standards of the National Instrument, NI 43-101, which were devised by Canadian securities regulators in the wake of the Bre-X mining fraud. The NI 43-101 reporting system follows mining project development through a sequence of economic studies of successively greater detail and higher confidence; from resource estimate, to preliminary economic assessment (PEA), to preliminary feasibility study (PFS), to (detailed- or bankable-) feasibility study (FS). In these studies, a discount rate commonly applied for valuing future cash flows is 8%. The net present value at an 8% discount rate is abbreviated "NPV8". Multiple scenarios are presented in the studies, including a base case, for each of a number of economic inputs. Metal prices and costs are held constant and not escalated for inflation. Hence, the discount rate serves as an approximation of a real return.
Mine 1: Kipushi
Kipushi is a brownfield mine which is being rapidly refurbished to exploit what drill results have proven to be the highest-grade zinc deposit of significant size on earth, at double the grade (i.e., percentage of recoverable elemental metal by mass of ore) of the next highest-grade mine.
A preliminary feasibility study (PFS) finalized in 2017 anticipates production of roughly 225,000 tonnes of zinc metal per annum, at a head grade of 32.1% zinc with by-product copper, for a total cash cost of USD $0.48 per pound of zinc, over an initial 10 year mine life. Including copper and other metals, the resource grades nearly 43% zinc-equivalent. To put these figures into perspective, grades of operating zinc mines are typically in the high single digits, some far less, and a 10% zinc-equivalent resource is generally considered high grade.
According to the PFS, at current zinc prices the after-tax NPV8 of Kipushi's mineral resources is USD $1.37 billion. Due to several recent mine closures and an ensuing worldwide deficit, the price of zinc has risen rapidly throughout 2016 and 2017 to USD $1.50/lb. Including capital costs, the mine is expected to be highly profitable, even at much lower zinc prices. Ivanhoe is accelerating Kipushi's development in an attempt to commission the mine as fast as possible, safely, in order to harness rising potential cash flows likely available in a tightening market where zinc is in increasingly short supply. It aims to achieve commercial production by late 2019 or early 2020.
Mine 2: Platreef
Platreef is a greenfield mine whose deposit was discovered by Ivanhoe's team of exploration geologists. It is the largest high-grade precious metals resource in the world, with roughly 100 million ounces of platinum group metals (PGMs), mostly platinum and palladium, as well as gold and rhodium, with base metal credits nickel and copper. Owing to its high grades and the large, thick, flat-lying geometry of the mineralisation, it is thought to be highly mechanisable (in contradistinction to existing PGM mines, which are more labour-intensive). Thus, upon the advent of commercial production in 4 years, in 2022, it is projected to be among the lowest-cost and largest PGM mines in the world.
According to a definitive feasibility study (FS) published in 2017, Platreef's mineral resource contains an estimated 41.9 million ounces of platinum, palladium, rhodium and gold, grading 3.77 g/t precious metals, at an "indicated" (higher) degree of confidence, plus 52.8 million additional ounces grading 3.24 g/t at an "inferred" (lower) degree of confidence, each at a 2% grade cut-off (i.e., operating cost break-even grade). The PFS anticipates production of 476,000 ounces per annum of these metals, with a head grade of 4.40%, at a by-product cash cost of USD $351 per ounce, or about USD $500-600/oz., including sustaining capital costs. At this rate of production, the deposit would provide roughly a 50-100 year mine life. The 19-metre thickness of the ore body makes it potentially highly mechanisable, as compared with existing PGM mines at a sub-1-metre thickness, which must be mined by hand-drill, a costly and low-productivity mining method.
The NPV8 of Platreef's mineral reserves, as measured by the 2017 FS for Phase 1 of the mine plan, is USD $916 million. The true value thereof is much greater than this, probably by a multiple, because this PFS analyses only small-scale initial mine development, at a rate of production which, given the scale of the mineral resource, is a mere fraction of what could be economically mined.
Mine 3: Kamoa-Kakula
Kamoa, like Platreef, is a greenfield project whose deposit was discovered by Ivanhoe's exploration team. It was, until recently, the world's largest high-grade copper deposit, containing an estimated 22 million tonnes of copper metal. A preliminary economic assessment published 4 years ago imputed an NPV8 of USD $1.4 billion to Ivanhoe's 40% interest, which would accrete to nearly USD $2 billion today due to additional expenditures, improved geological understanding and optimisation of the mine plan and closing of the discount. Owing to its exceptionally high grades, enormous scale, thick and flat-lying geometry, and favourable metallurgy, Kamoa was projected to be among the lowest-cost copper mines in the world, with the potential to become one of the most productive. However, in 2016 Ivanhoe discovered through ongoing exploration drilling a nearby zone, Kakula, with copper mineralisation at roughly twice the thickness and twice the grade of the already thick bonanza-grade Kamoa mineralisation. A preliminary economic assessment (PEA) published in 2016 indicates Kakula, unto itself, to be the richest known copper deposit on earth, and among the largest. Taken together, the Kamoa-Kakula copper deposit appears, from extensive drilling, to be among the greatest, if not the singular greatest, mineral discovery of the twenty-first century, and it is still growing. It is projected to be the lowest cost major copper mine in the world, and when it hits its stride it should be among the most productive.
The K&K project has a global resource, at a 1% cut-off grade, of 30.8 million tonnes of copper grading 2.78% at the indicated level, and 5.1 million tonnes of copper grading 1.94% at the inferred level. The most recent PEA, finalized November 2017, outlines a 44-year mine plan to produce 370,000 tonnes per annum of copper in concentrate, at an average head grade of 6.4% for the first ten years of mine life, ramping up to 565,000 tonnes per annum by its ninth year of operations, and producing copper at an average head grade of 5.5% for the first 24 years of production, the latter of which will output cathode (refined) copper from a direct-to-blister flash copper smelter.
Such an operation would set K&K among the world's larger copper mines, and make it the highest-grade major copper mine in the world. To put the scale of the resource into perspective, at the planned rate of production, this deposit would furnish a roughly 50-100 year mine life. To put the grade of the resource into perspective, in recent years, the average head grade of copper mines globally has fallen to nearly 0.6%. The expected (direct mining) cash cost at K&K is USD $0.51 per pound of copper. Including sustaining capital expenditures, the unit cost should be a little more than $1/lb. Including also pre-production capital of USD $1.2 billion, the mine is expected to be highly profitable at current copper prices of around USD $3.25/lb, or even far lower.
The 2017 PEA indicates an NPV8 of USD $7.2 billion for Kamoa-Kakula mine at USD $3/lb Cu, expected to be in cash-flowing commercial production within 3-4 years. Alternate mine plans under study and subsequent expansions could increase throughput dramatically through the exploitation of other mining zones, bringing the rate of production closer to that of Escondida in Chile, which is currently the world's most productive copper mine, producing approximately 1 million tonnes of copper cathode per annum. Thus, the true value of this project should be considerably greater than the NPV indicates, after accounting for the ramp-up to full productivity, the limits of which are as yet unknown. There can be little doubt that this is the most valuable pre-production mine in the world today and among the most valuable mining assets in the world.
Thanks to the equity capital to be provided by partner Zijin Mining Group Co. Ltd. (OTCPK:ZIJMF), the largest Chinese gold-copper mining company, as well as likely easily obtainable debt finance, initial equity capital requirements of Ivanhoe are expected to be less than USD $200 million to put K&K into cash-flowing commercial production. Assuming customary debt- or vendor finance, equity capital requirements to bring Kipushi into production should be on the order of USD $100 million. For Platreef, net of debt finance and a probable joint venture agreement, either with the company's existing 10% partner, namely Japanese parastatal mining company Itochu/JOGMEC, or others, an amount similar to that for K&K could be anticipated for equity capital requirements to put this mine into its first phase of production. The balance of Ivanhoe's treasury, net of all liabilities, amounts to roughly USD $200 million. Therefore, under these assumptions, all three projects appear financible with limited further share issuance, i.e., dilution. But if additional capital is needed, for example, in the event of a decision to pursue a more aggressive expansion of any of the company's projects, additional partners could be brought in for equity finance at the project level, or one of the mines could be IPO'd or sold outright. The company has disclosed that it has attracted a great deal of interest from a variety of well capitalized industry players and financial investors who have taken notice of the company's recent unprecedented exploration success.
Grade is King. Scale is Queen
This is an ancient truism of the mining business. In a commodity resource extraction industry, every producer, e.g., mining company or oil and gas company, sells its product for the same price on the world market, after deducting all transportation and refining expenses required to bring the product to market. So, with unit revenues fixed across the industry, the competitive war is fought on cost. A mine with higher grades, i.e., more pure metal as a percentage of rock ore by mass, than a competing mine producing the same metal, can generally produce the same mass of payable pure metal (e.g., ounce of platinum, pound of copper, or tonne of zinc) while mining, processing, and transporting less waste rock, and therefore using less diesel, chemicals, power, water, machinery, plant capital and labour in the process. The unit profit margin of a mine is the difference between the unit revenue (which fluctuates over time, but is equal for all mines at any given time) and the unit cost, which correlates inversely to the grade of the ore body. So in general, the higher the grade, the higher the profitability of a mine.
Economy of scale is another important determinant of a mine's profitability. Larger mines can amortise fixed costs such as general and administrative expenditures, and to a certain extent capital costs, over a greater production volume. This translates into a lower unit cost for these items.
There are numerous other factors which determine the cost structure of a mine. Among them are depth (shallower being cheaper and more productive); the geometry of the deposit, which determines the method of mining, and therefore, the cost and rate of mining each tonne of ore, the amount of waste which must be mined, the amount and cost of underground development, the amount of backfill required, etc.; its metallurgy (the chemical properties determining ease of recovery of payable metal and the concentration of toxic or unwanted by-products); other payable co-product metals which act as additional revenue, but are often regarded as cost-reducing credits; the availability of infrastructure including power, water, and plant and equipment; the cost of labour; pre-production capital cost; development time and expense; cost of capital, i.e., interest rates; and taxation.
However, two key factors in a mine's competitive position are grade and scale. Large, high-grade mines tend to be more profitable. In a cyclical industry this is of paramount, even existential, importance. When demand outpaces supply and metal prices rise to bring them into balance, all mines are profitable, but low-cost mines are more profitable; when supply outpaces demand and metal prices fall to bring them into balance, most mining operations do well to break-even on an operating basis (i.e., even before accounting for sunk capital), and many are forced to shut in, restarting only much later and at great cost, or often never again. In the lower part of the cycle, many mining companies with marginal operations fail, especially those which are heavily indebted. The mining operations at the lowest end of the cost curve (a graph plotting unit costs against global production volume) not only are able to skate through a severe industry recession unscathed, but may even engage in the "last man standing contest". That is, they have the flexibility to increase production in an already oversupplied market, further depressing prices, and thereby trading some of their profitability in exchange for the bankruptcy of their competitors. Thus, the adage "grade is king".
Scale is an advantage to miners not only for sheer microeconomic reasons, but also for financial reasons. Today, most investment capital is run by institutions. Institutions value size and liquidity, which the large mining concerns can provide better than the smaller ones. Also, larger firms (a.k.a., major or senior mining companies) tend to be more diversified, posing less risk to creditors. Therefore, there is a structural valuation premium assigned to the large capitalisation firms, which consequently have a lower cost of capital. These firms prefer to invest in large, long-lived mines, which make use of management time more efficiently, and reduce organisational complexity. As a result, the majors pass along their low cost of capital to target projects. Thus, by virtue of their attractiveness to seniors, Tier 1 mines (as determined by scale and profitability) are afforded a premium valuation.
Ivanhoe's three mining projects are at a dramatic advantage in that their grades are head-and-shoulders above the others in the industry. Each ore body is large and continuous with favourable metallurgical characteristics. Platreef and K&K are horizontally and vertically extensive, containing over one hundred years of resources at a high rate of production, and therefore, they are highly scalable. Each of the three mines is projected to be in the lowest quintile (20%) of the global cost curve. In spite of its remoteness requiring it to incur significant transportation costs relative to other high-grade zinc mines, possessing the highest-grade zinc reserves in the world and therefore requiring extremely low unit operating costs, Kipushi should be among the most profitable in the industry. Platreef is expected to be among the two or three lowest-cost PGM mines in the world, as well as the most productive. Although it is early to say, and there is much work yet to be done, in the opinion of this author K&K has the potential to be the lowest cost copper mine in the world, and one of the largest, if not the largest on earth.
From an investment perspective, the key question is: how much is it worth? Valuation is as much an art as it is a science. There are a number of methods applied to the valuation of mineral assets. Among these are net present value, cash flow multiples, in-situ value fractions, and real option value. Each has several variations and parameters, so there are innumerable approaches.
Net Present Value
The net present value approach is the most sound. It hinges upon the observation, popularised by John Burr Williams in his 1938 book "The Theory of Investment Value", that the value of a financial asset is the net sum of its future cash inflows and outflows, discounted to the present at an appropriate interest rate. The questions to be answered are (1) what are the future cash flows? and (2) what is an appropriate interest rate? Answers to both questions are critical to this so-called Dividend Discount Model (DDM) which calculates Net Present Value (NPV). In general, the former question is impossible to answer. However, in the former case, for mines, costs may be estimated based upon known characteristics of a deposit and its location, and revenues may be estimated on the basis of theoretical volumes and commodity price forecasts, however challenging these may be to estimate with certainty. These figures are the subject of the engineering studies discussed above. The latter question is a matter of much theoretical debate, contextual variation, and subjectivity. We shall explore this below.
At What Interest Rate?
Consider that the S&P 500, together with predecessor indices, has returned just shy of 9%, about r=8.9% per annum, including dividends but before taxes, since records were kept, roughly 150 years ago. Let us call this our US dollar-denominated fair nominal equity rate. In the economic studies for mining projects, neither commodity prices (which determine revenues) nor costs (capital or operating) are escalated for inflation. Both are held constant in perpetuity. Depending on the commodity and the time period measured, metal prices have risen at a compound annual growth rate of between 3-5% over the very long term. Let's call it growth g=4% per annum. Costs, say as measured by the consumer price index, which, for example, in the United States, has averaged a little over 3% per annum over the past century, may be assumed to do the same. Hence by the Gordon Growth Model (GGM, a corollary of the DDM), the fair discount rate for these real (unescalated) projected cash flows is r-g=4.9%. Let's say 5%. So the 8% discount rate often used for NPV calculations is actually a real return, and therefore arguably quite high (conservative), provided that cash flows have been fairly estimated. The Capital Asset Pricing Model (CAPM) argues that discount rates correlate with risk, or volatility. With regard to risk, the common assumption that natural resource extraction, as a higher risk business, is discounted more severely, leads to the conclusion that it exhibits higher long-run aggregate returns, which appears not to be the case. If anything, risk premia are lower in this industry. And this could be explained by mining investors' attraction to risk, or, more precisely, to the wider statistical distribution of returns among investees and over time. With regard to volatility, it may be noted that volatility is not equivalent to risk except to an investor with a short time horizon, or a forced seller such as a leveraged firm or investor subject to loan covenants, or a trader on margin. So, we argue here on the basis of historical equity returns and the "real discounting" of mining feasibility studies, that a discount rate of closer to 5% is fair.
Sydney Homer and Richard Sylla's landmark 1996 text "A History of Interest Rates" chronicles the credit markets of the past 5,000 years from the harvest loans of ancient Mesopotamia to modern US treasuries, UK gilts, and Japanese government bonds (JGBs). In spite of failing, due to its publication date, to capture the absurd contemporary phenomenon of negative nominal interest rates, it well illustrates the gamut of discounts throughout the history of finance. In the recent 500 years studied, high-grade credit rates fluctuated from about 2% to 10%, with an average of about 6%. Rates spiked during war time and were higher for poorer sovereigns, while rates compressed to about 2% during the height of the more stable and credit-worthy Dutch and British Empires. These were payable in specie, or hard money (gold- or silver-backed currency) so they could be considered real rates. The 30-year US treasury bond today yields a little under 3%. As well, depending on a number of factors, equity returns are often more favourably taxed than those of fixed income securities.
The above comparison is not direct, but it could be argued that today multinational corporations such as diversified mining companies, as credits, may be equal to or superior to all but the strongest sovereigns. Observation of the recent years' equity values of some of the larger listed mining companies such as Rio Tinto Plc (NYSE:RIO), BHP Billiton Plc (NYSE:BHP), Glencore Xstrata Plc (OTCPK:GLCNF), and Anglo American Plc (OTCQX:AAUKF), finds free cash flow multiples in the range of 20-40 times, whose reciprocals approximate the 2.5-5% range of real returns. Recently, these firms have typically paid 3-4% dividend yields, and (largely due the challenges of their size) have exhibited little if any production growth. This is further argument for a 5% or lower real discount rate.
Discount Rate, NPV, and IRR
For simplicity, let us consider the nominal discount rate. Suppose a cash flow model discounts via rate, r, to NPV, N, and the market capitalisation at time zero is M. The imputed return, or IRR, of the cash buyer of the asset is the imputed discount rate of the cash flow model which substitutes market value for NPV. If M is above NPV (M>N), i.e., the asset trades at a premium, then the imputed return, or IRR, R, of the market buyer of the asset, will be lower than the discount rate, r: R<r. Conversely, if M is below NPV (M<N), i.e., the asset trades at a discount, then the imputed return of the market buyer will be higher than the discount rate: R>r. For a perpetual constant cash flow, the identity M/N = r/R holds. That is, the multiple which NPV is of market value is the multiple of the discount rate which can be earned by a market buyer. E.g., an asset at a 50% discount will earn double the rate of return, and at a one-third discount will earn a return 50% higher than the discount rate, etc. Mines, as long-lived assets, are approximated by this relation.
The potential excess return of a discounted asset is in fact higher than that suggested by this relation. The reason for this is mean reversion. If r is a fair rate of return, say 8%, and the market trades at a 50% discount to the NPV8 of a perpetual cash flow, then the terminal IRR is 16%. But if the market revalues M to equal N, the return is 100%, amortized logarithmically over the time required for mean reversion; e.g., if the discount closes in three years, the annualised return will be 26%.
Thus it is understood that, assuming cash flow forecasts prove correct, assets purchased at NPV8 and held to maturity earn precisely 8%; assets purchased at a premium earn less, and assets purchased at a discount earn more. The excess or shortfall of the return is a function of the magnitude of the discount or premium, and, if the asset is resold, the time taken for mean reversion. This is an approach taken by many in the assessment of mineral assets. The thinking goes that this is an 8%-return business, and to earn an excess, a discount is required. The greater the better, and the wild card remains the revaluation time. As a mining developer, we are paid 8% (plus/minus changes in prices and costs, as approximated in the long run by inflation) for getting a year older, plus or minus the changes in the discount.
A New Model:
Exploration Internal Rate of Return (EIRR)
To apply the above analysis to mining assets in general is reasonable and sound. However, to think in this way about Ivanhoe Mines' common equity is to mistake its true nature. Ivanhoe is not a development company. It is an exploration company! Its business is not that of a run-of-the-mill mining operation, trading capital for metal, and turning time into interest. Its business is turning ideas into mines!
To see what I mean, consider the Platreef project. The last economic study was a definitive feasibilty study published in September 2017. During the nearly two-decade period from 1997 through to the completion of this recent study, approximately USD $400 million was spend on exploration and capital, most of which was spent after 2010. This PFS indicated an after-tax NPV8 of USD $916 million at a 100% basis. This amounts to around USD $590 million for the company's 64% retained interest in the project.
Taking NPV as the value of the asset, and netting against it exploration expenditures, for convenience assumed to be incurred at a constant rate over two discernible periods, prior to and subsequent to the Itochu joint venture partnership, expended continuously, one can calculate an internal rate of return for the long-term exploration campaign. This author used a little calculus but a discrete model will do. The exploration IRR (EIRR) is 8%. Note that this is after taxation, because the tax is netted out of the project NPV. This is an equity rate of return, over a long time period of 20 years.
On the other hand, if one applies instead, per the study parameters, a 5% discount rate, which was argued earlier to be a fairer rate, the 64% net interest of the USD $1,961 NPV5 would amount to roughly USD $1.25 billion, which would lead to a 15% EIRR, a high equity rate of return. Yet this still fails to capture the value generation. The FS models only Phase 1 of production, which is a 32-year mine life at a milling throughput of 4 million tonnes per annum (4 Mtpa), producing annually 476 thousand ounces (476 koz) of 4PE (PGMs platinum, palladium and rhodium, plus gold). In the earlier PEA, published in 2014, the planned Phase 2 expansion doubles throughput to 8 Mtpa and increases 4PE production to 785 koz per year, and the Phase 3 expansion trebles throughput to 12 Mtpa, for an annual production of 1,109 koz of precious metals. In this PEA, NPV nearly- and more than doubles, for Phases 2 and 3, respectively. Applying double the valuation of the FS to the project results in an EIRR of 15% in the NPV8 case, and for the NPV5 case, a 21% after tax rate of return.
To be precise, in the calculations above, the NPVs used are for 74% interest, including Ivanhoe's joint venture partner Itochu's 10%, because they included as a cash outflow the funds contributed by Itochu. A non-pooled calculation, treating the Itochu capital injection as an inflow, would result in a higher return still. In this model, the repayment to Ivanhoe of shareholder loans for the 26% carried interest of the Broad-Based Black Economic Empowerment groups which hold 26% of the equity, should roughly offset the cost to Ivanhoe of carrying its partner.
For Platreef, the price assumptions of the FS are $1,250/oz platinum, $825/oz palladium, $1,300/oz gold, $1000/oz rhodium, $7.60/lb nickel, and $3.00/lb copper. Of these, the platinum, nickel, and rhodium prices are above market, while the palladium, copper, and gold prices are below market. Most of the value of the reserves is in the Pt/Pd, in a 1:1 ratio. This basket is valued roughly on current market terms in the study. Rather than delve into alternate models, we maintain the independently audited FS model. Arguably, these metal prices are in the lower part of the cycle, and below normalized levels. A number of factors discussed suggest that the NPVs are conservative, and the EIRR is higher than indicated.
Consider now the Kamoa-Kakula (K&K) project. Over a period of 20 years from 1997 through 2017, a little over USD $400 million was spent on exploration and capital, net by the company. In 2015, a 40% interest in the project was sold to Zijin Mining Group Co. Ltd. For USD $412 million, payable in installments, now fully paid. The most recent PEA for K&K, which was completed November 2017, studies a 44 year mine plan, with 12 million tonnes per annum of throughput, a phased expansion with direct-to-blister flash copper smelter, and assumes a USD $3/lb copper price. According to this PEA, the project has an NPV8 of USD $7.2 billion, or USD $8.5 billion at the current copper price of USD $3.25/lb. Ivanhoe's 40% retained interest, net of Zijin's 40% and the DRC's 20% interest, is thus valued at USD $2.9 billion, or USD $3.4 billion at today's USD $3.25/lb copper price. Again, for simplicity one may assume continuous expenditure of exploration funds over these 20 years, thereby arriving at a cash flow model, and then impute an internal rate of return. This author used a little calculus, but a discrete model will do. At a USD $3.25/lb copper price and an 8% discount rate, the exploration IRR is roughly 20%. Note again that this is after tax, because the tax is netted out of the project NPV.
It is uncommon for a business to sustain a 20% compound annual return, after tax, over a 20-year period. This alone is impressive. However, the IRR estimate of this exploration cash flow model is conservative, firstly, because in reality expenditures were not continuous but end-loaded, both because of the greater cost of the later exploration stages dominated by diamond drilling, and also due to inflation. (These comments apply to the Platreef as well.) But more importantly, the NPV8 of the recent PEA simply does not come anywhere close to valuing K&K. For one thing, the company has disclosed that it is reviewing a possible 50% increase in mill throughput to 18 Mtpa. In view of recent exploration results, this appears likely. Head grades, and therefore profit margins, of the expansion may not be consistent with the mine plan, but for simplicity, a 50% increase in NPV brings this exploration IRR to over 23% after tax. Not included in the current mine plan or resource, a new zone called Kakula West, an unheard-of 4 kilometer step-out from Kakula, has been discovered. Even today, fully half of the K&K exploration licence area, which apparently presents numerous anomalous readings to be investigated, remains untested.
Moreover, at a 5% discount rate, which was argued to be a fairer rate for unescalated cash flows, the imputed exploration IRRs are 23% for the 12 Mtpa mine of the PEA; for the 1 ½ - scale (18 Mtpa) mine, 26%.
Notable also here is that we calculate the return on exploration net of Zijin's interest, which was purchased very cheaply, especially in hindsight after the windfall Kakula discovery. Pooling the joint venture, the EIRR for the 1 ½ - scale mine amounts to 27% for NPV8 and 31% for NPV5.
Either way, one may add additional exploration optionality, or land value, as is customary in market appraisals of mining projects. One may also consider still higher throughputs, as well as higher metal prices. A USD $3.25/lb copper price is arguably a reasonable long-term assumption. But there is a case to be made for a higher long-term copper price. Under such assumptions, the exploration IRR clocks in the neighbourhood of a 30% after-tax rate of return.
Now consider the Kipushi project. The project was purchased in November 2011 for consideration of USD $155 million, paid in installments over a period of one year. The mine was de-watered, and an exploration and development programme was undertaken. This included expansion drilling, a resource update, and a PEA mine plan for the newly expanded resource. Subsequent expenditures up to the effective date of the December 2017 PFS totaled approximately USD $250 million. Taking the economic analysis of the PFS and making adjustment for zinc prices to the current spot market of USD $1.50/lb, assuming USD $170/tonne in treatment and refining charges (TC/RCs), as well as adjusting for capital expenditures incurred, one may arrive at an NPV8 of USD $930 million, and an NPV5 of $1.25 billion, for Ivanhoe's 68% share of the project.
Again, assuming continuous expenditures over the 7 year development period, and a value of NPV8, the Kipushi investment is seen to have had an internal rate of return of over 23% after tax. And valuing Kipushi at NPV5, argued earlier as a fairer methodology, we have a 29% after-tax internal rate of return. Note that USD $1.50/lb zinc is roughly equal, in real terms, to the USD $1.10/lb zinc price at the time of the Kipushi acquisition. Hence, employing a USD $1.50/lb zinc price has the effect of controlling for cyclical factors.
This may be a conservative appraisal yet. One could argue that the current concentrate deficit suggests that not only does the zinc market still have a ways to run, but so do refining margins have room to compress, well below USD $170/tonne, as they have been recently, and therefore that these NPVs may prove unreasonably low appraisals for reasons of price assumption alone. But there are a number of other value drivers, such as unrealised value for additional resources already known but not incorporated into the initial mine plan, as well as those yet to be found through further exploration where the deposit remains open. These resources may extend mine life and/or add to productivity. Also, the PEA assumes no credit for the valuable germanium content of Kipushi's ore, which may yet earn credit from smelters. Thus NPV, and resulting EIRR, are arguably considerably higher still.
The key observation here is that the project was really a combination of an opportunistic asset transaction and a successful exploration campaign. Altogether, this was an exercise in astute capital allocation.
Firm Exploration Internal Rate of Return
There are a number of possible approaches, as discussed above. If we net out the company's share of the projects, treating joint venture capital as external, and use the double-scale NPV for Platreef under the FS pricing assumptions, the estimated 18 Mtpa NPV for K&K, based on the latest PEA, at USD $3.25/lb copper, and the PFS NPV for Kipushi at USD $1.50/lb zinc, using NPV8 we arrive at a weighted average return of 20%, and using, as argued, the fairer NPV5 figures, an after-tax exploration internal rate of return of 25%. Again, there are still numerous conservative assumptions built into this model.
It may be argued that most mining exploration firms are at best one-hit wonders. The vast majority of failures are no-hit wonders. To consider the financial returns of a firm which makes a discovery, likely quite high, would be to engage in selection bias. However, not only is Ivanhoe a three- or four-hit wonder (depending whether you count Kakula as separate from Kamoa), but, as described later, Executive Chairman Robert Friedland's previous public entities have put several Tier 1 mines into production, spanning the globe over a period of decades. Furthermore, the present Ivanhoe has spent USD $34 million on exploration on projects other than those studied here. Some were not pursued, while a royalty and shares were retained on the Syerston project in Australia. In view of the long odds of the industry, it is important in the exploration business to consider many properties, but quickly determine which ones are worth significant expenditures of scarce money and time. Ivanhoe's endeavours provide enough of a sample space to rule out luck, and determine that this is a winning team. The return calculated above amortizes the immaterial failures.
A 25% compound annual return accrues roughly to a double over 3 years, a tenfold gain over 10 years, a hundred-fold gain over 20 years, and a thousand-fold gain over 30 years.
Ivanhoe Mines as Exploration Juggernaut
Hopefully, this exposition will have proved that the firm is not simply a vehicle for churning through mining project NPV, but that it is a machine for combining intellectual and financial capital to generate NPV, not by accretion from a mine plan, but, as it were, out of thin air, and at very high rates of return on invested capital, of 20-30% after tax.
The importance of this metric cannot be overstated. "Return on invested capital", or ROIC, is the acid test for business quality, because it is a measure of the financial returns of the operating business, assuming no gearing from debt or other concentrations of return resulting from the capital structure. As well, using reasonable long-term metal prices in the NPVs for Platreef, K&K and Kipushi, and constant zinc prices between the Kipushi asset transaction and the present, isolates the exploration work and nets out gains from cyclical factors, so important to returns in the industry. That is to say, this analysis does not assume a favourable sale price, which remains none the less possible.
To put these ROICs into perspective, let us compare them to those of world's most celebrated investor, Warren Buffett. Buffett Partnerships Ltd. earned returns of nearly 33% annualised for 14 years, and subsequently Berkshire Hathaway Inc. earned returns of about 30% in the early days, falling gradually to 12-15% today, for a roughly 20% compound annual return over its 53-year history under current management. It is arguably more difficult to generate high returns on capital in a real old-line industrial business such as mining than in finance, since the latter has maximum flexibility in terms of both breadth of opportunity and liquidity. Buffett accomplished these results by a combination of trading, arbitrage, activism, financial gearing, leverage via insurance float, and high quality businesses generating 20-30% annual rates of return.
Henry Singleton ran Teledyne Technologies Inc. (NYSE:TDY) from 1960 through 1986. Buffett said Singleton had the best track record of any industrialist in the history of American business. Over this time, profits increased from $100,000 to $238 million, a compound annual growth rate (c.a.g.r.) of 35%, and shareholders' equity increased from $2.5 million to $1.6 billion, a 28% c.a.g.r. From 1971 through 1984, thanks to growth, securities investments, and share buybacks, Teledyne's earnings per share increased forty-fold, for a 33% c.a.g.r. This record was achieved through a combination of astute capital allocation through the gamut of industrial holdings of the conglomerate, as well as value-enhancing mergers and acquisitions, accretive share issuance, accretive stock repurchases, and the use of debt and insurance float combined with Singleton's superior stock selection and nose for value.
In any case, surely Warren, stalwart champion of high returns on invested capital, would respect the profitability of Ivanhoe Mines.
So, the key point here is that although investors may apply NPV and sensitivity analyses to assess mining firms as asset plays, options, or speculative vehicles, Ivanhoe is better viewed as a dynamic, opportunistic exploration company with disciplined capital allocation and high returns on investment. One may think of aggregate NPV, or firm NAV, as a sort of "book value", so that the mining projects are not the business, but the treasury, which may be disposed opportunistically in the most accretive way to raise funds for its high-ROE core business of mining exploration.
Retreating from all this financial arcana, let us emphasize: the bottom line is that this is a high quality business, because it generates high returns on invested capital. A firm which generates 20-30% after-tax returns is a rare gem which ought to trade at a rich premium to NAV. But as we shall see, Ivanhoe trades at a steep discount to NAV. This is nothing else but an extraordinary bargain!
As mentioned above, we take the most recent economic study, and calculate NPV5, not accreting for time, and not adjusting for capex, due to recency of studies. For Platreef and Kamoa-Kakula we multiply this by a factor of 2 and 1 ½, respectively, to reflect an estimate of scalability. We assess Ivanhoe's share: 68% for Kipushi, 64% for Platreef, and 40% for Kamoa-Kakula. We assume an exchange rate of CAD $1 = USD $0.80.
For Kipushi, the zinc price is adjusted to $1.50/lb, and the copper price is adjusted to at $3.25/lb, to reflect market conditions as of this writing. No value is awarded germanium. TC/RCs are adjusted to $170/t.
Kipushi valuation: USD $1.2 billion = CAD $1.95/share
For Platreef, the price assumptions of the FS are $1,250/oz platinum, $825/oz palladium, $1,300/oz gold, $1000/oz rhodium, $7.60/lb nickel, and $3.00/lb copper. Of these, the platinum, nickel, and rhodium prices are above market, while the palladium, copper, and gold prices are below market. Modelling price adjustments to the spot market arrives at similar NPV figures. Rather than delve into alternate models, we maintain the independently audited FS model.
Platreef valuation: USD $2.5 billion = CAD $4.00/share.
For Kamoa-Kakula, the price assumptions are $3.25/lb for copper, and $200/tonne for sulphuric acid credits.
Kamoa-Kakula valuation: USD $8.5 billion = CAD $13.60/share.
Working capital valuation: USD $200 million = CAD $0.30/share.
Ivanhoe valuation: USD $12.5 billion = CAD $20/share.
Note that at an 8% discount rate, the firm NAV8 is USD $7.4 billion, or CAD $11.80/share, and the firm NAV10 is USD $4.2 billion, or CAD $6.60/share.
The most notable sensitivity is to copper prices. Each +/- USD $0.50 change in the copper price represents a change in NPV5 of +/- USD $1.75 billion, or +/- CAD $3/share, which is +/- USD $2.5 billion, or over +/- CAD $4/share in the 1 ½ - scaled model. Talk about operating leverage!
I think the Platreef valuation is possibly a tad aggressive, as the PGM market remains in apparently inexorable surplus, and the scalability of Platreef hinges on the market being able to absorb the additional output of this mine, whose Phase 3 expansion constitutes as much as 10 - 15% of the current global demand for PGMs. All metal markets are cyclical, and low prices lead to underinvestment and concomitant constrained supply, as well as increased consumer utility and concomitant expansion in demand, both of which effects tend to lead to higher prices, so it seems reasonable to regard the Platreef expansion cases as very big long-dated call options. Demand for PGMs depends largely on catalytic converters for automotive internal combustion engines and industrial plants, the former of which demand driver is helped by increased global car sales and tightening fuel standards, especially in China, but hindered by the threat of electric vehicles and thrifting, i.e., designing catalysts which use less PGMs by mass. The promise of fuel cell vehicles which require a great deal of PGMs is somewhat remote, and also subject to thrifting.
The K&K valuation could be conservative, because of exploration potential. Also, copper prices may run hot as a result of years of underinvestment in capacity, increased electrification, and the growing prevalence of electric vehicles and renewable power, which exhibit high copper intensity.
The Kipushi valuation may be conservative due to price, primarily based upon supply considerations, in view of numerous major mine depletions and closures over the past few years.
I am neutral to bullish long term on PGMs, medium- to long-term bullish on copper, and short-, medium-, and long-term bullish on zinc, primarily based on supply considerations. One may apply a subjective discount for political risk or time- and cost-overruns. But I stand by my 5% discount factor for long-lived, world-scale Tier 1 mines, which is what they are truly worth.
Mining Stocks Have No Earnings
The general securities analyst accustomed to assessing equity valuations on the basis of price:earnings ratios (PEs) will generally find all resource companies unconducive to such analysis. But one may solve for the real discount rate, r, which matches NPVr to the enterprise value of the firm. In this case, it is about 13%. This is essentially equivalent to a free cash flow yield, after time-value adjusting cash flows to a constant perpetuity. Taking the reciprocal, we may regard Ivanhoe as a stock with a P/E of 8. In today's equity markets, most low-growth businesses trade at 20 times earnings or more. In view of the United States' 10-year Cyclically Adjusted Price-Earnings (CAPE) Multiple of nearly 34x earnings, and most other markets at a similarly high valuation, not least due to ultra-low interest rates, a PE of 8 is seen to be dirt cheap. Not only this, it has inflation-protecting pricing power, and arguably positive earnings momentum. And this accounts only for the value of the mines. Here, we have a mining stock at 8x growing earnings, with the high-return, low-capital intensity exploration business thrown in for free.
Discount to NAV
The value of Ivanhoe's mining projects is dependent upon a number of factors and unpredictable variables, principally future metal prices. However, independently audited estimates are based on near-current prices which are arguably near secular lows, towards the end of a long bear market in each of the key metals. Based upon the closing price on 11 January 2018 of CAD $4.04/share on the TSX (USD $3.23/share over-the-counter in the US), this base case valuation of CAD $20/share implies an approximately 80% undervaluation. This Price:NAV discount amounts to 66% and 39% at real discount rates of 8% and 10%, respectively, which were earlier argued to be overly conservative.
The Mining Cycle
A supply-demand analysis of each of Ivanhoe's reserve metals is beyond the scope of this article. However, suffice to say that the 5-year-long bear market in all metals has constrained both capital available for exploration and sustaining capital expenditures at existing mines, and as a consequence, future available mine supply. Meanwhile, the outlook for demand as a function of ongoing global population- and economic growth, increasing urbanization, and the requirements of advancing technology and green energy infrastructure, has remained robust. Owing to the industry's high capital intensity and long lead times, the sympathetic patterns of metal prices and mining equity values are deeply cyclical. After likely increases in depressed metal prices, cash flows would prove higher than anticipated, while improved sentiment would likely compress discount rates, taking Ivanhoe's equity value higher still.
Another wild card in Ivanhoe's valuation is ongoing exploration. In view of its geologists' serial Tier 1 mineral discoveries, further value creation via the drill bit is not out of the question. In particular, apart from expansion drilling at Kipushi and K&K, Ivanhoe holds additional exploration licenses in the DRC, including those in the so-called "Western Foreland" region, which unlike K&K which is joint ventured with Zijin and the DRC, are 100% Ivanhoe-owned.
Ivanhoe's sterling leadership and technical management team have proved highly successful mine finders and builders in challenging jurisdictions around the world, including in China, Myanmar, and Mongolia, as well as Canada, the United States and Australia.
Executive Chairman Robert Friedland has been unusually successful, in that over a period of decades, his companies have discovered and developed several Tier 1 mines, including Fairbanks Gold Limited's (now Kinross Gold Corporation (NYSE:KGC)) Fort Knox gold mine in Alaska, Diamond Fields International Limited's (later Inco Limited, now Vale SA (NYSE:VALE)) Voisey's Bay nickel-copper mine in Labrador, and the former Ivanhoe Mines Limited's (now Turquoise Hill Resources Limited (NYSE:TRQ) and Rio Tinto Group Plc) Oyu Tolgoi copper-gold mine in Mongolia.
Incredibly, as described above, three more Tier 1 mining projects belong to the current incarnation of Ivanhoe Mines Ltd., two of which, Platreef and Kamoa-Kakula, are new discoveries of its technical team, and the other of which, Kipushi, was rescued from the ravages of time, refurbished, and significantly expanded via exploration. Not only are these mines exceptionally rich, but it is also unprecedented in the modern day for an exploration company to control three virgin Tier 1 mines.
Unique Business Model
Ivanhoe Mines is a unique company in a number of respects. Firstly, each of its assets is essentially peerless worldwide. Secondly, there are few if any mining exploration firms with its depth of management and technical personnel, and which manage to remain sufficiently well funded to carry out continuous exploration and development activities at its whirlwind pace through the depth of an industry depression. Meanwhile, senior producing mining companies, which rely mostly upon acquisition of explorers and brownfield exploration, seldom conduct extensive greenfield exploration, or discover altogether new mining districts. Thus, the firm occupies a singular niche in the mining industry. Thirdly, the quality of work is high. This is evidenced in a variety of ways, such as by the level of detail of its engineering studies and technical reports, and by its clear and thorough public communication. Fourthly, it is strategic and forward-thinking. Examples include employing cutting-edge exploration and mining technologies and methods; partnering with other large or parastatal mining companies with expertise, access to capital and political influence; implementing novel community projects; thinking about how technology will influence commodity demand trends; and having its own vision of how to drive future value rather than being directed by the caprice of the capital markets. Ivanhoe Mines is innovative, dynamic, and strong.
High Quality Personnel
From this author's impression, all employees of the firm demonstrate a high degree of competence. In an industry fraught with wishful thinking, delays, cost overruns, and disappointment, management has consistently delivered on its promises, which have not been modest. Indeed, they have often exceeded them. In investing, time is money. A pattern of setting goals, communicating them, and achieving them, is valuable. Dictum meum pactum means doing what you say you will do, which is the key to trust in business. The entire team is of a high caliber with respect to both talent and integrity.
Alignment of Interests
Owner-operators, or firms with high insider ownership, tend to exhibit a confluence of interests between insiders and minority stockholders. Studies indicate that they provide superior returns. The Executive Chairman, Robert Friedland, owns 22% of the common equity, which stake is currently valued at over USD $500 million. The CEO, Lars-Eric Johansson, is also a significant shareholder, and so are most members of the board of directors.
Risks and Mitigants
The Democratic Republic of Congo has recently undergone political turmoil. This appears not to have had a material impact on the company's business; however, there can be no assurance it will not do so in the future. The country lacks the political and legal checks and balances which afford stability to more mature nations.
The South African PGM mining industry has been characterized by labour disputes, partly due to poor working conditions and the recession caused by low PGM prices. These challenges should be met by industry best practices afforded by a highly mechanizable and profitable mine.
Management is acutely aware of the importance of generating goodwill in its host communities and maintaining strong relations with its host governments. It has been proactive in building community relations via significant investments in its local communities, in health, education, agriculture, and water- and electric utility projects, as well as training and entrepreneurship programs. The DRC government owns 20% of the equity of K&K, and state-owned mining company Gecamines owns 32% of the equity of Kipushi. Historically Disadvantaged South African (HDSA) people have a 26% interest in the equity of Platreef. Through shareholder loans, the host governments and communities are thus able to participate in the equity returns of the mines without being required to provide capital for their development.
The influence of the industrially developed and resource-hungry Chinese state, with its undertaking of large infrastructure projects in developing countries in exchange for access to natural resources, has brought significant benefits of trade to the DRC. This is not to be taken lightly, as it is part of Beijing's coherent long-term strategy for global economic development and expansion of influence, which includes the ambitious "Belt and Road" master plan for building out land- and sea-transportation corridors linking East Asia to Europe and the West. Partnership with Beijing-backed mining giant Zijin should strengthen Ivanhoe's position.
Ivanhoe top brass (pun intended) have done well to align the interests of company management, shareholders, and host governments and communities towards the success of these mines. The mines present significant employment opportunities, large tax revenues, and other benefits of foreign direct investment into the local communities, which stand to prosper greatly from the economic development made possible by their operation.
All that said, there is no sugar-coating it. This is political risk with a capital R. Non-quantifiable risk. In view of political turmoil in the Congo, and that the nation suffered a civil war in the late 1990s, there is a possibility, however remote, of a recurrence of such an unfortunate episode. One may reasonably expect, that under international law the company may be able to retain title, but recognize that there would be a significant and costly delay in production. (Naturally, analysis of the financial consequences is in no way meant to trivialize the human cost of such an eventuality.) That said, some analysts may prove unduly pessimistic, in view of the staggering economic growth, development, and improvements in living standards that the country has undergone over the past 15-20 years. Also, the southern region of Katanga, where Ivanhoe's projects are situated, is more developed and more stable than other parts of the country which receive frequent attention and concern from international observers.
A non-producing mining firm with no revenues is dependent upon capital markets for financing its operations. Availability of funds cannot be guaranteed, as market conditions fluctuate and may be adverse at the time of greatest need for cash, allowing funding only on unfavourable terms, if at all.
Although the company has over USD $200 million in cash as of 30 September 2017, at the current rate of expenditure, this is little more than one year's expenses. It is important to note that when the shares were trading below CAD $1/share at the secular low for the natural resources capital markets, had there been a share issuance to raise meaningful funds for project finance, say USD $400 million, the share count would have had to be doubled, i.e., resulting in 100% dilution, which would have effected a 50% decline in NPV/share at these extremely undervalued levels. Instead, half of one of three projects was vended to Zijin for USD $412 million. A priori, this transaction was somewhat dilutive to NPV, and post-priori, in view of the subsequent Kakula discovery, it was highly dilutive to NPV; however, there were strategic benefits to partnering with Zijin, and given the then available information, the acute need for funds, and the severely depressed market conditions, it was a very good deal.
At current share prices, the firm could raise USD $300-400 million, or two years' expenses, by the issuance of 100 million shares, which would amount to minor dilution, and provide ample equity capital to advance projects to production. As well, a more accretive project-level transaction may be negotiable.
For all that most focus on political risk, perhaps the most prevalent cause for valuation error in mining is that the assumptions of engineering studies prove optimistic, and results disappoint, in one or more respects such as in realised production, head grade, recoveries, operating costs, capital costs, or development time. Mining projects, like most construction projects, are notorious for running over time and over budget, and this can cut sharply into NPV.
Given the high quality of the projects, they are less needful of, and therefore less prone to exaggeration. Also, the studies seem to this author to make reasonable assumptions and provide a relatively high level of detail in the planning. Time and cost overruns are to be expected, and these may be discounted, but one might give management the benefit of the doubt, until proven otherwise. Under alternate models, with multi-year delays and hundreds of millions of dollars in cost-overruns, the shares would still appear to be significantly undervalued.
Risks and Valuation
A common approach to accounting for political risk in resource valuation is to select a discount rate by jurisdiction on the basis of perceived political risk. Thus, goes the common approach, a rate of r% for a region with an established mining code and industry, and a mature legal framework, and (r+p)% for a region perceived as riskier in these respects, where p may range from 0 to say 15, depending upon the degree of risk.
The theoretical model often assumes a base rate of r=8 or r=10, saying this accounts for industry risk. This matter of industry risk and real discounting was discussed earlier. So, alternatively, if one begins with, as proposed, r=5, then high risk, where p=10, might be discounted at 15%. This implies the equivalent of a 10% probability of expropriation for every year of exploration, development, and production. This seems rather extreme. Even a 5% premium may be high for most jurisdictions. Outright expropriation or revocation of licence, whether for political or environmental reasons, does happen, but is relatively rare. More common are minor adverse developments such as increases in taxation or other payments, imposition of requirements to undertake capital projects for economic development which may not be NPV-optimal, and delays resulting from regulatory action or political disruption. These can happen anywhere, each specific risk being apparently more likely in certain places than others.
All this is somewhat subjective. It is not probabilistic in the mathematical sense, but simply unforeseeable. Therefore a rational investor discounts such eventualities based upon subjective appraisals arising from the available facts. I argue that such risks are more reasonably applied as a discount to NPV. Mathematically speaking, the discount factor is the expectation of loss; i.e., the sum of all prospective losses weighed by probability and severity. One can introduce non-linear (convex) loss functions, and models can become more complex. But the key point here is that political risk, like many risks, is to a large extent diversifiable, so that a linear loss function makes for a reasonable model.
In particular, the proposed changes to the DRC mining code, as yet unfinalized, of increases in the corporation tax from 30% to 35%, the royalty rate from 2% to 3.5%, and the free carried interest from 5% to 10%, would have a roughly negative 15% impact on the NPV of K&K and Kipushi.
Moat and Margin of Safety
Notwithstanding metal price fluctuations and political uncertainty, the low cost structure and high productivity of high-grade, world-scale mining operations constitute one of the most enduring competitive advantages in business. This is because competition comes only from other low-cost mines displacing high cost supply and thereby effecting a reduction in the marginal cost of production, i.e., the metal price. But such creations require a great deal of scientific research, capital, time and good fortune, all elements which Ivanhoe has provided in abundance. The current market value of Ivanhoe's equity is equal, as noted above, to a small fraction of a conservative assessment of its intrinsic value, which is highly resilient to metal price fluctuations, thanks to the low cost profile of the company's extremely high-grade mines. The company's strong balance sheet and cash hoard, its suite of mines and metals, and its bi-national asset base provide a measure of risk-mitigating diversification.
Although Ivanhoe's shares have appreciated by 700% in the past 24 months from their nadir, they remain considerably undervalued, after more extraordinary exploration results, development, and technical and political de-risking have dramatically increased value per share. So as not to be misled by the unfathomable depth of the mining equity cycle, investors are encouraged to assess the value proposition as it stands today. Leaving aside theory and abstraction, we close with an anecdote. The previous incarnation of Ivanhoe Mines Ltd., now renamed Turquoise Hill Resources Ltd., under the same management as the current Ivanhoe, developed the Oyu Tolgoi copper-gold mine in Mongolia with partner and now majority-owner and operator, senior miner Rio Tinto Plc. The former Ivanhoe, now Turquoise Hill, witnessed share price appreciation from less than USD $0.40 in December 2000 to more than USD $23 in January 2011, a more than 50-fold gain in 10 years' time, for a 50% annualised return.
The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun.
- Ecclesiastes 1:9
12 January 2018
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
I wrote this article because I regard the issuer's shares as undervalued and think they should appreciate. Sooner is more favourable to my net present value. However, I may be totally wrong, and may change my mind or my position without further notice. It was also an interesting case study.
Statements in this article include forward-looking statements. The future is uncertain. Other statements pertain to historical fact, and are believed by the author at the time of writing to be accurate, but are subject to error. Undue reliance should not be placed on such statements, and should be independently verified by the reader.
Investment in securities bears the risk of loss of part or all of principal investment, and should not be undertaken without prior consultation with a qualified financial adviser in view of the investor's individual circumstances and risk tolerances.
Always do your own due diligence.
Disclosure: I am/we are long IVPAF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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