- Ivanhoe holds three pre-production, world-class mines in Africa, i.e., Platreef for precious metals, Kipushi for zinc and copper, and Kamoa-Kakula for copper.
- These mines are characterized by some of the world's lowest costs and largest mineral resources, unique among the junior miners.
- The stock was sold off since March 2018 partly due to the mining code changes implemented by the Democratic Republic of Congo.
- The transaction value, NAV, and replacement cost estimated in this study indicate the existence of a large margin of safety relative to the current stock price.
- I believe the risk-reward profile supports a high conviction buy.
“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.” — Warren Buffett
Ivanhoe Mines Limited (IVN.TSX) ( OTCQX:IVPAF) holds three world-class mines in Africa, with enormous mineral resources, incredibly low costs, and attractive economics. The small-cap firm is run by an executive team led by the legendary mining tycoon Robert Friedland, which has a proven track record of shepherding giant mines in difficult operating environments to production.
The company is reckoned to be a deep value at the current stock price of $2.11. It offers a margin of safety north of 39-58% relative to the estimated intrinsic value and a discount of 20% with regard to the replacement cost. Even in the worst scenario of Ivanhoe having to completely write off the Kipushi and Kamoa-Kakula projects in the Democratic Republic of Congo, aka, DRC, the intrinsic value of Platreef in South Africa still covers the current stock price and some.
The recent operational achievements such as the Kamoa-Kakula PEA, Kipushi PFS, and Kakula mineral resource update are yet to be priced in. Furthermore, Ivanhoe is poised to release the Kipushi DFS in 2Q2018 and the Kamoa-Kakula PFS in 3Q2018, which may not only result in incremental growth in intrinsic value but also catalyze the materialization of a 62-133% upside by driving a reversion of the stock price toward that intrinsic value within the next few quarters.
Therefore, I believe the risk-reward profile of Ivanhoe may justify an entry by the risk-tolerant and patient investors.
Why does the opportunity exist?
Ivanhoe has been consolidating along with the entire mining sector as represented by the SPDR S&P Metals and Mining (XME) since the beginning of 2018. Then, the new DRC mining code, which was signed into law in March 2018, really dampened the investors' mood (see here).
After all, the previous commodity boom happened seven years ago; since then, during the industry downturn, the host countries have been generally business-friendly. The complacent investors were not prepared for a higher state take being demanded by the host country government now that the commodity prices start to rise.
On March 9, 2018, DRC President Joseph Kabila Kabange signed a new mining code into effect that revises and updates the country’s 2002 mining code, increasing the rate of royalties from 2% to 10% and eliminating the so-called Article 276 of the 2002 mining code and certain mining conventions, which provides that existing mining projects will continue to benefit from the terms of the 2002 code for 10 years after the implementation of a new code (see here).
The new mining code will definitely reduce the rate of return of the Congolese mines including the Kipushi and Kamoa-Kakula projects of Ivanhoe, which is why the stock was sold off when the news first broke back in February 2018 (Fig. 1).
Fig. 1. Stock chart of Ivanhoe. Source.
However, I believe that as the bearish mood takes hold of the investors, they may have become too pessimistic to notice:
- The Platreef project is located in South Africa and hence unaffected by the DRC mining code change.
- The Kipushi and Kamoa-Kakula projects in DRC are some of the lowest-cost mines in the world and, consequently, the most resilient in the face of an adverse business environment.
- Ivanhoe still has the opportunity to assess the economic viability of the DRC projects, in the light of the higher royalty rate as in the new mining code, before committing a large sum of capital investment. In this respect, Ivanhoe is in a slightly different situation from the other mining companies with operations in DRC, e.g., Glencore (OTCPK:GLNCY) (OTC:GLNCF), Randgold (GOLD), China Molybdenum (OTCPK:CMCLF), which had already sunk billions of dollars into developing DRC mines based on the lower royalty rate as in the old mining code.
As I will demonstrate below, I think the negative impact of the mining code change has already been priced into the current stock price.
Catalysts in the near future
All three mines operated by Ivanhoe have graduated from the early exploration phase. Platreef is around three years from the first production, the Kipushi DFS is expected in 2Q2018, and the Kamoa-Kakula PFS is scheduled for release in 3Q2018 (see here). Kipushi and Kamoa-Kakula have substantial exploration upside, which sets the stage for further mineral resource upgrades (Fig. 2).
Fig. 2. A map showing the mines in the Kamoa-Kakula Copper Project. Source.
Platreef. The financing arrangement is nearly done for Platreef, with an announcement of funding for development in the near future (see here).
- The platinum production of South Africa, the elephant in the room when it comes to global platinum production, is projected to fall off a cliff around 2021. Platreef is scheduled to come onstream in 2022, the timing of which could not be better (Fig. 3).
- However, even the new production from Platreef will only be able to delay the decline of South Africa platinum production by 2-3 years, after which a sustained supply shortfall of the metal will result and platinum price may go through the roof.
Fig. 3. The projected platinum production of South Africa. Source: PwC.
Kipushi. To support the Kipushi DFS, the company already carried out the second phase of underground drilling at Kipushi, with a total of 9,706m were drilled in 58 holes. The company is expected to update the mineral resource estimates and release the DFS in 2Q2018, which may turn out to be a boon for the stock (see here).
Kamoa-Kakula. The Kamoa-Kakula PFS is scheduled for release in 3Q2018. The mine bodies in the Kamoa-Kakula contracts are open in multiple directions with considerable exploration upside, where exploration work is currently ongoing (see here and here). An expanded PFS may further fuel investors' bullish sentiment.
Furthermore, Ivanhoe is currently exploring the wholly-owned Western Foreland exploration licenses situated immediately to the west of the Kamoa-Kakula license (Fig. 4)(see Source). The company may find another Kamoa-Kakula-style copper mineralization there; after all, this is the famed Copper Belt.
Fig. 4. A map showing Ivanhoe’s 100%-owned Western Foreland exploration licenses, west of the Kamoa-Kakula mining license. Source.
The operation is rife with risks of political, community relations, financing, and managerial nature.
Political risk, especially in DRC
The DRC signed a new mining code into effect in March 2018, implementing a considerably higher royalty rate. The foreign miners affected by the new mining code have formed a group trying to lure the DRC government to the negotiation table, in hope of extracting some compromise from it (see here). At this point, I think any optimism on the effectiveness of the miners' effort is probably misplaced.
As the commodities supercycle heats up, the host country tends to resort to increasingly aggressive tools in her toolbox, e.g., from royalty rate hiking, via windfall tax, to nationalization, to extract a higher state take; it almost always succeeds in getting what it wants.
Secondly, as a JV partner, the DRC state company has a track record of resorting to irregular measures to evade paying up its share of the capital costs.
- On April 22, 2018, Congolese state company Gécamines filed a lawsuit in the DRC seeking to dissolve Kamoto Copper Company, in which it has a 25% stake while Katanga Mining Limited (OTCPK:KATFF), a subsidiary of Glencore, holds the remaining 75% interest, accusing Kamoto Copper Company has failed to address the so-called "capital deficiency" problem. Gécamines is essentially attempting to force Katanga to convert a portion of existing intercompany debt owed by Katanga Mining Limited to Katanga into equity or, worse, forgive a portion of the billion-dollar debt (see here). The stock of Katanga tumbled 47% the next day at the breaking news of Gécamines's filing of the lawsuit (see here).
The DRC holds an interest in both Kipushi and Kamoa-Kakula mines, 32% in the former and 20% in the latter. Ivanhoe runs the same risk as Katanga Mining of being forced to effectively carry the state interest.
Thirdly, the DRC is reportedly again at risk of descending into widespread violence (see here and here). Capital-intensive, long-lead-time projects such as mine development require stable political and security environment, so the prospect of a violent disturbance in the country may pose a serious danger to Ivanhoe's operation there. A breakout of war can lead to years of a halt of operation.
Lastly, there were allegations that Ivanhoe had engaged in opaque business practice in acquiring and divesting mining assets in DRC, Kipushi and Kamoa-Kakula mines included, which had been vehemently denied by the company (see here and here).
As compared with Congo, South Africa has a relatively stable business environment. In South Africa, the attempt to increase the state take is yet to occur. Much to Ivanhoe's credit, the company added Kgalema Motlanthe to its board of directors in April 2018, who was President of South Africa for a period between 2008 and 2009 and subsequently served as the nation’s Deputy President from 2009 to 2014. He used to head the National Union of Mineworkers. I believe Mr. Motlanthe can play an important role in pulling strings and ironing wrinkles for Ivanhoe in South Africa and beyond.
The Broad-Based Black Economic Empowerment (B-BBEE) partners collectively hold a 26% stake in the Platreef project (see here):
• 20% held by a trust to benefit 20 local host communities, with an estimated combined population of 150,000, in the vicinity of Platreef mine.
• 3% held by a trust for Platreef’s historically disadvantaged, non-managerial South African employees.
• 3% held by a consortium of 187 local entrepreneurial companies and 333 individual shareholders.
In 2017, Ivanplats reconfirmed its Level 3 status in its third verification assessment on a B-BBEE scorecard. With a 26%-stake skin in the game, the local communities are incentivized to see the project succeed.
In Congo, Ivanhoe funds the so-called Sustainable Livelihoods Project initiatives. Local communities supply chickens and eggs from the poultry project and fruits and vegetables from the livelihoods garden to the mining operations, thus creating a symbiosis between Ivanhoe and the local communities (see here).
Ivanhoe's three mining projects are yet to enter the production phase. So the company expects to fund all of its exploration and development activities through debt and equity financing until operating revenues are generated.
- The company has a weighted average of 808,803,191 diluted shares outstanding as of end-2017. It has engaged financial institutions to raise funds to cover the Capex for Platreef with encouraging results (see here).
- The company also brought in joint venture partners Zijin and JOGMEC to fund the operations. Zijin is also committed to helping raise 65% of the capital needed for Phase 1 of Kamoa-Kakula (see here).
- The company may also sell royalties on the mining projects or sign offtake agreements to raise funds.
As of December 31, 2017, Ivanhoe had $181.419 million in cash and cash equivalents at hand. The net cash appears to be sufficient to support the cash outlays for the routine operations for another three years (Table 1). Please be advised Platreef is scheduled to come onstream and begin to generate operating cash flow from Platreef by 2022.
Table 1. Consolidated statements of cash flows for years ended December 31, 2016, and 2017. Source.
Robert Friedland, founder and executive chairman of Ivanhoe, is like a demigod figure in the junior mining sector. He is known for discovering and shepherding giant mining projects, e.g., the Voisey Bay nickel deposit in Labrador, Canada, and the Oyu Tolgoi copper mine in Mongolia, though environmentalists may hold their noses at the first sight of him (see here and here).
Friedland has assembled a board of heavy-weight directors with a proven track record of excellence in mining, finance or politics. The board is composed of ex-CEOs at major mining companies (2), Ivanhoe alumni (4), financiers specialized in mining (3), and a political influencer (1) (Fig. 5).
Fig. 5. The board of directors of Ivanhoe Mines Ltd. Source.
Lars-Eric Johansson, President and Chief Executive Officer of Ivanhoe since 2007, has many years of experience as a CFO at Boliden AB, Falconbridge, Noranda, and Kinross Gold.
Ivanhoe sold part of its interest in the Kamoa-Kakula and Platreef projects to raise funds for exploration and appraisal, which makes it possible to delimit a total transaction values.
- The $412 million that Zijin paid for 39.6% stake helps peg the Kamoa-Kakula project at $1,040 million.
- The $290 million that JOGMEC paid for 10% of the Platreef valued the project at $2,900 million.
- We do not have a deal price for Kipushi, but we can use analogous zinc mine transactions to come up with a transactional value estimate. On September 1, 2017, Glencore sold its 80% stake in the Rosh Pinah mine and its 39% interest in the Gergarub project, both in Namibia, as well as its 90% stake in the Perkoa mine in Burkina Faso to Trevali Mining Corporation (OTCQX:TREVF) for a total consideration of $417.8 million (see here). The Glencore-Trevali deal was done at around $0.5/lb of zinc equivalent, which would imply a transactional value of $2,513 million for Kipushi.
Ivanhoe's net interest in these three projects come to $3,977 million or $4.92 per share.
However, we must bear in mind that these projects have progressed way beyond the early stage of the exploration/appraisal when these transactions were priced; indeed mineral resources upgrades have been achieved. Therefore, the transactional value as given above may be on the conservative side.
In estimating the replacement cost of the mineral resources in the three projects, I discount the measured resources at 90% of the reported figure, the indicated at 50%, and the inferred at 10%; I assume the 3PE+Au price at $761/oz (the lowest of the 3PE), copper at $2.42/lb, and zinc at $1.01/lb, and then apply a factor of 5.73% to these commodity prices (which is derived from the 2002-2016 average net profit margins of top mining companies worldwide at 13.73% (see here) minus 8%, the capital cost).
Under these assumptions, I arrived at a replacement cost of $1,144 million for Platreef, $340 million for Kipushi, and $2,679 million for Kamoa-Kakula. The net replacement cost after taking net cash into consideration comes to $2,176 million or $2.69 per share.
I found that the NPV-8 values released by Ivanhoe for these three projects were estimated using relatively conservative commodity price assumptions (Fig. 6), which lends credibility to their project economic modeling. The $916 million for Platreef, $533 million for Kipushi, and $4,200 million for Kamoa-Kakula come to a total NPV-8 of $2,612 million, which results in a net asset value of $2,764 million or $3.42 per share, net of the net cash of $152 million as of end-2017.
Fig. 6. Commodity prices, with the solid green lines signifying Ivanhoe assumption in economic modeling. Source.
The various estimates of intrinsic value are summarized in Table 2. The net asset value only takes into account the portion of the mines included in the PFS or DFS, therefore, it should be considered the lower bound of the intrinsic value. The transactional value covers the entire projects, including not only the mineral resources supporting the NAV but also the exploration upsides, hence it can be considered a conservative estimate of the upper bound of the intrinsic value.
Table 2. The valuation of Ivanhoe by transaction value, replacement cost, and NPV. Note *: the NPV-8 for Kipushi is estimated at $533 million, $683 million, and $1.03 billion at $1.01/lb, $1.10/lb, and $1.25/lb zinc prices, respectively. Source: the author.
Relative to the $2.11 stock price of Ivanhoe as on May 3, 2018, the estimated intrinsic values represent a margin of safety in the magnitude of 38-57%. Please note, the current stock price is even lower than the replacement cost of the mineral resources by some 22%, providing an ample cushion for investors.
In the event of Ivanhoe being forced to suspend the operation of or write off its two mines in DRC, the Platreef project in South Africa alone provides an adequate downside protection. This is because Platreef's transactional value of $2,900 million or $2.29 per share is 8% greater than the current stock price of $2.11 as of May 3, 2018.
That margin of safety also implies that the stock has a potential upside of a 62-133% realizable through a reversion to the intrinsic value, and this is prior to giving any credit to the exploration potential existing in the three mines and in the Western Foreland exploration licenses.
Ivanhoe may be a junior miner, but the small-cap company holds not one but three world-class mineral deposits, which boast low costs and expansion potential. This makes it fit for inclusion in the junior miner basket of the portfolio. Fortunately, the recent selloff helped send it to the deep value territory in spite of major operational achievements, thus producing a sufficient margin of safety to compensate for the political risks associated with the mining projects (Fig. 7).
Although it will take another three years for Ivanhoe to start to rake in cash flows from the mining projects, a number of near-term catalysts as discussed above can potentially drive the stock up by some 62-133% within the next few quarters. Therefore, it appears to be an opportune time to go long Ivanhoe.
Fig. 7. Stock chart of Ivanhoe. Source.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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