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Mining Investing: Deconstructing Mining Asset NAVs

From My Newly-created Investment Blog "Dead Cat Bounce"

January 23, 2013 · by ADK · in Metals & Mining Investing

Investors evaluating mining companies will often encounter the "Price-to-Net Asset Value" (P / NAV) metric. P / NAV is only one of many metrics used to evaluate mining companies, as there are a slew of others metrics, commonly including:

For Explorers and Developers:

  • TEV / Anticipated Resource (for very early-stage developers)
  • TEV / Resource

For Junior Producers:

  • TEV / Production
  • TEV / Cash Flow (typically unlevered operating cash flow, if we're using TEV)
  • P / Cash Flow (this value of this metric can be obscured if a company has a lot of debt)

And, for more senior producers which consistently generate net income:

  • P / E

However, NAV, or Net Asset Value, is itself a loaded term: a NAV nominally represents the net present value of a mining asset, where the present value is represented by a DCF for the expected life of mine.

But a NAV is the product of a variety of assumptions, and you may find that different parties claim that a stock trading at a particular P/NAV have simply put different assumptions into what constitutes a NAV.

Before P/NAV can be assessed, we have to establish what a NAV is, and what affects our calculated NAV.

Reserves & Resources

A mining company's assets are evaluated on the basis of its reserves and resources. These are deposits which have been established with a level of geological certainty determined by a standards-setting body. The relevant regulation for Canadian mining companies must comply with is National Instrument 43-101 (NI 43-101). In Australia, the relevant body is the Joint Ore Reserves Committee (JORC).

An NI 43-101-compliant or JORC-compliant "resource" is a mineral deposit which has been penetrated by enough drills from enough angles to provide a regulation-determined level of certainty about the characteristics, such as its volume, grade, shape, deposit type, and depth/location of the deposit.

Although the standards required to comply with NI 43-101 and JORC are not identical, the capital markets usually assign a similar degree of value to compliance with either standard, with the former (NI 43-101) being more common for Canadian mine developers and the latter (JORC) being more common among Australian mine developers.

National Instrument 43-101: Levels of Certainty and Building a NAV:

National Instrument 43-101 (NI 43-101) encompasses three salient categories encompassing only two levels of geological certainty of a mineral resource.

Inferred Resources: These are the deposits known with the lowest degree of certainty permissible to still be compliant NI 43-101. "Inferred" is a misleading term, as inferred resources are not "guesses". For a deposit to exhibit an "inferred resource", it must have had numerous drills poked through it from various angles.

Measured & Indicated Resources (M&I): M&I resources are known with a greater degree of geological certainty than Inferred resources. An Inferred resource can become an M&I resource if additional drilling further confirms the size and quality of the deposit.

Proven & Probable Reserves (2P): 2P resources, known as "reserves", are interpreted by capital markets as comprising a superior quality resource than an M&I resource. However, they are not in fact resources which are known with greater geological certainty than M&I resources. Rather, an M&I resource can "graduate" to a 2P resource if an engineering firm has built a mine plan on the basis of an M&I resource. If, given the engineers' assumptions, it would be profitable to build and operate a mine, the mineral resource then becomes known a mineral reserve.

To create an NI 43-101 compliant "reserve", the engineers take an existing "resource", determine the cost of all of the equipment and personnel required to build a mine, evaluate how much they can extract per year from the deposit, and then sign off on it being classified as a "reserve".

Thus, a reserve is a resource which has been determined to be economically logical to turn into a mine.

It is a reserve which typically allows a NAV to be constructed.

Inferring a NAV

Most NAVs are constructed on the basis of an NI 43-101 compliant "reserve". However, for companies which lack an NI 43-101 compliant reserve, certain investors will infer their own NAV on the basis of an NI 43-101 compliant "resource", and some will make even more assumptions on the basis of just a few drill holes and knowledge of the surrounding geology.

NAV Sensitivities:

We believe that this is the most commonly misunderstood component of a NAV. Failing to communicate one's NAV assumptions can lead to a given equity price being interpreted as implying a different P/NAV to different market observers.

There are many moving parts, timelines, and political considerations required to determine the speed and cost of developing a mine. However, to assess purely the NAV itself, the most important assumptions to reconfigure are:

  1. Resource Price over the Life of Mine
  2. Initial Mine Development Capital Expense
  3. Fuel Costs
  4. Labour Costs
  5. Discount Rate

We will create and demonstrate a mine model and show all of the assumptions, and we will test all of these sensitivities to show how radically the NAV can vary by tweaking one or more of these assumptions.

Corporate NAVs versus Asset NAVs

When looking at a P/NAV for a single-asset mining company, we must remember that a mining company is a corporate entity, not simply the asset itself. Thus, we must remember to adjust the NAV by adding all cash and equivalents to the NAV, and subtracting all liabilities which are not inherent parts of the operation of the asset NAV (e.g. debt).

In the case of a mining company with multiple mining assets (e.g. ABX, Newmont, or Goldcorp), the NAV upon which the P/NAV is established is the sum of the individual project NAVs, and then adjusting it based on the corporate-level characteristics such as cash and debt.

Timing Is Everything: Delays Reduce NAV

Another category which can affect the NAV of a mine developer is a delay in the project. Because a NAV examines discounted cash flows which will be coming from the mine, even if the project economics remain fundamentally unchanged (i.e. resource prices, fuel costs, capex), merely delaying the project will decrease the NAV. This occurs because the payments will begin at a later date relative to the initial capital outlay used to build the mine. The more distant cash flows are worth less simply because they begin to occur at a later date, despite having the same dollar value.

Examining a NAV:

Here we have designed a very simple NAV model and shown all of our assumptions. Underneath we show the NAV sensitivity to a variety of the factors we have discussed.

For the purposes of this simple illustration, we assume all taxes are cash taxes. In reality there would be different tax and book depreciation, which would defer taxation until the later years of the mine. Since we discount future expenses which happen later, deferring taxation to a later date has the effect of increasing the NAV.

Hedging Energy/Fuel costs:

Due to their sensitivity to fuel prices, mining companies often seek methods of hedging their energy input costs.

Hedging is most relevant in cases where the metal being produced by the mine is strongly correlated with energy prices. Copper is one such metal; since copper and energy prices are positively correlated, some copper companies will find it hard to become more profitable even when copper prices rise, as their fuel costs may escalate by a commensurate amount.

The precise economics of a particular mine will determine whether or not correlated prices of the metal produced by the mine and energy costs will have a material influence. Mines with low cash costs will be insulated to a certain extent, as the increase in revenue owing to an elevated price of the produced metal will be far more helpful than the increase in energy costs will hurt.

One method of hedging one's business to the price of fuel is to purchase an oil hedge. However, oil hedges are usually short in duration, and it is not often practical or even feasible to hedge for an entire life of mine.

Another method of hedging a mining company to energy prices -only available to large, senior, profitable metal producers- is to purchase energy-production capacity. The mining company then has an embedded energy company within it, whose energy production is used to offset the rise and fall in fuel prices experienced by the mining operation. The energy produced need not be actually used by the mining operation; rather, the energy is sold into the market at market prices, which offsets the cost of buying energy at the various mining project operations, which are usually in multiple geographies.

Other Miscellaneous Mining Stock Price Catalysts:

Understanding an asset NAV is not sufficient to invest in mining companies. If the NAV were all that mattered, we would not expect mining company equities to be so volatile in the absence of a change in the fundamental drivers (e.g. a rapid swing in commodity prices).

A handful of other drivers which cause stock price swings in mining companies will be mentioned here, although this list is by no means exhaustive:

  • Awaiting Drill Results: Impact uncertain; sometimes trading volumes will decline until the drill result is announced. On other occasions, funds that believe they have good insight into how good the results will be before seeing them will load up if they expect a positive surprise relative to what they believe the market is pricing into the equity price.
  • Awaiting Declaration of Resource/Awaiting Resource Statement: This is an important step and represents a catalyst for mine developers. Once the reserve is announced, assuming it meets the market's expectation of size, grade, and ease of access, the stock will tend to rise.
  • Awaiting Declaration of a Mine Plan/Awaiting Reserve: This is another important step and represents a catalyst for mine developers. Once the reserve is announced, assuming it meets the market expectations, the stock will tend to climb, unless this has already been priced in.
  • Awaiting Approval/Regulatory Hurdle (e.g. environmental assessment): The regulatory process for mine development is long and has many steps, depending on jurisdiction. When the market is anticipating an approval, potential investors may wait until the approval is announced before buying stock.
  • Lock-Up Period Ending: If a financing has recently been conducted, and the newly-issued shares have a lock-up period, this can depress the equity price. This is because prospective new investors won't want to buy until they know the market won't be flooded with supply of stock once the lock-up period ends. This is basic economics; supply and demand. When the supply of tradable shares is going to increase by a significant degree (due to the ending of a lock-up period), it often makes sense to wait before purchasing until the new supply has come online.
  • Expectation of Delay: If delays are expected in the construction of a mine, or in the permitting process, this will have a negative impact on the equity price.
  • Expectation of Capex Increase/Overrun: If a project under development ends up costing more than the market expected, this will have a detrimental effect on the equity price. This is more pronounced when a developer runs out of money part way through development of an asset due to an unexpected overrun, as it now needs to go back to the market to raise more equity (or in some cases, debt or conduct an off-take) to continue to finance development of the asset.
  • Financing Required: If a mining developer is running low on cash and requires financing, this will usually depress the stock price. Since equity raises are typically performed at a discount to the market price, investors will be weary of dilution and will shy away from the company until a deal is performed.
  • Strike: A strike at the mine which halts production will have a detrimental effect on the business and on the equity.
  • Operating Target Miss: Missing operating targets, due often to experiencing a lower-than-anticipated ore grade or equipment failure, is usually going to have an impact on the stock price, but the severity, implication, and expected duration of the issue will determine how significant this is.
  • Non-Operating Earnings Miss (for senior producers only): This is a rarer occurrence than an operating miss. This can occur if, for example, a senior producer experienced a higher-than-anticipated tax rate during a quarter, it can miss expectations and this might cause the stock to decline.

Important in all this is liquidity; the market for senior mining equities (e.g. BHP Billiton, Rio Tinto, Anglo-American) is deep, but when trading small and micro-cap miners, you can pay a hefty premium (or accept a hefty discount) to get in (or out) of the name. If you're a retail investor and lack a trading terminal such as Bloomberg or ThomsonOne, make sure you at least attempt to get a sense for the bid-ask spread and depth of the market with your trading program, and determine the number of shares for sale / looking to be purchased at a given price.

Disclosure: I am long ABX.