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    A stark choice
    Created: 7 November 2008 Written by: Martin Li
    Commodity prices have fallen from their heady heights of early 2008 and equity markets are still jittery, so many mining investors are seeking refuge in companies offering actual or near-term production and the security of cash flow.


    EXPLORERS OUT IN THE COLD

    Christopher Goss, head of business development, oil, gas, mining & chemicals at the International Finance Corporation - the private sector investment arm of the World Bank - describes junior mining companies as "key to the future global supply of minerals". Mr Goss expects global supply to be more constrained than demand, and that prices will stay relatively strong.

    However, the majority of miners on the Alternative Investment Market (Aim) are explorers. While both explorers and producers have seen their share prices beaten up of late, Mr Goss believes that the ones to recover first are likely to be the ones that can show early cash flow ie, producers.

    Where does that leave explorers? Mining projects have long lead times of seven to 10 years, and most Aim miners are years away from potential production. Exploration companies that require finance face a stark choice, particularly if they have suffered project delays or have otherwise failed to deliver on promises. With share prices continuing to be battered by recent sell-offs, they can either raise painfully dilutive equity - assuming investors are willing to follow their cash - or go bust or be taken over. Dr Brock Salier, mining analyst at broker Ambrian, puts it succinctly: "The pre-producers are gone."

    PRODUCTION IS KING

    As Dr Salier sees the situation: "Production is king. Potential is valued at zero in the balance sheet, as is probably anything more than a year away." Reaching production provides miners with obvious cash flow benefits and enables them to exploit commodity prices that, even after recent softening, remain high relative to historical levels.

    Nearing production also provides benefits as it systematically removes the many obstacles that stand between mining explorers/developers and commercial revenues. Such obstacles include proving that an ore body exists and can be commercially exploited, obtaining licences and permits, designing, funding and building the mine and processing plant.

    A key milestone in most mining projects is completion of the bankable feasibility study (BFS). This document sets out a mining plan describing available mineral reserves and resources, optimum extraction method given the scale and nature of the deposit (such as underground or open-cast mining), estimated mine life, plus capital and operating expenses. This information enables estimates to be made of a project's cash flows and therefore valuation, and helps potential financiers determine whether, and on what terms, they would be prepared to finance project development.

    On completion of a BFS, companies are generally still a year or two from first production. During this period, they will raise finance, build their mine, processing plant and any other necessary infrastructure, hire staff and agree sales contracts.

    MINING VALUATION CURVE

    The share prices of junior mining companies often follow distinct patterns as the company progresses through the development of a project, from first discovering an ore body, through BFS, financing, development and construction, through to ultimate start-up of operations.

    It's important to be clear about when exactly a mining company qualifies as being in production. Starting to dig a hole in the ground doesn't count. Analysts disregard earth-moving operations, no matter how large the hole. What they want to see is the processing plant switched on (referred to as 'commissioning') and producing saleable products such as copper, diamonds, gold or metal concentrate.

    Even after the most rigorous planning, it's not uncommon for companies to experience teething problems when first commissioning their plant - it can be difficult to synchronise flow rates through the various crushers and separators to optimise throughput. Share prices often dip during this period but generally recover once output is optimised.

    NEAR-TERM PRODUCING MINERS

    Below are several near-term mining producers (one is already in production and several more are commissioning) that offer good potential for valuation upside.

    Minera IRL

    Minera IRL is a producing gold miner whose share price has closely followed the predicted pattern. It floated on Aim in April 2007 and raised £11.4m to develop its Corihuarmi gold project high in the Peruvian Andes. The company obtained a dual listing in Lima in late 2007, which helped widen its investor base and secure local support for its operations.

    Minera is a rare example of a mining company that has overdelivered on its promises. It achieved first gold production in March 2008 and in the second quarter achieved production 34 per cent above target at costs 56 per cent below target, and achieved a grade 77 per cent better than in reserve calculations. The company was targeting production of 36,000 ounces (oz) by the end of 2008, but achieved that target within six months of starting operations. Minera is now generating around £1m of monthly cash flow. Although the official life-of-mine estimate is short at only four-and-a-half years, management is confident that current resources will enable this to be increased to around seven years.

    The mining and processing operations at Minera's Corihuarmi project are relatively simple, which has enabled it to avoid the teething problems that cause many miners' share prices to dip in the immediate aftermath of first production.

    Reaching first production is an important achievement, although the market demands continued development and growth if valuations are to continue to climb. This invariably means new projects. In Minera's case, new projects include several exploration prospects, of which Ollachea - which has been mined by local people and offers high potential for new discoveries - offers the biggest upside potential. Possibly even more exciting is the potential for mergers and acquisitions in Latin America. With many smaller exploration companies running out of funds, Minera, with production cash flows augmenting a strong cash balance, is well-placed to benefit. Broker Fox-Davies has set a 70p target price for the shares.

    DiamonEx (first production: Q4 2008)

    DiamonEx is in the late stages of commissioning its Lerala plant in Botswana, which will be the world's newest diamond producer and Botswana's first independent (ie, non-De Beers/government joint venture) diamond mine. Lerala is a stepping stone to growth for the company, and should make it cash-positive before the end of 2008. This will enable the self-financing of exploration activities that have taken a back seat while the company has focused on getting Lerala into operation.

    This is important because, like Minera's Corihuarmi project, Lerala is cash-generative but doesn't offer spectacular growth potential. DiamonEx, too, needs to apply cash flows to bring a larger project into production. This could be the Sloan pipe in the US, which could be in production in around two-and-a-half years, although the company first needs to complete a lengthy permitting process and prove its diamond exploration credentials. Broker Fox-Davies has set a 36p target price for the shares.

    Platinum Australia (first production: Q4 2008)

    Despite its name, Platinum Australia's principal projects are in South Africa. South Africa is the world's primary platinum province, although its output has recently been constrained by well-publicised power shortages and labour relations issues. Platinum Australia is just starting up its first project, Smokey Hills, which has a platinum resource of 1m ounces (oz) supporting a seven-year mine life, although there's potential to extend this. The company is targeting 95,000 oz of platinum a year through open-pit and shallow underground mining. Platinum Australia has its own stand-by generator at Smokey Hills, which can power both plant and mine.

    The company's major upside should come from its larger Kalplats project, which is currently in the feasibility study phase and could start production in late 2010 or early 2011. Kalplats holds a 3.4m oz resource along a 12km deposit. With the ore body boundary not reached either along its length or at depth, there's significant potential to expand this resource further. The company is targeting production of 280,000 oz a year from several open pits for at least 20 years before mining underground.

    Discounted Smokey Hills cash flows alone underpin most of the company's valuation. Adding in the production and resource potential from Kalplats, the valuation upside could be significant. Broker Goldman Sachs JBWere has set a 153p target price for the shares.

    Ridge Mining (first production: Q4 2008)

    Ridge Mining is close to bringing its first South African platinum project, Blue Ridge, into production. It is targeting first concentrate sales from late 2008, at an annualised rate of 149,000 oz of platinum group metals. The main outstanding concern is whether Eskom, the national power company, will be able to supply electricity before the end of November. Ridge has a back-up generator that can provide all its power requirements, although at higher cost.

    Once Blue Ridge has achieved steady-state production, management plans to enhance performance by re-treating tailings (residual material) and completing the acquisition of the neighbouring Millennium ground, which will increase output and introduce economies of scale.

    Ridge's second and much larger project, Sheba's Ridge, is at the feasibility stage, the major investment issues concern power availability (which might be less of a problem by 2012/13, when production is forecast to begin) and construction of a smelter in partnership with other local mining groups. Sheba's Ridge would represent a substantial open mining operation producing 23,000 tonnes of nickel, 11,000 tonnes of copper and 350,000 oz of platinum group metals. Broker RBC Capital Markets has set a 215p target price for the shares.

    Talvivaara (first production: Q4 2008)

    All systems appear to be go for Talvivaara's Finnish nickel project which, with 336m tonnes of ore, is one of Europe's largest nickel resources. Mining commenced in April after mine construction was completed on time and on budget. Materials handling commenced in July, following the start of the bio-heapleaching process. Construction of the metals recovery plant is on track for the planned October/November start up. With some 90 per cent of project costs already committed, there should be little room for cost escalation.

    Chief executive Pekka Pera asserts that nickel prices remain "very attractive to Talvivaara", despite recent falls causing the closure or postponement of some higher-cost projects. Talvivaara signed a co-operation agreement with stainless steel company Outokumpu to explore the feasibility of producing manganese at the Talvivaara mine. Broker Seymour Pierce states that "this metal stream could add significantly to the top line of an already attractive business". It has set a 420p target for the shares but adds that, with the improved earnings outlook, a higher level could be achievable in a brighter market.

    Coal of Africa (first production: Q1 2009)

    Coal of Africa is ideally placed to take advantage of sharply rising thermal (electricity generation) and coking (steel-making) coal prices, and to help satisfy South Africa's supply-constrained power market. And it is another company that keeps delivering good news. It recently started mining coal from its most advanced project, Mooiplaats, with revenues expected from spring 2009, and has around £100m in cash to help bring its second and third projects into production.

    Mooiplaats is a large thermal coal project close to the Camden power station owned by Eskom (the South African power company), which it can feed by conveyor. The Makhado and Vele projects in northern South Africa should each produce 5m tonnes of coal a year. ArcelorMittal, the world's largest steel manufacturer and only significant producer in South Africa, recently acquired a 16.6 per cent stake in Coal of Africa and agreed to buy 2.5m tonnes of coking coal annually with an option to increase this to 5m tonnes. Makhado production should commence in mid-2010.

    Output from Makhado and Vele had been expected to be limited to ArcelorMittal's initial 2.5m tonnes, due to port constraints in Maputo, Mozambique. However, the company has made good progress towards increasing this allocation, which should enable it to increase output and therefore valuation - potentially substantially - by adding exports.

    The company has regularly reported increases to its coal resources. The combined resource currently stands at more than 1bn tonnes of coal, although this has been defined on only small proportions of Coal of Africa's acreage and the company is targeting over 2bn tonnes of coal at Makhado alone. Broker Mirabaud Securities has set a 306p target price for the shares.

    EMED (first production: Q2 2009)

    EMED is making significant progress advancing its two major projects: the Rio Tinto copper mine in southern Spain and a gold project in central Slovakia. Permitting remains the main obstacle to restarting the sizeable Rio Tinto copper mine, which can be restarted within six months thereafter. Spain's economic woes have left the local government there under pressure to expedite the permitting of the mine, which could create hundreds of jobs. Managing director Harry Adams hopes to clear the most important stage of the permitting process before the year-end, and to complete the permitting process by January. This would enable mining to resume in mid-2009, which will transform the company's financial profile and add significant near-term value.

    Meanwhile, drilling at the Biely Vrch gold deposit in Slovakia continues to return positive results - which have to date indicated a substantial 1.2m oz of gold - although the company is undertaking further drilling to confirm this to industry-recognised Joint Ore Reserves Committee standards. The central Slovakian licences cover a gold district that could include a cluster of similar deposits. EMED has already discovered two additional deposits that could add significantly to the gold resource and therefore the company's valuation. Broker Fox-Davies has set a 109p target price for the shares.

    Centamin Egypt (first production: Q2 2009)

    In its Sukari project, Centamin Egypt has defined probably the best gold project on Aim, with analysts estimating the final resource could reach a very substantial 15m ounces. Mining is scheduled to start in the last quarter of 2008 and the company remains on track to begin commissioning its plant in the second quarter of 2009. The main item on the critical path is completion of the engineering drawings, which should be received shortly.

    Initial open-pit mining should yield 215,000 oz per year, to be followed by underground mining supplying an additional 130,000 oz a year from 2011. Additional open-pit capacity from 2013 should enable Centamin to achieve long-term production of 700,000 oz a year.

    Valuation upside arises from the increasing gold resource, commissioning of the plant and first production, and the increasing likelihood of a takeover offer. A project of Sukari's quality will definitely interest major mining groups. These trade on PE ratios of around 14-18, whereas analyst models forecast that Centamin will trade on a PE ratio of around six for the first four full years of production. Broker Ambrian has set a target price of 80p for the shares, equivalent to a PE ratio of around 10, which would be immediately earnings-enhancing for the acquirer and provide an attractive premium to Centamin's shareholders.
 
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