re: broker report extreme

Morningstar's Recommendation: Gindalbie Metals Ltd

Recommendation: Extreme

Gindalbie?s principal asset is a 50% stake in the Karara iron ore project, a joint venture with AnSteel, China?s second largest steel producer. Production of magnetite concentrate started towards the end of 2012 with attributable iron ore production of five million tonnes a year expected in fiscal 2014. The Karara project is well developed placing Gindalbie ahead of Midwest peers. The Western Australian state governments desire to increase Midwest iron ore production provides good support. Single commodity focus and exposure to Chinese steel demand makes this a speculative play only suitable for risk tolerant investors.

Event04-Jun-2013
Gindalbie Metals’ share price slumped to its lowest level since 2005 this month, some 95% below the 2007 peak and implying a market capitalisation of just AUD 164 million. The market capitalisation is well below the book value of its 50% stake in the Karara iron ore mine, worth AUD 650 million as at 30 June 2012. More has been spent on the project since but capital expenditure simply isn’t being reflected in Gindalbie’s share price. Key concerns are that both Gindalbie and Karara are dangerously low on cash, raising the prospect of a dilutive equity issue.

Business Impact: Our base case scenario assumes short term funding issues are resolved without equity being issued however the risk of dilution causes us to increase the fair value uncertainty from very high to extreme. In addition, problems with the mine ramp-up mean we reduce our fiscal 2013 net profit forecast from AUD 48 million profit to a AUD 25 million loss. Single commodity exposure, extreme operating leverage and extreme financial leverage mean small changes to financial model assumptions have large impacts on our fair value estimate. Our fair value estimate falls 25% to 0.20 per share but we stress that fair value uncertainty is extreme.

Forecast Impact: --

Recommendation Impact: Extreme levels of risk means Gindalbie shares are only suitable for highly speculative investors.

Event Analysis
Gindalbie Metals’ share price slumped to its lowest level since 2005 this month, some 95% below the 2007 peak and implying a market capitalisation of just AUD 164 million. The market capitalisation is well below the book value of its 50% stake in the Karara iron ore mine, worth AUD 650 million as at 30 June 2012. More has been spent on the project since but capital expenditure simply isn’t being reflected in Gindalbie’s share price. Key concerns are that both Gindalbie and Karara are dangerously low on cash, raising the prospect of a dilutive equity issue. Our base case scenario assumes short term funding issues are resolved without equity being issued however the risk of dilution causes us to increase the fair value uncertainty from very high to extreme. In addition, problems with the mine ramp-up mean we reduce our fiscal 2013 net profit forecast from AUD 48 million profit to a AUD 25 million loss. Single commodity exposure, extreme operating leverage and extreme financial leverage mean small changes to financial model assumptions have large impacts on our fair value estimate. Our fair value estimate falls 25% to 0.20 per share but we stress that fair value uncertainty is extreme. As a high cost producer, Gindalbie has no sustainable competitive advantage, or economic moat. Returns on invested capital (ROIC) are likely to be very poor due to the high up front capital cost to build a magnetite iron ore mine. At the root of funding problems is the delay to Karara’s cash flows following the start of iron ore production last October. Gindalbie expects the mine to be cash flow positive in the September quarter but debt repayments start in November and look unachievable. Negotiations with lenders to restructure the debt repayments are underway. We expect lenders to allow Karara to repay interest only until it has sufficient funds to repay principal also. With USD 2 billion of debt outstanding at the project level, lenders need Karara to succeed. Excessive penalties will only be counterproductive. Repossession of the USD 3 billion, Australian based, project by Chinese banks could have geopolitical ramifications and is highly unlikely. And besides, an uneconomic iron ore mine in the middle of the desert is unlikely to have many alternative uses or much of a resale value. The lines between major shareholder, Ansteel, the Chinese government and Chinese lenders are somewhat blurred. Their collective priority appears to be diversification of iron ore supply away from the majors, BHP, Rio Tinto and Vale, and towards Chinese controlled projects such as Karara. Interest rates, of below 3% per annum, don’t adequately compensate for risks and we caution that iron ore production appears to take precedence over profitability and debt repayment.

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We estimate Gindalbie has around AUD 10 million in cash, insufficient to fund much beyond head office costs of around AUD 1 million per quarter. Liquidity will improve when the AUD 30 million loan, made to Karara last month, is temporarily repaid. Repayment depends upon Foreign Investment Review Board (FIRB) approval and could ultimately dilute Gindalbie’s shareholding in Karara to below 50%. We expect approval to be granted but to avoid dilution Gindalbie may need to issue equity to fund a new loan to Karara. Our base case scenario assumes Karara’s profits prevent dilution from occurring.

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Karara looks set to reach production capacity of 8 million tonnes in July. Initial concentrate grades were below our expectations but are likely to reach 68% iron from July with full plant commissioning. However, ramp up difficulties mean fiscal 2013 concentrate production and grades will be less than expected. Hematite production will exceed our forecast but grades are lower. The net result is a reduction to our fiscal 2013 net profit forecast from a AUD 48 million profit to a AUD 25 million loss. We also take a more conservative approach to fiscal 2014 forecasts but leave long term assumptions unchanged. Until Karara establishes its cash cost profile our forecasts have a very high degree of subjectivity. Cash costs could easily vary from company guidance, ‘all in’ costs, to the net profit level could be much higher than we expect and free cash flow (operating less investing) could also contain negative surprises. Ultimately, the key driver of Gindalbie’s share price will be the iron ore price, cash costs and the AUD/USD exchange rate. For those bullish on iron ore and China, Gindalbie offers highly leveraged exposure. The share price could easily double from current levels, around AUD 0.11 per share, and may be underpinned by the prospect of a takeover by Ansteel, but risks are extreme. Our primary concern is that Karara’s cost will be higher than expected and production difficulties will cause weak cash flows, funding difficulties and dilution of Gindalbie’s shareholding. In our bear case scenario, Karara fails to reach consistently profitable iron ore production resulting in regular cash calls and dilution of Gindalbie’s stake to zero. Under this negative scenario, Gindalbie also fails to sell its Loadstone iron ore deposit or develop the Shine deposit and we attribute the shares no value. In our bull case scenario, Karara successfully ramps up to nameplate production capacity and magnetite concentrate grades reach 68%. In this optimistic scenario, we assume a long term iron ore price of USD 110 per tonne (delivered China, 2013 prices) and a gross profit margin of around AUD 50 per tonne. Under this scenario, our fair value rises to 0.80 per share and indicates the extreme sensitivity of our fair value estimate to small changes in our assumptions.