article

Is Iron Road's Central Eyre Iron Ore Project Attractive Now?
Jan. 6, 2014

http://seekingalpha.com/article/1930011-is-iron-roads-central-eyre-iron-ore-project-attractive-now

Introduction

In this article I'll have a closer look at Iron Road (OTC:IRNRF), an Australian iron ore company with a market capitalization of $151M. Iron Road plans to develop its Central Eyre Iron project in South Australia. I will provide an overview of the project where after I will try to calculate how the project will hold up based on different assumptions.

Thereafter I will focus on the potential risks involved with an investment in Iron Road (or iron ore in general), which will result in my investment thesis at the end of this article after explaining how the project might be financed.

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As trading in Iron Road shares is quite limited on the US exchanges, I'd strongly recommend to trade in Iron Road through the facilities of the Australian Stock Exchange, where the company is listed with IRD as ticker symbol.

Executive Summary

In this article I will prove that even though the head grade of the Central Eyre Iron Project is just 16% Fe (which is quite low for an iron ore project), the CEIP will produce a concentrate grading 67% Fe which might be very attractive to its potential end customers.

I will explain why I think the definitive feasibility study might positively surprise shareholders as it will incorporate an expanded resource estimate and will be built in modules which should reduce the initial capital expenditures. However, the initial capex will remain the big hurdle, and I hope Iron Road will find a suitable partner with deep pockets to jointly develop the project. I think there's a high chance of success of finding such a partner, as Iron Road's end product is highly sought after by blast furnace steel mill customers.

2014 will be an important year for Iron Road and if the DFS confirms my expectations and if Iron Road is able to secure a partner for the project, the share price should be trading much higher than where we're at today.

The Central Eyre Iron Ore Project: A background

The company's Central Eyre Iron Project ('CEIP' from here on for simplicity's sake) is located on the Eyre Peninsula in South Australia approximately 100 miles away from Sheep Hill, where Iron Road plans to build a port facility.

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The project already has a very large resource estimate of 3.7 billion tonnes of ore at an average grade of 16%Fe. This might sound low, but Iron Road was able to produce a concentrate with an iron content of 67% Fe after conducting metallurgical test work. So even though the deposit is low-grade, a saleable concentrate can easily be achieved. On top of the current 3.7 billion tonnes of iron ore, Iron Road estimates an additional 8-17 billion tonnes of mineralized ore could be found on the property. Keep in mind this is just an internal estimate, and no guarantees can be made to effectively find an additional 8-17 billion tonnes.

The project is quite advanced, and a pre-feasibility study which was completed in 2011 outlined a production scenario of 12.7Mt per year of concentrate grading 67% Fe. The main hiccup will be the capital expenditures which came in at approximately $2.3B (including a 15% contingency). However, Iron Road is in the final stages to complete a Definitive Feasibility Study which is expected in the first quarter of this year. It's extremely likely the base case output will be increased to 20Mtpa which should bring additional economies of scale which should offset the higher initial capital expenditures.

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Playing with some numbers

In this paragraph I will tweak some numbers from the PFS to make a back of the envelope calculation of the updated NPV based on the new mining scenario. The initial capital expenditures in the PFS were estimated at US$2.35B, and one would think that this initial capex would increase as the throughput is expected to increase by 66%. However, in the latest update on the Definitive Feasibility Study ('DFS'), the CEO of Iron Road stated that the 'modular enhancements would reduce the capital expenditures'. The main question now is what kind of throughput each module will have, and that's what the uncertain factor in my assumptions is. I will start with an initial capex of $1.9B for a 10Mtpa output with subsequent additional incurred expenditures of $300M to add another 5Mtpa module in year 2 and 4 to reach an output of 20Mtpa in year 5. Again, these are just ballpark numbers, and we'll have to wait for the DFS results to see if this model is somehow representative or needs additional work.

The main reason for the capex reduction is the removal of a $420M cost for the pump stations of the slurry which was planned to be built. Under the new plan, Iron Road is looking into building a scaleable railway from the project to Cape Hardy where IRD plans to build its own port facility with a 30Mtpa export capacity. This would be the first port capable of handling Capesize vessels. This is extremely important, as using Capesize vessels (capacity: 100,000tonnes) have a lower transportation cost per tonne compared to for instance Supramax vessels (50-55,000 tonnes).

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I will use an opex FOB of $65/t for the 10Mtpa operation, decreasing to $60/t for a 15Mtpa plant and $55/t for a 20Mtpa plant from year 5 on. I will deduct a sustaining capex of $50M per year, $20M in exploration expenditures and G&A and interest expenses of $75M per year in the first six years of operation which will be replaced by further exploration expenditures from year 7 on. The used tax rate is 30% and the discount rate is 8%. In the following paragraph about the risks of investing in Iron Road I will explain why I feel comfortable using a discount rate of 6%. An initial mine life of 25 years will be used.

Let's see how things look using the current iron ore price of $135/t. I am assuming a FOB price of $105/t which is relatively conservative compared to the benchmark price. If everything would stay the same as today, the expected FOB price would be approximately $120/t.


So at the current iron ore price and expected mine life, the after-tax value of the project is a whopping $3.4B, which is much higher than the $1B in Iron Road's PFS. So what's causing this difference? First of all the gradual increase to 20M tonnes will be funded through internal cash flow. On top of that the 20M tpa production rate will have a huge influence on the Net Present Value. On top of that, my calculation is based on the current resource estimate which contains 3.7 billion tonnes of ore (of which approximately 3 billion tonnes will be processed), whereas the PFS was based on a resource estimate of 'just' 1.2 billion tonnes.

Unfortunately, I'm not convinced the iron ore price will stay at this level, and in the following calculation I will assume a FOB price of $85/t, which would correspond to a benchmark price of approximately $95/t.

Under my conservative scenario, the after-tax NPV decreases to $855M. If I would have to give a weight to both scenario's I'd use a 80/20 ratio in favor of the 'pessimistic' scenario. This ratio would result in a fair value of $1.35B, or $2.31/share.

So why are the shares not trading at $2 already?

Well, the market is obviously waiting to see the results of the definitive feasibility study, and let's not forget the initial capex of roughly $2B will be the main hurdle and might actually kill the project if the iron ore price deteriorates.

As I will explain in a later paragraph, I don't believe Iron Road will be able to raise the money on its own, and will look for a partner to help financing the project. Ultimately, I think Iron Road will end up with 50% of the project which would reduce the fair value to $675M. If IRD would have to issue, say, another 100M shares (raising money to bridge the gap between today and the start of the cash flow, assuming the incoming partner takes care of the equity part of the financing)), the fair value per share would be $0.95.

The main risks of investing in Iron Road

The first risk accompanying this project obviously is the iron ore price. Whilst the project definitely is viable based on the current iron ore price of $135/t, it's already more difficult based on an iron ore price of $90/t. Timing will be extremely important, as I believe this project will be funded as long as the iron ore price remains at the current levels. However, should the iron ore price drop between now and the date when funding is needed, potential partners and financiers might scratch their heads before committing. So the faster Iron Road advances, the better for the company.

A second risk could have been the geopolitical risk, but as Australia is a first world country and already a leading iron ore exporting nation, I think the geopolitical risks in Australia are low. On top of that, according to this filing of the South Australian government, the local government has given Iron Road's infrastructure plans the status of 'major development' and it looks like this means the CEIP and the infrastructure to link it with a new deep sea port at Cape Hardy will receive the thumbs up from the local government. This is the main reason why I feel comfortable using a discount rate of 6% instead of 8% or 10%.

How will this project be financed?

Iron Road thinks a 70/30 debt/equity ratio is achievable, and I tend to agree, as the rule of thumb usually is 2/3rd debt and 1/3rd equity. This means that the initial capex of $1.8B requires Iron Road to find $600M in equity. Another severe share dilution by issuing more shares is possible, but Iron Road is also mulling the possibility to sell a stake in the project to a potential partner (probably with deep pockets).

I strongly believe this is very likely the best way forward, as a buy-in from a partner would bring in a lot of cash into Iron Road's treasury and reduce its share of the capex. On top of that, if the partner would for instance be a Chinese steel company, it's very well possible the partner will also bring the entire amount of debt financing with it in a deal. So I am expecting some kind of strategic deal with an Asian steel company after the results of the feasibility study will have been released.

Chinese companies are keen on Australian iron ore as the shipping distance to the Chinese mainland from Australia is relatively short (much shorter than for instance shipping the ore from West Africa, Canada or Brazil which reduces the shipping cost. On top of that, I also think Iron Road's end product will be sought after, thanks to its relatively high grade of 67% Fe which should yield a decent premium over the benchmark price which is based on iron ore with an iron content of 62%Fe.

However, the possibility to sign up a partner for the project will be depending on the outcome of the feasibility study and the iron ore price at the moment. But as the CEIP looks viable at the current price and even at lower prices, I think the project has a good chance to be developed. On top of that, the additional exploration target of 8-17 billion tonnes might extend the mine life by another few decades, which might charm a prospective partner with deep pockets who would be willing to cough up the money to gain access to a long term iron ore offtake agreement.

Investment Thesis

Australia seems to have more iron ore projects than inhabitants, and Iron Road's project seems to be one of the weaker links in the iron ore production chain as its head grade has an iron content of just 16%. However, metallurgical studies have proven that its CEIP is able to produce a concentrate with a high 67% Fe content which will be welcomed in China.

The main problem with Iron Road is that it's highly unlikely the company will be able to secure funding for the project on itself, and that a suitable partner will have to be found. That's why it's imperative Iron Road works as fast as possible to complete the DFS and negotiations with prospective partners. If the iron price remains at the current level, I don't think Iron Road will have difficulties in finding a partner for the project. However, should the iron ore price dip again, potential partners might prefer to wait a bit on the side lines.

And I'd like to repeat again that the numbers I used in my calculations aren't 'fixed' and might need to be updated which I intend to do when Iron Road releases its study. At this stage and taking a 50% ownership of the project into consideration, I would use a ratio of 0.3X the after-tax NPV as price target, which would result in a price target of $0.29 which is approximately 10% higher than the current share price. If the DFS comes in in-line with my expectations I would raise the ratio to 0.4 which would increase the fair value per share to $0.39. The main catalyst will be to secure a partner which will fund the project towards production. If this could be achieved and construction starts, I would aim for a target price based on 0.7X the NPV which would result in a target price of $0.67.

Also keep in mind the company has approximately $45M in cash right now, which equals to a cash value per share of almost $0.08.