In this article, I'll have a closer look at Mount Gibson Iron (MTGRF.PK), which is an iron ore producer in Western Australia. It currently ships DSO iron ore from three different projects.
I will start with an overview of the company and will give a summary of its three operating mines. Thereafter I will have a look at the financials of the company to determine how viable its business is and if the company would be able to withstand a lower iron ore price. I will also talk about the influence on the production and cash flow when the Tallering Peak project will no longer produce iron ore from FY 2015 onwards. I will also make a case why I think Mt. Gibson Iron might be interested in one of Iron Ore Holding's projects to maintain its production profile down the road.
As the company is a steady dividend payer I will determine whether or not the dividend will be sustainable after the production cut. This will result in my investment thesis at the end of this article.
As trading on the US Exchanges is quite limited, I would strongly recommend to trade in Mt. Gibson Iron-shares through the facilities of the Australian Stock Exchange, where there is an average daily volume of 5.5 million (!) shares.
Where necessary, I used a USD/AUD conversion rate of 1.06 in this article.
Executive Summary
In this article I will provide proof that the market is currently valuing Mount Gibson solely based on its reserves and does not take any of its resources into consideration. I calculated the NPV5% of the reserves and found that the company is trading at 95% of its Net Present value, which indicates the market does not believe Mount Gibson will be able to convert resources into reserves.
In my second NPV calculation whereby I extend the Extension Hill mine life by 6 years and the Koolan Island mine by 3 years (which is still a conservative scenario as Koolan has resources for another 10 years and Extension Hill for 3 years but with upside exploration potential), I end up with a value closer to A$1 ($0.94)/share, meaning the company is trading at a discount of approximately 30% (based on relatively conservative parameters) and using a declining iron ore price in my calculations.
As Mount Gibson has a cash pile of almost A$400M ($375M), the company will very likely go out for some 'project hunting,' to put its cash to work. If Mount Gibson could do an accretive acquisition, the updated NPV will obviously be higher than it currently is. I expect a project acquisition to be one of the next catalysts, as Mount Gibson will have to have a plan ready to keep its production rate at the promised 7Mtpa for the foreseeable future.
Mount Gibson Iron is a perfect company for people who believe the iron ore price will decrease less than 20% in the next year and who believe the company will be able to convert (a part of) its resources into the reserve category. The company is currently trading at $0.66/share, and I would be interested to buy shares from $0.60 on, as that would mean the NPV/share as per the second calculation would be 66% higher than the share price.
Business overview
Producing mine 1: Tallering Peak
The Tallering Peak mine is entering its final year of production as the T1 deposit will provide the company with an additional 1-year mine life based on the current reserve estimate. The total production is expected to be 2.5 million tonnes, of which 700,000 tonnes will be lower-grade material.
Producing mine 2: Extension Hill
Mount Gibson's second operating mine is the Extension Hill mine, which is located approximately 160 miles southeast of Geraldton in Western Australia. The production at Extension Hill was a bit lower than the previous year because the company was focusing on decreasing the stockpiles, which had built up the previous operating year due to logistical constraints.
I would like to highlight the fact the company was able to sell 176,000 tonnes of iron ore under a 'mine gate' sales agreement, whereby a third party bought the ore 'at the mine gate' and railed it to its own port facilities. This agreement provided the same operational margins for Mt. Gibson as if it would have shipped the ore to its own port facility.
The Extension Hill mine still has 12.2M tonnes in reserves, which provide for a remaining life of mine of three years, as the company's rail capacity is constrained to just 3Mtpa and this is the annual output I will use in my financial model.
Even though the remaining life of mine is just 4 years, I feel confident the company will prove up an additional tonnage of DSO as Mt Gibson considers the region around Extension Hill to be very prospective. The company has applied for drill permits to drill no less than three high-priority drill targets to test potential DSO mineralization and even if just one of these targets will be drilled with success, the life of mine could be considerably extended. I will however base my calculations on the remaining reserves.
Producing mine 3: Koolan Island
Mt. Gibson's third operating mine is the Koolan Island mine in the northern part of Western Australia. Kooland Island has been in production since 2007 (when Mt. Gibson bought the mine which was a past-producer between 1965 and 1993), and the company is ramping up its production rate to 4Mtpa which should be reached by the end of next year. Last year's production was 3.5 million tonnes, and in my financial model I will use this production rate for the first two years moving to 4Mtpa thereafter.
The remaining life of mine at Koolan Island is just 7 years based on a 4Mtpa operation, but I'm confident the company will be able to convert resources into reserves, which would allow the mine to continue for another decade.
How much money does Mt. Gibson make?
Looking at the financial results of the 2012-2013 financial year, Mt. Gibson recorded a revenue from operations of A$852.9M ($802M) on a total production volume of 8.8M wmt. This means the company sold its ore at an average price of 'just' A$97.5/t ($92/t). This seems to be quite low, but this includes the sale of 700,000 tonnes of low-grade iron ore, which was previously considered to be mining waste. So this will definitely have had some influence on the average received price. Another major factor was the much stronger Australian Dollar.
Mt. Gibson recorded a net profit of A$157.4M ($148M), or almost 14 cents per share, meaning the company is currently trading at just five times its 2013 net profit. Even better, if I look at the Enterprise Value (as opposed to the market cap), Mt. Gibson is trading at just 3.5 times its net profit, which is extremely low.
My cash flow analysis and NPV calculation for the remaining mine of life
In this cash flow analysis I will have to make some assumptions as Mt. Gibson's production rate will show a lot of fluctuations over the next few years. For starters, I will use an output of 9Mtpa in 2014, decreasing to 6.5M tonnes in 2015-2016 and to 4 million tonnes until 2020.
As Mt. Gibson will again sell mine 'waste' as ore this year, I don't think the received price will be very different from last year and I'm counting on a received price of A$100/t ($94/t). Even though from next year on the average received price will increase as the company will stop selling the low-grade ore, I will keep the expected received price at A$100/t to reflect my expected lower iron ore price. From FY2017 on I will use a price of A$90/t ($85/t) until 2020.
The costs in 2014 were A$79/t and I will keep this number stable at A$80/t ($75/t) until 2015, as every increase in average grade (after the decision to stop selling the lower-grade ore) will be countered by the fact that the overhead costs will have to be spread out over a lower annual production. From 2016 on, I will use a production cost of A$75/t ($70/t) to reflect the lower transportation costs, as the Koolan Island project (which will be the only producing asset at that time) is located directly at a port which will greatly reduce the transportation costs.
As the company is already in production and Australia is a safe country, I will use a 5% discount rate (and a 30% tax rate) for my calculations. I will use an allowance of A$40M ($37M) per year for the combination of G&A expenses and exploration expenses. The company will also have to decrease the book value of its assets and I will use a straight line depreciation of the current A$820M ($770M) over 7 years, or A$130M ($122M) per year. This means the company will not pay income tax anymore from this year on. This is obviously a theoretic model, as if more iron ore will be found, the book values won't decrease this fast.
So based on this model, the remaining after-tax NPV5% of Mt. Gibson iron ore operations is A$500.3M ($470M). If I add the current working capital position of A$317M ($298M) (the current working capital position minus an allowance of A$100M ($94M) to cover the remaining long-term liabilities, the total value of the company would be A$817M ($770M). this means that at the current share price, the company is trading at 94% of its theoretical net present value based on my assumptions.
So at this point I don't think an investment in Mt. Gibson Iron will be very accretive, but keep in mind this NPV is solely based on the reserves and does not include any resources. If the company would be able to convert some of its resources into the reserve category, things could change dramatically. In the next situation I will add an annual production of 2.5Mtpa from 2017 on, which is not unthinkable if the company has exploration success at Extension Hill and is able to continue this production profile until 2023 (and spreading out the tax advantage over 10 years).
So suddenly the after-tax NPV increases by more than 50% to A$768M ($722M). If I would now add the net cash position of A$317M ($298M) again, the fair value of Mt. Gibson Iron would be A$1.08B ($1.02B), or approximately A$1.00/share ($0.94).
So basically, investing in shares of Mt. Gibson Iron is betting on the fact the company will be able to increase its reserve base to continue a steady production rate of 6.5-7Mtpa for the next decade.
In my opinion, it's extremely likely the company will increase its reserve base, and I would think this second NPV scenario will be closer to the truth. On top of that, the company could spend its current net cash position well by acquiring another project, which could be accretive for the Net Present Value.
At this moment, the market is valuing Mt. Gibson as if it will not increase its reserve base, and that's where the opportunity is.
How will Mt. Gibson increase its production numbers again?
It's obvious Mt. Gibson will have to acquire a new project to maintain its production rate at 7.5Mtpa from 2017 on, when the reserves at the Tallering Peak and Extension Hill mines will have been depleted. I'm not sure its exploration projects around Extension Hill will be able to fill the production gap from 2017 (which starts on July 1st 2016, so in less than three years already) on, so I think Mt. Gibson will put its cash at work and acquire new assets.
It will be easier (and probably cheaper) to outright buy a project, and I think this will be Mt Gibson's preferred choice. In an earlier article on Seeking Alpha I discusses a prospect generator called Iron Ore Holdings, and I think there's a decent chance Mt. Gibson will do something with one of IOH's projects as the company already has a lot of expertise in Western Australia, where IOH's projects are located.
However, as Mt Gibson has increased its port capacity at Geraldton Port and has tripled its storage capacity to 360,000 tonnes, Mt Gibson will very likely first look for opportunities inside a 150-mile radius from the port as it would be very beneficial. Unfortunately, the rail capacity from its Extension Hill project is limited to just 3Mtpa, so even if more reserves would be found at Extension Hill, it doesn't seem likely Mt. Gibson would be able to increase the rail capacity to rail the ore to Geraldton port. A possibility could be to truck the iron ore to the connection point on the rail spur where the Tallering Peak Iron ore is entering the rail track towards Geraldton. As the distance would be less than 150 miles, this could be a feasible solution to increase the tonnage of Extension Hill.
The Dividend
Mt. Gibson seems to be position itself as a steady dividend payer, as it has been paying an annual dividend of A$0.04 ($0.0375) since 2011. This results in a current of 5.4%, which is definitely attractive. As it's a franked dividend, there is a dividend tax advantage.
I don't think Mt. Gibson will increase its dividend before it has a decent plan to bring its production rate back up to 7-8Mtpa in 2017. Only when that issue will have been solved and when the mine life of the other projects will be prolonged, a dividend increase could be considered.
So whilst one could now definitely enjoy a 5.4% gross dividend, I wouldn't count on a dividend raise anytime soon. The company has been paying A$0.04 per year for three years in a row now, and it looks like it wants to keep the dividend leveled at this point. The current payout ratio is 29%, so Mt. Gibson will definitely be able to keep its dividend covered.
Investment Thesis
Even though Mt. Gibson is currently trading at fair value if you base the calculations only on the reserves in the ground, I think the market is underestimating the potential of unlocked value at its current properties through thorough exploration. I strongly believe the company will be able to convert a large part of its resources into the reserve categories and its current NPV is in excess of A$1.1B ($1.04B).
For investors who are optimistic about the iron ore price, Mt. Gibson could be a golden opportunity to take advantage of a market, which doesn't believe the company will be able to replace its current reserves. The share price could easily increase by 50% if the company is able to replace the current reserves and if it puts its cash to work so it will be accretive to the earnings later on. Meanwhile, the 5.3% dividend yield will keep most investors happy.
I won't initiate a position in Mt. Gibson soon, but I might be interested at a share price of $0.60/share.
MGX Price at posting:
72.5¢ Sentiment: Buy Disclosure: Held
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