fundamental valuation of sundance

To aid clarity I’ve divided this note between fact and comment.

Fact: Sundance have said that they might have enough iron ore to produce $1b per annum for 20 years. This profit stream is based on earning $30 per tonne and producing 35 million tonner per annum. The $30 is based on revenue of $50/t and a production cost of $20/t. The production cost includes the cost of upfront capital (to fund rail, ports and mine).

Comment: The profit stream in future dollars is worth $20b. Allowing for risk and converting to current dollars, the profit stream is worth maybe $4-5b.

Fact: Sundance have said it will cost $2.7b to build the infrastructure they need (that infrastructure includes rail, port and mine). Recognising the development risk, Sundance added a $0.5b contingency. Including this contingency they think it will cost $3.2b.

Comment: This cost has risen from their initial estimate. That rise is pretty much in line with rising costs in the rest of the industry. The Board is well qualified to assess the risks associated with the build. $3.2b to $3.5b is probably reasonable.

Fact: A Japanese steel producer has just agreed to a 65% increase in contract iron ore prices, reflecting high spot prices.

Comment: Despite rising iron ore prices for some years, the industry hasn't been able to supply enough iron ore. China needs enough iron to bring 1.3b individuals into the industrialised world. India will do the same. Why hasn't the mining industry been able to supply enough iron ore? It's not because they haven't been trying - BHP and RIO are investing billions. That suggests that the supply side restrictions are real and difficult to overcome. Growing demand and supply restricted by bottlenecks means structural upward pressure on iron ore prices for at least 5 years, probably two decades (the time required to build the infrastructure China needs). [Trivia point: China is building 100 airports between now and 2020, heaps of road and a lot of rail, plus buildings and more factories.]

Fact: To get the iron to China Sundance will spend $3.2b. They don't have that and they will need to get it. They will raise the funds through a combination of debt and equity.

Comment: The mix of debt and equity will be a key determinant in the value of SDL. The more equity they use, the more diluted the value of the mine. Capital markets over the last 6-9 months increased the price of risk. That means the mix of debt and equity will shift towards equity. However, combined with the increased cost of risk and debt is higher iron ore price. From a debt provider’s point of view that means less risk. Who knows what the mix will be? I’ve assumed they raise $1b equity and $2.5b debt. The share price that the equity is raised at will be a discount to the then current share price. That suggests, based on current prices, a price of circa $0.22 – which I use in the valuation.

Valuation: Currently there are 1.871m SDL shares. Raising $1b capital at 0.22 will increase the share based by 4.454m to 6,416m. Assume the value of the mine is $4b (after allowing for capital costs). The value per share is $4,000 / 6,416 = 0.62. Applying a 50% discount (appropriate to the risks involved) to the value gives a value of 0.31.

Upside risks: The valuation is based on $50 per tonne not $150 per tonne in the current spot markets. Structural price pressures will continue to push iron ore prices up. If the share price rises prior to the capital raising the dilution effect will be lower and the value will rise (for example a raising price of 0.30 raises the fundamental value of each share from 0.31 to 0.38).

Downside risks: A greater proportion of capital requirement is sourced from equity rather than debt. The share price falls prior to the capital raising.

Thoughts?