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Morningstar's Recommendation: Gindalbie Metals Ltd

Recommendation: Hold

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 5 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.

Event22-Jan-2013
Gindalbie Metals generated little or no profit over the past decade as it focused on constructing the huge Karara iron ore mine. Magnetite iron ore shipments began last month and management expects positive cash flow from April 2013. Yet Gindalbie owns just 50% of Karara so doesn’t have full control of its cash flows. If Karara fails to pay dividends, Gindalbie could ultimately run low on cash. However, capital raisings have replenished cash balances in recent months. We expect Gindalbie to lend AUD 50 million to Karara this quarter leaving around AUD 50 million in cash, sufficient to fund the business for a couple of years at least.

Business Impact: Our base case valuation is AUD 0.27 per share or an equity value of AUD 403 million. We assume no value for the Shine and Lodestone projects or for Karara’s Stage II expansion. Key operating assumptions include: cash costs of AUD 80 per tonne, a long term iron ore price of USD 90 per tonne (delivered China) and an AUD/USD exchange rate of 1.00. Arguments can easily be made for much higher or lower valuations. If Karara experiences further difficulties, Gindalbie’s share price may be supported by the potential for Ansteel to acquire its 50% stake in Karara. In 2012, Murchison Metals sold its 50% stake in the Crosslands iron ore project to joint venture partner Mitsubishi for AUD 350 million under similar circumstances.

Forecast Impact: --

Recommendation Impact: At 0.30 per share our recommendation, for very high risk tolerant investors only, is Hold. Recent share purchases by senior management provide some encouragement that guidance will be achieved.

Event Analysis
Gindalbie Metals generated little or no profit over the past decade as it focused on constructing the huge Karara iron ore mine. Magnetite iron ore shipments began last month and management expects positive cash flow from April 2013, but only at the joint venture level. Gindalbie owns just 50% of Karara so doesn’t have full control of its cash flows. If Karara fails to pay dividends, Gindalbie could ultimately run low on cash. Indeed, consistent cash outflows reduced cash balances to just AUD 35 million by last September. A AUD 40 million institutional placement in November replenished balances to AUD 71 million and a placement to Ansteel this month will raise a further AUD 22 million. Funds will be used to ‘…strengthen Gindalbie’s balance sheet and…fund contributions to the Karara Mining joint venture if required…’. The absence of a share purchase plan showed a disregard for small shareholders who suffered a 21% increase in shares on issue. Gindalbie’s cash burn fell to a trickle last year and we forecast annual head office and exploration costs of just AUD 10 million and AUD 5 million respectively. We expect the company will lend AUD 50 million to Karara this quarter leaving around AUD 50 million in cash, sufficient to fund the business for a couple of years at least. Our fair value estimate of AUD 0.27 per share implies an equity value of AUD 403 million but comes with a very high uncertainty. At 0.30 per share our recommendation, for very high risk tolerant investors only, is Hold. Recent share purchases by senior management provide some encouragement that guidance will be achieved.

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Magnetite production guidance of 8 million tonnes per year from April 2013 looks realistic. Initial magnetite grades of just 64% should improve to 68% following full commissioning. Hematite production guidance of 2 million tonnes per year also looks reasonable though the current resource only supports production for four years. Cash cost guidance increased 11% last November to AUD 72 - 76 per tonne making Karara a very high cost mine. We estimate royalties and shipping add a further AUD 6 and AUD10 per tonne respectively, implying AUD 90 per tonne delivered to China or USD 95 per tonne at spot exchange rates. If hematite reserves aren’t replenished, cash costs will be higher still. Our long term iron ore price forecast is USD 90 per tonne (delivered China) and assumes large low cost miners continue to increase production and depress prices while returns are strong. With additional capacity costing around USD 200 per tonne and cash costs of around USD 50 per tonne, the large miners can still achieve returns of 20% even at an iron ore price of USD 90 per tonne. Low cost African supply may also increase. However, we stress that long term iron ore price forecasts are highly subjective. Production expansion is easier said than done and iron ore demand may prove stronger than we expect. Some Western Australian iron ore producers consider the iron ore ‘floor’ price to be USD 120 per tonne. Although Karara will be high cost, its high grade magnetite concentrate should attract a 20% premium to the iron ore index price. With hematite ore included, we estimate an average price premium of 14%. At our long term iron ore price of USD 90 per tonne, we forecast a Karara price of USD 103 per tonne implying a margin of USD 13 per tonne before corporate, finance costs and taxes. Assuming an AUD/USD exchange rate of 1.00, annual gross profit would be AUD 126 million on a 100% basis. We estimate annual interest and debt repayment costs of AUD 50 million and USD 128 million respectively from fiscal 2014 or AUD 5 and AUD 13 per tonne of ore produced.

Sensitivities
Large borrowings and high production costs mean Gindalbie is highly geared. Table 1 shows a range of annual profit outcomes for different iron ore prices and exchange rates. In all cases we assume production of 10 million tonnes per year and cash costs of AUD 75 per tonne. At the spot iron ore price of USD 145 per tonne, Karara would generate over AUD 500 million in profit per year. At last September’s iron ore price low of USD 90 per tonne, we estimate breakeven profit at best.

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Stage II
Expansion of Karara’s output to 18 million tonnes per year (Stage II) could reduce cash costs but requires further investment and brings development risk. However, with AUD 3 billion already invested and the consequences of failure unthinkable, expansion may become critical. We attribute no value to Stage II development as the feasibility study is incomplete, funding yet to be identified and much still to be proven from Stage I. If management’s Stage II guidance is realised, our fair value estimate could easily double.

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Asset sales
The sale process for Gindalbie's Lodestone magnetite deposit has been underway since last July. Admittedly, potential buyers have only had access to detailed information since October but we don’t have high hopes for a lucrative sale. Similar assets sold for less than AUD 50 million in recent years and the environment has arguably deteriorated since. Development will cost billions and require a concentrator and rail and port infrastructure. If Gindalbie doesn’t want the project, we struggle to see why others would. Management also hopes to develop the 100% owned Shine hematite iron ore deposit, located close to Karara. Development costs could be around AUD 20 million with a project net present value of AUD 70 - 100 million. At this stage development details are scant and we attribute the project no value. Our base case valuation is AUD 0.27 per share or an equity value of AUD 403 million. We assume no value for the Shine and Lodestone projects or for Karara’s Stage II expansion. Key operating assumptions include: cash costs of AUD 80 per tonne, a long term iron ore price of USD 90 per tonne (delivered China) and an AUD/USD exchange rate of 1.00. Arguments can easily be made for much higher or lower valuations. If Karara experiences further difficulties, Gindalbie’s share price may be supported by the potential for Ansteel to acquire its 50% stake in Karara. In 2011, Murchison Metals sold its 50% stake in the Crosslands iron ore project to joint venture partner Mitsubishi for AUD 350 million under similar circumstances.