sdl valuation

SDL Valuation June 2010

Hi all,
As promised, this is a reviewed SDL valuation considering a recent update of DSO resources from SDL.

I guess most of you should now be familiarised with my DCF valuation, which is covered in the first part of my presentation for the base (415Mts DSO) and upside model (500Mts). To add further interest into the subject, I
have included sections dealing with SDL SP projection and comparisons to peers, so that we could have an idea on where SDL will be placing in near future with its competitors.

As with the total increase in DSO inferred resources from 215Mt to 415Mt, the current SDL price is now re-rated
to A$0.225 (phase pre-BFS), a value based on a P/NPV multiple of 0.35x. This metric is in-line with the wide
range of junior iron ore peer comparables (re. my interpretation as per below). SP will be re-rated again once SDL has sorted out its funding (phase pre-production).

Part I
Valuation using DCF

Key assumptions:
-Capex1 = US$3,360m
-Capex2 = US$4,200m (changed from US$2,800m)
-Avg FOB price(DSO)= US$63.12/t (changed from S$62.20/t)
-Avg FOB price(Concentrate/Pellets at +65% Fe)= US$66.30/t
-Estimated Production Cost(DSO)= US$19.65/t
-Estimated Production Cost(Itabirite Feed Ore)= US$32/t

-Debt at interest 10% (assumption fully debt funds with no dilution)
-Tax free holiday for first 10 years (0%) and 15% yhereafter
-Royalty = 2.5% of revenue

Corporate Structure
-Cameroon Gov = 25%
-SDL stake = 67.5%
-Number shares = 2,800m
-Parity A$/US$ = 0.9

NPV using WACC 11.3%

1- Base DCF Model
-Mining = 35Mtpa x 25 years
-DSO = 415Mt at 62% Fe
-Itabirite Feed Ore = 1,313Mt at +65% Fe

-Cash=US$50m (based on Gov stake at 25%)
-NPV at 11.3% = US$1,695m
-NPV per share = US$0.61 = A$0.67
-IRR=21% (project looks much more attractive than GBG (IRR of 14%))

Projection of share price:
Phase1: Pre-BFS
Using P/NPV multiple of (0.35x)
--> SP = A$0.67 * 0.35 = A$0.235

Phase2: Pre-production (post-BFS/funding)
Using P/NPV multiple of (1x)
--> SP=A$0.67

Phase3: Production
Using a conservative P/E (or P/NPV) = 2.5
--> SP = A$1.675

Current SP = A$0.135 (at 4/06/2010)
Note: current SDL SP is traded at a multiple 0.20x of P/NPV, well below of its estimated median price (phase 1).

2- Upside DCF Model (increase DSO)
-Mining = 35Mtpa x 25 years
-DSO = 500Mt at 62% Fe
-Itabirite Feed Ore = 1,313Mt at +65% Fe)

-Cash = US$50m (based on Gov stake at 25%)
-NPV at 11.3% = US$1,847m
-NPV per share = US$0.66 = A$0.73
-IRR = 22%

Projection of share price:
Phase1: Pre-BFS
Using P/NPV multiple of (0.35x)
--> SP = A$0.73 * 0.35 = A$0.255

Phase2: Pre-production (post-BFS/funding)
Using P/NPV multiple of (1x)
--> SP = A$0.73

Phase3: Production
Using a conservative P/E (or P/NPV) = 2.5
--> SP = A$0.73 * 2.5 = A$1.825


3- Point to notes
3-1 FOB price and Operating costs (for Concentrate / Pellets)
Currently spot price for Concentrate is from US $70 to 120
http://www.alibaba.com/showroom/iron-concentrate.html

To be on a conservative side, I use for SDL valuation the following figures for Concentrate (Itabirite Feed Ore):

FOB price for Itabirite Concentrate = US$66.30/t
Based on Sinter Fines FOB Price Forecast (SDL Investor Pesentation June 2010, P12),of US 102 cts per dmtu, and considering the Ore Feed concentrate of +65%Fe, the price per tonne can be determined as following: 102 * 65 = US$66.30

I have reviewed this value from my previous modeling to have a fair valuation. For Concentrate (Itabirite Feed Ore), it has been changed from US62.20/t to US$66.30/t.
From CF projection (diagram p.13), we can the Opex increases for Itabirite, so does the revenues (CF) from Y2025 onwards.

From my previous modeling, the value of US62.20/t has been used for both DSO (with 60% Fe) and Concentrate (with +65% Fe) and this had put the operating margin down for SDL.

Estimated Operating Costs for Itabirite = US$32
Usually operating costs for Itabirite would be an additional of US$10 from DSO price, i.e in SDL case: US$19.65 + 10 = US$29.65

By taking a conservative approach, I use a value of US$32, similar to GBG and Grange (Info March 2005) for their Magnetite ore project.
http://www.greenleader.com.au/framework/documents/displaydocument.asp?doc=526.pdf

"GBG operating cost A$35 for pellets (~US$32).
Granges pre-feasibility study estimates are $US640 million in capital costs and $US32/tonne operating costs FOB South East Asia, for a project producing 6.5 million tonnes of pellets per year."

3-2 CAPEX
SDL initial CAPEX of US3.3 billion looks massive, but actually it does not look challenging if we consider the
scale of resources: a +400Mt of DSO will generate enough cashflow to limit risk with a payback in less than 4 years.
It seems we have a 50% increase in Capex2 for phase Itabirite, this is self-funded from large revenues/cashflows generated by an increase of DSO (compare CF diagram in SDL AGM Nov 2009 report)

3-3 IRR and NPV
I also checked whether SDL has been impacted by RSPT. Since there are no negative change in NVP and IRR, its all looking good so far.

Recall internal rate of return (IRR) is one of a measure of deciding whether projects are worth pursuing. The same goes for NPV.

Recently in relation to the new proposed Government RSPT, I found few companies started redoing their project modeling/valuation, to re-gauge their IRR and NPV: a drop of these values provide an indication that the project
could be less attractive to develop.
In AFR, dated 3 June 2010 an article indicated that KMPG survey estimated that internal rate of return (IRR) on
projects for Iron Ore falls from 22.5 % now to 19.3 % based on the miners assumption of higher borrowing costs.
However the indicated value is still attractive. Also KMPG looks at net present value and found that NPV of its
typical iron ore, coal, and bauxite projects will fall.

Good project with potential upside tend to have a higher IRR (I would say between 17% and 25%). The IRR(s) I found for SDL for both Base and Upside models look attractive, when comparing to GBG. Kagara magnetite project is Gindalbies big play, and its a high capital intensity development.



3-4 Projection SP using multiple P/NPV (or P/E Ratio) (see Goldman note)
Referring to the example of Valuation Metrics provided by Ambrian report, we can try to determine a fair (acceptable) multiple value of P/NPV for SDL, so that we could use to do the projection of SP over different phases of SDL lifetime, which are:



Generally a low value multiple represents a higher risk, generally when the company are at early stage of exploration. That value increases over time when the company change from one phase to another:

The above is an example of Multiple (P/NPV or PE(x) used for DMC, GBG, and FMG.

GBG
RBC Broker rating (Dec 2008):
"This metric is broadly in-line with the presently wide range of Australian junior iron ore peer comparables
(albeit towards the upper end, reflecting imbedded call
option value in the Karara magnetite project). The Speculative Risk rating reflects the significant period to first production and residual approval, financing and development risks."

DMC - Mayoko project at ROC
(Ambrian valuation - March 2010)
"We base our valuation on this, applying a 0.25x NAV multiple to the DSO operation to reflect the early stage
nature of the project":
- Historic drilling in 1970s highlighted an inferred hematite resource of 33Mt at 55.5% Fe.
- Based on a high-resolution geophysical survey and field mapping during 2009, the company has released a target of 0.9-1.3Bt itabirite iron ore at 35-45% Fe, and the broker thinks over 250Mt could reached in 12-18 months

SDL
Based on my research, I use the following multiples for SDL:
SDL is still in phase 1 (pre-BFS), but its a mature explorer and is target to complete a DFS (funding included)
by end 2010. Since there are still uncertainties, I consider a current price target of A$0.225, which is based on a P/NPV of 0.35x

The above multiple will be re-rated as per below when SDL starts moving into pre-production and later on to production phase:



Diagram showing projection of potential SDL SP over different phases (using PE(x))



From Goldman (2007)
"At the conceptual full production rate, even on our LT pricing assumptions (well below
current prices), SDL is inexpensive on all key multiples:
- PE's: 5-6x
- P/FCF: 2-3x

On forward looking multiples (once production begins) SDL appears extremely inexpensive on all measures. In fact,in terms of PE and PFCF it is quite consistent with companies developing large mines with a fairly long lead time before the major re-rating begins."



3-5 Upside
There are further exploration potential for SDL DSO and Itabirite in near terms. If we consider Mt Nabeba where
research from Westcott seems indicated the size could be bigger than Mbarga, SDL could then easily double the current tonnage for Itabirite. Also dont forget Mt Letioukbala as well.

From June 2010 last report, SDL indicates that resources within regional iron ore province could support up to 100Mtpa production on integrated rail and port infrastructure. A target of 50Mtpa to 100Mtpa would definitively place SDL on FMG track.

Current SDL figures for DSO with 415Mt and Itabirite Feed Ore of 1,313Mt at +65% Fe could be mined for around 50 years considering a 35Mtpa. But the modeling shows that SP increases slightly if we extend the number of mine life from 25Y to 30Y, and above that range the % increase would be minimal. So at some point in time, SDL will need to upgrade its production tonnage from 35Mtpa to leverage its growth, hence a potential increase in its P/E ratio (or multiple of P/NPV).



Note: SDL presents a CF projection over 25 years of mine life at this stage.

The above graph shows the % increase in SP is minimal above 30 years of mine life, so cashflow keep decreasing
significantly above that range of period. Most mining companies tend to increase their production tonnage to leverage their growth (example of FMG looking to increase their production from 50Mtpa to 150Mtpa).

I guess at some stage, SDL will need to increase the production tonnage as 35Mtpa is only optimal for up to 500Mt DSO (considering we got a base of Itabirite Feed Ore of 1,313Mt at +65% Fe). Above this tonnage, SP will not
increase that much.

I did a very quick simulation to see how SP behaves up to 1,750 Mt DSO, considering the following scenario cases, using a base of Itabirite Feed Ore of 1,313Mt at +65% Fe:
* 875Mt DSO --> 25Years mine life
* 1,575Mt DSO --> 45Years mine life
* 1,750Mt DSO --> 45Years mine life

The result shows that 35Mtpa remains optimal for up to 500Mt DSO, and above this range the % increase in SP remains weak, if not insignificant with 1,750Mt DSO



3-6 Price sensitivities



Note: the discount rate I used for SDL DCF valuation is similar to Goldman (valuation 2007) and is rather conservative: as a comparison, some brokers use a discount rate of 8% for GBG. It seems Don mentioned a discount rate of 10% being used for their SDL modeling in the past, not sure how they are now.

For SDL multiple of P/NPV, please also refer to the above SP projection.

Part II
Projection SP using Enterprise Value (EV)
A simple valuation approach we could use to complement the DCF valuation:

-Number shares = 2,800m
-Parity A$/US$ = 0.9
-Current share price = A$0.14 = US$0.12
-Total resource = 2,740Mt (415Mt DSO + 2,325Mt Itabirite)
-M&I resource = 2,740Mt (415Mt DSO + 2,325Mt Itabirite)



Using Valuation Metrics from Ambrian analysis, we can determine the index factor IX (or multiple) of EV through
different phases:

Pre-BFS --> Pre-production (Post BFS) --> Production

IX could be interpreted as a risk factor or a multiple factor of an EV.

Lets called EV1 = Enterprise Value for Phase 1
EV2 = EV for Phase 2 = IX * EV1
EV3 = EV for Phase 3 = IX * EV1
where IX = (1 + %increase)



Projection SDL SP for Base model
-Total resources = 2.7 billion tones (415Mt DSO + 2,325Mt Itabirite)
-Parity A$/US$ = 0.9

Lets take a conservative approach by using the EV total resources instead of EV M&I (Minerals & Indicated):



Using EV Total resource (conservative approach)
Pre-BFS
EV = US$0.53 x 2.7 billion tones = US$ 1,431m
--> SP = US$0.51 = A$0.56

Pre-Production (BFS: Funding approved)
EV = US$2.05 x 2.7 billion tones = US$ 5,535m
--> SP = US$ 1.97 = A$2.18

Production
EV = US$4.96 x 2.7 billion tones = US$ 13,392m
--> SP should be around US$ 4.78 = A$5.31

In short using an EV with conservative approach:
For the base model (415Mt DSO), SP should be:
A$0.56 (pre-BFS) --> A$2.18 (post BFS/funding) --> A$5.31 (Production)

Note: EV should be around US$1.00/tonne of in-ground resource
Don Lewis CEO briefing 2008:
"The value of recent iron ore transactions in Brazil is also enlightening. The transaction value for itabirite projects in Brazil is approximately US$1.00/tonne of in-ground itabirite resource. Sundances current market capitalisation is equivalent to only US$0.05/tonne of in-ground resource clearly a significant mis-match given that the quality and nature of the Mbarga itabirite is similar to the Brazilian itabirite ores."

CarMichael (SDL Valuation - 2007)
"What is evident from this study is that explorers have an EV of A$1 to A$5 whereas producers generally have an EV of A$6 to A$13. The industry average between explorers and producers in this scenario is A$3.10/tonne.
If we use SDL s non-JORC high grade resources of 218mt @ 60% Fe, we see that the company has an EV of $1.17/tonne, well below the current calculated average of $3.15/tonne."

Part III
Peers comparison

Points to note for the below diagrams
GBG has been re-rated in pre-production phase.

SDL is still in Pre-BFS but share price is still below the median level. Expect SP to be re-rated soon when moving to phase 2 (pre-production)





Points to note:
-Sphere Minerals has an exceptional high quality of Concentrate Fe (%) for their Magnetite project, followed by GBG and SDL, which are in front of MMX for both Weight Recovery (%) and Concentrate Fe (%).

- "bubble size" for SDL Itabirite project is now bigger if we include Nabeba deposit (According to Westcott, Nabeba deposit could be bigger than Mbarga for Itabirite).





Points to note:
- Sphere has a high quality of DSO Hematite (65% Fe) but their size is small.
- SDL has a high quality DSO grade of 62% Fe and is well in front of FMG, AGO, MMX, BC Iron, and FRS .
- Note that the "bubble size" for SDL DSO (High Grade Hematite) project is now bigger if we include Nabeba (from
215Mt to 415Mt as at June 2010)
- Considering the "upside potential from additional DSO targets and Direct Reduction grade pellet production", SDL is well place to be a direct competitor of FMG.

Thats for now, folks, I hope this will help and looking forward to getting your positive feedbacks. I didn't think the valuation could take so long this time but its definitely worth to do it (lol)

Cheers - BS
(Always DYOR)