Extracting economies of scale
After a gestation period of two years, CNMC’s Sokor Gold Project has finally produced encouraging results. We expect strong revenue and earnings ahead, as the company benefits from the economies of scale due to its capacity expansion.
CNMC has been hitting new all-time highs in terms of gold production in the past year. Given the new capacity coming onstream, CNMC is expected to enjoy lower production cost per oz due to the economies of scale. Its FY14 gold production may be double that of FY13. We expect CNMC’s FY14 revenue and earnings to soar accordingly.
Gold mine in early stage
CNMC holds a 10-year mining concession for a 10km2 field in the state of Kelantan, Malaysia (Sokor Gold Project) and has the right of first refusal for the renewal of the concession by another 21 years. According to an independent consultant, as of 31 Dec 2013, the known deposits in the Sokor Gold Project contained gold of 465k oz (15k oz in proved reserve, 163k oz in probable reserve and 289k oz in resources, refer to Fig 5 for details). Furthermore, the independent consultant believes that there is still considerable potential to locate additional resources within the Sokor Gold Project.
Benefits from economies of scale
CNMC completed its second leach yard in 3Q13 and third in 1H14, bringing its total ore processing capacity to 1m tonnes p.a. We estimate that CNMC’s production could reach 25-30k oz in FY14 (FY13: 12.6k oz). Given the higher production, we expect CNMC’s cost of production per oz to decline from US$780 now to below US$700 in 2H14 (vs. peer average of US$1,200). This gives CNMC a wide margin of safety to weather the downside risk of gold price.
We value CNMC at 10x CY15 P/E, implying a fair value of S$0.43. This translates to a 46% upside from the last close price. The 10x CY15 P/E represents a 22% discount to the lowest CY15 P/E of its peers (that range from 12.8x to 24.8x, with average of 18.8x), as we factor in its undiversified operating asset base and limited operating history. Key risks include: 1) a possible failure to renew the concession rights for the Sokor Gold Project; 2) CNMC fails to turn probable reserve to proven reserve; 3) the gold price volatility.
1.1 Young gold mining company in Malaysia
CNMC Goldmine Holdings Limited (CNMC) was listed on the Catalist Board on 28 Oct 2011 and is the first gold mining company to be listed on the SGX. CNMC started operations in 2006 and is principally engaged in the exploration and mining of gold, as well as the processing of mined ore into gold doré bars. The group is currently focused on the development of the Sokor Gold Field Project, which is located in the state of Kelantan, Malaysia. The first gold pour was achieved on 21 Jul 2010.
1.2 Flagship project - Sokor Gold Project
Through its 81%-owned subsidiary, CMNM Mining Group Sdn, Bhd (CMNM), CNMC owns the contractual rights, which were granted by the Kelantan State Economic Development Corporation (KSEDC), to mine and produce gold and other minerals found within a mining area of approximately 10 km2 within Sungai Amang and Sungai Sejana, Mukim Sokor, Sokor, Tanah Merah, Kelantan, Malaysia for a period of 10 years expiring on 7 Apr 2018. The company has the right of first refusal for the renewal of the mining rights for another 21 years. We understand from management that CMNC has initiated talks with the relevant authorities on the extension of the concession.
The Sokor Gold Field Project and CNMC’s ore-processing facility are both located at the Sokor Block, which is approximately a 2.5 hour drive from the Sultan Ismail Petra Airport, Kelantan or 1.5 hour drive from the Tanah Merah railway station. The location of the project is approximately 80km southwest of Kota Bharu, the state capital of Kelantan. The project site is accessed by a sealed road to Kampong Bukit Pauh and then, by an all-weather gravel logging track. The closest village is located 18km from the site. The nearest town is the district centre of Tanah Merah, which is located approximately 40km from the site. Tanah Merah is approximately 40km from the state capital, Kota Bharu, which has a daily flight service from Kuala Lumpur (55 minute flight).
The mining area has access to telecommunications, water and roads. It is also equipped with its own power generator. The proximity to land and air transport, as well as the existing infrastructure and communication access easily enable the delivery of supplies of diesel, potable water and other equipment or materials required for its mining operations to CNMC.
Reported mineral resource estimates of known deposits
In its 2013 annual report, CNMC included an updated mineral resource and ore reserve estimates report. The report was prepared by Optiro Pty Ltd (Optiro), an independent consulting and advisory organisation incorporated in Australia. The mineral resource estimates were prepared for four known deposits: Manson’s Lode, New Discovery, Ketubong and Rixen. The estimates for the gold and other mineral resources contained in the Sokor Gold Project as at 31 Dec 2013 are shown in Figures 5-7.
As at 31 Dec 2013, the total measured, indicated and inferred gold resources for the Sokor Gold Field Project (above 0.3 g/tonne gold cut-off grade for Rixen and 0.5g/tonne gold cut-off grade for Manson’s Lode, New Discovery and Ketubong) were 9.14m tonnes (at 1.5g/tonne) or a total of 465k oz of contained gold. Furthermore, Mansion’s Lode contains a significant amount of other mineral resources, including silver, lead and zinc. In particular, it contains up to 0.65m tonnes of other mineral ore, with an average silver grade of 59g/tonne, lead of 1.5% and zinc of 1.5%.
To date, CNMC has focused its exploration activities on the known deposits in the Sokor Block. This means that there has only been limited exploration (reconnaissance mapping and rock chip sampling) in extensive areas within the concession. These areas are strong prospects for gold and base metal mineralisation and CNMC plans to expand its exploration programme to these areas. It also intends to obtain an exploration licence for the surrounding areas.
Optiro believes that the Sokor Block and the surrounding area have considerable potential to locate additional gold resources. However, this would require CNMC to achieve a higher rate of drilling than in the past.
Given the clear geographical demarcation of gold, exploration and mining rights and licences, mining companies do not generally compete directly with each other in terms of mining operations. However, CNMC competes against other mining companies for new exploration and mining rights and licences beyond its current mining area.
2.1 Gold price: long-term potential vs. short-term pressure
Gold prices surged by more than 500% in 2000-12, posting gains for 12 straight years as the dollar weakened. The gold price rally accelerated in Dec 2008 to Jun 2011 as the US Federal Reserve expanded its balance sheet through debt purchases or quantitative easing (QE) and kept borrowing costs at record-low levels in order to revive economic growth amid the recession. Gold bullion price reached a historical high of US$1,923.70 per oz in Sep 2011. However, the gold price plunged in 2013, mainly due to the US economic recovery and the market’s expectations of the Federal Reserve’s QE withdrawal.
There is now wide disparity in analysts’ gold price forecasts. The Bloomberg survey is shown in Figure 8. The bearish analysts postulate that the stronger US economy and the QE withdrawal would lead to a deflationary environment in the near term, while the bullish analysts believe that the possible downside has been priced in and the Federal Reserve’s QE in the past few years has led to excessive liquidity in the market, which will cause strong inflation when the global economy recovers.
We acknowledge that gold prices are likely to face near-term pressure from the QE withdrawal and still-benign inflation but we think that the gold price will be well supported at the US$1,200 per oz (global average gold production cost, according to the World Gold Council). If the gold price drops below that level, the gold mining companies would lower production, which in turn, would cause a reduction in global gold supply.
In the longer term, we believe that gold would still be valued as an asset and sought by investors due to its nature of preserving value in an inflationary environment and its safe haven status in times of uncertainty. 2.2 Sokor project still in early stage, full potential has not been discovered
As at 31 Dec 2013, the Sokor Gold Project had total proven gold reserves of 120kt and probable gold reserves of 3,600kt. In addition, it had measured, indicated and inferred gold resources of 5,430k, which could be turned into gold reserves. The Sokor Gold Project registered total contained gold of 465k oz, compared to the group’s total production of 12.6k oz in FY13. Going forward, we expect CNMC’s to replenish its gold reserves via drilling activities.
Furthermore, the independent consultant Optiro believes that the Sokor Block still contains considerable potential. CNMC also intends to obtain an exploration licence for the surrounding areas to locate additional gold resources.
2.3 Expect CNMC to ramp up production in 2014
We expect CNMC to ramp up its gold production in FY14. In 3Q13, the company completed the construction of its second leach yard, with ore processing capacity of 140k tonnes per cycle. In 1H14, construction on the company’s third yard was completed, with capacity of 600k tonnes p.a. CNMC’s three leach yards have total processing capacity of 1m tonnes p.a.
CNMC’s operating results to date have been encouraging. CNMC produced 4.01k oz gold in 1Q14, compared to a mere 0.68k oz in 1Q13, although 1Q is a seasonally weak quarter due to the Chinese New Year. We highlight that the company registered record-high gold production of 4.36k oz in Jun 2014, which implies that it is likely to post stellar 2Q14 results. Given that all three leach yards are now in operation, we think that CNMC could achieve gold production of 25-30k oz in FY14, double that of the 12.6k oz in FY13.
2.4 Lower cost of production due to economies of scale
CNMC’s production cost is much lower than the US$1,200 per oz average production cost of international gold mining companies (based on the World Gold Council data). In 1Q14, CNMC’s average production cost per oz was a mere US$781. The low production cost was mainly attributable to the cheap labour cost in Malaysia, as well as the close proximity of its Sokor Gold Project to urban facilities. Going forward, we expect CNMC’s production cost to decline further to less than US$700 per oz, as it benefits from the economies of scale due to the ramp-up in its production.
2.5 Future exploration beyond Sokor
We expect CNMC to carry out more exploration activities within and beyond the Sokor Gold Project in order to locate more mineral resources. In Dec 2013, CNMC entered into an agreement with Menteri Besar Incorporated (Perak) and its wholly owned subsidiary Amanjaya Natural Resources Sdn Bhd to form a joint venture company in order to undertake a tin mining project in the state of Perak, Malaysia. The JV will be finalised to undertake the exploration and extraction of tin resources located in an approximately 700-acre site in the state of Perak once CNMC has ascertained that the tin resources can be extracted in an environmentally, socially and economically-viable way. Through its 80%-owned subsidiary, CNMC holds 64% effective interest in the JV. This JV could provide CNMC with an additional profit stream.
3.1 Subject to fluctuations in gold price
CNMC’s business is very sensitive to changes in the gold price. Gold prices fluctuate heavily, as they are affected by numerous factors, including market expectations of inflation rates, exchange rates, interest rates, global and regional political and economic crises, as well as governmental policies on the central banks’ gold reserves. Historically, the international gold price has fluctuated widely in response to the changes in the above-mentioned factors. Obviously, CNMC has no control over the factors that affect the international gold prices.
3.2 Concession extension
CNMC derives most of its revenue and profit from the concession rights to mine and produce gold and other minerals from the Sokor Gold Project. CNMC’s current concession period of 10 years is due to expire on 8 Apr 2018 and it owns the right of first refusal for the extension of the concession for another 21 years. Should CNMC fail to extend the concession, its business and valuations would be negatively affected. We understand that the company puts significant effort into maintaining a good relationship with the Kelantan government and the local community. CNMC has initiated talks with the relevant authorities to extend the concession and management is confident that it will obtain approval for the extension.
3.3 Uncertainty with regards to new discoveries
CNMC may not be successful in discovering new gold reserves to keep its mining operations commercially viable. CNMC conducts ongoing exploration activities but there are no assurances that these exploration activities will result in the discovery of new mineable reserves. Even if a viable deposit is discovered, substantial capital expenditure and time (from the initial exploration phase) may be required before production commences, resulting in significant changes to capital cost and economic feasibility. Furthermore, the actual production results may differ from the projections at the time of the discovery. 3.4 Single customer
TCS Trading, an approved buyer by the Kelantan State government, is CNMC’s sole customer. Therefore CNMC’s business and operations depends on its working relationship with TCS Trading.
3.5 Severe weather conditions and natural disasters
Severe weather conditions such as heavy rainfall and natural disasters like landslides, earthquakes, fire and flood may require CNMC to evacuate its personnel or curtail its operations. Such events could also cause damage to CNMC’s mines, equipment or facilities, which could result in the temporary suspension of operations or reduction in productivity. During periods of curtailed activity due to adverse weather conditions, natural disasters or other events beyond its control, CNMC may continue to incur operating expenses although there is a slowdown or complete halt in production. Any damages to its projects or operational delays caused by such events could materially and adversely affect CNMC’s business and operational results.
4.1 Topline to expand, driven by fine gold sales
We expect CNMC’s revenue to increase going forward, mainly driven by the increasing sales of fine gold. The slight slowdown in 1Q14 is not a concern, as 1Q is seasonally weak due to the Chinese New Year. Given the commencement of the new second and third leach yards, CNMC’s gold production is likely to soar. We forecast that CNMC’s total gold production will reach 25-30k oz in FY14, double that of the 12.6k oz in FY13.
4.2 Margin expansion to be driven by reduction in production cost per oz
CNMC’s all-in production cost was US$781 per oz in 1Q14 and we expect this to decline further, thanks to the economies of scale from the commencement of the third leach yard in May 2014. Hence, we anticipate that CNMC’s EBIT and net margins will improve from 41.5% and 31.3%, respectively, in 1Q14.
4.3 CNMC to enjoy 5-year tax-exemption period
On 14 May 2014, CNMC received the Pioneer Certificate from the Malaysian Investment Development Authority (MIDA). Pioneer status entitles the Sokor Gold Field Project to 100% income tax exemption on its statutory income for a period of five years from 1 Jul 2013 (retrospective) to 30 Jun 2018. The tax benefit attributable to FY13 profit will be reflected in CNMC’s 2Q14 bottomline.
Going forward, we estimate that CNMC will enjoy tax savings of US$3m-4m p.a. This will have significant positive impact on CNMC’s bottomline. 4.4 CNMC expected to remain net cash
At end-1Q14, CNMC was in a net cash position. The company generated positive operating cash flow of US$0.3m in FY12 and US$4.9m in FY13. Given the anticipated earnings expansion ahead, we expect CNMC’s operating cash flow to improve further. Therefore, we expect CNMC to strengthen its net cash position unless there is significant capex for mining or production facilities related to new initiatives.
4.5 Dividend prospects
CNMC does not have a fixed dividend policy. The company paid a maiden dividend per share of 0.1 Sct in FY13. The dividend is symbolic, representing dividend payout ratio of 12.2% or dividend yield of 0.33% (based on the current share price). We think that CNMC could raise its dividend payout, given the anticipated earnings expansion ahead and its minimal debt.
5.1 Current P/E multiple much lower than its peers
Based on consensus estimates (only 1 research house covers this stock currently), CNMC is trading at 8.0x CY14 P/E and 6.1x CY15 P/E. We expect CNMC to deliver EPS of 2.92 UScts in FY14 and 3.42 UScts in FY15, which translates to 8.1x CY14 P/E and 6.9x CY15 P/E. The international gold mining stocks trade in the range of 12.8x and 24.8x CY15 P/E, with an average of 18.8x.
We conservatively value CNMC at 10x CY15 P/E, which translates into a fair value of S$0.43. This is at a 22% discount to the lowest CY15 P/E valuation of its global peers, as we take the following into consideration:
1) Although management appears confident, there is still uncertainty about the renewal of the Sokor Gold Field Project mining concession, from which most of CNMC’s earnings are derived,
2) CNMC’s operating history is much shorter than its international peers and as such, may face higher operational risks;
3) Its mining projects are not geographically diversified.
However, we acknowledge that the factors below favour CNMC:
1) The Sokor Gold Project is still in its early stages and could have considerable upside potential;
2) CNMC’s production cost per oz is a very low US$781 (in 1Q14), compared to the World Gold Council estimate of US$1,200 for an average gold mining company. Therefore, CNMC enjoys a much wider margin of safety in terms of business profitability.
5.2 Future catalysts
Potential future catalysts include the confirmed extension of the Sokor Gold Field Project, higher gold price, better-than-expected gold ore grade and potential new income stream from its tin exploration and mining business.