|Shares Out. (in M):||2,004||P/E||0||0|
|Market Cap (in $M):||401||P/FCF||0||0|
|Net Debt (in $M):||137||EBIT||0||0|
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Red5 (ASX:RED) is a cheap and well-managed (yes, despite the operational misses in the last 2Qs I do believe it's well managed for reasons I highlight below) gold miner with meaningful catalysts for re-rating over the next 12-24 months. RED operates two mines in Australia and owns two dormant mines in the Philippines. The most recent presentation of the company can be found here: https://www.red5limited.com/site/PDF/cbd5b345-2f8e- 4330-b4c5-9cee3e21b0c7/NoosaMiningVirtualConferencepresentation.
RED’s investment case fits the “opportunistic” framework: there’s some stuff that needs to be cleared before we can resell the shares to a new owner at a profit in 2-3 years time. Who will that new owner be? Someone looking for a “clean” equity story in a safe jurisdiction, the GDXJ index and/or an algorithm chasing growth stocks. Free cash flow generation at $1,500/oz, a rising gold price environment, management’s track record of value creation and the presence of adult supervision in the registry (Electrum) mean that we shouldn’t even need one.
RED is >75% cheaper than the alternatives. The stock trades at $69-132 EV/M&I Resources (depending on how harsh one wants to be with inferred resources and the Philippines) vs a peer group average of over $400/oz.
RED is also cheap on an EV/Reserve basis relative to peers breaking rocks in the same region:
RED has four meaningful catalysts that should bring the stock price up in the near future:
Final Feasibility Study for RED’s new mine (KOTH open pit) to be published around September this year.
Debt package worth A$140-160m to be secured by year end.
Ramp-up of the KOTH open pit in 2022.
Monetisation of Philippines assets to occur at some point in the next few years.
RED’s private market value can be framed as the sum of three components:
KOTH open pit = $336m at $1,500/oz gold price ($714m at $2,000/oz).
Rest of Australian assets = $774m at $300 EV/M&I Resource.
Philippines assets = $100m ($50 EV/M&I&I Resource).
When put together, it’s easy to reach a close to $1.5bn valuation for the equity, which compares very favourably to the current market cap of $401m. Debt is not a major issue as RED should be doing over A$150m of EBITDA at $1,500/oz gold price by 2023 (0.6-1.25x NFD by then). I expect RED to produce over 200KOz per year from 2023+. A $1bn price tag would put RED shares trading at about $5,000 EV/Production, also in line with peers.
In the following valuation exercise, I’m assuming that the company succeeds in raising the A$160m of debt that’s seeking to ramp up King of the Hills open pit and that the full A$122m of cash that sits on the balance sheet today are used to build the mine and for working capital purposes. Hence my EV is A$753m ($538m).
A) KOTH open pit = $336m at $1,500/oz gold price ($714m at $2,000/oz)
RED’s best asset is an open pit 10-years life of mine project that should be up and running from 2022 onwards at King of the Hills. The Final Feasibility Study will be published around September 2020, so we only have the Preliminary Feasibility Study (https://www.red5limited.com/site/PDF/d59268b3-5c7a-4f5e-9869-dc56e4db0dd1/ Maiden145MozopenpitOreReserveforKingoftheHills) to come up with an estimate of the NPV of the project.
Key attributes that make the asset be of high quality are:
Open pit project (worse things can happen below the ground than above it).
Bulk mining rather than narrow veins, which means that operationally it’s more simple to mine (easier to go all in crushing ore rather than have to be cautious focusing on specific mineral veins).
High grade (1.24g/t vs 1.5g/t world avg) and modest AISC of $A1,167 ($833/oz, middle of the pack figure).
Upfront capex is modest, costing A$218m ($153m) to build the mine. The bulk of it goes to building a new mill, as infrastructure is good in the area.
No refractory ore, with free milling to be used (no need to break up the chemistry of the ore before leaching it with cyanide). Expected recoveries are well over 90%, backed up by historical recoveries of 94% back when the mine was operated by its previous owners.
Tailings are non-acidic, which substantially reduces the likelihood of suffering from environmental issues.
It’s a brownfield project. KOTH is a +100 years mine, with a small underground operation already up and running in the site. RED has been trucking the ore from KOTH to Darlot (which is circa 90km away) for processing purposes (something that will change once KOTH standalone mill is operative). This is possible due to the proximity of the mine to Goldfields Highway.
Some non-obvious attributes of the PFS that point out to a likely very positive FS are:
Low gold price used. The estimate for the 1.5MOz of reserves contained in the initial 10-years life of mine plan were calculated using a A$1,530/oz ($1,071) gold price (page 7 of the PFS). This means that the opportunity for the actual mine to be bigger than what’s projected in the PFS is substantial. For example, at $1,500/oz gold price, the reserve base goes up by 50% (from 1.5MOz to 2.26MOz) while the mining grade only goes down by 20% (from 1.27g/t to 1.02g/t), which should keep AISC at modest levels.
Larger processing capacity. Upfront capex budget includes the building of a 4MTpa processing plant. The scale of the processing plant reflects the ultimate potential of the mine. At that processing capacity per year, peak production could reach 175,000 ounces per year at 1.24g/t (ignoring the grade dilution between mining and processing steps). As the mine progresses from the initial 10-years open pit operation to the underground plan, we might well see annual gold production going over that 175,000 ounces (as mining grade will be higher underground).
10-years mine plan excludes a lot of gold. The PFS doesn’t include the underground project. I provide a ballpark estimate of the value of this resource in section B of this writeup.
Further exploration potential may be large. Minute 1:40 of the following 3D presentation for a visual understanding of the potential to find more stuff in the property: https://www.youtube.com/watch?v=FMgtr WBLjqI&t=119s.
I’ve checked how large the upside exploration potential could eventually be with a mining engineer who visited the property recently and with an ex-employee of the company who led the exploration operation at KOTH. Oddly enough, the engineer was even more bullish than the geologist. None of them gave me an specific estimate of what the ultimate size of the mine could be, so I’m restricting my estimates to what the company has reported so far in the Measured and Indicated category.
The fair value of just the 10-years life of mine project as described in the PFS (1.5 MOz vs a total resource base of 3.3MOZ of M&I resources considering KOTH + adjacent satellites) using the gold industry standard of a 5% discount rate is substantial when compared to RED’s market capitalization:
B) Rest of Australian assets = $774m at $300 EV/M&I Resource
The rest of Australian assets are a combination of the remaining operations at KOTH (the underground mine that will complement the open pit + a few satellite projects) and the Darlot complex. Management believes that Darlot can sustain production for another 5 more years when considering the opportunities to complement the existing operation with output coming from satellite assets. The engineer I spoke to put this number at “well above 10 years”, while the geologist was (again) more prudent. Management is more conservative and guides for +5 years.
Using the existing Measured and Indicated resource base for the remaining Australian assets, I get to a fair value of $774m. This valuation assumes a conservative $300/oz EV/Resource (>25% discount to peer group) and excludes inferred resources, which in light of the ambitious exploration drilling programme that the company plans to do over the next couple of years (A$20m per annum) seems a conservative perspective to me.
C) Philippines assets = $100m
RED owns two mines in the Philippines which, as I explain later in this writeup, were de-facto expropriated by the Philippines government in 2017. The outlook for these assets is uncertain at this point. RED is spending about $4m per year on maintenance activities, although management plans to realise value in the near future.
How? They mentioned to me that they’re having conversations with Chinese and local mining companies to either do a JV (if they trust the other party) or sell it entirely (if they not). Something in between might be a sale instrumented via a royalty rather than cash in order to retain some upside optionality. My checks about the market for Philippines assets point out that it’s a buyers market in light of Duterte’s and covid uncertainties.
I won’t pretend to give a detailed fair value estimate for these assets given the material uncertainty that exists around them, but a ballpark estimate should be something in between $40m (the PV of current annual spend using a 10% discount rate) and a $50 EV/oz on Measured, Indicated and Inferred Resources (>75% discount vs the average multiple of development projects), or $100m.
Why does the opportunity exist?
Stock was a nanocap until last year.
Technical, financing, permitting and ramp-up risk until 2022.
Recent operational performance at Darlot has been poor.
FCF won’t turn positive until 2023.
1. Stock was a nanocap until last year.
RED operated a single mine in the Philippines until 2017, when it was de-facto expropriated by Duterte. That same year, RED acquired two brownfield projects in Australia for a total consideration of $34.5m ($18.5m for Darlot and $16m for King of the Hills - KOTH). The sellers were Goldfields and Saracen.
A few things stand out:
At the date of acquisition, the expected life of mine of both projects was less than 6 months.
In 2019, Darlot produced 102,012 ounces and 92,783 in 2020. With a resource base of 1,450,900 ounces, it should be able to sustain a similar production rate for many years to come.
KOTH resource base grew from 402,000 ounces in resources to 4.4MOZ M&I&I today including satellites.
The price paid to Saracen for KOTH looks ridiculous in hindsight ($3.9 EV/ounce). Today, KOTH is the 12th largest gold deposit in Australia. Why did they manage to buy so cheap? According to an Australian engineer I spoke to, because Saracen did not care about the asset and it underinvested in exploration.
Despite the stock is up by 650% since the 2017 lows, the substantial transformation experienced by the business is still fairly under the radar for most investors. No major broker covers the stock. This should change as RED becomes a >200KOz producer with middle of the pack AISC ($1,200/oz Darlot, $800-850/oz KOTH).
Key takeaway of point #1: Management has a track record of value creation. RED will get out of the convoluted small cap dog shelter and enter the “investable” category in the next 24 months.
2. Philippines overhang.
RED owns two assets based in the Philippines (Siana and Mapawa). All operations were suspended in April 2017 after the company reported difficulties with the obtention of environmental permits. 28 mines were suspended in the Philippines that year and 75 mineral production sharing agreements were cancelled, all “thanks” to the new mining minister appointed by Duterte after he was elected prime minister in 2016 (https://business.inquirer.net/233 543/mining-firms-rush-regain-lost-ground). RED is burning A$6m ($4m) a year in care and maintenance activities conducted at Siana. The Board is “carefully evaluating how best to maximise value from this project”. In its current form, RED is likely uninvestable for ESG money, something that will change when they monetise these assets (the closer this is to a sale, the better in this regard).
Key takeaway of point #2: RED should be worth more money after the Philippines assets are monetised.
3. Technical, financial, permitting and ramp-up risk until 2022.
RED still has to go through four major milestones before the stock becomes investable for mainstream funds:
Publication of the Final Feasibility Study
KOTH’s Feasibility Study will be released in Sep 2020. The Pre-Feasibility Study was released in August 2019, highlighting the potential to develop an initial 10-year mine plan with average annual production of 140,000 ounces at A$1,167/oz AISC ($817/oz at the current exchange rate). The PFS is not bankable, so the company needs to release a full FS in order to get the money that it needs to go ahead with construction. The release of the final FS will be the first major catalyst for the stock to re-rate higher.
Securing the debt package
Of the A$218m that will be needed to build the mine according to the Pre-FS, RED raised A$125m ($94.1m) via an equity placing done at A$0.18/sh in March this year. The Board participated with $470k. Electrum Group participated in the placing with A$20m and now owns 5.7% of the company. Though the amount of financing that RED needs to raise is small (management is targets A$140-160m, or about $100m in US dollars), there’s still uncertainty around whether management will be able to get the money. I think this uncertainty is low given that:
A bulk calculation using $1,500/oz gold price, A$1,167/oz AISC and 140KOz per year gives a total project payback of less than 1.5 years assuming a 70KOz, 140KOz, 140KOz ramp-up over 2022-2024.
KOTH is a brownfield project, which lowers operational risk substantially in front of the eyes of financiers.
Darlot’s free cash flow and the Philippines assets offer some additional support to the project.
Clearing the mining permits
KOTH’s first ounce of gold was poured in 1897. It has been opened and closed many times since then. The last time the mine operated was in 2015, when St Barbara closed as the prevailing gold price ($1,100/oz) was too low relative to KOTH’s operating costs back then ($1,100-1,200/oz AISC). I don’t expect any major permitting issues given the +100 years old history of the mine, tailings are non-acidic and there are other mines around.
Ramping-up the open pit mine
Here the perceived risk is probably higher than the average project given that the project is a brownfield, bulk mining open pit operation. An ex-employee I spoke with pointed out that the two key risks that the company faces in the ramp-up will be: 1) Building the mill, which is very large and 2) Building the open pit, which may be a bit of a head scratcher as a wall fell down in 2005 when the previous owners tried to build an open pit. Knowing the asset first hand, he considered this risk a mild one which management should be able to overcome.
Key takeaway of point #3: RED stock price should go up meaningfully as the remaining operational hurdles to transition from Darlot (a so-so asset) to KOTH (a great one) are cleared over the following 24 months.
4. Recent operational performance at Darlot has been poor
The company slightly missed production targets for Q4 2020 (FY ends in June) and the stock subsequently tanked by 40%. Despite the miss being a small one (21,000 ounces vs 26-30,000 guidance), some of the smaller investors who participated in the placing apparently felt cheated and they dumped the stock. This was preceded by a previous miss in Q3 2020 (20,077 ounces vs 25-29,000 guidance).
My checks suggest that the problem they had at Darlot was that the project came with subpar equipment. A ballpark estimate of the maximum spend that they may eventually need to do at the site is $50m (makes sense given it’s about half the cost of KOTH new mill for a mill that is 4 times lower than that one). They could get this from KOTH free cash flow fairly easily in case it’s needed in the future. The fixes implemented allowed the company to be back to 3.5g/t in June 2020.
RED’s management team insists that the operational issues have been resolved and remain confident in Darlot's production guidance for 2021 of 90-98,000 ounces. The fact that a substantial portion of the mill feed will come from Great Western open pit from next year onwards as opposed to KOTH underground and Darlot underground assets should reduce the operational risk of the Darlot + Satellites mining complex and maybe allow them to hit or exceed 2021 guidance (they are not idiots, so the updated guidance should be below what they expect).
Key takeaway of point #4: recent production misses are temporary rather than perpetual, but fast money doesn’t care. This is an opportunity to buy the stock before it transitions into a smoother production profile.
5. FCF won’t turn positive until 2023
There’s a lot of money to be spent in ramping up KOTH (A$218m), exploration (I’m assuming A$40m in the next two years) and care and maintenance for the Philippines assets (A$6m annually). FCF to equity won’t turn positive until 2023 under a $1,500 gold price and assuming there’s no delays in production.
The fact that they've just "found" 39,900oz of gold in the stockpiles that Saracen left behind will help them more than what the market reacted when this was announced yesterday (https://www.red5limited.com/site/PDF/4c0973c7-1339-4e83-8edd-5090df93e083/KingoftheHillsFinalFeasibilityStudyprogressupdate). unced At $2k gold and let's say $500/oz AISC (stockpiles, no need to mine'em), they've got an extra $59m of pre-tax FCF from this pile of sand that was not included in the PFS and that could be used to reduce upfront outlays at the site (or to fund a full upgrade of Darlot's mill which as I mentioned would cost $50m at the very most).
Key takeaway of point #5: The stock market being cash-impatient, the lack of near term FCF will weigh on the stock price until KOTH is up and running. By 2023, RED will do between A$96m and A$216m levered FCF at $1,500-2,000/oz gold price, or 17-39% FCF yield using the current market cap of the company of A$561m.
We’re being paid 3 to 1 (conservatively) to underwrite a series of risks that are well mitigated, mostly because of a combination of: 1) Management track record of value creation and skin in the game, 2) Knowledgeable and hands-on investors involved likely ready to step in should management loses focus, 3) Asset quality higher than what the market perceives and 4) Philippines overhang likely to be cleared in the near term.
Appendix I: Simplified cash flow model
Gold price $1,500/oz