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Valuing junior/exploration miners

Management is a key variable…but there is real resource risk: small-cap analyst Keith McLachlan.

SIMON BROWN:  I’m chatting with Keith McLachlan, a small-cap analyst still on garden leave until the end of the month. Keith, I appreciate your early morning time. In junior miners – and perhaps ‘junior’ more than ‘exploration’, there’s a gap in between – I’m thinking Renergen, which we both hold, Orion as well, where they’ve proved that there are assets underground. They’re going to be pulling them out of the ground perhaps later this year. My question is, is valuing these companies as simple as saying: ‘How much have they got underground? How much can they pull a year?’ and therefore we get a sense of revenue? Or is there a lot more nuance to trying to grasp a valuation here?

Read/listen: Renergen surprised by new gas find

KEITH McLACHLAN: Morning, Simon. The short answer and then the long answer. The short answer is yes, it’s that simple. But the long answer is that answering that isn’t that simple. So it might be a short question of saying, what’s in the ground, how much does it cost to get it out, and what’s the present value of it? But what goes into those assumptions is incredibly nuanced and complicated. So the long and short answers don’t leave you with a lot to go on. 

But these companies definitely have potentially a lot of value, particularly because they’ve got two variables that are working in their favour, assumed it works. 

The first one is hopefully there’s an economically profitable resource under the ground. And second, as they are de-risking that resource, arguably their cost of capital is coming down. In other words, they’re going up the value curve so those cash flows become nearer and it becomes safer.

SIMON BROWN: That cost of capital – in essence, they become less risky to funders, be it shareholders via rights issues, be it bankers or whoever as they start to prove it. I was just chatting with Lullu Krugel (chief economist for PwC SA) and talking around economic recovery the government has promised – this starts to become perhaps more than anything about management’s ability to actually deliver on what it is hoping to achieve.

KEITH McLACHLAN: Well, absolutely. Management is a key variable here: how they go about it, how they plan for it, how they communicate it even to the market. But understand that there is real resource risk. It is a variable outside of management’s control because, once they’ve put their flag in the sand and they say, ‘this is our resource, we are de-risking it’, and as they de-risk it, in classical mining you would go from a speculative resource all the way up to a bankable feasibility study before you start putting together financing and the like. 

But by the time you’ve arrived at a bankable feasibility study, there is either a resource there that is bankable, or there is not, and that’s not really that much up to management.

And hence there is a very real value curve they’re going up. And, in the classical sense of the word, some companies may believe there’s a resource and when they arrive at that point it’s just not economically viable and therefore we don’t hear about them any more.

SIMON BROWN: I get you. They get to the end; the accountants say the numbers simply don’t work. That must be soul-destroying. I suppose what’s also important here, and certainly, we’re seeing it with Renergen, Orion in a kind of different roundabout-ish way – start small, get it going, and then kind of step up to a phase two, which will be markedly bigger and less risky because they’ll have that cash flow from the initial resource.

KEITH McLACHLAN:  This is when management adds a significant amount of value, and it’s really a process of capital allocation. So you’re dancing on a knife blade, trying to develop the resource in the cleverest way possible with the most amount of operational optionality and the least amount of dilution while de-risking it at the same time. And, as we’ve seen, in most instances the best way to do this is incremental capital allocation, and Renergen is a very good example. They ran a CNG (compressed natural gas) pilot plant very, very small, to prove the resource and to build a market. Then they ran the numbers and they said, actually, we’re going to develop a much larger phase one project. CNG is only so good. We want to make it LNG (liquefied natural gas), because it’s far more fuel-efficient for our in customers, and we can get better realisations on that. In fact, we’ve proven that helium is there; helium is going to be part of phase one. 

And then phase one in fact is towered over by phase two, which is going to be multiples the size of phase one…. They’ve thrown the darts at the board, they’ve hit something really good. Then they’ve fired a bullet, they’ve hit the board again – well, hopefully, they will do so, all the indications are they will – and then they fire the big cannon and the big cannon in phase two takes this group (assuming phase two is successful) to the stratosphere. It becomes a completely different sized group in terms of production and profile and the like. And preferably you want that, you want a de-risking approach.

Orion is slightly different because they’ve got a brownfields asset. In terms of the brownfields asset, they’ve got a huge amount of production data actually there, from hundreds of years – maybe (just) many, many years – and so they can work with what the previous guys have done. And then they can look at this and go, can we be clever (in) how we reinvigorate this asset? The resources are already proven, now they just need to be clear about the capital allocation, and how they get it to production. 

SIMON BROWN: You made a point there earlier, resource risk – I take that. There’s another risk here as well. This is an industry with management risk. The management has to do what they say, but also they’ve got to do it sort of step by step to make it actually work, otherwise, the whole thing can just fall apart, even if they’ve got the resources.

Keith MacLachlan, small- and mid-cap analyst, I appreciate your early morning time.

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