CNMC Goldmine Holdings Limited - Phillip Securities 2016-09-15: Sitting on a gold mine

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CNMC GOLDMINE HOLDINGS LIMITED 5TP.SI

CNMC Goldmine Holdings Limited - Sitting on a gold mine

• Abundant resources and reserves at Sokor field with extracted gold grade higher than cut-off grade.
• Current minimum ore processing capacity is expected to be ramped up in the upcoming future, from the current 1.2mn tonnes per annum.
• All-in sustaining cost and All-in cost trended down over the past 5 years and are currently maintained at around US$500/oz.
• Other resources such as Silver, Lead, and Zinc have yet to be explored, thus the value of these resources are not priced in yet.
• The acquisition of Pulai Project is awaiting to be sealed and expected to create positive synergies.
• We initiate coverage on CNMC with a Buy rating and a DCF-derived target price of S$1.03 using a cost of equity of 9.8%. Together with an estimated dividend of SG cents 1.4 for FY16, implied upside is 102.6%.

Company Background

• Commenced operation in 2007, CNMC is the first gold miner listed on Catalist board in SGX in 2011.
• The group is engaged in gold production and related businesses such as exploration, mining, and the processing of ore into gold dores.
• Currently, the group is focused on the flagship project, Sokor Gold Field Project, which is located in the State of Kelantan in Malaysia. Covering an area of 10km2 , Sokor is estimated to contain 618,000 ounces of JORC-compliant gold resources, including mined ore reserves, as of Dec-2015. The field is comprised of four identified areas, namely, Manson’s Lode, New Discovery, Sg. Ketubong, and Rixen.
• As of Dec-2015, total measured, indicated and inferred gold mineral resources for the Sokor Gold Project were 13.83mn tonnes at 1.39g/t gold with contained gold of 618,000 ounces (2014: 10.81mn tonnes at 1.5g/t gold with contained gold of 506,000 ounces).
• In Jun-2016, the group signed a non-binding letter of intent with Pulai Mining Sdn Bhd to acquire a 51% stake. Pulai mining is a brownfield with 11 licenses covering roughly 38.4km2 to explore and mine for gold, iron ore, and feldspar.

Investment Thesis 

1. Overview on supply and demand of the gold market 

• Eye on the gold value chain, there are mainly five gold supply channels, namely, mine production, artisanal production, recycled gold, official sector sales, and net producer hedging. Mine production dominates the majority of supply and sees relatively lower volatilities in numbers yearly, while the latter three channels are subject to the macroeconomic environment, resulting in volatile supply.
• According to the GFMS Gold Survey 2016, the supply from mine production has been trending up over the past decade, from 2,497 tonnes in 2006 to 3,158 tonnes in 2015. Scrap supply (artisanal production and recycled gold), the second largest contribution, was relatively price-sensitive, tracking the rise and fall of the gold price, since the scrap holders selectively and speculatively monetised gold in hand during the upswing period and were deterred to sell when gold price was under downward pressure. Likewise, net producer hedging, which is the change in the physical market impact of mining companies’ gold loans, forwards and options positions, moved inversely with market price and expectation. In the gold bull market, gold miners leveraged financial instruments to defer deliveries at a higher price, while in the bear market, they locked in the selling price in order to avoid further downfall.
• As for the demand drivers for gold, demand generators can be classified into 4 broad categories - jewellery, investment, official sector, and industrials. Over the last decade, demand derived from jewellery-making and investment purposes ranked as the top two, which were influenced by the market sentiment towards gold price. However, the amount of industrial demand was on an apparent downtrend, with the drop from 482 tonnes in 2006 to 361 tonnes in 2015, due to the development of substitute materials.
• Lastly, since the 2008 global financial crisis turmoil, the official sector, especially central banks and major financial institutions, started increasing their gold reserves, reversing a previous trend, partly due to the authorities’ weakening faith in the fragile currency markets. Rising regional conflicts worldwide also lifted the demand for gold in treasury vaults. After all, gold has been recognised as the perfect risk avoidance asset amongst all.

2. Main driver of gold price: Money supply 

• US started to launch the quantitative easing (QE) program in order to deal with liquidity crunch during the subprime crisis in 2008. A total three rounds of QE lasted for seven years, initiated in 4Q08 and ended in 4Q14. The three rounds of QE (highlighted in grey) distorted the normalised growth of monetary base over the past decades. As a result, asset prices were inflated exponentially. For instance, US equity market reached a new high in early 2013 right after the 3rd round of QE was announced. With the continuation of QE, S&P 500 index skyrocketed and reached the all-time high of 2,193 in Aug-16. The flooded monetary base tremendously boosted liquidity which drove equity prices up.
• The gold bull market began in 2005 and ended in 2012. Subject to dire sentiment widely spreading during the subprime crisis, those gold positions were inevitably liquidated. However, gold rallied swiftly right after the 1st round of QE was announced, since the market pursued less risky assets, among which gold is viewed as a traditional safe haven. Benefiting from the 2nd round of QE, the unstoppable inflows of capital pulled up gold prices to the all-time high level of US$1,920/oz. The paradox was triggered in 2012 because gold markets turned the other way round when more capital was pumped into the market during the 3rd round of QE. One of the reasons could be investors shifted capitals to equity and bond markets to pursue higher yields. Therefore, the gold price was supressed.
• Central banks are responsible for controlling the money supply, thus the expansion or contraction of their balance sheets can be viewed as the proxy for the direction of money supply. When the supply of fiat currencies outpaces the stock of gold bullion, gold prices will rise and vice versa. The combined balance sheet of major central banks, namely Federal Reserve (Fed), People Bank of China (PBOC), Bank of Japan (BOJ), European Central Bank (ECB), and Swiss National Bank (SNB), indicates the universal expansionary monetary policy. Correspondingly, gold price has aligned with the increment of money supply until the price correction occurred in 2012. Though, according to World Gold Council (WGC), the total official gold reserves of those central banks mentioned above were increased in recent years, the tonnage growth substantially fell behind the growth of money supply. Therefore, we do believe that gold price has overly corrected and will have more potential room to grow.

3. Gold performed well in recessions 

• Gold has been treated as a safe haven asset, especially during times of recessions or crises. The reason behind this pattern where investors increasingly pursue gold during such periods of economic turmoil is the anticipation of monetary and fiscal stimulus, which immensely expands the monetary base. Accordingly, gold, which is priced by paper money, becomes more valuable. Referring to Figure 8, the average return of gold over the past 6 recessions (highlighted in red) is 22.2%, and gold generated positive returns in each period.
• Is the next recession coming soon? We need to take a look at several economic barometers to judge. Here we trace US GDP growth and unemployment rate back to 1940s and track industrial production rate even further down back to 1920s. When US GDP YoY growth fell below 1%, the economy was either underwhelmed in a recession or stepping into a recession. US GDP growth had decelerated since 2015 and reported at 1.2% for 2Q16. A recession could be approaching us now when the growth rate is approximating to 1%, the alert line. At the manufacturing side, shown in Figure 10, there were 23 periods of contraction and 6 failed (July 1934, April 1952, July 1956, July 1967, July 1985, June 2003) to bode a recession shown by the highlighted box, implying an accuracy rate of 73%. The failed signal showed that the duration of contraction lasted less than 4 months. However, the current downtrend of industrial production has been lasting for 11 months, implying US economy is heading towards a recession.
• Another indicator is the unemployment rate turning point. When the Unemployment Rate ticked up above the 12-month moving average and formed a bottom, the US Economy tended to enter into a period of recession. 10 out of 14 instances have been proved to signal a recession successfully with 71% implied accuracy. The unemployment rate increased from 4.7% in May-16 to 4.9% in Aug-16, and is only 0.1% away from the current 12-month moving average of 5%. Again, this strengthens our expectation of the arrival of a recession.
• In a nutshell, throughout history, there have been several predictable repeating patterns when we analyse the economy, though we are aware that historical patterns may not neccesarily give a good forecast of the future. What we discussed above convinced us that there is a higher probablility of an impending recession, and gold will soon show its investment value when recession and market fears set in.

Investment Merits 

1. Sokor project has had abundant resources and reserves to explore so far.

• CNMC has been hiring Optiro Pty Ltd (Optiro), the independent advisory services firm, to provide mineral resource estimates. 
• We summarised the historical levels of mineral resources of Sokor project over the past 5 years. The total gross amount of measured and indicated gold, which could be converted to a probable ore reserve, according to the guidelines of the JORC Code (2012), has been trending up due to the incremental amounts of indicated gold and the flattish amount of measured gold. 
• Meanwhile during the period, the respective gold grade of measured, indicated, and inferred gold dipped 0.2g/t, 0.2g/t, and 0.1g/t, but we think the mild declines would not impact the business significantly, as the cut-off grade (lowest grade to be considered of economic value) is much lower than the current level. Since there was no activity related to the Ketubong deposit over the past 4 years, no ore reserve estimate was reported for it. 
• The gross amounts of ore reserves and mineral resources of Manson’s Lode, New Discovery, and Rixen pits attributable to CNMC have been increasing amidst a declining rating of the gold grade. However, compared to the cut-off grade, which is based on 95% mining recovery and 5% dilution at zero grade as well as a gold price of US$1,100/oz, the ore reserves and mineral resources gold grades are substantially higher, enabling CNMC to maintain its lucrative high margins.

2. Awaiting the ramping up of capacity in the foreseeable future 

• CNMC conducts a combination of heap and vat leaching processes in three yards, with the heap leach being the predominant processing method in 2015. By the end of Apr-16, the Group expanded the leaching capacity by another 200k tonnes/year. Together with the previous capacity of 1mn tonnes/year, total current minimum capacity stands at 1.2mn tonnes/year. The tonnage of ore processed was lifted exponentially over the past 4 years, and it reached the production peak in 2015. According to the management, 2.2mn tonnes ore processed was close to the maximum capacity. With 20% increase in leaching capacity in 2016, we expect the output of gold dore will surpass last year’s amount.
• Furthermore, CNMC had just received the approval from Kelantan State Lands and Mines Office (PTG) of Malaysia for large scale operation for Sokor gold field project. The approval enables CNMC to mine unlimited amounts of ore at Sokor with the mining lease extended to 2034. There is no doubt that the Group is planning to expand operations in order to lift gold production volumes, thus we expect more gold output in the upcoming years.

3. Low all-in cost offers buffer against fall in gold prices 

• In order to improve profitability, expanding ore processing capacity and reducing operating costs are the most effective ways given that gold price is driven by the market and beyond the company’s control. CNMC has been striving to lower all-in sustaining costs (AISC) and all-in cost (AIC), and maintain them at a low level. With the increasing gold production volume, the Group is reaching economies of scale, and as a result, AISC and AIC have been trending down.
• Moreover, the convergence of AISC and AIC was due to a reduction in costs related to new operations and construction of facilities. The all-in margin averaged at US$612/oz (48% in percentage term) over the last 12 quarters. 
• There are three major factors which enabled the Group to drive the downtrend of AISC and AIC. 
  • Firstly, open pit mining technique, an ore extraction process that is conducted at the surface of a mining site, is applicable to the deposits at the Sokor. Meanwhile, the group prioritised heap leach (HL) sources (Rixen, then New Discovery) and left the carbon-in-leach (CIL) processing (Manson’s Lode) to the later part of the schedule. In other words, the Group mines the lower cost pits prior to higher cost pits. Since the Group currently focuses on mining at Rixen pit and keeps silent at other pits, the surge in mining costs is not expected in the near term. 
  • Secondly, apart from the blasting and drilling fleet, which are outsourced because of lack of related licences, the mining fleets, as well as administrative and technical services staffs, are all in-house employees. Thus, the Group is able to reduce the labour cost outflows to contractors, who charge a premium for providing services. 
  • Lastly, the Group has been ordering raw materials like leaching chemicals directly from China instead of procuring from the local market. Through these measures, CNMC further compresses the operating costs. However, with the depletion of ores at Rixen pit, the mining will start to shift to New Discovery and Manson’s Lode, resulting in higher mining costs. 
• We expect AISC and AIC to increase correspondingly as the mining shifts. In a nutshell, we expect AISC and AIC to increase, driven by capacity expansion, but still fluctuate within the range between US$500/oz and US$600/oz.

How Do We View CNMC? 

Endeavours to mining business itself 

• CNMC’s business model is purely simple, extracting gold from ores mined from the ground and selling it. Based on track record, CNMC does not keep any stocks of physical gold.
• Furthermore, according to Optiro Qualified Person’s Report, gold bullion is sold on the spot market to local buyers, and there are no prevailing supply and demand constraints in the local gold industry. Therefore, finding buyers and monetising the gold bullion would not be an issue for CNMC. 
• Besides, the Group does not hedge or arbitrage on the gold price and FX (MYR/USD). 
• Management mentioned that transactions are based on average intraday spot price and FX. When gold price is on the uptrend, miners benefit more without hedging, and vice versa. From management’s point of view, 

CNMC strategizes to maximise gold production and minimise operating costs. 

• We think that CNMC is still at the early stage of exploration and production, and its focus on mining is the right move. 
• After all, the output of underlying assets is the determinant of the mining business.

Other treasures underground awaiting to be explored and monetised 

• CNMC has only engaged in gold mining so far, except in 2012 when it also mined at Manson’s Lode pit and shipped those concentrated ores containing silver, zinc, and lead to China for separation and extraction. There is abundant Silver, Lead, and Zinc resources, awaiting to be mined. The respective average prices are US$24/oz for silver, US$2063/t for Lead, and US$2028/t for Zinc over the past 5 years, and all started to rally in early 2016. 
• So far, the value of these resources has not been priced into the valuation of CNMC, so we believe potential upside for profitability and stock price is large.

Catalyst: Pulai project 

• Pulai Mining produced and sold more than 260kg of gold worth approximately RM38mn from Mar-11 to May-13. Besides, though there were no deliberate efforts to systematically explore feldspar deposits, more than RM500k in revenue was still generated through feldspar mining in 2015. The previous exploration suggested that Pulai has similar mineralisation features (geological background, tectonic structure, and geochemistry) as the Sokor gold mine. 
• Besides, Pulai mine also contains iron ore resources, around 10,000 tonnes of which were extracted with the grade ranging from 50% to 55%. 
• According to Management, on the premise that CNMC manages to seal the deal, it could possibly take three years to commence mining operations and generate decent positive cash flows. Therefore, we can expect positive synergies in the foreseeable future once the acquisition is accomplished.

Valuation Methodology 

• From FY12, Management started generating increasingly positive Cash flows from Operations (CFO), amidst the downtrend of gold price. This was due to management’s effort to expand capacity to achieve economies of scale. In other words, the impact of the declining gold price was offset by a substantial increase in production volume of gold. In FY14 and FY15, the Group started generating enough CFOs to cover capital expenditures.
• Here we use discounted cash flow (DCF) which is based on free cash flow to equity (FCFE) as the valuation method to value CNMC.

Investment Actions 

• We initiate coverage on CNMC with a Buy rating and a DCF-derived target price of S$1.03, using a cost of equity of 9.8%. 
• Together with an estimated dividend of SG cents 1.4 for FY16, implied upside is 102.6%.

Investment Risks 

• Here we list the key risks for consideration: 

Upside

• Gold Price: CNMC's sales of gold bullion are based on intraday spot gold price. If it surges to a higher level, the top line will increase substantially. 
• Gold Grade: The gold grade is determined by the mineralisation features in nature. It has nothing to do with operations and market movements. If the extracted ores happen to be higher grade ones, the production volume will increase, given the same processing capacity. 
• Capacity: The control of capacity is at the discretion of company strategy. Currently, we see higher probability that the company will keep expanding it. 
• FX: The functional currency is RM while the presentation currency is US$. It can see currency translation surplus when RM appreciates against US$.

Downside

• Gold price: If gold price trends down, the profit margin will be shrunk.
• Gold grade: Lower gold grade requires the company to expand capacity in order to maintain similar profitability.
• Ore reserves and resources: Profitability will taper off after ore reserves and resources are being depleted if no new mines are found.
• FX: When RM depreciates against US$, it will suffer from currency translation deficit.
• Policy: Mine resources are actually owned by the state government. Any unfavourable policy changes can turn the business the other way around.

Chen Guangzhi Phillip Securities | http://www.poems.com.sg/ 2016-09-15

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