Take a look at an extract from exclusive CRUX Investor Company Report on K92 Mining (TSX:KNT), originally written in October 2020 for Club Members. Included here is the Executive Summary and the Red Flags and Green Lights sections.
K92 Mining was brought to our attention and we were intrigued by its quiet approach to business in a jurisdiction we don’t know much about. So we decided to write this Company Report.
Its organic growth model is attracting attention as is its free cash flow position. They have been self-funding since 2018. K92 Mining operates the high-grade, underground Kainantu Gold Mine, located in the Eastern Highlands Province of Papua New Guinea. The major catalyst moment for this gold producer came in May 2017, when a near-mine discovery called Kora North transformed the gold mining value proposition on offer to gold investors. K92 Mining is now a low-cost producer and targets organic growth to continue producing value for investors as well as significant high-grade gold ounces in the ground.
NOTE: This is only a short preview, not the full report which can be found in the Club.
K92 Mining Incorporated (“K92”) (TSXV:KNT, OTCQX:KNTNF) is a Canadian company that has been advancing the Kainantu project in Papua New Guinea since 2015 after it had purchased it from Barrick Gold Corporation (“Barrick”). The market capitalisation is C$1.4 billion (US$1.08 billion), and on a fully diluted and adjusted basis the Enterprise Value (“EV”) is C$1.53 billion (US$1.15 billion).
Kainantu is now one of the lowest cost gold mines globally, with production planned to increase from levels of 82,000 ounces per annum (“ozpa”) in 2019 to target 140,000 ozpa in 2021 as the processing plant capacity doubles. K92 is also installing a twin decline that will enable production tonnages to increase from current levels of 200,000 tonnes per annum (“tpa”) to 1 million tpa by 2025, which would take gold production to 318,000 ozpa. The twin decline is being sized with a long-term vision of producing 3 million tpa in the future – a further expansion option which is not considered in this report.
In parallel with the decline development K92 is targeting resource growth at a variety of different scales. On the known veins, infill and expansion exploration is ongoing, to support mine plans and resource estimates. Within the mining lease the Company estimates that the established veins only represent one fifth of the veins that are present, so exploration is ongoing to target new resource areas. Finally, the mining lease sits within a broader 700 km2 project area, and regional exploration is ongoing targeting other vein systems and porphyry deposits.
The goal of the company is to grow earnings by increasing low cost production, and to grow capital value by continuing to add economic ‘ounces in the ground’ through exploration. The management team has done an excellent job of execution on the plan thus far, having more or less created a billion dollar company from scratch in five years. It should be noted, however, that the company is a one-trick pony for good or ill. Even the Company name reiterates the focus… Kainantu, K-nine-two, K92 (geddit? Ed.) The low cost of resource ounce discovery, the geological endowment of the mining lease, the high grade asset all mean that any other project will struggle to match the return of investing in Kainantu itself. Diversification, by virtue of Kainantu’s uniqueness, is largely off the table, which in some ways is no bad thing. The management team is liberated from all of the distractions of trying to build a diversified business, and it can channel Steve Jobs and ‘do one thing well’. The skill set required of a management team tasked with development and exploration of a single project site is specific, and the current management team look up to the task. So far so good.
The flip side of focus is a lack of diversification. A single asset company in a frontier market will trade at a discount to full value due to the risk associated with it being a single asset. The revenue stream from a single asset is binary in that it is either flowing, or it is not. Strikes, pestilence, plague, earthquakes, revolution can all happen (Covid-19 anyone?), let alone commonplace ground failure, community protests and blockades or labour dispute. For a diversified company the impact of one mine closure can be mitigated by support from other divisions. Not so for K92, with all of its eggs in the Kainantu basket, with everything hinging on the safe expansion.
As Kainantu matures as a project the pressure to mitigate risk via a merger will grow, and CRUX Investor feels that a good outcome for shareholders would be for K92 to end up as part of a bigger company. But there is a lot of runway at Kainantu before then.
The EV per ‘mineral inventory’ ounce figure is US$353/oz, which is probably about right for a single-asset producer. The high EV/oz figure reflects both the high grade and high margin production, and also the prospect for significant resource growth. CRUX Investor believes that the quality of the asset, the mineral endowment and the potential for spectacular discovery justify this valuation. Furthermore, when CRUX Investor runs the slide rule over the Kainantu plans, making what we believe to be prudent adjustments, the NPV emerges at US$1.75 billion, which is significantly higher than the current EV of US$1.15 billion.
Even accounting for a single-asset discount, the valuation of K92 at an EV/NPV of 0.66x is, in our opinion, harsh. CRUX Investor feels that with continued quarterly performance the discount will be unlocked, and a reasonable level would be 1x of NPV, which would suggest a 52% rise in the current share price. Note that the Tier 1 gold producers are currently trading at around 1.3x NAV, and that the NPV figures calculated by CRUX Investor do not include the option value of future resource discoveries.
To arrive at the NPV figures, CRUX Investor undertook a desktop valuation, reviewing historic data, and using industry norms to critique expansion plans. There are significant technical challenges ahead, and when working through the data CRUX Investor found there were a number of Red Flags in the plans and assumptions that will hopefully be managed and resolved. Equally the asset is high grade, and producing low cost gold at a high margin, so there is much to like, and many Green Lights. The building blocks of the report are shown below.
When K92 Mining bought the asset, the project area included a defunct mine complete with all infrastructure, including a processing plant. The mine was closed down not because it had depleted all its mineral resources, but because of operational difficulties experienced by Barrick, and probably also because it did not have the scale of production to be of interest to Barrick. Management reports that Barrick viewed the exploration potential of the larger licences as the real prize. Initially the acquisition consideration was set at US$2 million, followed by up to US$62 million over 10 years based on additional discovered reserves.
After refurbishment of the processing plant, K92 started production on a very small scale in 2016 from Irumafimpa, the deposit previously mined by Barrick. Irumafimpa was high-grade, but it presented mining problems including being a very narrow structure with poor ground conditions. Fortunately, exploration drilling had discovered wider, higher grade veins adjacent to Irumafimpa, referred to as Kora, which was almost immediately identified as the area on which to focus. K92 started in 2016 developing underground towards Kora, and the development also provided drill platforms to enable exploration of the previously untested area between Kora and Irumafimpa. The company planned for production from Kora by mid-2018, which target it easily beat as commercial production was declared in February 2018.
Further good news came in 2019 when it was announced the contingent payment of up to US$60 million was replaced by a fixed amount of US$12.5 million. This was paid to Barrick on 23 August 2019.
The production performance has seen a dramatic improvement in grade with mining at Kora, initially at 10 g/t gold equivalent (“Au Eq.”), improving to almost 21 g/t Au Eq. in 2019 settling at 15.6 g/t Au Eq. for the first half of 2020. Copper and silver are present in the veins, and they are valuable by-products contributing to the economics of the operation. At such grades the operation is a real money spinner. Unlike so many of the gold mining operations in the industry that are of dubious long-term economic value, Kainantu has become, a “veritable gold mine” in both the literal and the metaphorical sense.
The latest resource estimation arrives at mineral resources of more than 15 million tonnes at a grade of almost 10 g/t Au Eq, using a very low cut-off grade of 1.0 g/t Au Eq. However, CRUX Investor ‘Red Flags’ this resource estimate for a number of reasons. The concern here is that a large majority of the resources are in the Inferred category and the grade estimation relies heavily on underground sample grades in an area that seems to have a more consistent grade than away from 506/10/2020 the sampled area. Furthermore, the consultants did not top-cut very high composite grades, which could result in serious overestimation of gold content. The PEA itself notes, for example, that a top-cut applied to just four samples in one particular vein would account for a drop in resources of 0.7 million ounces (“Moz”). And yet no top-cut is applied to the resource estimate. There is risk here, but the operation has a history of positive resource reconciliation performance which is a testament to the quality of the asset. [More gold is produced than the models predict.] In the PEA, the consultants present a mine plan which would allow for mining of 10 million tonnes, assuming a cut-off grade of 5.5 g/t Au Eq. This “mineable inventory” processed at the current rate of 0.2 million tonnes per annum (“Mtpa”) would yield a life of mine (“LOM”) of 50 years. To sweat the Kainantu asset faster management now aims to increase the processing rate to 1.0 Mtpa, which is being dubbed Phase 3 Expansion. Net free cash flow will benefit from cost reductions through economies of scale.
On paper the expansion makes eminent sense. The challenge is to achieve this from narrow deposits with difficult ground conditions. The main risk associated with K92 is that actual mining conditions may dictate a change in plan and a scaling down of the company’s ambitions. Confirmation of the mine plan is now the subject of numerous studies the most important of which is geotechnical work. The company is currently working to increase the number of sub-levels in the mine to eight by year end 2020. By having more operating sub-levels, the Company will have more operational flexibility and more throughput (by virtue of having more faces to mine and bigger stopes) to increase the amount of ore mined.
This valuation has given the production ramp up the benefit of the doubt, accepting the doubling of production by 2021 (i.e. treating 0.4 Mtpa), ramping up further after 2022 to reach a rate of almost 1.0 Mtpa in 2025. What Crux Investor does not accept is the suggested operating cost rate of US$87/t when reaching the target throughput rate as it is too far below the actual US$304/t in H1 2020. With much uncertainty about what underground mining method will prove practical and the degree by which costs are fixed, this valuation has made a guestimate of the unit production cost of US$170/t which is 70% higher than proposed by the preliminary economic assessment (“PEA”) study, but also 44% lower than current unit cost.
One Red Flag noted by CRUX Investor was that the PEA did not calculate the economic performance on an after-tax basis. The omission is a glaring shortcoming as this item will be the major cash drain after (CRUX Investor-upward-adjusted) operating costs. Taxes and death are the only certainties in life; why ignore them? Not including the post-tax figures only diminishes the reputation of the consultant, and by implication the Company for not having insisted on the realworld conclusion. Certainly, the project is robust enough to carry the burden.
At the gold spot price of US$1,899/oz on 2 October 2020 the project has a cash operating margin of 74% which is extraordinarily high. The spot prices compared to the gold price of US$1,500/ oz used in the PEA, more than makes up for the upward revision of operating cost and the introduction of taxation, which includes 30% income tax and 15% on expatriation of funds, and accounting for corporate overheads. The pre-tax net free cash flow attributable shareholders of US$2.84 billion is almost exactly the same as the pre-tax US$2.86 billion cash flow shown in the PEA. Discounted at 7.5% to reflect the “new project” status of the production expansion gives an after-tax value of US$1.75 billion. With the extremely high cash margins the sensitivity to changes in gold price, operating cost and capital expenditure is very low. Even at a discount rate of 10%, the NPV gives a value of US$1.51 billion.
To arrive at a full NAV for the Company, Crux Investor should add the option value of the broader mining lease and exploration licences to the NPV figure for the expanded mine. We acknowledge that there is the considerable blue-sky potential from additional discoveries in the Kainantu project area. Given the obvious considerably size of the mineralised system in the Kainantu project area, evident from the numerous targets identified there, CRUX Investor is of the opinion that it is highly likely the company will find additional resources in due course. In a sense, though, that is ‘in for free’, and the company can fund it all from cash flow.
As noted above, the company’s fully diluted Enterprise Value of K92 at the prevailing share price on 2 October of C$6.88 is, at US$1.10 billion, clearly lower than the calculated intrinsic value. CRUX Investor believes that the haircut is too severe, and we expect the discount to be unwound as K92 Mining continues to create money by mining gold, and discovering more economic ounces that can be mined at a high margin in the future.
At risk of repeating the prior chapters, Kainantu is a fascinating prospect but it is not without its challenges. The mine has consistently returned more gold than was expected from ore, but the PEA study contained some omissions and flaws. The management team has done an excellent job on the operation so far, but now the Company is undergoing a major expansion on a single asset with resource estimate risk, and perhaps most importantly a new mining method on relatively narrow veins and some difficult ground conditions. The Ying and the Yang.
When trying to ascertain the balance of risk and reward, challenge and opportunity, CRUX Investor comes back to the key facts that the asset is great. High grade, under-explored, highly prospective, and producing strong cash flows, Kainantu is the real deal.
As ever, the best way to review a company is to strip away the emotion, and look at the hard numbers. When CRUX Investor puts hard numbers on top of the partial data provided by the PEA, it is noteworthy that the NPV generated is a 34% premium to the EV figure. On top of that is the exploration potential of the full licence, not quantified here. And a further key point is that the gold sector as a whole is trading on a ratio of 1.3x NAV, so K92 is trading on a relatively punitive basis.
Still, for completeness’ sake, here is the list of Red Flags and Green Lights...
Single asset company, meaning that the revenue stream is either flowing or it is not. Binary outcome for the bottom line, which will ensure that the Company will always trade at a deeper discount than diversified peers
PEA contains some inconsistencies, unrealistic (in our opinion) costs, missed some essential expenditures, and incorporates some risk
High proportion of Inferred Resources relative to Measured and Indicated Resources
Lack of top-cuts in the estimation, when by the PEA’s own admission a top-cut would reduce the main resource lode (K2) by 22%, or 700,000 oz
Switch to longhole open stoping carries the inherent risk of being a new mining method, despite the switch making eminent sense from an expansion perspective
Unproven ground conditions and the unknowns associated with the Clay Fault Gouge zone when longhole open stoping
Expansion plan is ambitious and targets set by mining companies are often missed
Unrealistic (in our opinion) operating costs used in the PEA, adjusted by CRUX Investor for the valuation work
PEA valuation calculated pre-tax, whereas any real-world analysis needs to be post-tax
Strong management track record established since operations began in 2016
Excellent grade, with Kainantu among the highest grade operating mines worldwide (15.6 g/t Au Eq. in H1 2020)
Low discovery cost per ounce, testament to the mineral endowment of the property
Multiple exploration opportunities, and resource expansion potential at depth, in the mine area, and further afield within the broader exploration licences
Very strong cash margins (74%), a function of grade, price, and cost
Production forecast to grow from 82,000 oz in 2019 to 318,000 in 2023, on a lower cost base per ounce
K92 trading at a 30% discount to NPV 7.5, and 15% discount to NPV 10
Peers trading at 1.3x NAV, so relative valuation is punitive
Retail investors often do not have access to the types of company reports that are paid for by institutional investors, costing up to $100,000. Research companies and brokers are restricted by regulators in regards to sharing that information with retail investors, which puts retail investors at an immediate disadvantage.
Less information available = worse investment decisions. We are looking to change this by providing unbiased, unpaid for company research, specifically and exclusively for retail investors, HNWIs and family Offices - closing the gap between institutions and individuals.
Club subscribers can access the full report & quarterly updates in the Club. Not a member? Join the waitlist here.
Any advice contained in this website is general advice only and has been prepared without considering your objectives, financial situations or needs. You should not rely on any advice and / or information contained in this website or via any digital Crux communications. Before making any investment decision we recommend that you consider whether it is appropriate for your situation and seek appropriate financial, taxation and legal advice.