Sandfire Resources NL (ASX: SFR) is one of Australia's lowest-cost copper producers and operates the high-grade DeGrussa copper-gold mine, located 900km north of Perth in Western Australia.
This article will build upon the previous article in the series (which you can find here) as we dig a little deeper into the critical areas investors need to analyse when valuing a mining company.
The DeGrussa mine was developed at lightning speed which is rare in the mining industry. The first exploration drill hole hit the deposit on 28 April 2009. Within 3 short years, the orebody was defined, mining feasibility studies completed and the first shipment of ore was sent out of Port Hedland in April 2012 – a sharp contrast to the usual 10 to 20 years it takes from the discovery of a mineral deposit until production begins!
Sandfire is a low-cost producer and places itself in the lowest quartile of production costs globally, as shown below. As a commodity producer, the surest way to survive during a market downturn is to operate low-cost assets and have low levels of debt – the safest level is none.
Debt
Sandfire Resources has rapidly reduced its debt beginning in the 2013 financial year (FY13) once the DeGrussa mine was fully operational and the cash started flowing.
The company had $120 million debt remaining at the end of FY15 which results in a net debt balance of just $13 million once the $107 million cash hoard is accounted for.
The interest coverage ratio (EBITDA/interest expense) for FY15 is extremely safe at 31x. Sandfire is in a strong position and can pay off its debt over the next few years from existing cash reserves and operating cash flows.
Cash Costs
To quickly recap the previous article – C1 cash costs include mining, haulage, milling and administration costs. Total sustaining costs are more difficult to estimate and can vary significantly depending on which costs are assigned to what category and in which year.
For example, mine development costs include costs incurred in accessing the ore body and the costs to develop the mine to the production phase and are often excluded from C1 costs but are an essential part of the operation.
Around 8,000m of underground mine development was completed at DeGrussa in FY2015 for a cost of $70 million. Mine development is expected to drop to around 1,000m per year from the end of FY17 with a subsequent reduction in mine development costs and, therefore, total cash costs after FY17.
There is no standard rule for these costs and they will vary widely across companies as well as between open-pit and underground mining operations. It is important to carefully read the notes in the financial statements to understand each company's treatment and classification of these costs.
My estimated C1 cash costs, total cash costs and price received per pound of copper are shown below.
Sandfire is still profitable despite the copper price sitting near a 5-yearly low. The depreciation of the Aussie dollar against the US dollar has helped mining companies with Australian operations such as Sandfire who are effectively receiving 25% more for their product compared to 1 year ago.
Mine Life
Sandfire's DeGrussa mine is its only operating asset which poses a large risk for the company and investors as the current reserves are expected to be exhausted in 6 years time. Current exploration activities around the mine aim to increase the life of operations beyond 2021. If this is unsuccessful it will significantly reduce the value of the business.
DeGrussa has been classified as a VMS deposit (volcanogenic massive sulphide). These deposits are often one part of a larger cluster of deposits in a localised area, increasing the probability of finding additional copper deposits. Talisman Mining Limited (ASX: TLM) recently announced promising drilling results at its Monty Project, in which Sandfire has a 70% interest. Monty is located only 10km east of the DeGrussa mine and could provide a source of copper ore to extend operations beyond 2021.
A good example of a large VMS system is the Noranda area in Canada. Over an 85-year period, 20 economic VMS deposits have been discovered within a 25km radius.
Drilling will continue at the Monty project to define the size and grade of the mineral resource. No estimates of its size have been provided by Sandfire to date.
Other Projects
Sandfire has a 36% stake in Tintina Resources, a North American copper company aiming to develop its Black Butte copper project. If the project is approved mining would commence in 2020. However, the project will struggle to make a profit if copper is below US$3.00/lb and it is unlikely to be approved unless there is a significant increase in the copper price by 2017 when the investment decision is expected.
The company also has a 38% stake in Toronto-listed copper explorer WCB Resources which is active in Papua New Guinea. It is unlikely this will provide any value to Sandfire in the near future.
The Copper Industry
The copper price is now sitting near a 5-yearly low and has been affected by slowing Chinese growth whilst global production levels continue to grow. An overview of the copper industry can be found in my previous article.
Although many copper mines will be operating at a loss, the iron ore industry has proved that it can take several years of low prices before higher-cost operators finally drop out of the market.
It is impossible to predict future moves in markets and commodities (although many will try!) For this reason, you should only invest in companies which are profitable in the current environment and can survive further downside in the copper price. Again, minimal debt and low-cost operations are the keys.
Valuation
The copper price is the main factor (and the exchange rate, to a lesser extent) that will affect Sandfire's free cash flow (FCF). The FCF and share price valuation are plotted against the copper price in the chart below.
FCF valuations require numerous assumptions and predictions. To keep it simple, I have used the current spot price for copper (US$2.4/lb) and USD/AUD exchange rate (AU$1 = US$0.7) for the remaining life of the project out to 2021. This provides a better understanding of what the project is currently worth compared to what it could be worth if the future copper price forecasts turn out to be correct, which is unlikely.
I value Sandfire at around $3.00 per share in the current price environment, significantly below its current market price around $5.80 per share. To achieve a $5.80 per share valuation the copper price would need to average around US$3.0/lb over the life of the project – a 25% increase from current prices.
My valuation does not assign any value to the future potential of the Monty deposit or any other exploration success in the area. For example, if the Monty deposit provides 5 years of additional copper production then my current valuation would increase by 45% from $3.00 to around $4.40 per share. This can be fully evaluated once Sandfire provides further information in the future.
Summary
Mining operations are exposed to many risks and the risks which affect Sandfire's performance the most – the commodity price and currency exchange rate – are out of its control.
I believe the current share price around $5.80 per share overvalues Sandfire Resources considering the current price of copper and uncertain industry outlook.
Investors buying today must be confident that copper prices will increase in the near future to over US$3.0/lb and also expect exploration success will extend the current operations beyond 2021.
Sandfire Resources is a great company, but I don't invest based on future predictions. I will wait until there is a clear turnaround in the copper price, Sandfire increases its reserves through successful exploration results, and the share price drops to an attractive price.
