Alkane Resources — Update 31 January 2016

Back during the rare earth bubble of 2011, while the market was in hot pursuit of exposure to rare earth elements (REEs), Alkane’s strategy to develop a A$1,000/oz (C3-equivalent) gold mine was met with some scepticism in the market. Now, five years later, Alkane’s gold mine provides it with cash without diluting its shareholders, to invest not only in extending that mines life and exploring its highly prospective land packages nearby, but also providing pre-development investment into its flagship DZP.

Other than for exploration activities (which, though certainly worthwhile progressing, we view as non-core in the current market), the following sections provide development highlights relating to the TGO and DZP.

A maiden underground reserve estimate of 61.6koz of gold has been declared for the TGO, paving the way for our long-held assumption for the underground mining phase at the project. Alkane’s financial assessment indicates that an additional 47.7koz of inferred gold should be extracted, which are incidental to mining the reserves. This is supported by empirical data from the existing open-pit mine of the same deposits that indicate conversion of 100% of inferred ounces to mineable reserves, as well as the fact that the TGO mined an additional 41% of gold ounces at Wyoming Three, compared to the initial resource block model.

Since the TGO DFS was completed on the Wyoming One, Wyoming Three and Caloma deposits in 2010, which stated an initial 7.5-year mine life extracting c 369koz of gold, Alkane has drilled and added further ounces at the Caloma Two deposit to its resource inventory. Coupled with Caloma Two resources and these new underground reserves, the TGO’s mine life should now be in excess of 10 years at current production rates. Further expansion of the UG resource/reserve base is likely as and when drilling can take place from more advantageous drill positions underground.

Alkane will initiate the underground development phase of the TGO by end CY16 pending successful debt funding of the initial development capex of A$20m. The company states that in the current market, raising equity will not take place unless a significant uptick in its share price occurs. Our DDF model demonstrates positive cash flows are maintained with this debt included at current gold prices and costs of production levels. This scenario has been performed without any DZP funding assumptions included.

Alkane guides that first UG production will commence nine months after the start of developing a portal from the Caloma open pit and last for 2.75 years or 33 months. However, as stated above, production is likely to continue beyond this time frame, which is based solely on defined JORC-compliant ore reserves. We have therefore taken a view based on the fact that open-pit production has exceeded geostatistical resource estimates as a key reason to include mining a further 48koz of gold. This is the amount of gold Alkane has estimated in the inferred category for the UG mine phase, but which for regulatory reasons it has not been able to include in its UG mine plans. Based on the UG mine producing 20koz of gold pa, the 48koz of inferred gold extends the UG phase by a little over two years. Therefore, in our assumptions we forecast UG mining to extend to FY22. We expect Alkane to make use of far more advantageous drill positions to delineate further UG reserves as and when these positons become available for use. Our new TGO life-of-mine gold production profile is given in Exhibit 1.

The following exhibit details ytd production and cost metrics for the TGO, plus our forecasts quarter-by-quarter to year end.

Exhibit 2 above demonstrates that if the current run rate of gold production at the TGO persists until year end, it would likely result in gold production at the top end of Alkane’s 60-70koz range. Also, if production costs were to be maintained at Q216 levels (A$1,316/oz), it would still manage to bring its average AISC production cost just within budget at A$1,296/oz (Alkane’s guidance on AISC costs for FY16 is A$1,200-1,300/oz).

However, we note that, based on our forecasts above, the milled head grade would need to increase 13% from Q216 levels but, considering the average for the TGO so far is 2.11g/t, we do not consider this a major concern and Alkane’s site management should be able to achieve its stated gold production target through managing throughput (ie tonnage milled) if the gold grade persists at Q216 levels.

The following exhibit is a graphical representation of historical production volumes and grades at the TGO from the start of mining during Q214 through to Q216, plus our estimates for Q3-Q416, to achieve a gold production target of 69koz, with 65koz of gold sold.

Alkane continues to advance the DZP in terms of pre-development engineering designs, commercialising its memoranda of understanding and purchasing land required to develop the DZP. The main points of progress are:

We adjust our valuation for H116 TGO production data. We also refine our existing underground production schedule such that both Alkane’s announced 62koz UG reserve base is fully exhausted from H218 to FY20, along with current stockpile levels blended in with this and open-pit ore during the same time period. We also note that UG gold production is likely to be above modelled estimates – akin to current open-pit ROM to reserve reconciliations. We also include A$20m in UG development capex funded under our current assumption purely via bank debt and push out DZP financing and capex assumptions to FY17 (previously FY16) to account for Alkane’s ongoing DZP financing negotiations. On this basis, our fully diluted SOTP valuation at a 10% discount rate is A$1.02. Exhibit 4 below details the breakdown of this SOTP valuation and compares it to our previous valuation, published in our October 2015 update note.

Our valuation is based on a dividend discount approach and therefore discounts all free cash from operations in the form of theoretical dividend payments using a 10% discount rate to reflect general equity risk. Our DDF-based model includes Alkane’s current financing strategy for the DZP (see our October 2015 update note), as well as debt funding for the TGO UG phase and a new DZP working capital facility totalling A$4m (see following financials section for our treatment of these items).

Note that the above valuation is post-dilution. If the DZP is not successfully developed and we remove all financing assumptions and dilution for this project, Alkane’s shares, based on gold production from the TGO only, are worth A$0.36.

Alkane’s cash position at end H116 was A$14.764m. We expect gold production to come in at the top of its 60-70koz gold production target at end FY16 and we forecast AISC costs to be at the upper end of guidance at A$1,296/oz. We forecast total FY16 exploration expenditure (which includes DZP development expenditures) of A$8.0m (H116: A$4.0m) and include A$3.7m in land purchases and a A$4m working capital facility (treated as debt, repaid over five years starting in FY19, bearing 10%) relating to the DZP. We also include A$20m in UG development capex for the TGO and assume this is met by debt repaid over five years bearing 10%, starting in FY19 as UG production is firmly bedded down.

On this basis, we estimate that Alkane will finish FY16 with cash of A$18.5m.

Note that our end FY17e net debt position (A$517m) has reduced materially from the A$928m in our last note (published in October 2015). This is due to delaying all financing assumptions for the DZP by one year to FY17, with first production resulting in maiden DZP revenues starting in FY18 (previously FY17). This is in line with Alkane’s current DZP project development timeline.