Endeavour Mining — Maiden fully consolidated valuation (EDV+SFO)

Results in Q120 were characterised by record revenue, record adjusted EBITDA and record operating cash flow. At least as importantly, all operations were reported to be operating near normal (albeit with a revised roster to counteract local quarantine requirements) and all of Endeavour’s employees who had contracted COVID-19 were reported to have recovered.

Overall gold production in Q120 was 10.5koz in excess of our forecasts, driven mainly by output at Houndé and Agbaou, while gold sales were 13.2koz in excess of our forecasts. All four mines recorded lower than expected unit costs. Better grades were recorded at Karma, but worse grades at Ity (although these were offset by better recoveries and higher throughput). Royalties were higher at all four mines (not least as a result of the higher gold price) and taxes were higher at three out of the four mines (the exception being Ity). There was also a higher than expected minority charge at Karma. A full explanation and description of the factors and forces affecting operations in Q120 vs Q419 is provided in Endeavour’s press release on 13 May 2020 accompanying its results and also its management discussion and analysis (MD&A). In conclusion however, at 30.3c/share, adjusted net earnings per share were materially ahead of both Edison’s and the market’s forecasts at the time.

While Q120 was, to all intents and purposes, unaffected by the early effects of COVID-19, it is clear that there have been some consequences in Q2. In the main, these have arisen due to travel restrictions on technical and engineering consultants and have particularly affected maintenance schedules. As a result, Endeavour has adjusted some of its mine scheduling. In general, therefore, the refinements that we have made to our Q220e forecasts relative to our last note (see Starting strong, published on 27 May 2020) involve the following:

In general, we have then re-scheduled the balance of ore and waste mining at all four mines for the remainder of the year such that, in many cases, there is little change to the aggregate and average values for each operating parameter for the full year. We have also refined our forecasts for SEMAFO’s Mana and Boungou mines to reflect operational detail on a quarter by quarter basis provided by management.

In the light of these changes, our updated forecasts for Endeavour (on both a pre-acquisition and a pro-forma basis) for Q220–Q420e for the remainder of the year are as follows in Exhibit 1, overleaf. Readers wishing to compare the updated forecasts, for Q220e in particular, with our prior forecasts may do so by comparing the numbers in Exhibit 1 with those in Exhibit 5 of our last note (see Starting strong, published on 27 May 2020). Note that, for the moment, we have left our gold price forecasts unchanged for the remainder of the year, despite the fact that the spot price of gold is trading near US$1,760/oz at the time of writing, compared to our forecasts for Q320 and Q420 of US$1,720/oz (NB an indication of the effect of the gold price remaining at current levels for the remainder of the year on adjusted net EPS from continuing operations is provided in Exhibit 2). This reflects, among other things, the recent nature of the move in the gold price (from US$1,720/oz to US$1,760/oz) and will be reviewed on the announcement of EDV’s Q2 results around 2 August.

Items included in the reconciliation between adjusted net earnings attributable and total net and comprehensive earnings are losses from discontinued operations, deferred income tax effects, gains/losses on financial instruments, other expenses, share-based compensation and acquisition costs (all shown independently in the table above), plus the tax impact of adjusting items, non-cash and other adjustments and the minority interest attributable to the adjusting items (not shown independently).

With the exception of Q220, readers’ attention is drawn to the general uplift of pro-forma per share estimates relative to pre-acquisition ones – indicating, among other things, the accretive nature of the acquisition. However, they are also cautioned that forecasting on a quarterly basis is prone to large variations between actual and forecast numbers. To this end, it is worth noting that the top end of Endeavour’s (pre-acquisition) production guidance is 47.7koz gold (6.9%) above our forecast for the year, which is worth a material US$76.9m in additional revenue to the company (net of royalties) and therefore has the ability to increase our (pro-forma) estimate of Endeavour’s FY20 profit before tax by a material 11.9% (all other things being equal). As such, the exhibit above should be regarded as indicative, rather than prescriptive, particularly with respect to individual quarters. Within that context a comparison between Edison’s FY20 adjusted net EPS from continuing operations estimates and consensus estimates, by quarter, is as follows:

Historically, Endeavour has a good record of meeting its production and cost guidance targets and FY19 was the seventh year in succession in which the company achieved its production cost and all-in sustaining cost (AISC) targets.

In general, the first half of FY20 is expected to be an extension of circumstances in Q419. Ity will continue to mine into harder fresh ore at Daapleu, which will restrain recoveries before a degree of improvement in H220. However, its CIL plant should naturally be less affected by the uncertainties of the Q3 rainy season than its historical heap leach operation. In addition, the second lift of its tailings storage facility has now been completed, with the result that management believes that the mine, which is located in an area of acknowledged high rainfall, is now better prepared for the FY20 wet season than at any time in the past. Performance at Houndé will depend largely on its ability to mine Kari Pump in H220, for which a permit is expected to be received in Q3. In the meantime, it will continue to mine predominantly hard ore at a relatively high stripping ratio in H120, although this will be somewhat mitigated by its plant continuing to operate at or above nameplate capacity. Whereas, Edison has, up until now, declined to assume a contribution from Kari Pump’s materially higher grade ore in H220, we have now started to do so from Q420 onwards. At Agbaou, harder ore is expected to be mined, while the overall stripping ratio is anticipated to decrease slightly and throughput and recovery rates to decrease marginally owing to the harder ore blend. In the meantime, tonnes stacked at Karma are projected to increase as a result of the installation of the new stacker system and grades and recoveries to remain consistent with Q419 (albeit to improve upon FY19 generally, which was adversely affected by maintenance downtime related to the installation and commissioning of the tripper conveyor in addition to the heavy rains, which resulted in an increase in unit mining costs among other things).

In the wake of our updated operational and cost assumptions for the remainder of the year, a summary of our outlook for each of Endeavour’s operations is now as follows:

In the wake of Q120 results, Endeavour’s production and cost guidance for FY20, compared with Edison’s forecasts, is now as follows:

In our last note on the gold price (see A golden future, published on 11 June 2020), Edison argued that the recent, sharp increases in the total US monetary base might be expected to support a (nominal) gold price of US$1,892/oz and potentially as high as US$3,000/oz. While there is a historically strong and statistically significant correlation of 0.909 between the gold price and the total US monetary base from 1967 to 2018 however, there is very little visibility as to how, or to what extent, the total US monetary base may be expected to evolve. Currently, we know that it is expanding at a rate of approximately US$110bn per month, which equates to an expected increase in the gold price (using the historical correlation) of approximately US$500/oz per annum. Anecdotally, the total US monetary base may probably be expected to continue to increase for a time until the COVID-19 crisis has been managed and then to flatten off for a discrete period until a period of tapering is attempted by the Federal Reserve (in a similar fashion to the aftermath of the global financial crisis). However, neither the extent of any increases nor the extent of any subsequent tapering nor the timing of either is easy to judge. In consequence, Edison’s strategy now is to maintain a flat, nominal gold price of US$1,892/oz into the future from FY21. Note that this may be contrasted with our previous approach to gold price forecasts (see Portents of economic weakness: Gold – doves in the ascendant, published on 14 August 2019), the results of which were as set out in the table below:

In the absence of more general deflation, a flat, nominal gold price of US$1,892/oz is, self-evidently, a declining gold price in real terms, which is an unlikely long-term scenario, given that the gold price has historically increased by 2.0% per annum in real terms from 1914 to 2018 (see Portents of economic weakness, Gold: Doves in the ascendant, published in August 2019). Moreover, during the period 2013–18, the gold price was relatively flat, averaging US$1,270/oz. Its average price in 2018 was also US$1,271/oz and this therefore might be considered an appropriate floor price from which to grow the gold price in real terms. Both of these scenarios may be plotted into the future as follows:

As may be seen from the chart above, the two lines cross between 2025 and 2026 at a level fractionally below US$1,500/oz. All Edison’s gold company valuations are conducted in real terms. Consequently, and in the absence of much immediate visibility as to the evolution of the total US monetary base, Edison’s new gold price scenario for valuation purposes is for the gold price to remain at US$1,892/oz in flat nominal terms (ie declining in real terms) until the price (in real terms) crosses with the increased US$1,271/oz 2018 price. At that point we assume that the price will flatten out (in real terms) at US$1,494/oz (note that this may be contrasted with our prior methodologies for gold price forecasting, which were set out in our report, Portents of economic weakness, Gold: Doves in the ascendant, published in August 2019).

Endeavour is a multi-asset company that has shown a willingness and desire to trade assets to maintain production, reduce costs and maximise returns to shareholders (eg the sale of Youga in FY16, Nzema in FY17 and Tabakoto in FY18). Rather than our customary method of discounting maximum potential dividends over the life of operations back to FY20, therefore, we have opted to discount potential cash flows back over three years from FY20 and then to apply an ex-growth terminal multiple of 10x (consistent with using a standardised discount rate of 10%) to forecast cash flows in that year (ie FY22). In the normal course of events, exploration expenditure would be excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, we have included it in our estimate of FY22 cash flows on the grounds that it may be a critical component of ongoing business performance in its ability to continually expand and extend the lives of the company’s assets. Note that, in the aftermath of the acquisition, the combined entity’s immediate strategic imperatives will be the continuation of exploration at Ity and Houndé plus investigating the potential to extend the mine lives of Mana and Boungou.

Aside from our updated FY20 operational and cost expectations (which form the majority of the content of this report), readers are cautioned that this updated valuation of Endeavour is not comparable to previous Edison valuations on account of three other factors:

With that caveat, our estimate of Endeavour’s cash flow in FY22 on the above basis has increased to US$5.39 per share (cf US$4.05/share in our last note on a pre-acquisition basis). On this basis, our terminal valuation of the company at end-FY22 is US$53.89/share (cf US$40.49/share previously on a pre-acquisition basis), which (in conjunction with forecast intervening cash flows) discounts back to a value of US$44.90/share at the start of FY20 (cf US$33.46/share previously).

Endeavour’s valuation on a pre-acquisition basis on a series of commonly used measures, relative to a selection of gold mining majors (the ranks of which it will soon be joining once its takeover of SEMAFO is complete), is as follows:

Of note is the fact that Endeavour’s valuation is materially cheaper than the averages of the majors on all six measures shown in Exhibit 8, regardless of whether Edison or consensus forecasts are used. On an individual basis, it is cheaper than the majors on at least 86% (31 out of 36) valuation measures if Edison forecasts are used and 75% (27 out of 36) of valuation measures if consensus forecasts are used.

Endeavour had US$476.6m in net debt on its balance sheet at end-Q120 cf US$535.9m at end-Q419 and US$515.3m on a pro-forma basis, including restricted cash held by SEMAFO. This (pre-acquisition) level of net debt equated to a gearing (net debt/equity) ratio of 63.9% (cf 74.7% at end-Q419) and a leverage (net debt/[net debt + equity]) ratio of 39.0% (cf 42.7% at end-Q419). Note that US$476.6m reconciles with Endeavour’s Q120 balance sheet; it differs from the figure of US$472.7m quoted in some of the company’s other materials because the latter is calculated on the basis of the value of the minimum equipment finance obligations discounted back to present value rather than being presented on an undiscounted basis.

With capital expenditure relating to the Ity CIL project now having been, to all intents and purposes, completed, Endeavour has no major capex commitments in the future until the development of its next project. In the new gold price environment, cash flows were strongly positive in Q120 and we expect them to remain strongly positive into the foreseeable future, such that (including the merger with SEMAFO) we are forecasting that the company will have net debt of just c US$26.3m as end end-FY20 (cf US$367.2m previously), after La Mancha’s US$100m investment into the enlarged company, which will equate to a gearing ratio of just 1.4% (cf 40.2% previously) and a leverage ratio similarly of just 1.4% (cf 28.7% previously). Thereafter, net debt would decline rapidly such that, all other things being equal, we estimate that the company should be net debt-free early in FY21 (cf early in FY22 previously). Hence, we believe that Endeavour could make a dividend distribution to shareholders as early as FY21.

On 23 March, Endeavour announced that it had entered into a joint, definitive agreement with SEMAFO, whereby it will acquire all of the issued and outstanding securities of SEMAFO by way of a Plan of Arrangement under the Business Corporations Act (Québec). Under the terms of the agreement, Endeavour will pay 0.1422 shares for each SEMAFO common share, resulting in its issuing an additional 47.6m shares (cf 111.0m currently in issue). Based on the 20-day volume weighted average prices of each company until 20 March, these terms represented a 27.2% price premium for SEMAFO shareholders. Based on the closing prices of each company’s shares on 20 March, they represented a 54.7% premium for SEMAFO shareholders and implied an equity value for SEMAFO of c C$1.0bn (NB now c C$1.5bn). In the aftermath of the transaction, existing Endeavour and SEMAFO shareholders will own approximately 70% and 30%, respectively, of an entity producing c 1Moz gold per year and which generated an estimated US$121.6m in pre-financing cash flows in FY19 (see our note EndAFO a good thing, published on 1 May 2020).

Endeavour’s principal investor, La Mancha, has committed to invest US$100m into the combined entity in order to provide for a larger free float and greater stock liquidity which, for the purposes of our forecasts in Exhibits 1 and 11 is assumed to occur at the prevailing share price early in Q320.

Pursuant to the rules of the TSX, the transaction has been approved by an overwhelming majority of both sets of shareholders. In addition, Endeavour shareholders have also approved the issuance of US$100m in Endeavour ordinary shares to La Mancha.

In addition to shareholder and court approvals, the transaction is subject to applicable regulatory approvals including TSX approval and the satisfaction of certain other customary closing conditions.

At the same time, the deadline of 25 June, by which time the minister of innovation, science & economic development was required to decide whether to order a national security review of the transaction, has now passed, with the result that it is anticipated that the transaction will close towards the end of June 2020 or the beginning of July.

During the year ended 31 December 2019, Endeavour put in place a gold revenue protection programme in order to maximise cash flow certainty during its debt reimbursement phase. Similar to the strategy it put in place during its recent construction phases, this comprises a deferred premium collar strategy using written (sold) call options and bought put options to (effectively) create a synthetic short position. The programme began on 1 July 2019 and will end on 30 June 2020 and covers a total of 360,000oz (approximately 50% of Endeavour’s pre-acquisition total estimated production over the period), with a floor price of US$1,358/oz and a ceiling price of US$1,500/oz. As at 31 March, 120,000oz remained outstanding under the collar derivative liability, implying (among other things) that contracts over 90,000oz of gold were exercised in Q120.

While it is tempting to assume that a gold price above US$1,500/oz will automatically result in losses on Endeavour’s gold revenue protection programme, recent history would suggest that this is not a foregone conclusion. Exhibit 9, in particular, details Edison’s estimates of the losses and gains incurred by the programme during the past three quarters within the context of the gold price movement during the quarters and the extent of potential losses in Q220, assuming that all remaining ounces covered by the revenue protection programme are exercised during those periods:

Self-evidently, the extent of actual losses realised depends on, among other things, the timing and the exact price of gold when the contracts are exercised. Nevertheless, while the extent of the potential realised losses on the gold revenue protection programme in Q220 could not be considered trivial, it is worth noting that, historically, gains (or losses) on the gold revenue protection programme have not always been the largest constituent part of total gains (or losses) on financial instruments, as in Q419 and Q319, as cases in point, below, and have also, on occasion, been counteracted by offsetting factors (eg Q120, below):

As a result of the inherent uncertainties surrounding gains (or losses) from financial instruments, they have been excluded from our forecasts in Exhibits 1 and 11. While the gold price protection strategy programme is a limited one therefore, investors should nevertheless be aware that the remaining contracts outstanding potentially represent an up to US$32.16m (US$0.290 per share gross of tax) risk to our (pre-acquisition) Q220 earnings forecasts (albeit not our normalised or adjusted earnings forecasts).

Since the onset of the pandemic, governments in West Africa have acted decisively to implement appropriate response measures, using (where appropriate) their recent experience in dealing with Ebola in the region as a precedent. Out of three states of alert, West Africa is currently at a ‘Level 1’ state of readiness (ie that the virus remains predominantly outside West Africa), with the potential to escalate this to ‘Level 2’. In practice, this means that both Burkina Faso and the Ivory Coast have closed their borders and commercial flights both into and out of the countries have been suspended. Within this framework however, ‘key industries’ are allowed to remain operating and, in both countries, ministers are reported to be very keen that gold mining should continue. For their own protection therefore, mines have been isolated from the rest of the country.

Whether as a direct result of these measures or not, of all of the (populated) continents in the world, Africa to date has been the least affected by COVID-19. Endeavour has been supporting the national response in close collaboration with the health authorities in its host countries. In addition, it has mobilised and dispatched an expert medical response team to the region to provide it with an on-hand unit to respond rapidly to any infections that might arise at its mines.

At the asset level, each of the company’s operations are continuing to manage and respond to COVID-19 within the framework of the company’s incident management and response plan, which was activated at the outbreak of pandemic and has been validated by an epidemiologist special advisor to the company. As part of the response, a business continuity program has been put in place to protect employees while ensuring the safe operation of the company and its mines. Since early March, access to all mine sites has been strictly controlled with health screening in place for visitors, employees and contractors, and all non-essential travel has been cancelled. Endeavour has also asked any employee or contractor who is feeling unwell to stay at home and office workers are required to work from home. Subsequently, it further augmented its preventive measures by introducing a mandatory 14-day quarantine period for any employees or contractors arriving in West Africa.

Consequently, Endeavour states that it has not witnessed any impact to production or operations at any of its mines or exploration activities as a result of COVID-19. It also states that it has sufficient inventory of supplies and equipment until at least the end of July 2020, while suppliers have confirmed that placed and forecast orders are intact. In the meantime, Endeavour has stated a readiness, if necessary, to charter its own planes to keep its operations supplied with necessary supplies and equipment.

From a financial perspective, Endeavour calculates its current cash-burn rate to be of the order of c US$70m per month, with the potential to reduce to US$25–30m per month (including paying all salaries) in the event that all mines are put on care and maintenance. As such, its current access to c US$300m of liquidity equates to approximately four months’ worth of costs at current rates of operation or 10 months at reduced rates.

Simultaneously, Endeavour’s president and CEO Sébastien de Montessus has said that he will donate 30% of his base salary, and members of the leadership team and the board of directors have also volunteered to donate a portion of their salaries or fees for three months to combating the outbreak. As a company, Endeavour has said that it will match these funds to result in a total donation of approximately US$1m. The funds will be deployed by Endeavour’s community relations and medical teams to source much needed medical equipment for local community health centres and also to provide financial support to families and schools that have been affected by a loss of income as a result of the disease. These donations, combined with the amount already spent at the mines and supporting national and local efforts in Cote d’Ivoire, Burkina Faso, and Mali, will bring Endeavour’s total contribution to c US$6m (which has now been included in ‘corporate costs’ in our Q220e financial forecasts, as discussed above).