Endeavour Mining — Refining forecasts ahead of results

Ahead of its results on 5 May, we have refined our forecasts for Endeavour to take into account recent changes to the gold price and some very minor operational considerations at its mines:

Items included in the reconciliation between adjusted net earnings attributable and total net and comprehensive earnings are losses from discontinued operations, gains/losses on financial instruments, other expenses 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). As noted previously, Endeavour has now changed its definition of adjusted net earnings attributable, such that deferred tax effects and share-based payments are no longer included in the adjustments to total net and comprehensive earnings, and this is now the manner in which our FY22 forecasts (above) are presented. Readers are also reminded that Endeavour changed its definition of cash costs in Q420 to include royalties. The decision was made so that Endeavour may be more consistent in reporting within the context of its peer group. For reasons of comparability with past results, however, as well as ease of forecasting (given that royalties are reported as a discrete item distinct from operating expenses), we are continuing to show total cash costs excluding royalties. Depending on the gold price and the valuation of its 2.5% net smelter royalty as part of the consideration for its sale, Endeavour may also record a small profit or loss relating to its sale of the Karma mine in Q122. This is not included in our estimates on the basis that it is (a) likely to be immaterial within the context of Endeavour’s broader accounts and (b) non-recurring.

Within this context, a comparison between our quarterly and full-year forecast and consensus forecasts for FY22 is as follows:

Of particular note, in the context of our financial and operating forecasts for the individual quarters, is the absence of any material decline in either production or profitability in Q3 (being the quarter historically most susceptible to disruption from the seasonal rains in West Africa). In this case, however, we are expecting a material increase in production at Sabodala-Massawa in Q322 and H222. Ore at Sabodala-Massawa will be primarily sourced from the Sofia North pit, supplemented by lower-grade feed from the Sabodala pit, in H122, whereas it is intended to be sourced from the higher-grade Massawa Central and Massawa North in H222. Note that, in the case of FY22, we have not (yet) attempted to forecast any tax instalment payments, which typically inflate Endeavour’s tax charge in the second quarter of any particular financial year. It also typically declares local entity dividends in Q2, which will affect cash flows in Q322.

Self-evidently, one of the main assumptions behind our forecasts is there are no major deleterious effects to ongoing operations as a result of the COVID-19 pandemic. We also assume no collateral escalation of geopolitical tensions into West Africa. To date, the effect of COVID-19 on Endeavour’s operations in West Africa has been negligible and is expected to remain so, as the company has now been able to vaccinate more than 50% of its workforce in an ongoing programme of pandemic mitigation. In addition, Endeavour has further mitigated future risks as far as possible by setting itself up to operate under level 2 COVID-19 restrictions (see our note New senior gold major looking to join FTSE 100, published on 17 December 2020) and by preparing multiple different levels in its pits from which to produce, thereby affording it greater operational flexibility if there are disruptions.

On 4 April, Endeavour announced its decision to proceed with the development of its Sabodala-Massawa expansion project, based on the results of a recently completed definitive feasibility study (DFS). A summary of the salient features of the DFS’s results is as follows:

Edison has not yet incorporated the Sabodala-Massawa expansion project into its longer-term forecasts – and therefore valuation – below. We will do so at the time of the next substantial update note on the company. In the meantime, however, it is worth noting that we estimate the project will add US$3.46 in incremental value per Endeavour share. Readers should also note the project’s US$560 valuation per (project) ounce mined.

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, Tabakoto in FY18, Agbaou in FY20 and Karma in FY22, and the acquisition of SEMAFO in FY20 and Teranga in FY21). Historically, rather than our customary method of discounting maximum potential dividends over the life of operations back to FY22, in the case of Endeavour, we have instead opted to discount five years of forecast cash flows in FY22–26 (NB excluding the Sabodala-Massawa expansion project) back to the start of FY22 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 FY26). In the normal course of events, exploration expenditure would have been excluded from such a calculation on the basis that it is an investment. In the case of Endeavour, however, it was included on the grounds that it was a critical component of ongoing business performance in its ability to continually expand and extend the lives of its mines.

In this case, our estimate of cash flows in FY26 has remained, to all intents and purposes, unchanged at US$3.97/share (cf US$3.96/share previously), giving rise to a terminal valuation of the company at end-FY26 of US$39.67/share (cf US$39.65/share previously), which (in conjunction with forecast intervening cash flows) then discounts back to a valuation of US$36.47/share as at the start of FY22 (cf US$36.57/share previously):

Given its elevation into the ranks of the world’s foremost producers of gold, however, we believe Endeavour can increasingly attract lower-cost finance and, as such, a CAPM-derived WACC can also be considered (as discussed in our February 2021 initiation on Newmont Corporation). Long-term nominal equity returns have been 9% and 30-year break-evens are expecting an inflation rate of 2.5432% (source: Bloomberg, 28 April) compared to 2.5623% previously. These two measures imply an expected real equity return of 6.30% (1.09/1.025432) and applying this to our forecast cash flows would imply a terminal valuation for Endeavour of US$63.01/share (cf US$63.17/share previously) and a current valuation of US$59.48/share (cf US$59.78/share previously).

In the meantime, Endeavour’s valuation remains at a material discount to those of its peer group, as shown in Exhibit 4, below.

Endeavour’s valuation on a series of commonly used measures, relative to a selection of gold mining majors (the ranks of which it has now joined since its takeovers of SEMAFO and Teranga have been completed), is as follows:

Of note is that Endeavour’s valuation is materially cheaper than the averages of the majors on all of the measures shown in Exhibit 4 regardless of whether Edison or consensus forecasts are used. On an individual basis, it is cheaper than its senior gold mining peers on at least 38 out of 54 (70%) of valuation measures if Edison forecasts are used and 37 out of 54 (68%) valuation measures if consensus forecasts are used. Reverse engineered, the average valuation measures of its peers imply an average share price for Endeavour of US$36.62, or C$46.97 (or £29.39), per share.

According to its Q421/FY21 balance sheet, Endeavour had net cash of US$13.2m at end-December, despite making US$43.9m in share repurchases during the quarter. This compares with net debt of US$143.6m at end-Q321, US$147.6m at end-Q221, US$220.2m at end-Q121 (after the completion of the Teranga acquisition and the injection of US$200m by La Mancha) and US$43.3m at end-FY20 (before the Teranga acquisition). This figure of US$13.2m also includes lease liabilities of US$51.1m and an option premium of US$34.6m. Excluding these two items results in a net cash position of US$98.9m. This figure also excludes US$30.6m held in the form of ‘restricted cash’ and US$40.0m in shares of Allied Gold received as consideration for the sale of Agbaou, both held in ‘other financial assets’. It also differs slightly from the US$76.2m net cash figure calculated by Endeavour and quoted in its announcements owing to the discounting, variously, of certain committed future payments to present value.

Readers should note that inclusion of the Sabodala-Massawa expansion project into our forecasts in Exhibit 5, below, will increase capex in FY22 and FY23 by approximately US$116m and US$160m, or 29.1% and 42.0%, respectively. Even so, we expect the inclusion of this to do little to dent either Endeavour’s strong net cash generation or its net cash position at the end of these years.

Note that, for the purposes of our financial modelling in Exhibit 5 and for simplicity’s sake, we have assumed that the consolidation of Endeavour’s and Teranga’s balance sheets took place retrospectively on 31 December 2020. In this case, we estimate Endeavour would have consolidated c US$242.6m in net debt on its balance sheet and c US$349.2m in gross debt as a consequence of its Teranga acquisition (as at end-December). As such, on a pro forma basis, we estimate that Endeavour would have had US$323.1m in net debt on its balance sheet at end-FY20, which we calculate would have equated to a gearing (net debt/equity) ratio of just 8.8% and a leverage (net debt/[net debt+equity]) ratio of 8.1% on the group’s enlarged equity base.