Entrée Resources — A royal premium awaits

Since our Initiation note in January 2018 Entrée Resources has published its 2017 results and released its full NI43-101 technical report on the 2018 Reserve case for developing HNE Lift 1. We have incorporated these into our forecasts and valuation, with only modest changes to our figures. We note the unique investment characteristics of Entrée Resources whereby the debt carry arrangement with OTLLC over Entrée’s interest in parts of the OT mine, secured at a favourable rate, in effect offer investor returns more akin to a relatively secure royalty stream, while offering the benefits of investing in a producer. At this point, we believe the market values Entrée Resources predominately as a conventional producer.

Given the structure of the EJV and consequent royalty/producer investment blend, in this section we examine the valuation and compare values ascribed by the market to mining and royalty/streaming companies. We see a stark contrast in P/E and price to cash flow (P/CF) ratings between the two groups. The following chart compares a broad basket of stocks which represent, in large part, some of the most recognisable and traded mining, streaming and royalty companies. Indeed, the constituents provide a benchmark for the type of rating Entrée’s future cash flows could afford the company, which is probably still considered more of a conventional mining equity. Albeit one with a JV interest in a significant portion of the world’s soon-to-be third largest copper producer, as opposed to one managing the development of a wholly owned asset.

As we show in Exhibit 1 above, streaming and royalty companies (OR, SAND, WPM, FNV and SSL) on average trade on a current year P/E multiple of 62.8x earnings, with the only outlier being Wheaton Precious Metals (possibly due to its ongoing dispute with the Canadian Revenue Authority). This compares to an average P/E of 23.4x for a broad swathe of copper and gold miners (the 10 companies on the right hand side from ANTO to RRS).

2023 will be a ramp-up year for Entree, as its share of Hugo North Lift 1 development production results in the first year of positive earnings. We estimate EPS for Entrée Resources of 0.7c in 2023, placing its shares on a forward P/E multiple of 53x for that year. While 53x (albeit on early stage EPS) is at a material premium to conventional mining peers, when viewed against its royalty/streaming peers, it represents a substantial discount. Alternatively, as HNE lift 1 enters sustainable production in 2026, Entrée’s P/E multiple drops significantly lower (averaging 1.3x from 2027 to 2031) than the average 23.4x earnings given for the miners in Exhibit 1. This is to be expected, as in reality it is too early for the market to ascribe value to these future earnings. Entrée’s forward earnings multiples are given in the following table and are based on the outcome of its 2018 NI43-101 technical report:

We see a similar pattern when comparing the same group of companies using P/CF. As seen in Exhibit 4 below, miners average 8.3x cash flow compared to royalty/streaming companies on 19.5x. Entrée’s forward P/CF multiples are given in Exhibit 3:

A calculation of a project level IRR is not readily achievable using Entrée’s JV structure with OTLLC. This is because a typical mine development requires upfront capital expenditures, whereas Entrée’s share of OT’s production occurs intermittently throughout OT’s mine life.

If we were to value Entrée as a royalty company (ie Entrée receives cash amounts back after debt repayment), the internal rate of return at the company level is, in our analysis, materially higher than that which we calculate from its pre-loan account project level profits. This unique debt carry arrangement affords Entrée a particularly advantageous corporate structure in that it pre-funds Entrée’s capital commitments at minimal risk with Rio Tinto (a low-risk mining major) as operator of the project).

In summary, we estimate that an investment in Entree shares at a price of US$0.38 (C$0.48) per share could generate an IRR of 19% over the 34 years from 2018 to 2052. This compares to a 9% return if the investment was made purely at the project level - thus demonstrating the benefit to Entree’s management of securing a highly favourable financing structure from OTLLC.

The following bullet points are taken from Entrée’s 2017 annual report, released 9 March 2018 (and as reported by Turquoise Hill Resources). OTLLC, which is Entrée’s JV partner and owns 100% of the OT mining licence, is jointly owned by the government of Mongolia (34%) and Turquoise Hill Resources (66%). Turquoise Hill is 51% owned by Rio Tinto.

A number of news items relating to OT have hit the press recently. A timeline of these events follows:

Oyu Tolgoi is a US$5.3bn development in one of the world’s most impoverished and land-locked countries. Without a sea-border, the country is reliant on access through neighbouring countries to trade its goods and services. With its natural resources only just being realised in terms of value and scale, and its government new to dealing with the vast sums of cash being invested, it is understandable that the government is reassessing plans for the country’s mineral sector, which is deemed critical to national development under the framework of the 2017 intergovernmental forum (IGF) Mining Policy Framework.

This does not mean that the tax, worker conditions and power plant issues experienced since the start of 2018 as mentioned above do not increase risk for OT stakeholders. However, as long as the Mongolian government does not impose the extreme measure of resource expropriation, or materially alter the structure of its relatively new mining code, it should be able to continue developing OT, a mine that is expected to contribute some 30% to Mongolia’s gross domestic product. Already, the benefits of the OT project to date are evidenced in the following Turquoise Hill slide in its latest corporate presentation.

The following three sections provide a summary of Entrée’s 15 January 2018 Entrée/Oyu Tolgoi Joint Venture Project, Mongolia, NI43-101 technical report, outlining the size, scope and top-level technical attributes of the EJV deposits.

Current mining operations at OT comprise the extraction of the 900Mt of code compliant ore reserves from OTLLC’s 100%-owned ‘Oyut’ open pit operation and the development of the vast underground infrastructure required for bulk-tonnage block caving operations.

In terms of the EJV mineral resource estimate (MRE), metal prices used to define MRE extents (ie the mineralised body of rock in which the block cave model sits) according to the business development template 31 (BDT31) are: US$3.01/lb Cu; US$1,250/oz Au; US$20.37/t Ag; and US$11.90/lb Mb. The PEA states all metallurgical recovery rates used to define MRE cut-off grades (COG) are based on metallurgical test work results and not assumed.

These metal price assumptions used to derive COG are reasonable for a MRE, although we note the silver price assumption of US$20.37/oz is c 25% above the current spot price of US$16.24/oz Ag (19/3/18). However, MRE silver grades are close to background levels at 3.72g/t for EJV HN Lift 1 and 3.59g/t for Lift 2. Heruga’s silver grade is assumed at 1.583g/t in the PEA mine plan and 1.39g/t in the resource estimate, that is, the same as Hugo North Lift 1. Further, life of mine total gross silver revenues mined from all EJV deposits represent only 2% of the total revenue achieved as given in the PEA.

Molybdenum grades are only considered high enough to potentially support construction of a molybdenum recovery circuit at Heruga, hence the recoveries of molybdenum are not used in the MRE for Hugo North Extension. We note that the COG on a copper equivalent basis (CuEq) for Hugo North Extension mineralisation is 0.37% CuEq. This COG has also been used to define the inferred-only category MRE for Heruga. The COG for Heruga is likely to change as further drilling and MRE preparatory drilling, sampling and laboratory testing yields values different to that used to define the Hugo North Extension MRE COG.

Lift 1 of the Hugo North Extension orebody, the first of the JV deposits to be developed at the OT project, is situated from 700m below surface to c 1,400m below surface, and, due to the size and grade, will be extracted via large-scale caving methods. Hugo North and Hugo North Extension Lift 1 will be mined as three panels (ie three large independent mining areas of the resource). The Hugo North Extension area is stated to be located at the northern portion of Panel 1.

The 2016 Oyu Tolgoi Feasibility Study assumes overall underground production is capped at 33Mtpa for the foreseeable mine life. This production cap is dictated by the mill’s capacity and is also the fundamental constraint used to limit production growth in Entrée's 2018 PEA. Production rates will ramp up to an average 95,000tpd (ie 33Mtpa assuming 95% mill availability) during the peak period of combined production from the Hugo North/HNE Lift 1, which occurs from 2027 to 2035. After 2035, production will decrease until both orebodies have been mined out to plan in 2039. HNE Lift 2 and Heruga are currently inferred-only MREs and as such, a considerable amount of work is required to reclassify the resource, convert into reserves and form a mine development plan.

The most important fundamental factor in determining Entrée’s attributable cash flows is the eventual mine plan for extracting the subset of Entrée’s mineral resources contained within the EJV property. As development of Entrée’s 20% subset of mineral resources is to take place during the overall mining of the OT project, there are periods where little to no cash flow is generated. Most notably, these periods coincide with a transfer of mining activity from HNE Lift 1 to HNE Lift 2 and then to Heruga. Although no investment decision has yet been made, the 2018 PEA contemplates the mining out of Heruga inferred category mineral resources situated within the EJV property.

Entrée’s share of products will, unless Entrée otherwise agrees, be processed at the OTLLC facilities by paying milling and smelting charges. The OTLLC facilities are not intended to be profit centres, therefore minerals from the EJV property will be processed at cost. OTLLC will also make the OTLLC facilities available to Entrée on the same terms if spare processing capacity exists to process other suitable mill feed.

The Phase 1 concentrator was commissioned in early 2013. The nameplate processing capacity of 96kt/d was achieved in August 2013. The process plant employs a conventional semi-autogenous grind (SAG) mill/ball mill/grinding circuit (SABC) followed by flotation.

Phase 1 uses two grinding lines (Lines 1 and 2), each consisting of a SAG mill, two parallel ball mills, and associated downstream equipment to treat up to 100kt/d of ore from the Oyut open pit. Operating data have been used in the Phase 2 design, which addresses the delivery of Hugo North/Hugo North Extension underground plant feed via Lift 1 in conjunction with open pit mining.

The intent of Phase 2 is to treat all of the high-value Hugo North/Hugo North Extension Lift 1 ore delivered by the mine, supplemented by OTLLC’s open pit ore to fill the mill to its capacity limit. The Phase 2 concentrator development programme will optimise the concentrator circuit to enable it to maximise recovery from the higher-grade Hugo North/Hugo North Extension Lift 1 ore and to allow it to handle higher tonnage throughput. Components that require upgrading to accommodate the gradual introduction of ore from underground include: the ball mill; rougher flotation circuit; flotation columns; concentrate filtration, thickening, and bagging areas; and bagged storage facilities. Reagents and media required will include lime, primary collector, secondary collector, frother, tailings flocculant, water treatment chemicals and grinding media. With the addition of the concentrator conversion loads, the peak operating load demand from the existing 220kV concentrator substation will increase by an estimated 20MW (from 116–136MW), and the nominal operating (diversified) load will increase by an estimated 19MW (from 106–125MW). The concentrator raw water demand varies seasonally. Annual average raw water demand is projected to be 0.45m3/t ore processed.

We have used the new 2018 Reserve Case and 2018 PEA for valuing Entrée’s attributable share of cash flows achieved from mining the Hugo North Extension (Lifts 1 and 2) deposits, using a DCF method, discounted by 10% to reflect general equity risk and metal prices (as per our January initiation report). We omit the Heruga resource from our DCF valuation due to a) the considerable capital required to develop this distal asset; b) Heruga’s very large inferred-only resource being too high-risk to value using a DCF approach; and c) the cash flows received from this asset not being additive to the DCF result obtained based on cash flows from the Hugo North Extension deposits (Lift 1 and Lift 2). Our valuation of Heruga is based on a comprehensively derived in-situ copper resource multiple applied to its inferred category mineral resource; see the following section. Assuming Entrée and its JV partner develop Hugo North Extension Lifts 1 and 2 as per the January 2018 Reserve Case and 2018 PEA, and operating costs and metal prices are close to our metal price forecasts, then the attributable earnings per share and theoretical dividend per share due to Entrée would follow the following earnings profile for the valuation period 2018 to 2052:

Since our January 2018 initiation report we have revised our accounting of Entrée’s attributable capex which will not be recognized in the cash flow statement. Rather capex will be reflected as balance sheet debt accruing as development occurs on the EJV, with any amounts after debt repayments recognized as net cash flow from OTLLC financing arrangement in the cash flow statement.

As a result and on the above basis, we value Entrée’s shares at C$2.76 (US$2.16) per share.

NPV calculations beyond a 20-year time horizon result in vastly diminished returns in current money terms and deliver marginal value that is not truly reflective of the inherent value of the asset in question. This is the case with Heruga, a very large inferred resource at present that is unlikely to be developed in the next 20 years. As such, we view an in-situ valuation of Heruga’s current inferred only resource, utilising our proprietary and unbiased database of junior mining explorers, as the most appropriate way to define a secure absolute value of Entrée’s large Heruga resource. The following table uses in-situ resource multiples as contained in our November 2017 report, Mining overview: Unlocking the price to NPV discount.

We note that Entrée’s management states that the contribution to its total PEA NPV of US$278m from Heruga, based on a DCF approach, is approximately US$1.5m. Our assimilation of the Heruga DCF into our own financial model implies there is no value attributed to mining this asset at all. Therefore, the current 2018 Reserve Case and 2018 PEA outlined strategy for developing Heruga significantly undervalues this asset when compared with its in-situ value based on current market data for in-situ copper resource multiples. Placing our total in-situ value of C$0.65 (US$0.51) per Entrée share, for 20% of Heruga’s inferred resource, alongside the negligible attributable value on an NPV basis (less than one cent per share) clearly demonstrates the disparity between valuation approaches.

Exhibit 10 summarises our base case valuation:

Entrée Resources at end December 2017 had cash of US$7.1m and a loan account totaling US$7.8m (previously cash of US$7.7m at end September 2017), to be repaid to OTLLC at the Royal Bank of Canada prime rate (2.95% as of 13 July 2017) plus 2%. The PEA and our model use 5.2% pa. This debt will be repaid as sustainable production commences in 2026. The EJV stipulates that Entree’s attributable capex is to be advanced via a loan agreement held with OTLLC. This loan account is to be repaid from 90% of cash flows available from net revenues from Entrée’s attributable production in a month, less its share of operating costs for the month. Entrée will then use the remaining net revenues from the sale of its attributable production, as well as cash payments received from Sandstorm, to purchase and deliver metal credits to Sandstorm under the Sandstorm agreement.

The following line chart gives the annual cash amounts net of debt repayment due back to Entrée over the course of the entire development horizon (ending 2097):

Total attributable capex to Entrée for the building out of HNE Lift 1 is US$52.3m (C$65.4m). This is added to the OTLLC loan account as and when the development takes place. We also note that the 2018 PEA includes a total of US$79.1m (reserve case) and US$369.3m (PEA case) in amortisation charges that are treated like an operating cost and therefore not added to the OTLLC loan account. This covers development and sustaining capital not on the joint venture property (shafts 2, 3, 5, underground construction of Lift 1 and 2, infrastructure, concentrator, tailings and reclamation).

With first sustainable cash flows eight years away in 2026, Entrée has pared back all corporate expenditure to avoid any foreseeable need to return to the market to raise further funds. Management indicates that central costs have now been reduced to around US$1.2m to US$1.5m per annum. As long as this level of expenditure is maintained, we consider the company will be able to reach full production in 2026 without requiring additional capital. Entrée also, potentially, has C$8.2m tied up in in-the-money warrants and options.

On the delivery of metal credits, Sandstorm will make a cash payment to Entrée equal to the lesser of the prevailing market price and US$220 per ounce of gold, US$5 per ounce of silver and US$0.50 per pound of copper (subject to inflation adjustments). After approximately 8.6 million ounces of gold, 40.3 million ounces of silver and 9.1 billion pounds of copper have been produced from the entire current EJV property, the cash payment will be increased to the lesser of the prevailing market price and US$500 per ounce of gold, US$10 per ounce of silver and US$1.10 per pound of copper (subject to inflation adjustments). To the extent that the prevailing market price is greater than the amount of the cash payment, the difference between the two will be credited against the deposit. This arrangement does not require the delivery of actual metal, and the company may use revenue from any cash source to purchase the requisite amount of metal credits.