KEFI Gold and Copper — Counting down to production

KEFI has made a number of announcements that are pertinent to its future in recent weeks. In the first, it announced the renewal of its Jibal Qutman exploration licence in Saudi Arabia, which opens the way for the commencement of field programmes and environmental studies, etc, ahead of the award of a mining licence. In the second, it announced continued progress with project financings (including final costs and schedules for a combined open pit and underground mine) at Tulu Kapi. In the third, on 21 November, it outlined the final finance plan, which remains consistent with that published on page 6 of its 2021 annual report (ie US$320.0m cf US$300m – see Exhibits 2 and 3). It expects that syndicate member contributions will be adjusted as required.

An important feature is that much of KEFI’s equity contribution is arranged with regional investors who convert into KEFI shares at share prices in 2026 and beyond, well after production commences – a most unusual and important feature that demonstrates the depth of KEFI’s alignment with other regional investors and with the financial regulators in Ethiopia. The balance, if any, will be dealt with in the months after the signing of definitive agreements at year-end 2022 (cf October previously). We have assumed the exercise of outstanding warrants (at a strike price of 1.6p/share) in early 2023 coinciding with the syndicate-approved sequence for drawdowns and disbursements. Launch by the year end on signing the definitive agreements would be a very successful outcome in the context of macroeconomic uncertainty and in a country in which the working environment might reasonably be described as challenging.

KEFI’s announcement of 20 October regarding Tulu Kapi came just three days after the renewal of the Jibal Qutman exploration licence in Saudi Arabia. As well as the original licence, the renewal also gives KEFI access to the 270km2 Jibal Qutman Exploration Area, including the Jibal Qutman North and Jibal Qutman Southeast exploration licences, which cover a ‘significant portion of the highly prospective ‘Nabitah-Tathlith’ gold belt’. KEFI’s target for the completion of a 2Mtpa definitive feasibility study (DFS) by end-Q422/early-Q123 remains on track. In the meantime, it has indicated that project funding for its operating joint venture company Gold & Minerals (G&M) in Saudi Arabia will be finalised as soon as a mining licence has been awarded.

KEFI has updated detailed mine engineering and planning for the bulk mining (>90%) and selective mining (<10%) of its ore and waste, as well as now integrating the underground mine with the open pit mine. These have subsequently been built into contractually detailed schedules with its mining contractor. This is an area on which KEFI has focused intensively, not only to reliably measure average grade, but also to manage grade variability during operations, based on tightly defined reserves derived from the wireframing of the entire ore system.

Exhibit 1 compares KEFI’s current plans and our assumptions regarding the Tulu Kapi mine with those at the time of our last Outlook note (see Hawiah developing rapidly behind Tulu Kapi, published on 17 March 2022). Commissioning is now expected in late-2024 (cf end-2023 previously) and ramp-up to full production in 2025 (cf 2024 previously) with the life of processing operations therefore continuing into 2034 (cf 2032 previously) and updated costings.

KEFI’s proposed mining method and equipment specification at Tulu Kapi are considered straightforward and technically sound by the lenders’ independent technical expert. In this context, it is significant that less than 10% of the total material movement is categorised as ‘selective’ under the draft mining contract specifications, indicating that the mining methods to be used are generally very standardised.

Readers should note that, while direct comparison may be made between the old and new mining plans with respect to timing and processing rates, owing to the integration of the open pit and underground mining plans, it should not be made with respect to grades, unit mining costs or sustaining capex (which now includes capex for the underground operation). As a consequence, while the superficial increase in sustaining capex is US$26.2m, or 95.3%, over the life of the mine, from US$27.5m to US$53.7m, the underlying increase is a more modest 8.7%, given that the updated figure includes c US$23.8m in capex allocated to the underground project (previously US$38.0m). For those other items for which direct comparison is possible, we estimate that unit oxide milling costs have increased by 44.7% (from US$9.68/t to US$14.01/t average over the life of the mine), fresh ore milling costs have increased by 41.8% (from US$8.26/t to US$11.71/t) and fresh hard ore milling costs have increased by 38.7% (from US$10.09/t to US$13.99/t) – in each case assuming an above inflation escalation of power costs per annum.

Additional costs include a 7% government mining royalty, US$8.88/oz in offsite refining, insurance, transport and offtake costs (unchanged) and an US$11.6m provision for closure costs (cf US$14.5m previously). Onsite general and administrative costs are forecast to be US$80.5m over the life of the mine (cf US$64.4m previously), an increase of 25.0%.

As a result, including offsite costs and the 7% government royalty, we calculate that average cash costs per ounce over the life of the Tulu Kapi operation will have increased by 12.8% relative to our prior estimate from US$889/oz for the open pit and US$664/oz for underground (weighted average US$849/oz) to US$958/oz for the integrated operation.

At the corporate level, we continue to assume head office costs of £1.0m pa (unchanged). A carried-forward tax loss of US$95m has also been applied to future pre-tax profits before tax is payable.

In its announcement relating to Tulu Kapi, KEFI noted that, owing to global inflationary pressure, its project capital requirement has increased by c US$20m to US$320m (including US$6.6m in pre-production losses), which is (a) modest and (b) unsurprising. Excluding the US$6.6m in pre-production losses during the ramp-up phase of development (KEFI estimate), our capex expectations in November 2022 have increased by 9.6% relative to those at the time of our last note in March 2022, with most of the increase (in absolute terms) attributable to the capital costs associated with the processing plant, as shown below:

Based on these updated estimates, pre-production capex of US$285.8m (excluding financial items) equates to US$1,746 per annual average ounce of gold production at full capacity (cf US$1,983/oz for the open pit only previously).

KEFI’s approach to its funding requirements has been consistent in seeking to share risk with contractors and to minimise dilution. During 2014 and 2015, it revised its inherited DFS as a precursor to opening project construction and mining to international tender, with the specific intent of reducing upfront capex by introducing contract mining. Since then, it has introduced project-level equity (eg the government of Ethiopia and a consortium of Ethiopian investors) as well as senior secured debt provided by banks that are already working in Ethiopia, committed to the country and familiar with local market conditions and many of Tulu Kapi’s stakeholders. In this case, the adoption of senior secured debt is considered to be more compatible with Tulu Kapi’s consortium of financiers than other forms of finance. It is also anticipated to result in material savings in the cost of debt servicing, administration and other charges, especially during the project’s development and start-up period. As such, the development capital requirement of KEFI’s Ethiopian subsidiary is anticipated to be financed largely at the project level, approximately as follows:

The lender terms have been agreed subject to formal credit committee approval of both banks, one having approved last year and now both processing formal approvals of the updated terms sheet. Otherwise, of particular note is the US$50m increase in the amount of funding from convertible instruments. Importantly however, in both cases, conversion is at KEFI’s discretion at the price of KEFI’s equity at the time of conversion well after production has commenced and no earlier than FY26, rather than at a pre-arranged price or a discount. Readers’ attention is also drawn to the US$11.5m we estimate will need to be raised in additional equity at the listed company level and which could either be raised in the conventional manner, or via the exercise of up to 0.7bn warrants from recent placings at a price of 1.6p/share. Although these are currently, self-evidently, out of the money at the moment, the possibility exists that they may still be exercised in conjunction with other sources of funding being finalised (thus de-risking the project and causing the share price to rise) or on account of existing shareholders wishing to maintain their pro-rata holdings in the company. In both cases, the consequences of these assumptions are considered in the ‘Valuation’ and ‘Sensitivities’ sections of the note, below.

Otherwise, the government’s policy directive requiring a maximum 50% debt gearing (defined as debt/[debt+equity]) for new projects has been waived in the case of Tulu Kapi, which has prior approval to expand the debt portion of its funding requirement to 70% of the total. In addition, clarification received from the regulator (the National Bank of Ethiopia) indicates that historical exploration spend on the project of c US$95m will be deemed to contribute towards equity for the purposes of this calculation.

KEFI’s partner in Saudi Arabia, which funds 70% of all equity requirements at its Saudi operating company, G&M, is the Al Rashid family (a Fortune 100 family), with which KEFI has agreed a broadly similar funding approach to that at Tulu Kapi. At the same time, the Saudi sovereign wealth fund’s Saudi Investment Development Fund has publicly stated its priority to provide up to 75% project debt for new mine developments. Accordingly, KEFI’s equity share of the development requirements for Hawiah and Jibal Qutman should be just 7.5% (30% of 25%) of combined capital expenditure of both of US$199m (US$160m plus US$39m) – that is, just US$14.9m. In this context, Edison’s estimate of the wider group’s funding requirement over the next five years, and its satisfaction, is shown in the table below for the development of all three of its projects:

For the purposes of our valuation (below), Edison has assumed that KEFI will raise US$11.5m in top company-level equity initially in order to satisfy its immediate Tulu Kapi requirements.

At a long-term gold price of US$1,650/oz , on 2 September 2022, KEFI calculated an updated project value for Tulu Kapi (on an attributable basis) of c US$124m, and aggregate updated project values for all three of its near-term projects of c US$269m (see slide 7 of the company’s 25 October presentation), which translates into valuations per currently outstanding KEFI share as shown in Exhibit 5, below:

In our report Gold stars and black holes, published in January 2019, we calculated a mean enterprise value of 30.9% of project NPV for companies with projects at the DFS stage of development and 11.7% of project NPV for companies with projects at the PEA stage of development (ie Hawiah). These percentages suggest a sector-derived average pre-funding valuation for KEFI of 0.794p/share based on Tulu Kapi alone and 1.288p/share based on KEFI’s trio of projects. Post-funding, these risk-adjusted NPVs jump materially.

In the context of our valuation of KEFI, it is worth noting that the company’s financing arrangements will leave it with zero debt at the parent company level, with group subsidiaries directly servicing any senior or mezzanine debt. As a result, dividends to KEFI shareholders from mid-FY25 should be possible. Therefore, we have assumed KEFI will distribute 60% of group cash flow in FY26–30, of which 81% (less a 10% Ethiopian dividend withholding tax) will be attributable to KEFI shareholders. To this end, KEFI has secured a special exemption from exchange controls and has agreed a London clearing account controlled by its TKGM operating subsidiary (note: there are no exchange controls in Saudi Arabia).

Based on our (unchanged) long-term gold price assumptions, we calculate that all three projects are capable of generating a combined free cash flow to KEFI of c £84.0m per year for six years, from 2026 to 2031 (inclusive), based on the mineral resources as last reported in 2021. With average (maximum potential) dividends of 0.63p/share (cf 0.90p/share previously owing to additional dilution) for the five years from 2026 to 2030 inclusive (after deduction of a 19% minority interest), this implies a valuation for KEFI of 2.19p/share when discounted back to FY23 at Edison’s customary rate of 10% per annum (cf 2.62p/share to FY22 previously). This valuation then rises to a maximum of 2.92p/share on the cusp of KEFI’s (assumed) maiden dividend in FY26:

Note that our estimate of KEFI’s peak earnings of 1.55p/share in FY30 will put it on a P/E ratio of just 0.6x in that year (relative to its valuation in the same year) or 0.5x its current share price. In the meantime, we estimate that an investment in KEFI shares on 1 January 2023 at a price of 0.76p will generate an internal rate of return for investors of 29.4% over the next 13 years to 2035 in sterling terms. To this may then be added at least a further 1.18p/share in value for Guji-Komto (fully diluted, attributable at a long-term gold price of US$1,524/oz – see On the cusp, published in July 2021).

Our base case discounted dividend flow valuation of 2.19p is inherently dependent on our gold price assumptions, cash costs, the discount rate, the price at which a future assumed US$11.5m/£9.4m in equity is raised (currently assumed to be the warrant exercise price of 1.6p in the ‘base case’ valuation) and the prices at which up to US$90m in convertible loans are converted (or not) into equity in no less than three years’ time.

Quantitatively, KEFI’s most significant valuation sensitivity is towards commodity prices. Whereas our valuation is 2.19p at Edison’s long-term gold price of US$1,524/oz, it rises by 101.8%, to 4.42p/share, at currently prevailing metals prices. Moreover, this 4.42p/share valuation itself rises to a peak valuation of 5.88p/share in FY26, as shown in the graph below (directly comparable to Exhibit 6, above):

In this case, we estimate that an investment in KEFI shares on 1 January 2023 at a price of 0.76p would generate an internal rate of return for investors of 43.1% over the next 13 years to 2035 (fully diluted) in sterling terms (plus 1.18p/share for Guji-Komto).

Our valuation is also dependent on the discount rate applied to the (maximum potential) stream of dividends payable to KEFI’s shareholders to the following extent:

With most of KEFI’s equity having already been raised however, its valuation sensitivity to the price at which future equity is likely to be raised is relatively modest:

Finally, if we assume that US$90m in charges and loans are fully converted into equity at Edison’s valuation of KEFI’s shares in three to four years’ time, this would result in a valuation of 1.92p/share (note that these loans are otherwise assumed in our ‘base case’ scenario to be retained on KEFI’s balance sheet as debt).

As is typical for exploration companies, KEFI has funded its pre-development activities with regular equity raisings. As a result, it had £2.3m in net cash on its balance sheet as at 30 June 2022 (cf £0.8m of net debt as at 31 December 2021, £1.3m in net debt as at 30 June 2021 and £1.3m in net cash as at 31 December 2020), after £4.0m in operating and investing cash outflows before working capital and after having raised £7.6m (net) in equity over the prior six months. As per our analysis above, we estimate that KEFI will raise a further US$11.5m/£9.4m in equity over the next eight months (which may be achieved by the exercising of outstanding warrants issued in 2021 and 2022 at a price of 1.6p per share, cf the currently prevailing price of 0.76p/share – hence the exercise of such warrants is not assured) in order to fund the development of Tulu Kapi (note: Hawiah, in particular, is assumed to be funded from internal cash generation). The government and local Ethiopian investors will then subscribe their US$28.5m in equity investment at the project level (included in £33.7m in equity financing in our fully consolidated group forecasts in Exhibit 10, below) at the same time that the convertible subscriptions are also closed and ahead of final debt funding of US$190m (as per Exhibit 3). On this basis, we forecast a maximum net debt funding requirement overall for the group of £241.6m or US$295.9m in FY25 (cf £188.1m or US$247.2m in FY24 previously). Obviously, raising funds of this order of magnitude is not without risk for a company with a market capitalisation of £30m and a project that is based in Ethiopia. However, we believe that this risk is mitigated by the fact that the term sheet regarding the terms of KEFI’s bank loan is already reported to have been signed and is subject now only to credit approval by the co-lenders (credit approval from the lead bank having already been secured, to our understanding). As such, this form of funding is considered to be more easily compatible with the project’s consortium than a number of other alternatives. Hence, KEFI is expecting the signing of definitive agreements at end-2022 and drawdowns/disbursement of equity to commence early in 2023 and the committed debt to be drawn down and disbursed as and when required in 2024.

On the asset side of KEFI’s balance sheet, we note that the debt:equity ratio of development spending is approximately 60% of debt (US$190m debt-funded out of US$320m capex) if convertible loans are reported as equity capital (being proposed as convertible at KEFI’s election). In addition, we are aware that KEFI is considering whether its write-off of nearly all historical expenditure remains appropriate in the light of project development – ie it is possible that its balance sheet may change significantly as a result of project development commitments.