Endeavour Mining — Q2 outperforms ahead of likely Q3 index inclusion

A full analysis of Endeavour’s Q221 results relative to our prior forecasts is provided below:

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). Readers are reminded that Endeavour changed its definition of cash costs in Q420 to include royalties. The decision was made so 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 discreet item distinct from operating expenses), we (at least for the moment) are continuing to show total cash costs excluding royalties unless specifically indicated otherwise (eg the ‘Actual’ Q121a column in Exhibit 1, above).

Quarter-on-quarter comparisons for Endeavour’s results in Q220 are inevitably exaggerated by the fact that the company had completed neither its acquisition of SEMAFO at the start of Q220 nor its acquisition of Teranga at the start of Q121. In addition to Endeavour’s actual reported Q121 results (in the ‘Actual Q121a’ column), therefore, we have also attempted to provide our best estimate for Q121 results on a pro forma basis (ie on the assumption that the takeover of Teranga had occurred on 31 December 2020 and that Sabodala-Massawa and Wahgnion had therefore contributed to Endeavour’s profit & loss account for the full three-month period, rather than merely the part-period since 10 February). To construct these notional pro forma Q121 results estimates, we made a number of assumptions, chief among them being that the over-sale of gold relative to production occurring in the period since 10 February was also presumed to exist in the period from 1 January – that is to say, there was no corresponding under-sale from 1 January until 10 February. Otherwise, we assumed the unit costs that prevailed from 10 February until 31 March also prevailed during the full three-month period and that both sustaining capital and non-sustaining capital costs were incurred in the entire period pro rata to the costs incurred in the 10 February to 31 March one. Finally, we treated taxation independently for both Sabodala-Massawa and Wahgnion and added what we believed to have been the tax payable in the period from 1 January to 10 February for both mines to what was otherwise disclosed as paid by the group for the three months. For earnings per share calculations, we assumed the quarter-end number of shares in issue of 252.6m shares prevailed over the entire period. The results of this process are provided in the column entitled ‘Est Q121a pro forma’ in Exhibit 1.

On a pro forma basis, therefore, it can be seen that Endeavour’s actual operational performance in Q221 was similar to our estimate of its performance in Q121 (column marked ‘Est Q121a pro forma in Exhibit 1, above). Production and revenue in both periods were broadly the same. While headline profit after tax in Q221 was only 6.3% higher than in ‘Est Q121a pro forma’, however, Endeavour’s underlying performance was materially better, with the adjusted net EPS level increasing by 35.9% as a result of a decline in earnings attributable to minority interests from 20.8% to 12.1% and after adjustment for more one-off, exceptional losses incurred in Q221 (eg losses on financial instruments).

Relative to our prior expectations for Q221, however, Endeavour’s results were significantly better. Whereas we had expected Endeavour’s overall performance to moderate in Q221, gold produced and sold was more than 20% higher than our prior forecast at the same time as unit costs (expressed in US dollars per ounce sold) declined. Whereas revenues were 23.2% higher than our prior forecast therefore, operating expenses were only 15.9% higher, leading to a 31.0% positive variance in gross profits. Moreover, US$15.3m of the US$38.2m variance in operating expenses could be attributed to non-cash operating expenses relating to the reversal in the period of the fair value adjustment of inventory on hand at the acquisition date, especially at Sabodala-Massawa (note: these costs are automatically excluded in the calculation of adjusted net earnings from continuing operations attributable to shareholders). Depreciation was higher than our expectations as well. In part, this mirrored the extent to which production was also greater (given that Endeavour depreciates on a ‘units of production’ basis). However, there were also notably higher than expected depreciation charges relating to Sabodala-Massawa and Wahgnion (ie the assets acquired with Teranga) as well. Corporate costs were also higher, albeit these were artificially inflated by a US$5.4m charge relating to the expenses of Endeavour’s LSE listing. Had these been excluded (as they are in the calculation of adjusted net earnings), then underlying corporate costs were also actually lower than our prior expectations, at US$10.5m. As a result of the inclusion of certain one-off exceptional items, such as losses from financial instruments (which Edison anyway declines to attempt to forecast), the positive variance in actual results relative to our prior expectations was constrained to 13.9%. If these one-off, exceptional losses are excluded, however, then the variance in actual compared to expected results increases to a material 61.9% (adjusted net EPS from continuing operations). Readers should note that this performance follows a first quarter in which Endeavour also produced c 20% more gold than we had expected and sold c 30% more, which similarly drove a positive variance of 14.8% in adjusted net earnings attributable to shareholders on a pro forma basis (see our note Endeavour Mining: Showing its mettle as well as its metal, published on 28 May 2021).

As well as exceeding our forecast, at US$0.727/share, actual adjusted net EPS for the quarter also comfortably outperformed the consensus analysts’ forecast of US$0.54/share as well as the top end of the range of expectations, of US$0.65/share:

Full details of each mine’s operational performance and outlook are available in Endeavour’s press release. As per Exhibit 1, output from each of the company’s nine mines exceeded our expectations, with the exception of Boungou by a small amount. Financially, each of them performed in line with, or outperformed, our expectations, with the exceptions of Boungou and, again by a small amount, Sabodala-Massawa and Wahgnion – although these last two both experienced material non-cash operating expenses relating to the reversal in the period of the fair value adjustment of inventory on hand at the acquisition date, without which they would have outperformed our expectations, financially speaking.

While a number of factors can be invoked to explain both the operational and financial outperformance of Endeavour’s mines relative to our prior expectations, in general, it may be reduced to five main factors:

As disclosed on 7 June 2021, Endeavour has implemented a shareholder returns programme that is composed of a minimum progressive dividend that may be supplemented with additional dividends and buybacks, providing the prevailing gold price remains above US$1,500/oz and Endeavour’s net debt/adjusted EBITDA ratio remains below 0.5. The minimum progressive dividend policy has a target of distributing at least US$500m to shareholders over the next three years. To date, minimum dividends have been indicated at US$125m, US$150m and US$175m for FY21, FY22, and FY23, respectively, payable semi-annually (cf a maiden FY20 dividend of US$60m). At the half-year stage, however, Endeavour has declared an interim dividend of US$70m (or US$0.28/share) – ie 12% above the level that might be expected pro rata with its minimum guided level of US$125m for the full year), causing us, among other things, to increase our forecast dividend for the full year, from US$0.50/share to US$0.56/share. The ex-dividend date for the interim dividend will be 9 September 2021 and the record date will be 10 September 2021. The dividend will be paid on or about 28 September 2021.

In tandem with its FY20 results, on 18 March 2021, Endeavour announced a normal course issuer bid (NCIB) or share buyback programme to supplement its policy of augmenting shareholder returns. The NCIB commenced on 22 March and will end on 21 March 2022 and will allow Endeavour to buy up to 12.2m ordinary shares, or approximately 5% of its total issued and outstanding ordinary shares at the time of the announcement, whereupon the purchased shares will be cancelled. At Endeavour’s current share price of C$29.32 (US$23.25), the NCIB is worth, in total, c US$280m and compares extremely favourably with its FY20 dividend payout of US$60.3m and our forecast of its payout in FY21 of US$139.1m. Combined, the NCIB and FY21e dividend distribution together represent c US$419.3m in aggregate returns to shareholders – equivalent to a dividend yield of 7.2% – in FY21.

Note that, owing to the inherent uncertainty surrounding whether purchases are made and at what price under the NCIB, we have not attempted to include potential future share buybacks in our financial forecasts in Exhibit 10, below, but only historical ones. To date in FY21, we estimate that Endeavour has repurchased a total of 3.4m shares at an average price of US$22.27 (C$28.08), resulting in total cash outflows of C$97.8m, or US$77.5m.

Historically, Endeavour has a good record of meeting its production and cost guidance targets and FY20 was the eighth year in succession in which the company achieved its production cost and AISC targets.

In the wake of Q121 results, Endeavour reiterated production and cost guidance for each of its mines for FY21, as shown in Exhibit 4.

Readers should note that Endeavour’s guidance includes production from Sabodala-Massawa and Wahgnion from 10 February onwards only. They should also note that, for the purposes of our forecasts (below) we have left Agbaou fully consolidated into Endeavour’s ‘pro forma’ accounts. For those who wish to deconsolidate it, Agbaou’s profit and loss for the period in which it was under Endeavour ownership in Q121 is reproduced below. All told, however, we would note that its contribution to Endeavour’s bottom line was, to all intents and purposes, immaterial during this period.

In the meantime, we understand it is not Endeavour’s intention, at least for the time being, to reflect Karma as an asset held for sale (despite its now being classified as ‘non-core’). With these provisos, our updated forecasts for Endeavour for the remainder of FY21 and in the wake of Q221 results, by quarter, on both an ‘as reported’ and ‘pro forma’ basis are as follows:

The net result of these changes (including a 4.3% decrease in our forecast gold price for the remainder of the year, from US$1,868/oz to US$1,787/oz) is a modest 4.3% decrease in adjusted net EPS from continuing operations, from US$2.143/share to US$2.050/share (on a pro forma basis – see our notes, Showing its mettle as well as its metal and Picking up the crown, published on 28 May 2021 and 14 June 2021, respectively, for direct comparison) and a similar 4.7% decrease in adjusted net EPS from continuing operations, from US$2.115/share to US$2.015/share (on an ‘as reported’ basis).

As before, 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).

Notwithstanding the detailed appearance of our forecasts, readers are cautioned that forecasting on a quarterly basis is prone to large variations between actual and forecast numbers. As such, the exhibits both above and below should be regarded as indicative, rather than prescriptive, particularly with respect to individual quarters. With this caveat, a comparison between our FY21 adjusted net EPS from continuing operations estimates and consensus estimates, by quarter, is as follows:

Self-evidently, one of the main assumptions behind our forecasts is that there are no major deleterious effects to ongoing operations as a result of the COVID-19 pandemic. To date, the effect of COVID-19 on Endeavour’s operations in West Africa has proved to be negligible and is expected to remain so. Nevertheless, Endeavour has mitigated future risks as far as possible by both 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 also by preparing multiple different levels in its pits from which to produce, thereby affording it operational flexibility in event of disruptions.

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 and Agbaou in FY20 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 FY21, in the case of Endeavour, we have instead opted to discount six years of forecast cash flows in FY21–26 back to the start of FY21 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 is barely changed at US$4.07/share (cf US$4.03/share previously), giving rise to a terminal valuation of the company at end-FY26 of US$40.67/share (cf US$40.30/share previously), which (in conjunction with forecast intervening cash flows) then discounts back to a valuation of US$35.46/share (cf US$35.88/share previously) at the start of FY21, as shown in the graph below.

Given its elevation into the ranks of the world’s foremost producers of gold, however, we believe that 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 currently expecting 2.2069% inflation. These two measures imply an expected real equity return of 6.65% (1.09/1.022069) and applying this to our forecast cash flows would imply a terminal valuation for Endeavour of US$61.19/share (cf US$61.76/share previously) and a current valuation of US$55.59/share (cf US$56.96/share previously). Readers should note that, given its beta of 0.49 (source: Refinitiv, 18 August 2021), even this (real) discount rate of 6.65% is likely to be conservative.

In the meantime, Endeavour’s valuation remains at a material discount to those of its newly acquired peer group, as shown in Exhibit 9, 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 the fact that Endeavour’s valuation is materially cheaper than the averages of the majors on all but one of the measures shown in Exhibit 9 if consensus forecasts are used and all of them if Edison 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, similarly, 38 out of 54 (70%) if consensus forecasts are used. Reverse engineered, the average valuation measures of its peers imply an average share price for Endeavour of US$31.60, or C$39.86 per share.

According to its Q221 balance sheet, Endeavour had net debt of US$147.6m. This compares with net debt of US$220.2m as at end-Q121 after the completion of the Teranga acquisition and the injection of US$200m by La Mancha and with net debt of US$43.3m as at end-FY20 (pre the Teranga acquisition). This figure of US$147.6m includes lease liabilities of US$50.7m and an option premium of US$44.6m. Excluding these two results in a net debt position of just US$52.3m or just 1.3% of the company’s balance sheet equity of US$4,441.7m at end-Q221. Note that this figure of US$52.3m also excludes US$29.7m held in the form of ‘restricted cash’ in ‘other financial assets’. It also differs slightly from the figure of US$77.1m quoted elsewhere in Endeavour’s announcements owing to the discounting, variously, of certain committed future payments to present value.

Note that, for the purposes of our financial modelling (see Exhibit 10, below) and for simplicity’s sake, we have assumed the consolidation of Endeavour’s and Teranga’s balance sheets took place retrospectively on 31 December 2020. In this case, we estimate that 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 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 (see Exhibit 10, below).