Caledonia Mining — Record production and 14% increase in grade

Q317 saw record gold production of 14,936oz at Blanket at an AISC of US$827/oz, a 15% decrease compared to Q316, driven by a reduction in G&A arising from lower sustaining capital and recognition of the export incentive credit in 2017. However q-o-q G&A is up 8% (36% above our forecast) driven largely by, inter alia, an increase in employee costs resulting from Caledonia appointing its own in-house legal counsel and a strengthening of the South African rand.

Exhibit 1 shows our forecasts compared with actual Q317 results. Caledonia’s Q317 revenues came in 2% above our forecasts, almost entirely as a result of the company’s record production. We have marginally adjusted our FY17 gold price upwards on a pro rata basis from US$1,256/oz (used in our last note) to US$1,258/oz now. Other income of US$663k is the receipt of an export credit incentive from the government of Zimbabwe. Blanket receives an export credit incentive to the value of 3.5% of its gold sales. This is factored into our valuation for the entire forecast period from FY18 to FY26.

As a result of revenues slightly exceeding our estimates and recognition of credit incentive, partly offset by higher than expected G&A coupled with moderately higher royalty payments (up 9% cf our estimate driven by Q3’s record production) and depreciation (6% above), the company’s Q317 PAT was flat at US$3.88m versus our estimate of US$3.93m.

In terms of earnings, our forecast for Q317 IFRS earnings per share came broadly in level with that reported by Caledonia, with only EPS on a normalised basis coming in 7% lower (41c vs 44c) than our estimate, driven by an adjustment to deferred tax which is governed by the company’s timing of capital expenditures. The other adjustment to normalised earnings is FX, which was immaterial during the quarter at US$3k. The following exhibit details Caledonia’s ytd quarterly income statement and our estimates for Q417 earnings are largely in line with our previous estimates. Normalised EPS has decreased on an FY17 basis by just under 4%.

We maintain our previous forecast of 54koz produced for FY17, this being the lower end of Caledonia’s recently narrowed production target of 54-56koz gold produced. We estimate that this production will incur unit cash operating costs of US$686/oz, before drifting lower as higher production in subsequent years decreases the effect of Blanket’s fixed cost base. The ability to mine more gold while maintaining a stable fixed cost base is a key reason for expanding Blanket’s production and, as shown in Exhibit 3 below, will have a material positive effect on decreasing unit costs going forward.

Third quarter production was also bolstered by a slight increase in the mined gold grade at Blanket. A q-o-q increase of 14% from 3.08g/t (Q217) to 3.52g/t (Q317) was recorded and supports management’s view that gold grades will return from recent lows and back up towards the long-term average for Blanket of c 3.8g/t. Of all the operational data announced to market in the company’s third quarter release, this grade increase is the most reassuring and we look forward to seeing it maintained at similar levels during subsequent quarters.

Allied to the increase in gold grade mined is a very slight increase in gold recoveries (see right-hand chart below). Tonnages mined and milled for the quarter remained flat compared to Q217.

Along with the improved geological confidence that underpins the company’s increase in NI43-101 resources, management has taken the view that it is prudent and in the best interests of Blanket’s future longevity that an extension to the central shaft’s depth, from 1,080m to 1,330m, should be made. Importantly, the US$18m of additional capital expenditure required for this extension is to be funded entirely via Blanket’s internal cash flow generation. We note that the depth extension to the central shaft has been calculated using a long-term gold price of US$1,260/oz.

Caledonia states that the central shaft depth extension is not expected to affect payment of its dividend. We have maintained our forecast for a FY18 dividend equal to that paid out in FY17.

Development down to a depth of 1,080m underpinned the company’s 2014 investment plan. With the development of a brand-new, single nine-metre shaft in a central position to Blanket’s main ore-bearing lodes and providing an additional 330m of vertical access below the 750m level, Caledonia envisioned production at Blanket well into the 2020s. This original plan had enough measured and indicated resources and reserves to pay back 97% of the original US$70m cost of the investment plan’s development. However, future mining at that time had been pinned to mining far lower confidence inferred resources. This situation has since changed with the ongoing drilling being undertaken to target the deeper reaches of Blanket’s orebodies. The following section explains how Caledonia has successfully evolved its NI43-101 compliant resource base over time (Exhibit 5).

The extension to the central shaft’s planned depth will also be significantly cheaper to develop now, rather than in the future when all construction equipment and services have been removed. Furthermore, as production commences, it would be highly undesirably to have to stop production intermittently to allow additional waste haulage from the central shaft, which will, on completion, become Blanket’s main production ore and waste haulage route to surface.

Caledonia released a resource update on 2 November 2017, which, among other things, detailed a 6% increase in measured ounces from 671koz (December 2016) to 714koz and a 47% increase in inferred ounces to 887koz. The improvement to Caledonia’s Blanket resource base has, however, been far more impressive when viewed over time, and indicates a high level of background activity in improving its geological processes. During our site visit in October 2016, we saw a meaningful push towards digitisation of existing paper-based geological information, which is an important factor in visualising in 3D the viabilities in Blanket’s orebody structures and grade variations. The improvements to Blanket’s resource base (and, by extension, reserves) should indicate to the investor a far more confident view of the quantum of gold available to mine, its gold grade and grade variability – all important factors for the consistent running of any mine.

As shown by the above graphs and pie chart, the evolution over time of Caledonia’s resource base at Blanket has been positive and material. The lack of a measured resource category before 2015 was a hindrance on the company’s ability to scope out the future potential viability of expanding Blanket’s production, both above and below the 750m level – the historical depth limit to Blanket’s gold production before the advent of the investment plan.

The long-term average mined gold grade assumption for Blanket is just under 4.00g/t gold at 3.84g/t. The support for this grade level is given by the grade of Blanket’s 2017 measured resource category of 3.90g/t. While the average resource grade has modestly declined from the previous estimate given in 2016 (with respect to the indicated and measured categories only), this is as a result of greater geological confidence derived from more infill drilling, and should allow the company to better target, and most importantly, mine and blend various ore streams from Blanket’s numerous orebodies with far better confidence and accuracy. In providing a more accurate estimate of grade and its variability across each orebody, Blanket should be able to provide improved operational performance and greater consistency over IFRS earnings forecasts.

We have adjusted our valuation for Q317 results, but also for our recently revised gold price forecasts and other factors given in the following sections.

Following the release on 16 November 2017 of our annual mining overview, Unlocking the price to NPV discount, a new world order, we have revised our long-term gold price forecasts. For background to the changes made, please refer to the aforementioned report (pages 79 onwards).

As advised by the company, the deepening of the central shaft development by 250m from 1,080m to 1,330m will cost an estimated US$18m. The development has been costed using a gold price of US$1,260/oz (well below our forecasts in Exhibit 7). The additional capital expenditures required for the depth extension is to be funded purely by Blanket’s internal cash flow. We factor this additional capex into our valuation, with US$12m allocated to FY18, and the remaining US$6m spent in FY19. Note that the additional capex is not being made to support the existing Investment Plan’s planned mining schedule. The central shaft depth extension is supported by production in addition to our base case valuation scenario, which we have not yet been able to update as we await more details from the company.

We have also adjusted our US$/£ exchange rate up 4% from 1.29 to 1.34.

On this basis and largely as a result of the aforementioned additional capex requirement, our base case valuation for Caledonia’s shares decreases 7% from 933p to 869p per share. Our valuation uses a 10% discount rate to reflect general equity risk.

Forcing our model to reflect Caledonia’s current share price of 500p results in an implied discount rate of 21%. Furthermore, on applying a spot gold price of US$1,280/oz across all forecast years results in a valuation of 838p.

Caledonia finished Q317 with a cash balance of US$11.8m, a q-o-q increase of 8%. This follows ytd cash generated from operating activities of US$16.6m, net cash used in investing activities of US$15.6m, US$3.6m in net cash from financing activities (including US$2.4m in dividends paid on a quarterly basis and a US$1.1m loan repayment in connection with Caledonia’s small-term loan facility). We now forecast Caledonia finishing FY17 with a cash balance of US$11.5m (compared to our previous forecast following Q217 results of US$10.5m). As a result of the additional capex spend associated with the central shaft over the next couple of years, we see Caledonia’s cash pile decreasing in FY18 to US$8.7m, before a substantial increase, under our assumptions, in FY19 to US$36.9m.