Exploring Mincor's improved outlook

How do you value exploration success? That's the challenge for investors with an interest in the nickel miner, Mincor Resources.

On one hand it is a rock-solid producer of high-grade nickel ore, a steady profit generator and a reliable provider of dividends, which pleases people with a conventional view of business.

On the other hand it is an exploration success story as it continues to generate a flow of excellent drilling results on tenements around its primary assets in the nickel fields near the WA mining centre of Kambalda.

When we first looked at Mincor is was as a conventional business, and we liked what we saw. David Gilmour, who analysed the stock, has refreshed his view and still likes it (see his update below).

But, what cannot go into a spreadsheet is the event which has generated most interest in Mincor over the past few weeks: discovery news.

On January 15, after a one-day trading suspension requested by management, Mincor revealed fresh, high-grade, nickel intersections at its Cassini project, including 6.42 metres assaying a world-class 7.25% nickel.

The market reaction was swift and positive with Mincor's shares rising by 20% from a pre-announcement 61 cents to high on January 16 of 73 cents.

After that initial excitement the stock settled back but has recently risen back over the 70 cents mark thanks to more encouraging exploration news of that sort than cannot be included in a financial analysis spreadsheet.

What's happening is a classic example of how value is created by exploration and how it is impossible to value using conventional tools because there are too many risk factors involved, such as not knowing whether the drill results will ever lead to the development of a mine.

Speculators, who are a different breed to investors, are undeterred by drilling results not fitting a financial model, in the same way they are not concerned whether early test results from pharmaceutical research will actually lead to the production of a new drug.

What that boils down to with Mincor is that it represents either a reliable profit generator and dividend payer from its current nickel-mining business, or an exploration story underpinned (and funded) by a nickel-mining business.

The first view fits our financial model. The second view makes Mincor an exciting, but risky, explorer with a number of potentially value-creating projects on its books.

Since that January 15 report drilling at Cassini has continued to yield encouraging results with a fresh assay reported last week of 6.73 metres at 4.81% nickel, an important result because it stretches out the new zone of mineralisation by another 130 metres to 430 metres.

Two other interesting drill results accompanied the latest Cassini drilling, including a thick and high-grade 8.81m assaying 7.72% nickel at a target called Voyce, and 2.39 metres assaying 6.45% nickel at Durkin North.

The next few months could be exciting for Mincor with its ongoing nickel-mining business starting to enjoy the benefits of selling metal in US dollars from a business operating on an Australian dollar cost base with the local nickel price rising to $A8.77 a pound, comfortably above Mincor's production cost of $A5.07/lb.

But the more interesting development (from a speculator's perspective) is a management decision to boost the company's exploration budget by 40% to $14 million thanks to the flow of success in the field.

Operations

Alongside posting several exceptional discoveries, Mincor has also reported strong production from its existing mines for the first half of 2014-15.

For the second quarter Mincor produced 2,469 tonnes of nickel-in-ore. Together with the first quarter that's a total of 4,984 tonnes in the first half, marking 59% of targeted production of 8,500 tonnes for the full year.

While grades were lower than the previous quarter at an average of 2.89%, the company managed to beat expectations by lifting its mining rate. Tonnes of ore mined jumped 11% to 85,365 tonnes on an already impressive first quarter, largely thanks to a very good result from the Mariners mine. The other operating mine, Miitel, performed slightly better than anticipated.

Cash costs are also tracking well below guidance of $A5.30/lb of payable nickel for the full year, with an average of $A5.00/lb for the six months to December. Cash costs are those relating to mining, milling, ore haulage, administration and royalties.

Productivity and costs per payable nickel are likely to improve even further for the rest of the year as Mincor reaps the full benefits of its new leasing equipment and mining fleet. Two new haulage trucks were delivered during the quarter, bringing the total number of new trucks to four.

An excellent second quarter and the benefits of new equipment add to our belief that Mincor is well placed to exceed its production guidance for 2014-15, particularly when it only needs to maintain its performance of the first half to do so.

Valuation

Persisting weak nickel prices in the short term have had a negative impact on our valuation for Mincor, but this has largely been offset by the benefits of the falling AUD/USD exchange rate and an increase in our production forecast for 2014-15.

In line with consensus forecasts, we have reduced the nickel price in our model to $US7.30/lb for the remainder of 2014-15, before lifting it to $US8.70/lb in 2015-16 and $US10.19/lb the year after.

On the other hand, we now assume the Australian dollar averages US85 cents during 2014-15 and 80US cents after that, down from the previous estimate of US90 cents, and that Mincor produces 9,400 tonnes of nickel in ore this fiscal year. Given the Australian dollar is trading around US77 cents now with downward momentum, our forecast may prove conservative.

Overall the changes have reduced our net profit forecasts, however, and we predict a $1.7 million loss for 2014-15 before a return to profit the following year.

Investors shouldn't fear a reduced dividend despite the absence of a net profit for FY15. Even with the decline in nickel prices Mincor's cash balance rose by $3.7 million to $53.6 million in the second quarter, leaving the company plenty of room to deliver returns to shareholders.

We have also factored in the 40% lift in exploration spending to $14 million for 2014-15 in the wake of Mincor's promising discoveries to date.

Summary

As we stated in our initiation piece on Mincor, our investment basis for the company rests on attractive free cash flows, higher nickel prices, a likely better-than-anticipated year of production and good results from the exploration program.

Stronger nickel prices have failed to materialise so far but, in the meantime, exploration results and good production have pushed Mincor's share price higher.

We maintain our “buy” recommendation on the stock with a discounted cash flow valuation of 79 cents.

That being said, Mincor is a relatively high-cost producer and is highly leveraged to the nickel price. This means that if the nickel market were to deteriorate beyond its current depressed levels, Mincor would be one of the first nickel miners to suffer and its exemplary record of delivering dividends would be at risk.

Our continued positive outlook for the stock relies on improving conditions for the base metal.

To see Mincor Resource's forecasts and financial summary, click here.