Kingsrose Mining's thorny crown

After posting two perfect years of production, Kingsrose Mining announced a trinity of woes had beset operations in the September quarter.

The death of a worker at Talang Santo, Kingsrose’s second mine, resulted in a two-week suspension of operations. Unexpectedly large volumes of water lengthened the delay while crews pumped surplus water from the mine. The final anguish came with lower than expected output from the Way Linggo mine.

On their own, any of these three issues would be a minor hiccup. Combined, they’re a disaster. Production fell from over 10,000 ounces in the June quarter to just over 4,000 in September, a 60% drop. Lower production forced costs to rise from $258 an ounce to $484 an ounce, a rise of almost 90%.

Despite the bad luck, Kingsrose remains among the lowest cost producers on the ASX, generating total margins of over $600 an ounce. That figure includes capital costs, mine development costs and royalties. Under normal production rates, net profit margins would be over $1,000 an ounce, a figure few miners can reach with cash costs, let alone total costs.

Restoring production rates is crucial to restoring credibility. Unlike most miners, Kingsrose hasn’t built up a large reserve inventory to help funding pleas. Low capital costs eliminated the need for bank debt and the company’s strategy has always been to use early operating cashflow to fund resource expansion. So far all has gone to plan; resources in the last quarter, for example, rose 25% to 485,000 ounces of gold.

The strategy is, however, open to one significant risk. If production unexpectedly falls, so does cash available for exploration. Then, activity grinds to a halt. To avoid this possibility, Kingsrose has arranged a $5m debt facility to tide over working capital. With Indonesian authorities allowing mining to continue this month, the disruption should only be short term and the loan hasn’t yet been drawn down. Normal production should resume in the next quarter.

With the company’s woes likely to be short lived and easily corrected, the 22% fall in the company’s share price since our first recommendation on 28 May 12 (see An instant gold portfolio (Speculative Buy – $1.195) has created an attractive buying opportunity.

Taxing times?

All infant mines suffer bouts of bad luck. The darker prospects for the miner’s future come not from operations but from political interference.

Indonesia has an abundance of minerals and bureaucracy. It’s a terrible mix. The government recently rewrote mining laws to encourage investment in mining but it is now threatening changes. By the tenth year of operation, miners must sell half of their operation to a local partner. It’s unclear whether that proposal will survive.

An election is due in 2014 and Indonesia has a history of announcing new laws only to rescind them later. As any sale is required to take place at market rates, no value should be lost, in theory. How it will be applied in practice remains to be seen. The threat from the Indonesian parliament remains the key risk.

Despite the risks, the upside remains enticing. We estimate that at normal production rates and with current resources, Kingrose’s assets are worth between $1.40-$1.60 per share. Ordinarily, that would not qualify as a large enough margin of safety for a risky gold miner.

But with stunning drilling results and a huge selection of appealing targets, the probability of further resource expansion is unusually high. Resources of well over 1m ounces—more than double what has been uncovered so far—are likely to be recovered at rich grades and low cost. Kingrose's asset value could grow substantially.

Best of all, management has highlighted a preference for dividends over profitless production growth. We estimate Kingsrose will generate free cashflow of between $30m-$40m at current gold prices, rising to about $60m a year as production expands over the next two years.

The share price has rebounded 5% since 30 Oct 12 (Speculative Buy – $0.89) and, at current prices, the company’s production is being attractively discounted while immense expansion potential is being entirely ignored.

For those that can stomach some risk, Kingsrose remains a SPECULATIVE BUY for 2% of a diversified portfolio.