Now that you have a good knowledge of commodities and mining operations, let's take a look at some companies.
Western Areas Ltd (ASX: WSA) is Australia's lowest cost nickel producer and operates the Spotted Quoll and Flying Fox mines in Western Australia (WA), but is it a good investment?
This article covers some key areas you need to assess when considering an investment in a mining company.
Debt
In the current climate of low commodity prices, debt can be crippling to a company. Lower earnings result in less money to pay the interest bill.
Western Areas scores well in this department. On 2 July 2015 the company paid off its final $125 million of bonds and is now debt-free for the first time since 2004. This will result in annual savings of around $20 million.
Debt has to be considered in terms of the business cash flow. The interest coverage ratio is calculated as earnings before interest and taxes (EBIT) divided by the interest expense = (EBIT/interest expense). A value of 1 indicates that all of the companies earnings are being used to pay the interest on its debt. A value below 1 indicates the company is not generating sufficient earnings to cover its interest expenses.
For example, from the financial statements in Western Areas' 2014 annual report, we find that: Net income = $25.5 million; interest expense = $15.3 million and tax paid = $12.3 million.
Interest coverage ratio (FY2014) = ($25.5+$15.3+$12.3 / $15.3) = 3.5
Western Areas produced enough earnings in 2014 to cover the annual interest repayment 3.5 times – this is very safe. As they are currently debt free this metric no longer applies.
Cash is king
When you are a price-taking company operating in a commodity market one of the few ways to beat your competitor is by having lower production costs – this is critical for the survival of mining companies in the current environment. Worst-case scenarios should be used to assess the profitability of the company if prices collapsed further.
Western Areas provides its "C1 cash costs" at each reporting date. C1 costs include mining, haulage, milling and administration costs. This provides a good indication of the mining costs, but it does not cover all costs required to sustain the mining operation in the future.
Total sustaining costs are more difficult to estimate accurately and include other charges such as interest payments, royalties, capital investments, mine development and exploration expenditure. A significant number of companies do not provide a total cost figure and items such as exploration and mine development expenditure are difficult to assign and can vary dramatically from year to year.
Charted below is Western Areas C1 cash cost (from company reports), my estimated total sustaining costs and the approximate price received for their nickel.
Western Areas sells its nickel concentrate to other refining companies including BHP who deduct a refining charge which results in the company receiving around 70% of the spot nickel price. Nickel is currently priced around US$4.75/lb, therefore, Western Areas will theoretically receive around US$3.40/lb.
My estimated total sustaining cost for Western Areas is currently around US$3.50/lb, which makes it Australia's lowest cost nickel producer and places it in the lowest 25% of global producers.
Although it is a low-cost producer the company is operating near its breakeven point (estimated total cost is US$3.50/lb whilst receiving US$3.40/lb for its product) and would be producing little free cash flow at current nickel prices.
Free cash flow is important as it is the cash available to the company's shareholders (think dividends) after all operating expenses have been paid and required business investments have been made.
Management and company performance
It is always important to look back through the annual reports and ensure that the management team has achieved its stated goals.
The 2009 Western Areas annual report contained a chart forecasting annual production out to 2016. After making a few small adjustments for mines that never reached production, annual production rates have closely matched or exceeded the forecast.
Mining companies often provide ambitious forecasts leading up to the start of mineral production. Many mine sites never reach their target production output and it is important for investors to assess the credibility and performance record of the company.
Mine life
The investment community assigns more value to those companies which have proved ore reserves that can sustain the annual production rate for 10-years which provides more confidence about future cash flows. If you remember from our article on reserves and resources, 'proved' reserves are those with the highest degree of certainty.
The Spotted Quoll mine has an existing 10-year mine life at current production rates whilst the Flying Fox mine is lower at around 3 to 4 years. This may be a concern to some investors, but it is important to understand the nature of these mineral systems.
Fellow nickel miner Mincor Resources NL (ASX: MCR) operates in the Kambalda region of Western Australia and has maintained ore reserves at only 3 to 4 years of mine life for the past 13 years. These types of ore bodies tend to be continuous at depth and as mining progresses additional reserves are often discovered and replaced as the known reserves are depleted.
Due to the steep inclination of the mineral ore body and the depth of mining operations at Western Area's Flying Fox mine (currently around 1,000m) it would be impractical and extremely costly for the company to conduct a drilling campaign from the surface to try and prove reserves which could extend the mine life.
Fun Fact: Xstrata's Mount Isa Copper mine is rated as Australia's deepest mine at 1,900m (1.9 kilometres), while the world's deepest mines are reportedly a pair of South African gold mines – around 3.9km deep each.
The Spotted Quoll mine is shown below which illustrates the issue.
There is no guarantee, but it is possible that as Western Areas progressively mines deeper it will be able to replace the reserves and keep a mine life of 3 to 4 years for many years yet, just as Mincor has.
Valuation
The free cash flows of resource companies are often erratic from year to year and valuation using this method requires many forecasts and assumptions and should, therefore, be used as one part of the overall company analysis.
I estimate that if nickel prices remain at current levels around US$5/lb Western Areas is worth around $2.50 per share. However, if the nickel price returns to US$7/lb or US$8/lb then my valuation for the company increases to around $4.50 per share and $6.50 per share respectively.
Summary
Western Areas is a quality nickel miner which has consistently achieved its goals. The decline in the nickel price has significantly reduced free cash flow, but the company is debt free and has approximately $70 million cash in the bank and an undrawn $125 million corporate loan facility which should see it through years of low prices if need be.
As the lowest cost nickel producer in Australia and extremely cost-competitive on the global stage, it is expected that Western Areas will emerge from the current downturn in a stronger position as other companies are forced to curtail production and possibly close mines. However, this process may take longer than expected. The depreciation of the Aussie dollar and a lower oil price has helped resources companies cut their production costs. For example, some iron ore mining companies have continued operating longer than many expected after the crash of the iron ore price.
Western Areas is one of the best resources companies available on the ASX and should produce excellent returns to shareholders if there is an improvement in the nickel price beyond US$6/lb. Investors confident in the longer-term outlook for nickel might want to take a closer look at this company.
