Restucturing terms negotiated, guidance on growth projects lowered

Last week Kazakhmys provided the details of its divestiture plan. The listed entity, which will be renamed to Kaz Minerals PLC, will retain higher-margin assets in the East Kazakhstan and transfer $240mn worth of working capital to the private company. The terms of restructuring have not changed much, the amount of working capital to be left with the private entity came largely in line with our and analyst expectations. However, the company significantly downgraded production estimates and raised operating cost guidance for Aktogay and Bozshakol projects. On top of it, it appears that capex for Aktogay project may increase further. Despite attractive restructuring terms, we reduce our 12M target price to 264 GBp due to deteriorating economics of growth projects and downgrade our recommendation to a Sell.

Restructuring terms bring no surprises

On July 23, the company announced that it has entered into a definitive agreement to split the company as was announced previously. The mature and loss-making assets will be carved out to a private entity while higher-margin assets will remain in the public company, which will be renamed to Kaz Minerals Plc. The public entity will own four existing mines in the East Kazakhstan, three refinery plants and three growth projects – Aktogay, Bozshazkol and Koksay. Mature assets, will be carved out to a separate private entity – Kazakhmys Corporation. In order to ensure the viable existence of Kazakhmys Corporation, the management decided to transfer $240mn worth of working capital including $150mn in cash, ~$80mn of unspent capital expenditures and ~$10mn of VAT and MET refunds. This was broadly in line with our expectation of a $200mn cash payment on separation.

The parties have also initiated two-way service agreements which would allow both companies to provide each other transitional and longer term services. The management stated that costs would increase as a result, but remain commercially attractive and on arm’s length. The company’s revised guidance already incorporates the new service agreement terms.

Growth projects’ economics deteriorate

The management downgraded its production estimates for Bozshakol and Aktogay to 100kt and 90kt, respectively, in the first ten years of production, from the previous average of 123kt and 106kt, respectively. The cost guidance for Bozshakol increased from $0.60-$0.80/lb to $0.80-$1.00/lb. On a brighter side, the cost guidance for retained assets was reduced by $0.10/lb to $1.20-$1.40/lb in 2014.

Figure 1. Overview of key parameters     
  Guidance Model assumptions  
  Updated Previous Updated Previous % change
Bozshakol          
Production average (ktpa) 100 123 100 123 (19%)
Net cash costs($/lb) 0.80-1.00 0.60-0.80 0.90 0.70 29%
Capex ($mn) No change 2200 No change 2285  
           
Aktogay          
Production average (ktpa) 90 122.5 90 122.5 (27%)
Net cash costs($/lb) No change 1.10-1.30 No change 1.20  
Capex ($mn) No change 2000 No change 2253  
           
Retained assets          
Production average (ktpa) No change >94 No change >94  
Net cash costs($/lb) 120-140 130-150 130 140 (7%)
Capex ($mn) No change 72 No change 72  
Sources: company data and HF reseeach estimates   

The capex for growth projects of Aktogay and Bozshakol remained unchanged, but the management did mention that it expects Aktogay budget to increase after the tender process for new contractors is completed. Currently, we assume total capex per ton of capacity at Bozshakol at $22 850, while at Aktogay at $25,000.        

We calculate these changes to translate into a 35-40% reduction in NPV estimates of Aktogay and Bozshakol projects.

Production results for 1H2014

1H2014 production results came in slightly lower than we expected. The company produced 139kt of copper cathode equivalent, 3% less than we expected, which implies that the full-year results will probably be closer to the lower end of the company’s guidance range of 285-295kt. The drop was mainly attributable to the declining production and grades at Zhezkazgan mines. On a positive note, we see significant improvement in grades of the East mines (from 2.35% to 2.55%) which will remain with the listed company after restructuring. Production of by-products was mixed with zinc and silver output declining by 2% and 27%, respectively, and gold output staying flat. A drop in silver output was attributable to decrease of silver content in Zhezkazgan region.

Figure 2. Summary of production results
  1H2014 1H2013 YoY, % HF FY2014E % above/ (below) HF estimates
Ore extracted, kt  18 175 19589 (7%) n/a n/a
Copper cathode equivalent, kt 139.2 144.3 (4%) 144 (3%)
Average copper grade, % 1.02 0.96 6% n/a n/a
           
Zinc in concentrate, kt 61.7 63.1 (2%) 60 4%
Average zinc grade, % 3.38% 2.99% 13%    
           
Silver, koz 5 224 7 145 (27%) 5 461 (4%)
Average silver grade, g/t 15.29 14.75 4%    
           
Gold, koz 51 51 0% 62 (18%)
Average gold grade, g/t 0.57 0.52 10%    
Sources: Company data and HF Research estimates   

 Valuation update

Recall that previously we have valued the company using two scenarios (restructuring and continuing as is) with equal probabilities of execution. With the conclusion of the preliminary restructuring agreement, we now adopt the restructuring scenario as our base and only valuation scenario.

In our model, we have revised one-time working capital payment amount to the private entity to $160mn (previously assumed $200mn). For operational forecasts, we used midpoint of the cost guidance range provided by the company. We model 4% annual cost inflation in the forecast horizon and 2.5% in the terminal year.

Additionally, we have downgraded production estimates for growth projects reflecting management’s new guidance. We expect the capex budget for Aktogay to be higher than Bozshakol on a per ton basis due to more complex sulphide ore processing involved. Koksay project remains cash flow neutral for the purposes of modeling as the project economics are uncertain at this stage.

 F3_and_4_(ENG)_original.png

After the restructuring, we forecast the EBITDA margin to normalize at around 35%-37% in the long-term (45% in the previous estimates). We estimate that revenue and EBITDA will grow at 5.4% and 5.3%, respective, CAGR during 2015-2024.

The company’s nebt debt is expected to peak at $2.5bn over 2015-2016 and will start declining afterwards when both Aktogay and Bozshakol commission and start generating operating cash flows.

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The company’s stock price is extremely sensitive to changes in copper price, unit cost and cost of capital assumptions. A 5% change in copper price results in 20% change in the fair value estimate, while a  0.5ppt change in the unit cost growth rate translates into a 14% change in the fair value estimate. A 0.5ppt change in WACC moves the fair value by 23%, while terminal growth rate change by 0.5ppt results in a 13% change to the fair value estimate. In a nutshell, the stock offers a highly leveraged exposure to copper price.  

F6_and_7_original.png 

As a result, we reduce our 12M target price to 264 GBp which implies a 19% downside to the stock price on the previous day close. We downgrade our recommendation to a Sell as the stock is overvalued fundamentally. We believe the returns are skewed downward as KAZ equity carries significant risks related to the execution of growth projects (further capex overruns, opex increase, delays with project commissioning), the company’s FCFs will remain negative up until 2017 and balance sheet gearing will rise. Although the stock is a leveraged pure copper play, we believe for investors making a directional bet on copper there are better copper equity stories than KAZ.

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