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Morningstar | Raising our Independence Group FVE to AUD 4.00 Despite Soft 1H. See Updated Analyst Note from 03 Feb 2019

Despite a weak first-half 2019 profit result, we raise our fair value estimate for no-moat rated Independence Group by 5% to AUD 4.00 per share from AUD 3.80 previously. The increase reflects a two-year lengthening in our assumption for Tropicana’s mine life with underground mining increasingly likely, as well as the time value of money. First-half fiscal 2019 net profit after tax of AUD 0.9 million was down from AUD 3.2 million a year ago and was below our expectations. We lower our fiscal 2019 net profit forecast by 44% to AUD 73 million as a result. We expect stronger production and lower unit costs and depreciation to drive the significant second-half improvement.

The weak first half was primarily due to the soft fourth-quarter nickel price, which averaged USD 5.20 per pound versus our prior USD 5.70 per pound forecast. That nickel price softness was relatively short lived with nickel subsequently rebounding to around USD 5.60 per pound. The lower copper price also detracted modestly. Depreciation and amortisation costs were also higher than expected at Tropicana as production came from an area with higher deferred waste mining costs. However, we make no changes to our longer-term assumptions as this effect should smooth out over the life of the mine.

Independence shares are close to fairly valued. Both the Tropicana and Nova-Bollinger mines have admirably low operating costs of around AUD 650 per ounce and less than AUD 2.00 per pound of payable nickel, respectively. The company is entering a period of high free cash flow with both mines now fully capitalised. Management’s attention is turning strongly to growth, an area which we think is the key challenge. Independence has had some success in extending asset lives through near-mine exploration, but ultimately the finite nature of reserves means new mines need to be found and developed to at least sustain profits and to potentially grow.

Independence is entering a phase of heightened exploration activity, which brings a relatively small chance of large value increases but also a significant risk of modest value destruction. Exploration will focus on the company’s extensive Fraser Range acreage, with Tropicana and Nova-Bollinger at the northern and southern ends, respectively. Drilling activity is elevated and will see 40 targets tested in 2019. Independence has been at this point in its mine life cycle before--low capital expenditure requirements, high free cash flow and depleting reserves. These challenges in the past were met with near-mine exploration, greenfields exploration, and the scrip-based acquisitions of the Jaguar mine and Nova-Bollinger. The results were mixed. The acquisition of Jaguar clearly destroyed value. Nova-Bollinger improved overall asset quality and mine-life but Independence paid a full price.

This time around, the focus is squarely on value generation from exploration and development on the Fraser Range. This targeted approach is probably better. Growth in shareholder value through acquisitions is difficult and large amounts of capital are often at risk. There are generally smaller amounts of capital at risk for exploration and the expenditure is over a longer period, versus large irregular bets on acquisitions. Just like at other times when free cash flow has been strong and management wants to grow, Independence is in a period where the exploration drive can impact the valuation.

Independence is in strong financial shape. Free cash flow more than doubled in the first half of 2019 to AUD 109 million. This reflected increased sales volumes from Nova and Tropicana, positive working capital movements and AUD 12 million from the sale of a royalty asset. We expect free cash flow to remain strong for the forecast period given both mines are low-cost and capital expenditure requirements are modest. This cash flow expectation could change if Independence finds a new deposit and invests to develop a mine, but the company is well placed to fund this growth internally. Net cash is nearly AUD 100 million, up from about AUD 120 million net debt a year ago.

Independence has changed its capital allocation and dividend policy. The company now aims to return 15% to 25% of free cash flow to shareholders through dividends and potentially buybacks. This compares with a prior target of a minimum of 30% of net profit after tax. The change reflects elevated depreciation and amortisation, principally from the Nova acquisition, which means free cash flow is much higher than net profit.

Despite the change, the focus will remain on growing per share value with most free cash flow retained and invested. We think this is appropriate given the finite nature of the firm’s mines. Reserves are sufficient for about seven years at Nova and nearly 10 years at Tropicana. The business in its current form does not naturally lend itself to be a high and consistent dividend payer. The ability to fully frank dividends will be limited. We expect the approximate AUD 200 million of net tax losses to mean the company won’t pay tax or generate franking credits until fiscal 2023. It has franking credits sufficient for only about AUD 10 cents worth of dividends, meaning unfranked dividends and buybacks will be considered.

Second-quarter fiscal 2019 production at Tropicana of 137,000 ounces of gold was about 10% ahead of our expectations due to higher gold grade. We don’t extrapolate this strength though as the average grade processed fluctuates from quarter to quarter. Our full-year forecast for 538,000 sits at the upper end of the company’s 500,000 to 550,000-ounce guidance range. Nova Bollinger nickel output increased 11% quarter on quarter to about 7,600 tonnes of nickel with the mine now fully ramped up and grades improving. Production was about 4% ahead of our forecast. Guidance remains to produce 27,000 to 30,000 tonnes of nickel and our forecast sits at the top of the range. Cash costs at both mines remain impressively low.