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Morningstar | Soft Finish to Fiscal 2018 for Independence Group but AUD 3.90 FVE Maintained

Independence Group's fiscal 2018 adjusted net profit after tax rose 26% to AUD 53 million. The increase reflected the first year's contribution from the Nova-Bollinger nickel mine and better profitability at the 30%-owned Tropicana gold mine. EBIT from Nova was AUD 36 million from a modest negative last year while Tropicana increased 48% to AUD 86 million thanks to a higher gold price and production and lower cash costs. At the Jaguar mine, sold in June, EBIT declined more than 60% to AUD 13 million after a troubled year. The Long nickel mine also closed after an immaterial contribution and reserve depletion. Despite the profit increase, the result was weaker than expected due to soft fourth-quarter nickel production and sales at Nova and another problematic quarter at Jaguar.

However, we maintain our AUD 3.90 per share fair value estimate for no-moat-rated Independence Group. There are several offsetting factors in our unchanged estimate. On the negative side, our earnings forecasts have decreased with higher estimated depreciation and lower reserve grades at Nova following the company's latest downgraded estimate. On the positive side, management is optimistic on the potential to grow processing plant throughput at Nova to 1.8 million from 1.5 million tonnes a year and deliver cost savings by focusing on scale efficiencies and optimisation of what is a new mine. At Tropicana, the company also expects to deliver unit cost savings through an incremental expansion while also enhancing gold recoveries. The optimisation of Nova and Tropicana, along with the time value of money, offsets much of the impact of the lower reserve grade at Nova.

Independence is also enthusiastic about the potential for extensions to reserves and resources at both Nova and Tropicana. Recent exploration at Tropicana is encouraging and the company expects to mine higher grade ore from underground. Exploration around Nova-Bollinger is earlier stage, but drilling will ramp up in fiscal 2019.

The market was very optimistic about the potential for exploration success at Nova to extend life, but the approximate 22% reduction in nickel reserves in fiscal 2018 was a key driver of the approximate 10% decline in the share price in the last month. However, we still think there is significant potential for exploration success at Nova, given the discovery is new, the company's acreage is extensive and drilling around the known deposit has been limited with the focus on getting the existing reserves into production. We still think it's realistic to expect incremental discoveries to extend life at Nova and we don't think reducing mine life by the year implied by lower reserves is appropriate. At Tropicana, recent exploration success supports our view that life there is also likely to extend. In fiscal 2018, Independence added 790,000 ounces of gold to reserves, almost double the amount lost to depletion with mining.

There is also an outside chance a new discovery could be made with regional exploration on the broader Fraser Range acreage in the belt between Nova and Tropicana. However, the effort is not without risk and we don't yet see a reason to assume exploration will materially add to or detract from shareholder value. Expenditure is meaningful with Independence budgeting AUD 51 million for exploration in fiscal 2019. Near-mine exploration accounts for AUD 18 million of the budget with most centred on Nova. Higher-risk greenfield exploration accounts for AUD 33 million and with it comes a broad range of potential outcomes. The spend is meaningful but the company's approach is fundamental and methodical.

We can see justification for elevated exploration activity given the Fraser Range is a large, relatively new belt prospective for nickel and gold. The company's Fraser Range exploration effort primarily focused on data gathering and target generation in fiscal 2018. Fiscal 2019 will be the year when those targets are drill tested and Independence is small enough that a discovery can be meaningful. As data points emerge with drilling, it may become apparent that the expenditure will add or destroy value, but at this early stage it's difficult to form a definitive view. We expect the market will be sensitive to both positive and negative results.

Independence is in strong financial shape with net debt of just AUD 2 million, down from AUD 161 million a year ago. Buoyant operating cash flow of AUD 278 million reflected the better year at Tropicana and the first contribution from Nova. The free cash inflow of AUD 173 million compares with negative AUD 196 million last year, which was hampered by expenditure to build Nova.

Total dividends increased 50% to a still modest AUD 0.03 per share fully franked in fiscal 2018, representing a payout ratio of 34% of earnings. We expect the payout to grow with expected higher future earnings and the strengthening financial position. However, management would like to build net cash up to AUD 400 million to be able to develop any new exploration discoveries quickly. This will slow what could otherwise be a rapid increase in the payout ratio. Independence has issued new equity at unfavourable times when previously developing new mines. So we think there is logic in being able to finance any new discoveries through development without needing to rely on financial markets, which can be fickle, particularly when commodity prices fall.