This will be a long post that will cover:
- What a mine’s cash flows look like over its life.
- Crazy accounting rules.
- Uneconomic behaviour caused by stock promoters and charlatans.
Discounted cash flow
Websites such as Investopedia have general background information on DCF models.
I would argue that investors should use a discounted cash flow (DCF) model as a way of modelling the economics of a mine. Investors should NOT use P/E multiples, EBITDA multiples, or P/B ratios because those models fail to take into account the depleting nature of a mine.
As an example of a DCF model in mining, I will use Table 22.5 (page 191 in the PDF) from a 2012 feasibility study prepared for Noront (PDF). Click the image below for a larger view.
There are many, many assumptions behind a cash flow model (no political risk, clear legal title, mineral estimation, metallurgy, cost of labour, taxes, mineral production, commodity prices, etc. etc.). A single spreadsheet simply summarizes all of the underlying assumptions. A key line in the spreadsheet is the projected after-tax cash flow (“c/flow after tax”). I created a graph out of the numbers below:
In general, the cash flow of all mines have some resemblance to the graph above.
- In the initial years, there is negative cash flow as the mine is built.
- If exploration and engineering costs are included (the Noront feasibility study excluded such costs), those costs would also contribute to negative cash flow in the early years.
- Many feasibility studies for publicly-traded companies underestimate the amount of time it takes for a mine to be approved. In first world countries, it usually takes 7-10 years from initial discovery of a deposit to initial production. Technical reports often underestimate delays caused by politics, NIMBYism, environmentalists, etc. etc.
- A mine plan tries to maximize the net present value (NPV) by mining the most profitable ore first. Because of this, cash flows decline over time. This is an important concept to grasp as producing mines will generally have their best days behind them. While management teams often claim that future cash flow will increase, it is unlikely that such claims will turn out to be true.
- The table above does show some year-over-year increases in cash flow. This can happen when there is a lot of rock that must removed before the next most profitable ore can be mined. In other words, there can less profitable rock in the way that must be removed first.
If we can assume that cash flow will decline over a mine’s life, then there are obvious implications for short selling. Valuing a cash flow negative mining asset becomes easy if we can project that future cash flow will be worse than the past.
Problems with DCF models in practice
In my opinion, DCF is an excellent tool that investors should use for mining assets. Mine engineering textbooks focus on DCF as the tool that mine engineers should use in feasibility studies. However, there are problems in practice:
- Feasibility studies prepared for investors are often inflated. For example, the Bloom Lake feasibility study prepared for Consolidated Thompson wasn’t anywhere close to reality (Cliffs Natural Resources bought Consolidated Thompson and provides some economic data on Bloom Lake). The mine is currently shut down as iron ore prices have fallen below the mine’s operating cost.
- Junior miners often withhold material information from investors or release misleading information. For example, Graham Farquharson of Strathcona did an interview in The Northern Miner in response to Pretium’s comments about Strathcona’s views. In my opinion, Pretium’s SEDAR filings tell a very different story and omit material information disclosed in the Strathcona interview. In an ideal world, this would not happen as Pretium’s securities regulator should have forced Pretium to disclose what Strathcona was making a stink about. As well, Pretium’s NI 43-101 technical reports should not have omitted Strathcona’s disagreement and views when describing the history of Pretium’s flagship deposit.
- Some mining CEOs are crazy. They intentionally chase uneconomic projects. In the junior mining world, this often happens because the part-time CEO wants to raise money by telling a great story. A mothballed mine on “care and maintenance” does not make a good story. Raising money ensures that there will be money for the part-time CEO’s salary plus “travel and entertainment” expenses. Some senior miners adhere closely to GAAP- growth at any price. Because of growth at any price, many gold stocks have performed worse than physical gold during a bull market in gold.
- Often, mining companies do not disclose enough information for investors to build a decent DCF model and to perform due diligence on the assets.
In an ideal world, institutional investors would perform a reasonable level of due diligence on their mining stocks. In theory, they could request publicly-traded companies to publicly disclose any feasibility studies produced for a mining project, either internally or by joint venture partners. In practice, some publicly-traded miners raise capital to build mines without releasing any feasibility studies.
Ideally, mining companies could at the very least release basic information to investors:
- NPV and IRR.
- Mine life.
- Estimated production and removal of waste ore for each commodity produced.
- Estimated metallurgical recovery rates.
- Estimated operating costs, initial capex, and sustaining capex.
- (Allocation of estimated corporate overhead.)
- Later on, actual production numbers should be provided so that investors could compare projected versus actual results.
- The level of accuracy of the feasibility study.
This information could allow investors to build reasonably good DCF models. The obvious problem is that DCF can be a garbage-in garbage-out model. If a promotional management team releases inflated numbers, then the investor’s DCF model could wildly overestimate a project’s economics. A basic safeguard against this is to compare actual versus projected results.
To perform more extensive due diligence on a DCF model, investors should look at:
- Political risk.
- Whether the company has clear legal title to the deposit.
- The reasonableness of various technical assumptions supporting the engineering projections. This is a very complex question to answer as it requires domain knowledge in civil engineering, mineral processing, resource estimation, mine engineering, etc. etc.
- The 3-D model of the orebody, to verify the reasonableness of the mineral estimation model. It is highly unfortunate that few analysts see the value in performing this check as looking at the 3-D model can reveal common ways in which a resource is inflated.
- Assay results. Companies should not omit assay information for unwanted elements (e.g. sulfur, arsenic, etc.).
- Independent assays on drillcore splits. This verification is the reason why Freeport Mcmoran didn’t get burned on Bre-X while every investment bank analyst failed to spot the Bre-X fraud. (What actually happened is that Bre-X destroyed all of its drillcore, so Freeport Mcmoran brought in their own drilling team at great expense to obtain new drillcore.) See my post on data verification.
- Operating cost assumptions, such as the number of employees, wage rates, use of fly-in fly-out labour, etc. etc.
- The integrity of management.
Performing actual due diligence requires sophistication in politics and law on top of various different disciplines of engineering. It’s going to be hard. Interestingly enough, institutional investors rarely perform such due diligence.
Simply looking at management’s integrity is a shortcut method that doesn’t require a deep understanding of a wide range of complex subjects.
The underlying problems
The biggest issue with mining is that there are various uncertainties such as the size and grade of the resource, operating costs, metallurgical risk, etc. etc. Because of the uncertainties, it can be difficult for investors to build accurate models. The uncertainties will always create room for charlatans to game the system and to mislead investors into overestimating a project’s economics. I don’t see a great solution that could prevent charlatanism from happening.
However, I think the most pragmatic approach is for mining companies to disclose more information about their existing mines and potential mines. Insiders should not have an information advantage over investors. Investors could be given access to feasibility studies (internal and joint venture), 3-d models, assay results, etc. etc. Basically, investors should be provided with more information to help them form their own conclusions as to what a mining asset is worth.
Generally speaking, accounting rules require mining companies to estimate the life of a mine. To do this, the company will likely be using a discounted cash flow model to model the economics of the mine. However, I don’t believe that accounting rules actually require the company to disclose the details and assumptions of the DCF model used.
Suppose that the units of production method is used to determine the depreciation expense for a mining asset. Again, this method likely requires building a DCF model as the company needs to estimate mine economics to estimate the total number of units produced. Companies do not have to disclose the DCF model or the projected production for each year.
In general, commonly-used accounting standards do not help investors in valuing mining assets. Investors could overcome some of these issues if companies were forced to disclose more information.
Capitalization of stripping expenses
Most mining operations need to remove waste material to access the ore. IFRS accounting standards force the mining company to capitalize the cost of removing waste material (for surface mines). The argument is that moving waste material “improves” access to the orebody. Because expenses should be matched to the time period that the revenue is recognized, some stripping costs are capitalized so that the expense is recognized in a future time period.
In the normal operation of a mine, waste may need to be removed weeks or months ahead of time before the corresponding ore can be removed. Access ramps and declines may need to be created a year or so in advance to access lower levels of a mine. In open pit operations with multiple pits, there will be overburden (waste material) covering the secondary pits. The mine operator may delay the removal of that overburden until they are ready to mine the secondary pits. An argument could be made for capitalizing expenses for short periods of time. However, I think it is unreasonable for waste removal costs to be capitalized for several years or over the life of a mine (which can be 2-4+ decades).
In my opinion, capitalization of stripping expenses creates accounting distortions. Dirt (or waste rock) is not some type of asset that generates revenue. Mining companies move dirt around because they have to, not because they want to. They want to minimize the expense of moving dirt around. If the cost is unavoidable, the mining company wants to defer the cost as much as possible as doing so maximizes the net present value of the mine. Generally speaking, mining companies move dirt around to make money in the short term rather than sometime in the future. Capitalizing stripping expenses over long time horizons inflates accounting earnings in the short term (with offsetting accounting losses in the long term).
In practice, some companies abuse this accounting rule to inflate earnings. It is worth searching through annual reports for the phrase “capitaliz” (to find capitalize, capitalized, capitalization) to figure out whether or not the company is capitalizing stripping costs excessively. While accounting rules generally force all miners to capitalize stripping costs, some miners find loopholes to capitalize far more costs than their peers. Excessive capitalization of stripping costs is likely a sign of dubious management.
In my opinion, it would be much simpler if stripping costs were always expensed. The accounting burden on the company would be lower. Comparability would be better as there will not be a situation where some companies capitalize excessively and others don’t. There would be significantly less abuse. One minor downside is that capitalizing all stripping expenses violates the matching principle by a very short period of time (usually weeks to months). Very little accuracy is lost, since accounting rules do a terrible job at approximating the actual economics of a mine anyways (marking the mine to a DCF model has the potential for being the most accurate).
For further reading, see the white paper “Deferred stripping – see what the miners are raving about“.
Often, mining companies will defer exploration of deep targets until after exploration or production shafts are sunk. Because of this, initial resource estimates can be revised upwards due to new discoveries.
One reason why mining companies defer exploration is because deep drilling is expensive. A shallow exploration hole might cost $100/ft while a multi-kilometer hole might cost $300/ft. As well, exploration holes curve and increasingly go off-target the longer the hole goes. The hole could miss its intended target.
After shafts are sunk into the ground, the cost of exploration is greatly reduced because exploration holes can be much shorter. When the project turns into a mine, the exploration shaft can be reused as part of the mine’s infrastructure.
Before a mine is built, mine engineers will conduct various studies to examine the relationship between mine size and the net present value of the project. The benefits of a larger mine are:
- Cash flows are received sooner because the larger mine extracts the ore faster.
- Various economies of scale exist.
The downside to a larger mine is higher capex. There is some optimal mine size that balances out the benefits and downsides, optimizing the NPV of the project.
Mechanization is one benefit of scale
For surface mines, larger machines offer improved economies of scale. A larger machine is more productive but still requires roughly the same number of human beings to operate and repair the machine. (There are limits to mechanized mining once the mining company is buying the largest machines possible.) For underground operations, larger machines may not make sense if the deposit consists of small veins. Larger machines would be detrimental if their size led to the dilution of the ore with waste rock.
Typical mine lives
NPV is usually maximized with a mine life of between 6 and 20 years. Underground mines tend to have longer optimal mine lives due to limitations to mechanization, higher capex intensity due to the cost of mine shafts and hoisting equipment, etc. etc.
Mine lives longer than 20 years
In general, I am very skeptical about feasibility studies that claim a mine life longer than 20 years. For potash deposits, a very high mine life is reasonable if the mine is so big that it can oversupply the local market for potash. Otherwise for non-potash deposits, I am skeptical as to why the mine life is so long. It would make more sense if the mine was built larger as doing so would increase the NPV of the proposed project. What is probably happening is that the feasibility study greatly understates the mine’s operating costs. With more accurate operating cost projects, the mine life would be something more reasonable.
I am highly skeptical about mines that will be built in multiple stages (an old blog post of mine essentially makes the same points I do here). The NPV of a mine would be maximized if the mine was built in a single stage. By proposing additional stages, charlatans can claim that the increased scale will produce economies of scale. They can make the claim that the improved operating costs will make the expansion feasible. In practice, many mine expansions seem to be an exercise in fooling gullible investors when the economies of scale do not materialize.
To be fair, mine expansions can make sense when commodity prices have risen dramatically.
In theory, mines close to each other can generate some synergies by sharing spare parts and eliminating duplicate personnel. In practice, synergies can be achieved with joint ventures. For example, Noront and Cliffs Natural Resources shared an exploration camp in the Ring of Fire area. An expensive merger between the two companies was not necessary to generate synergies. Where mergers do occur, mining synergies do not seem to materialize very often.
In my opinion, mergers between mining companies often do not make sense. Usually when a mining merger happens, one party is taking advantage of the other. Both companies may have flawed assets and are looking to do deals to get out of their predicament (e.g. one party may have a mothballed mine that doesn’t make a good story stock). However, the management team of one side may not realize that the other company’s assets are more flawed than theirs.
Of course, many companies will pursue strategies that are the opposite of a merger. They might spin off assets into “pure play” companies that focus on a specific commodity. I do not see the value in companies shuffling paper around with mergers and “un-mergers” (spinoffs).
What I actually do
In general, I am fearful of the garbage-in garbage-out problem with DCF models. I rarely build DCF models. I know my limits. I understand that I cannot perform very good due diligence on mining assets as publicly-traded miners typically provide very little useful and reliable information on their assets. As well, the publicly-traded mining world is filled with charlatans, stock promoters, and smart people trying to sell shares at inflated prices. The short side is easier than the long side because it’s easier to find bad people with bad assets than it is to find good people with good assets.