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Northern Star Resources (ASX: NST) – Fully priced with a Neutral Rating

The projected price for Northern Star is A$6.25[2] based on a discount rate of 7.02% weighted average cost of capital using the discounted cash flow model. This translates to a downside of 5% from the current price. We maintain a neutral position on Northern Star shares as the company is correctly priced.

Summary

  • History of strong financial position
  • Slightly positive industry outlook
  • Long term approach taken by the management
  • Management’s attempts at reducing operating costs
  • Decreasing production rates over the past year
  • Low dividend yields but high growth outlook

The Business

Northern Star Resources Limited (Northern Star) is an ASX 100 gold production and exploration company with a Mineral Resource base of 10.2 million ounces and ore reserves in highly prospective regions of Western Australia and the Northern Territory.

In 2010, the Northern Star management decided to shift its focus, to become a producer of gold instead of merely exploring new mines. In 2011, the company recorded its first profit, and revenue has grown from 115m in FY2011 to 850m in FY 2017, representing a CAGR of 39.6%. Its stock price had risen dramatically to its current price of A$6.57 as of 17 May 2018.

Northern Star is currently the third largest gold producer in Australia. It has its Paulsen mines which make up 11% of its revenue, the Jundee operations which make up 45% of its revenue and the Kalgoorlie operations which make up 44% of its revenue. The mines shall be discussed in depth in the later sections.

In general, the metals and mining industry can be considered to have high cyclicality and it is also highly capital intensive.

Northern Star’s strong growth

Northern Star has been able to bring up its production of gold quickly especially in the last 5 years. However, revenue from FY2015 to FY2017 have not changed by a significant amount. Even so, profit after tax has doubled between the same period. This is strong evidence of the success of management’s current efforts to reduce operating costs to maximize profits.

Strong financial position

Northern Star has a very low debt-to-equity ratio of 3% and this is also typical of most companies in the gold mining industry. This means that it is well positioned to secure additional financing through debt. Furthermore, it has cash and cash equivalents amounting to A$439.1m as of Q3 FY2018. This is a large amount of cash reserves for a gold mining firm. The management has utilized a small portion of the cash reserves to increase production in the third quarter by purchasing the South Kalgoorlie Operations for A$80m (of which A$18m was paid by cash), bringing the production capacity of Kalgoorlie operations to 300,000 ozpa by the end of 2018. The company has spent a further A$33m in the latest quarter in expansionary capital to increase production and gold inventory on their existing mines. The large amount of cash in the balance sheet provides the spending power for Northern Star to increase productivity and to generate new mines.

Key financial ratios

2013 2014 2015 2016 2017 5y avg
ROA 18% 6% 15% 20% 23% 16%
ROE 26% 9% 28% 33% 35% 26%

Source: Author’s calculations

Bar 2014, both Return on Asset (ROA) and Return on Equity (ROE) have been increasing. This reflects the company’s business as its mines start to generate revenue at a consistent level coupled with the management’s efforts at reducing operating costs. Northern Star as a much higher ROE as compared to the industry which delivered only 11% in ROE[3]. This implies that Northern Star can utilize its assets more efficiently than the industry to produce profits.

2013 2014 2015 2016 2017 5y avg
D/E 0 2% 5% 3% 2% 3%

Source: Author’s calculations

The debt-to-equity (D/E) ratio of Northern Star is low with its 5-year average at 3%. Firstly, this indicates that the company can obtain additional financing through debt, which is cheaper than issuing new equity. Secondly, based on the Dupont analysis[4], the firm has good fundamentals (profit margin and asset turnover), as a high ROA can be achieved by having a high leverage ratio, which is not the case for Northern Star.

 

Industry Outlook

Supply side

McKinsey’s forecasts based on qualitative factors suggests that declining ore quality and limited accessibility of new deposits will squeeze supply in the coming years, potentially increasing the prices of commodities in the future.[5]

Demand side

The demand for gold is increasing especially within the past few years. Countries like China have seen an increase in demand for gold bar and coins over the past few years due to the concerns over property, shares, bond markets and the yuan. United Kingdom has seen a 300% increase in its gold imports since 2016 due to the Brexit vote which renewed appetite for gold. India’s gold imports had surged 67 percent in 2017 from the previous year amid a rebound in retail demand. The scrapping of 500 and 1,000-rupee banknotes, which accounted for 86 percent of the cash in circulation, was the major factor in the increase in demand for gold in India as consumers look for commodities like gold to ensure the tangibility of their assets. [6]

Source: Bullionvault

Gold prices have increased steadily over the past 5 years, albeit with some volatility. By incorporating the demand and supply side analysis, we can conclude that the future gold prices are likely to increase slightly in the near future. This bodes well for the companies in the gold mining industry as an increase in prices of commodities means a higher profit margin. However, based on McKinsey’s reports, mining revenues could grow at 4 to 6 percent over the next decade, albeit at lower margins due to cost inflations.

Cost inflation

McKinsey’s outlook on the mining industry, cost inflation due to internal factors will plague all commodities. Most mines will suffer from declining ore grades and deteriorating mine conditions, such as deeper shafts and longer hauling distances. Northern Star has recently drilled beyond the 3km mark underground at a hole near its Jundee operations[7] in search of new gold deposits which implies that operating costs will increase in the future. McKinsey estimates that inflation in terms of costs will average 4 to 7 percent going forward[8].

Long term view taken by the management

The management takes a long-term approach by organically increasing its Resource and Reserves base through exploration programs and extension of mine lives. Northern Star will continue to invest aggressively in exploration to generate new mines in the future. The management had been acquiring mines and incurring capital expenditure in order to increase production capacity of existing mines and to develop new mines. The Central Tanami Project is an exploration project in the Tanami region which will be integral to Northern Star’s organic growth strategy to create a concentrated centre of production in future years. Optimization studies for the redevelopment of the Central Tanami Project have commenced.

The long-term approach taken by the management is extremely positive for its future outlook. The aggressive search for new mines bode well for the future revenue of Northern Star as it proactively searches for new mines to generate revenue.

Management’s attempts at reducing operating costs

Historical trends

Northern Star has been successful in reducing operating costs through productivity and procurement initiatives for their current mines in Kalgoorlie and Jundee. The operating costs in Paulsens are erratic but given that Paulsens make up 11% of the revenue of Northern Star, it is not a significant factor in the overall profits of the company. The margins of the Kalgoorlie operations and the Jundee operations have increased to very positive levels. Net operating profit before tax/Revenue stands at 41% for the Kalgoorlie operations and 38% for the Jundee operations. This proves that the company has been very effective at reducing operating costs for the Jundee and Kalgoorlie operations, which are the significant sources of revenue for Northern Star. The total production for FY 2017 was 514,735oz at an All-in-Sustaining Cost (AISC) of A$1,013/oz.Source: Northern Star Resource Limited AR’17; Author’s calculations

Decreasing production rates over FY 2018

Results over the past FY

Gold sold in the March quarter totaled 119,976oz at an AISC of A$1075/oz. The total production for nine months ending 31 March is 387,254oz at an AISC of A$1,053/oz. Based on Northern Star, the updated forecast for FY 2018 is 540,000 – 560,000 oz at an AISC of A$1,000 – A$1,050/oz, which was within the previous guidance set out at the beginning of the financial year.

However, the company has been facing a decrease in production rates over the past year coupled with an increase in its AISC, and that may be of some concern in regard to its future outlook. Current production rates have lowered by 13% since the first quarter.

Sep’17 Quarter Dec’17 Quarter Mar’18 Quarter Total
Ounces sold / (oz) 138,459 128,819 119,976 387,254
AISC / (A$/oz) 1,021 1,067 1,075 1,053

Source: Northern Star Resource Limited March 2018 Quarterly Activities Report

Future outlook

Northern Star’s production forecast for the quarter ending in June is above 150,000oz. We look at its purchase of the South Kalgoorlie operations and the capital expenditure on expansionary capital as indicators that Northern Star will be able to achieve its production forecast of 150,000oz in the next quarter. We also expect Northern Star to put in more of its cash into use to attain better productivity in terms of ores recovered and the AISC. The operating costs for FY 2018 will be expected to increase by a small amount compared to FY 2017.

Risks & Mitigation

Central Tanami Project

Optimization studies are currently being carried out in the Central Tanami Project. There is an uncertainty with regards to the volume of gold deposits in the region and the profitability of the mines.

Increasing operating costs

McKinsey forecasts expects that deeper shafts and longer hauling distances will cause margins to be squeezed in the future. [9]

We assume that operating expenses/revenue will slowly increase over next few years as we take the cost inflation issues into account. We expect a slightly lower cost inflation than as stated by McKinsey as we believe that the company’s strong track record of reducing operating costs and large cash position proves that the company can control the cost inflation at acceptable levels.

Northern Star Valuation

The dividend yield of Northern Star is 2.27%, which is not significant. We use the DCF model to determine if Northern Star can utilise its income to reinvest to create additional value within the company.

Growth till 2027

The current production growth of the financial year 2018 is expected to be 5% based on the 540,000 ozpa forecast. However, we assume that Northern Star will be able to achieve its production target of 600,000 ozpa by the end of 2018 as stated under “Future Outlook”. We assume that 10% revenue growth is reasonable as we have considered the purchase of the South Kalgoorlie Operations and additional capital expenditure to increase production and productivity. Thereafter, we assume that the Central Tanami project will start to generate revenue and Northern Star should grow at a slightly faster rate of 12.2% (industry average)[10]. As the mining industry gets increasingly saturated in the future, the industry growth will slow down to levels reflected by the economy growth rate. We assume that the terminal growth of the company will be equal to Australia’s 5-year average GDP growth rate at 2.43%[11].

WACC

The bottom up beta approach was used in the calculation of the cost of equity. The cost of debt was used by taking 10-year AUD-denominated corporate bonds and implementing a regression based on the credit ratings. The D/E ratio used was 3% as the company has been keeping its debt at very low levels, which is in line with the guideline companies.

WACC 7.02%
Cost of Equity 7.16%
Risk-free rate 2.86%
Beta 0.73
Equity Risk Premium 5.92%
Cost of Debt (by interpolation) 3.72%

Source: Bloomberg & Author’s calculations

DCF analysis

We used a WACC of 7.02% and a terminal growth rate of 2.43%. The intrinsic value of Northern Star is measured to be A$6.25. This represents a 5% downside from the current price of A$6.57.

Changing the WACC and terminal growth rate
Current price: A$6.57 WACC 6% WACC 6.5% WACC 7.02% WACC 7.5% WACC 8%
Terminal rate 1.5% 6.74 6.14 5.62 5.22 4.87
Terminal rate 2% 7.26 6.53 5.93 5.47 5.07
Terminal rate 2.43% 7.82 6.95 6.25 5.72 5.28
Terminal rate 3% 8.81 7.66 6.77 6.13 5.59
Terminal rate 3.5% 10.04 8.51 7.37 6.58 5.94

Source: Author’s calculations

Operating Expenses/Sales

We conducted a sensitivity analysis with regards to the operating expense over sales ratio. From the table, we can conclude that operating expense over sales ratio is a very significant factor in determining the intrinsic value of Northern Star. Should Northern Star’s operating expenses be at higher levels, the value of Northern Star will be lower than the current intrinsic value. However, should Northern Star be able to maintain its operating expense/sales ratio at current levels by increasing productivity, this will cause a significant increase in the value of Northern Star.

Changing operating expenses/sales
Current price: A$6.57 WACC 7.02%, Terminal growth 2.42%
Operating expenses/sales 71% A$10.58
Operating expenses/sales 71% – 76% A$8.65
Operating expenses/sales 71% – 83% A$6.25
Operating expenses/sales 77% – 83% A$5.90
Operating expenses/sales 83% A$5.62

Source: Author’s calculations

Relative Valuation

We have excluded Westgold Resources Limited from the guideline companies as the company has yet to generate revenue through gold mining, hence it is not a good guideline company as compared to Northern Star.

Based on the TEV/EBIT ratio for guideline companies, Northern Star is significantly underpriced. This is because the operating costs of Northern Star is lower than its peers which results in a higher EBIT compared to the guideline companies. The fair value based on the average TEV/EBIT of the guideline companies is A$8.76.

However, when using P/E ratio, it suggests that the market thinks that Northern Star is overvalued. The average P/E ratio of the guideline companies indicate that the price of Northern Star should be A$4.86. The reason why the price of Northern Star is high is due to the better growth prospects and its ability to maintain low operating costs.

Given Northern Star’s strong economic performance over the last few years, I believe that Northern Star will continue to maintain strong growth rates and a healthy balance sheet. I am confident that the relative valuation using P/E ratio is not indicative of the intrinsic value of Northern Star as it fails to account for the better growth prospects in Northern Star compared to the guideline companies.

Guideline Companies TEV/EBIT P/E
Evolution Mining Ltd 7.61 26.03
St Barbara Ltd 6.21 11.80
Regis Resources Ltd 7.56 14.32
Resolute Mining Ltd 6.72 8.54
Sandfire Resource Ltd 4.23 13.01
Westgold Resources Ltd 19.85 29.05
Saracen Minerals Hldg Ltd 12.26 25.31
OceanaGold Corp 4.58 9.02
FV based on TEV/EBIT FV based on P/E
Average 8.76 4.86
1st Quartile 5.98 2.84
Median 6.96 4.1
3rd Quartile 13.46 7.97

 

Source: Bloomberg & Author’s calculations

Chart 10

Source: Author’s calculations

Conclusion

Even though the business of Northern Star is robust, it is correctly priced by the market, mainly due to the high capital gains that the share has seen over the past 5 years. With a low dividend yield of 2.27%, the value of the company will mainly depend on its ability to generate new mines and to maintain productivity levels.

Based on the current FY results, the outlook for revenue is positive, but operating costs has been higher in FY 2018. We expect that Northern Star utilize some of the large cash reserves they have to improve productivity levels in the future.

We believe that Northern Star has the potential to increase its value in the future due to the positive and long-term approach that the management is taking. However, it remains to be seen if the management can attain their goals. As of now, the future looks bright as the management has upheld their growth strategy to generate new mines and increase productivity levels in the past few years. As mentioned under “Operating Expenses/Sales”, we shall focus on Northern Star’s productivity levels in the near future and whether the management is able to maintain operating costs at current levels. Should they be able to do so over the near future, Northern Star will be poised to provide even greater value to its shareholders. As for now, we take a neutral position on Northern Star.

 



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