Caledonia Mining Corporation
March 26th 2021
For many investors, Zimbabwe is an off-limits jurisdiction. But putting aside preconceived ideas and viewed objectively and, in my opinion, its natural resources sector has much to offer. Caledonia Mining (LON: CMCL) is a Gold mining company that I have been interested in for several years and, yes, I am a shareholder.
In summary, it's the largest Gold miner in Zimbabwe and has one operating mine - The Blanket mine. Employing around 1,600 people. The company owns 64% of the mine while the remaining 34% is owned by local Zimbabweans, including 10% by the workforce. For 2020, Blanket produced 57,899 oz of Gold. An increase of 5% year on year. Its guidance for 2021 is 61,000-67,000 oz of Gold. As of December 2020, it had measured and indicated resources of 805,000 oz of Gold at 3.72g/t and inferred resources of 963,000 oz of Gold at 4.52g/t. Very importantly, it has managed to increase its overall resources over the last ten years in the face of increasing production. And, as it points out, it has a 112-year record of converting inferred resources into reserves. The upshot is that it has a 14-year life of mine and a fully-funded investment programme. While its Central Shaft presents many development opportunities with exploration potential at depth. And the realistic prospect of further extending the mine life.
Zimbabwe - An Established Gold Producer
It's not a new kid on the block. Zimbabwe was the third-largest Gold producer in Africa up until the 1980s. The following gives some idea of current production levels in the country.
It's also worth mentioning that the Zimbabwean Government appears intent on enforcing its "Use it or lose it" laws when it comes to mining assets. The country has a problem with mining assets being held without being developed for very long periods. In part, this results in serious issues with artisanal miners exploiting the vacuum. They make very little money while the Government makes nothing. This has no direct impact on Caledonia but it could open up opportunities for the company. Why? Caledonia is the country's largest Gold producer and recently signed a memorandum of understanding with the Zimbabwean authorities in respect to purchasing assets directly from the state.
Financials - Strongly Cash Generative
It has just released its annual results for 2020. Unsurprisingly, given the recent rise in Gold prices, there was a substantial increase in revenue. Gross revenue increased by 32% to US$100 million. While gross profit increased by 50% to US$46.6 million. Its production costs were up 20% (Its all-in sustaining cost [AISC] per ounce [Before export credit] increased by 20% to US$1,028). While the company argues that stripping out controllable costs and the increase was around 16%. Its administrative expenses have increased by around 42%. This reflected an increase in wages (Increased man-hours worked and a new bonus structure). But what is really noticeable is the huge rise in management liability insurance. This has increased by a whopping 1100% to US$1.032 million and appears linked to the risk of ESG class action litigation in the US (It's listed on the NYSE).
Towards the end of last year, the company gave a presentation that illustrated the projected strength of its cash generation. Based on a Gold price of US$1,214 per oz, it estimated that it would create free cash flow of US$29 million in 2021 and US$30 million in 2022. And it seems intent on using that cash to expand its operations and becoming an international mid-tier Gold producer in the medium term.
Key to its business model is its dividend policy. It pays quarterly dividends and clearly has a progressive approach to dividends - those dividends have been on a rising trend line since 2013. However, unlike many dividend-paying miners, it presents investors with a yield and growth proposition. It has linked growth in output and profits with growth in dividends. But the one problem with that is the repatriation of money. It's Zimbabwe and there is a chronic shortage of foreign exchange. The company has worked hard at overcoming this problem but there's no guarantee that it will do so indefinitely. Its Gold output is purchased by the Reserve Bank of Zimbabwe. The company receives 60% of this payment in US Dollars and the rest in local currency. Good treasury management is key to its operations and, thus far, it has succeeded. Its workers get paid in a mix of local currency and US Dollars. While it pays for its electricity supplies on the same 60/40 basis that it receives payment for its production. It may seem a little convoluted but it works. It's also worth mentioning that the Zimbabwean authorities announced in December 2020, its intention to sell a majority stake in the Reserve Bank's refining unit (Reserve Bank of Zimbabwe’s Fidelity Printers and Refiners [FPR]) to the country's Gold miners. I would suggest that this will give the Gold mining industry a better deal and Caledonia will be part of this change. Importantly, it is in effect privatisation. The exact opposite of what many investors fear about Zimbabwe.
Options On Brownfield Sites Signals Expansion
Over the last two years, the company has investigated some 25 potential acquisitions. It appears focused on brownfield sites and has no interest in purchasing large mining operations. It's targeting potential resources of at least one million ounces of Gold and annual production of at least 50,000 oz of Gold. Importantly for investors, any acquisition must be dividend enhancing. In December 2020, it purchased exploration rights over Glen Hume and Connemara North in the Gweru mining district (See below).
Glen Hume, a 350-hectare prospect, gives it an exploration period of up to 15 months. The upfront cost of the option was US$2.5 million in cash. Although there is some small-scale mining being conducted on-site, this is regarded as insignificant. Should it go ahead and develop, the total consideration would be US$5 million (A further US$2.5 million in either cash or shares) plus a 1% net smelter royalty. It has begun exploration drilling - Reverse circulation/diamond drilling.
Connemara North, about 35 kilometres from Glen Hume, comes with an 18 months exploration period. The initial cost is US$300,000. While the total cost would be US$5.3 million (Cash or shares) and a 1% net smelter royalty if it presses ahead with development. The area is the northern section of a previously producing open-pit leach operation that was put on care and maintenance in 2001 by First Quantum Minerals. Using figures drawn from the US Geological Survey for 2000, the Connemara mine produced 671kg of Gold in 1999 from 663,200 tonnes of ore at a grade of 2g/t. While it had remaining resources of 6.5Mt at 2.53 g/t. Apparently, First Quantum had planned on extending the operation, presumably, to exploit its northern zone. But Caledonia has not presented any information outlining the previous owner's drilling results. The impression I have is that the mine was closed for macroeconomic and political reasons. Those were grim times, according to the Zimbabwean Central Statistical Office, some 6% of the country's workforce was employed in the mining industry in 1980. By 2002, that had fallen to just 0.2%.
These two properties are about 30km apart. Should they both be viable, then there could be considerable economies of scale - the properties are linked by a good road. Although the company points to an abundance of skilled labour in Zimbabwe, not surprising given the incredibly high unemployment rates, it's unclear how these properties are served by the necessary utilities.
Solar Photovoltaic Project Looks Set To Mitigate Energy Issues
Zimbabwe is heavily dependent on electricity supplies from South Africa and Mozambique. The former has its own supply problems while paying for imports is difficult for a country short of foreign exchange. The company requires clean and consistent power supplies but the quality from the grid is low and variable. This causes problems, especially with sensitive equipment. It currently deals with the situation by employing diesel-fuelled generators but this is expensive and creates logistical issues. Caledonia's spending on diesel increase by 260% from 2019 to 2020. This appears to be directly related to power outages. Its preferred solution is to install a photovoltaic (PV) plant. When I last spoke to its management, the 12MW Solar PV project was pencilled in for commissioning by the end of 2020. That, presumably, due to COVID has been put back to the end of 2021. At a cost of around US$12 million and with a projected saving of some US$3 million per annum, it's expected to provide all the company's daytime baseload needs and around 27% of its total electricity requirements. The project was financed through an at-the-market offering of 597,963 ordinary new shares in September 2020. Incidentally, the associated costs were expensed rather than capitalised.
Central Shaft Is On Track For Commissioning
Caledonia's Central Shaft project is a major engineering feat. Some 1,200 metres deep, six metres wide and incorporating four compartments, it changes the economics of the Blanket operation and opens up the prospect of deep exploration. The company has clearly stated that this is on course for commissioning in Q1 2021, slightly delayed due to COVID restrictions. Its No.4 Shaft is not optimally located to fully exploit its ore bodies. If all runs according to plan, the Central Shaft will lift production to 80,000 oz of Gold per annum by 2022 and give it greater flexibility and operating efficiencies. That should reduce its AISC - it's looking at an AISC of around US$700-US$800 per ounce when production is fully ramped-up.
Incidentally, although the Central Shaft is obviously where the company's future lies, the No. 4 Shaft and sub-750 metres, according to the company, still has exploration potential.
Not For The Fainthearted - But Perspective Is Needed
Zimbabwe has some dire problems, so any investment in the country will come with considerable risk. Crude, possibly, but Caledonia's quarterly dividend could be viewed as a canary in the coalmine. So long as it can repatriate its profits and pay dividends, then it seems fair to assume that it can operate. At a practical level, its biggest issue appears to be low-quality electricity supplies. That problem should largely be resolved by the year-end with the commissioning of its 12MW PV plant. In the meantime, it can make do with diesel generators to cope with interruptions in power supplies.
On a broader note, the mining industry provides the bulk of Zimbabwe's foreign exchange; Gold is its biggest export, in terms of value. And the Government is keen for the industry to develop. Any hope of getting the country out of its economic problems will almost certainly involve the mining industry. And the miners will only operate in Zimbabwe if it's profitable. It's also worth mentioning that this is a company that pays its social rent and has been doing so before ESG became a bandwagon. It has made a considerable contribution to the community in which it's based.
The commissioning of the Central Shaft and the subsequent decline in capex looks set to significantly increase free cash flow. It appears to have the ability to increase dividends and grow the business. My prime concern is the operating environment and this will have to be watched closely. But I'm inclined to think that investors in the Gold mining sector may be over-estimating the dangers of investing in Zimbabwe and, possibly, under-estimating the dangers of investing in other jurisdictions.
* Illustrations sourced from Caledonia Mining
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