Not all that glitters is gold

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1 TUESDAY, 22 JULY 2014 Philex Mining Corporation: Not all that glitters is gold We are initiating coverage on PX with a HOLD rating and an FV estimate of Php9.30/sh based on the discounted cash flow method. We believe that the company s most significant plans have already been priced in. Moreover, the company is currently vulnerable to numerous risks which prevent us from assuming a more bullish target. The most prominent risks facing the company are regulatory uncertainties and flattish metal prices. Metal prices at a standstill. Gold and copper spot prices quoted in the London Metal Exchange are one of the most important determinants of PX s earnings since revenues from gold and copper comprise 97% of PX s total revenues as of end So far, gold and copper prices for the year have been flattish, with YTD averages at US$1,284.90/oz and US$3.20/lb, respectively. These are barely different from their full-year averages last year of US$1,297/oz and US$3.27/lb. Although prices of gold and copper increased last month after the European Central Bank disclosed further monetary stimulus, it is uncertain whether the increase is sustainable as inflation is not yet a concern. Silangan mine to decide on variables. A large part of PX s value is hinged on the successful development of the Silangan project as we estimate this project to account for around 80% of PX s fair value. The Silangan project will also be PX s primary future earnings growth driver. There are several variables blurring the roadmap to Silangan s mine development, the most relevant of which involves the choice of mining method, which will affect mine development and operating costs. New mining law is the biggest hurdle. The biggest risk facing PX, and the mining industry in general, is the proposed revision in the mining law, ideally effective by the end of the current administration. If the proposal were to be passed into law, that would bring PX s effective income tax rate (as currently measured) to about 65% (excluding excise taxes and royalties) from just over 30% currently. Based on our estimate, the passage of the revised mining law would cut PX s FV by ~ Php6.54/sh or 70%. Trading at a premium to our FV estimate, and relative to peers. Recall that PX s stock price recently got a 30% boost following the announcement that authorities formally lifted the suspension of its current mine in Padcal after a tailings spill in mid Because of this, we believe that PX s valuations are no longer attractive. At Php11.84/sh, the stock is trading at a premium to our FV estimate of Php9.30/sh. PX is trading at a 14E P/E of 45.5X and an EV/EBITDA multiple of 17.4X. The company s stock is relatively expensive since it is trading at a significant premium to the global average 14E P/E of 25.5X, and the average EV//EBITDA of 7.5X. FORECAST SUMMARY in PhpMil E 2015E Net revenues 15,324 8,698 9,802 11,089 12,467 % change y/y 20.9 (43.2) EBIT 8, ,465 2,064 2,616 % change y/y 42.3 (97.2) EBIT margin (%) EBITDA 8,851 1,002 2,913 3,722 4,920 % change y/y 34.8 (88.7) EBITDA margin (%) Net income 5, ,285 1,552 % change y/y 45.6 (96.4) NPM (%) EPS (Php) % change y/y 45.3 (96.4) RELATIVE VALUE P/E (X) P/BV (X) ROE (%) Dividend yield (%) source: PX SHARE DATA HOLD Rating Ticker PX Fair Value (Php) 9.30 Current Price Upside (%) SHARE PRICE MOVEMENT Apr May Jun Jul-14 PX PSEi ABSOLUTE PERFORMANCE 1M 3M YTD PX PSEi MARKET DATA Market Cap 59,836.39Mil Outstanding Shares 4,937.00Mil 52 Wk Range Mo Ave Daily T/O 57.30Mil Garie Ouano garrie.ouano@colfinancial.com

2 Company Background Philex Mining Corp. (PX) is a mining company engaged in the exploration, development, and production of metallic minerals and petroleum. Most of the company s revenues come from the sale of copper and gold concentrates. It currently operates the Padcal mine in Benguet, whose mine life is expected to last until the year PX is currently engaged in exploration efforts in Padcal in order to extend its mine life. The company is also gearing up to develop the Silangan mine, which is expected to be the company s next operating mine. The Silangan project is currently in the prefeasibility stage, and is expected to start operations by The company also has interests in petroleum service contracts locally and abroad (Peru) through its subsidiary Philex Petroleum Corp. (PXP, 64.8% owned). The energy segment is still a small part of the business, contributing only about 2% to total net revenues. 36.2% of the company is owned by First Pacific Company Limited, where local tycoon Manny Pangilinan sits as CEO. Exhibit 1. Revenue breakdown (as of 2013) 1% 2% Gold Copper 44% 53% Silver Petroleum and others Source: PX Existing mine generates Php13-16 Bil in revenues PX currently generates profits by operating the Padcal mine in Benguet. On an annual basis, PX produces around 9.1 Mil tons, with its ore having an average grade of 0.20% copper and 0.44 grams of gold per ton. As a result, PX generated around Php13 to Php16 Bil in revenues annually during the past years of regular operations, with revenue fluctuations depending on the prevailing gold and copper prices. Earnings were unusually low during the past two years as Padcal suffered from a disruption in its operations due to a tailings spill in Nevertheless, the Pollution Adjudication Board of the DENR officially lifted its cease-and-desist order last June, signaling PX s return to regular operations. TUESDAY, 22 JULY 2014 page 2

3 Metal prices at a standstill One of the most important determinants of mining industry revenues are global metal prices since pricing is typically benchmarked against spot prices in the London Metal Exchange. In the case of PX, the most relevant prices are those of Gold and Copper, since revenues from these comprise 97% of PX s total revenues as of end-2013 (53% gold, 44% copper). So far, gold and copper prices for the year have been flattish, with YTD averages at US$1,284.90/ oz and US$3.20/lb, respectively. These are barely different from their full-year averages last year of US$1,297/oz and US$3.27/lb. Consensus estimates for average copper prices are forecasting a further decline in the second half to US$3.10/lb due to slowing demand from China. Consensus gold price forecasts for the second half are also expecting a flat year, with estimates averaging US$1,286.10/oz. Although prices of gold and copper increased last month after the European Central Bank disclosed further monetary stimulus, it is uncertain whether the increase is sustainable as inflation is not yet a concern. Exhibit 2. LME prices for Gold and Copper Source: Bloomberg For these reasons, we assumed that applicable prices would settle at a full-year average of US$1,300/ oz for Gold and US$3.20/lb for Copper. At the said levels, our earnings forecast for PX would reach Php1.3Bil and Php1.6Bil for 2014 and 2015, respectively. Silangan mine to decide on variables A large part of PX s value is hinged on the successful development of the Silangan project as we estimate this project to account for around 80% of PX s fair value. The Silangan project will also be PX s primary future earnings growth driver. The Silangan project is currently at the pre-feasibility stage which PX expects to conclude by the end of July 2014, while the definitive feasibility study (DFS) is set to be completed by late There are several variables blurring the roadmap to Silangan s mine development, the most relevant of which involves the choice of mining method, which will affect mine development and operating costs. TUESDAY, 22 JULY 2014 page 3

4 Between underground and open pit The underground method used in the Padcal mine may not be a viable method for the Silangan mine since the ore bodies comprising the mine are below sea level, presenting a technical complication against underground caving. As of this writing, management is considering using an open pit method as an alternative. According to management, the most significant consequence of deciding in favor of open pit is a 30% reduction in mine development costs, as well as lower cash costs once the mine is operational. The total project cost slated for the Silangan mine is US$ Bil, roughly equivalent to Php57-65Bil (assuming an exchange rate of Php43.5 to a dollar). Of that amount, Php10Bil has already been spent, and about Php6.7Bil is set to be spent this year and next. That leaves a total of about Php Bil for mine development. If the company decides in favor of open pit, that will bring mine development costs down to approximately Php Bil. We think the most likely scenario is for the company to pursue the open pit method in developing and operating the mine because of the significant reduction in capex and operating costs, and because of its relative technical simplicity. Moreover, according to management, the only major hindrance against open pit mining is the potential disapproval of surrounding communities, with whom the company already has a good working relationship with. Thus, our base case assumes the open pit scenario. We assumed that the capex for Silangan s mine development will amount to Php33.8Bil, the upper end of the range estimate for the open pit scenario. Meanwhile, we based our operating cash cost assumption per ton near the three-year historical average of Padcal s operations (adjusted for inflation) at Php560 per ton. Capital raising exercise likely needed for Silangan Project Under the open pit assumption, the capex requirement for Silangan s mine development will amount to Php33.8Bil. Assuming that the company finances half of that amount through debt, and assuming PX s current operations will be able to generate operating cash flows of around Php7.5Bil for the next two years, we estimate the company would still have to raise Php9.4Bil to cover the balance of the capex requirement. Management indicated that the additional capital could be raised through either a Php12Bil rights offering or through the sale of a stake in the Silangan Project to a partner. However, details for such arrangements are still not available since talks can only begin once the DFS is completed by As our base case scenario, we assumed that capital expenditures for Silangan s mine development will be covered through equity and debt financing, and that the company will retain full ownership of the mine. TUESDAY, 22 JULY 2014 page 4

5 Padcal mine life extension dependent on tailings facility Extending Padcal s mine life is also an important growth driver for PX. The Padcal mine is currently expected to last until the year 2020 only, with remaining proved reserves at 66Mil tons as of end The company plans to extend Padcal s mine life by declaring additional reserves from the surrounding areas. According to management, a total of 80Mil tons in reserves is declarable. However, additional reserves can only be declared once the company is able to find a suitable site to serve as a tailings pond, which is still being reviewed at this time. As our base case scenario, we did not account for the possibility that additional reserves would be declared since the requisite tailings facility is still uncertain. However, if the additional reserves were to be declared, this would result to an extension in Padcal s mine life by about eight years, translating to an Php1.10/sh increase in our fair value estimate. New mining law is the biggest hurdle The biggest risk facing PX, and the mining industry in general, is the proposed revision in the mining law, ideally effective by the end of the current administration. The proposed revision aims to increase the government s share in mining industry revenues. Under the proposal, mining companies would be required to remit to the government either 10% of gross revenues or 55% of net adjusted mining revenues (NAMR), whichever is higher. NAMR basically pertains to EBIT with exploration costs added back. If the proposal were to be passed into law, that would bring PX s effective income tax rate (as currently measured) to about 65% (excluding excise taxes and royalties) from just over 30% currently. Management indicated that PX s operations would be negatively affected by the new mining law. Based on our estimate, the passage of the revised mining law would cut PX s FV by ~ Php6.54/sh or 70%. It would also make it more difficult for PX to find a partner for its Silangan mine development. Nevertheless, as of this writing, the President has not yet signed the standing proposal. Only when the President has signed it will the proposal go through the legislative process, which more often than not takes a significant amount of time. Consequently, we assumed that the current tax regime would hold under our base case forecast. Trading at a premium to our FV estimate, and relative to peers Recall that PX s stock price recently got a 30% boost following the announcement that authorities formally lifted the suspension of its current mine in Padcal after a tailings spill in mid Because of this, we believe that PX s valuations are no longer attractive. At Php11.84/sh, the stock is trading at a premium to our FV estimate of Php9.30/sh. We arrived at our FV estimate by using the discounted cash flow method, assuming a WACC rate of 9.1%. We also do not think that we were being conservative in our forecasts as we assumed an average gold price of US$1,300/oz and an average copper price of US$3.20/lb, which are slightly higher than their YTD averages. We also assumed that the Silangan project would push through; that PX will retain full ownership of the project; and that there would be no change in the mining tax regime. TUESDAY, 22 JULY 2014 page 5

6 PX is trading at a 14E P/E of 45.5X and an EV/EBITDA multiple of 17.4X. The company s stock is relatively expensive since it is trading at a significant premium to the global average 14E P/E of 25.5X, and the average EV//EBITDA of 7.5X. Exhibit 3. Relative Valuation Company Ticker 14E P/E EV/EBITDA Alacer Gold Corp. ASR CN Lundin Mining Corp. LUN CN Taseko Mines Ltd TGB US Vedanta Resources Plc VED LN African Barrick Gold Plc ABG LN IAMGOLD Corp. IAG US Yamana Gold Inc. AUY US Agnico Eagle Mines Ltd AEM US Industrias Penoles SAB de CV PE&OLES* MM Panaust Ltd PNA AU Oceanagold Corp. OGC CN Atlas Consolidated Mining AT PM Philex Mining Corp. PX PM Average ex-px Source: Bloomberg, COL estimates Risks Increase in metal prices could serve as bright spot. Gold and copper prices are currently trading below their three-year historical averages of US$1,500/oz and US$3.60/lb, respectively. Bullish opinions on gold, currently comprising 46% of global coverage, are saying that gold could be bottoming out, and upward price action could be seen moving forward. Meanwhile, contrarian opinions on copper are citing the low copper prices as precisely the reason for a slowdown in supply, which should eventually match a slowdown in demand, ridding the market of the supply surplus which is currently causing depressed prices. If long-term metal prices return to their three-year historical averages of US$1,500/oz for gold and US$3.60/lb for copper, there would be a 45% increase in our FV estimate to Php13.50/sh. Exhibit 4. PX FV/sh sensitivity to metal prices Copper prices (US$ per lb) Gold prices (US$ per oz) TUESDAY, 22 JULY 2014 page 6

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9 Investment Rating Definitions BUY HOLD SELL Stocks that have a BUY rating have attractive fundamentals and valuations, based on our analysis. We expect the share price to outperform the market in the next six to twelve months. Stocks that have a HOLD rating have either 1.) attractive fundamentals but expensive valuations; 2.) attractive valuations but near term earnings outlook might be poor or vulnerable to numerous risks. Given the said factors, the share price of the stock may perform merely inline or underperform the market in the next six to twelve months. We dislike both the valuations and fundamentals of stocks with a SELL rating. We expect the share price to underperform in the next six to twelve months. Important Disclaimers Securities recommended, offered or sold by COL Financial Group, Inc.are subject to investment risks, including the possible loss of the principal amount invested. Although information has been obtained from and is based upon sources we believe to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute the judgment of COL s Equity Research Department as of the date of the report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. COL Financial ans/or its employees not involved in the preparation of this report may have investments in securities or derivatives of securities of securities of the companies mentioned in this report, and may trade them in ways different from those discussed in this report B East Tower, Philippine Stock Exchange Centre, Exchange Road, Ortigas Center, Pasig City, 1605 Philippines Tel: Fax: Website: TUESDAY, 22 JULY 2014 page 9