Baobab Resources - Downside Potential

http://www.baobabresources.com/
Baobab Resources Logo
Baobab Resources (LSE:BAO) has seen its share price flourish since late 2012 with the share price rising from around 8p to heights of near 35p during which shareholders will have more than trebled their money. However, as covered in "5 technically weak mining shares" the rise could now be over with the shares quickly retracing to a more sustainable share price. The junior miner has seen its shares recently slump to lows around 14p/share, but has briefly recovered to the current level at 18p/share. Through having 300 million shares in issue, the company is capitalised at £54m. Considering the position of the company, this looks very generous.


From a technical perspective, as highlighted before, the shares are still looking very weak and traders are likely to expect the share price movement to mirror the movements that were achieved in 2011. 3 directors of the company do have significant share holdings with over 10m shares between them and furthermore, there is a strong institutional backing with various holdings millions of pounds worth of shares, which is interesting considering the share is still a relatively smallcap company. The free float of the company is circa 68% so there is good liquidity especially considering the volatile price movements and the bid/ask spread is narrow. Despite the share having reached double the current price, only recently is it becoming clear that the pessimistic share price route is most likely thus why I have a 12-13p target price for the share for the short-medium term. I am relatively confident that this price target will be met.

The fundamental question is "Who are Baobab"? The company, which listed on the AIM in 2007, is a Mozambique focused mining company through a wholly owned subsidiary, Capitol Resources. The company's primary asset is entitled Tete where Baobab has an 85% stake and is partnered with International Finance Corporation (IFC - a part of the World Bank Group). The Tete project focuses upon a commodity called Pig Iron which sells at around $400/tonne. The project recently had its JORC compliant resource base upgraded by 200MT with the asset standing at 727MT inferred and indicated. The Tete resource also has a NPV10 of $1.3bn and the company is now seeking a third-party adviser to help create a corporate road-map. Clearly there is no issue with the assets themselves. They are high quality, but many other mining firms on the LSE with similar resource bases are valued at much less than Baobab. The risk to the downside scenario is if the company does release a resolution to the financial situation (in combination with the adviser) - the likelihood is though that this will take an extensive period of time thus will not obstruct the downside potential.

courtesy of www.steveconover.info
The investing environment in Mozambique is favourable with the country not facing civil unrest that many other African countries experience, although it is likely a harsher tax regime will be implemented over the next decade as the country's natural resources move from the exploration to production phase. To counter this, Baobab has noted that the Mozambique ministry gives favourable tax schemes for company's with projects that 'add a significant amount of value to the country, create local employment, and are export orientated'. The geographical position of the resource is good with low cost power expected to be generated from the nearby hydroelectric dams (when online) and the asset is in good company with multiple coal extraction projects being undertaken in close proximity by major firms including Rio Tinto, Anglo American and Eurasian Natural Resources. The result is continual investment which can only be positive for the area as a whole.

The company released its pre-feasibility study for the Tete project in late March with the following salient points:
- Long-term mine life: 1Mtpa pig iron production for 37 years exploits just 15% of the current global resource
- Production of high-demand, low-impurity commodities at lowest quartile operating costs, maximising the Project’s unique access to low‐cost raw materials.
- Base case scenario of 1Mtpa pig iron production estimates a capital expenditure of US$1.14bn and delivers strong project economics, with a pre-tax NPV10 of US$1.3bn, pre-tax IRR of 22% and a payback period of 4‐5 years

- Very competitive operating cost of US$225/t pig iron firmly establishes the project as one of the lowest cost producers globally
- The pre-feasibility study modelled 1Mtpa pig iron production over a 37 year period which results in the production of just 15% of the global resource base

By this point you may well be thinking that Baobab's fundamental position is actually quite good, and to an extent it is, but with all investment propositions there are catches, and Baobab has a number of potentially damaging hurdles to clear.

Referring back to the Pre-Feasibility Study (PFS), there is an issue. The study did not account for taxes making them unrealistic. This lack of tax additions were explained by the company as being because no scheme had been arranged to date so any assumptions could be misleading. My response to this would be, that's fair enough, but it does little to change that the figures that have been headlined are overestimates.
courtesy of F H Mira on flickr
But this is not the most significant problem the company faces - the upfront CAPEX required for exploiting Tete is huge with the PFS stating total upfront CAPEX of $1,143M. The next question is "What is the state of the company's financials". Unfortunately for shareholders this does not make good reading.

Taking into account a ~£1m equity placement through its ELF and ~£3m generated through a third-party converting their warrants, the cash balance stands at £5m assuming that the residual £1m pre-placing has not already been exhausted. That £1m has probably already been spent repaying the trade and other payables ~£1m deficit. The likelihood is that it already has exhausted its funds and that the company is already running near empty. £14m does remain on the ELF, but this will be drawn down in tranches which will eventually also be exhausted considering the fast rate of cash burn the company has. The release of shares into the market is also likely to dampen sentiment.

Furthermore, before the large CAPEX requirements, money will be required to fund the Definitive Feasibility Study (DFS). With most mining projects like this, debt funding combined with some equity financing will likely be undertaken on a long-term basis to help fund through the 4-5 years to the payback boundary. Considering the production at the asset will likely happen during H2 2016 at the earliest, there is little to support the share price in the way of cash flow at present. With mining companies struggling to gain positive market sentiment at the moment, it is mirrored by the fundamental position of the company that 12-13p could be achieved.

Managing Director Ben James noted the following within the Tete resource upgrade RNS:
‘With the base case PFS complete and results of increased production models due in shortly, Baobab is now in a position to accelerate the appraisal and execution of corporate strategies that will ensure the successful development of the Tete project. These initiatives will run in parallel with the continued technical initiatives as the Company maintains momentum into the DFS.’

The point that it comes down to is that Baobab is capitalised at £54m. If the company was capitalised at £30m then it would be far more difficult to say that Baobab is overvalued as the downside risks would be much reduced. The reality is that it is overvalued. The financial position of the company is currently dire, the technical position of the shares is weak and there are no foreseeable catalysts that could  pump the shares back towards the 20-25p region. In my opinion there are some much better value mining shares in the LSE at the moment such as Afferro Mining (although it is likely it will be taken over) which has a cash balance only slightly less than its £75m market cap. Consequently there is downside potential for Baobab targeting the stated 12p-13p region that could be reached in the short-term (i.e. 1 week to 3 months). This would translate to 28-33% worth of downside. If this is reached it is likely I will place Baobab back into neutral territory are re-evaluate in the future. Share price hype may have trapped a few investors here.

Baobab moved from sell to neutral on 02/07/13 at 12.88p equating to ~28% of downside

12 comments:

  1. I concur with the down side statement. It is amazing and astonishing to read people on the baobab bulleting boards who are citing takeover offers at levels multiples higher than the current price

    CraigJ

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  2. What a complete waste of time reading this note.

    The sell recommendation boils down to: a) funding is needed, b) the charts don't look good, c) the market cap looks high

    Unfortunately there is no substance to these conclusions.

    a) welcome to start up companies. They tend not to have lots of money and need financing. Cash flow is important but so is asset backing which this company has. Lack of funds should not necessarily mean sell. This company already trades at a big discount to the project npv - surely at least some of this reflects funding risk already?

    B) I don't believe in charting. Too many variables I'm afraid. But there will always be one chartist who calls it right and so it perpetuates the movement. It has very limited proven success.

    C) this is the big one. Why is 50 million market cap too high? Why would 30 million be reasonable? To answer this question you need to do some form of proper valuation analysis and not simply say stuff like the company is overvalued... there isn't one shred of fundamental valuation theory here to back up the claim the company is overvalued.
    Do your own DCF or relative multiple comparison, for example.

    I don't mind an opinion but it has to be properly reasoned - yours seems very superficial.

    And before you write me off, I am a valuations professional who has worked in the city for 15 years.

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    Replies
    1. A prime example of my earlier comment! Vindicated to the core. Too much ramping and lots of investors get suckered into the cause. The market does not believe the company can do anything which no cash.

      CraigJ

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  3. Grim outlook on the company, may be justified, time will tell so wont repel!

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  4. Expect you to be right on this one :-). Investors starting to panic

    Freddie

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  5. This is the biggest load of tosh ever.

    This article has failed to take into account the updated PFS figures, which will significantly affect the Capex. It has failed to take into consideration the fact a JV is in the pipeline, which would all but eliminate funding issues with the mine. It has failed to take into account most of the costs of the DFS have already been spent (it's been underway a while) It's failed to take into account a lot of things...

    BAO is a gem of a company, no-one is "panicking" Freddie, as the rise from 13-18p recently shows. The resource in the ground is worth billions, Baobab operate in a very investment friendly environment (the Moz government would do ANYTHING to get this out the ground...they've wanted an iron ore mine for ages...hell they'd probably pay for it themselves if we asked) and they will give us a good tax deal.

    Factor in the resource area is surrounded by mining majors, including Rio/Vale/Jindal etc...Jindal in particular have been very open about looking to partner with a company to set up an iron ore mine in Tete. Baobab are kinda the only company that falls into that bracket...

    So to say the share price has no catalysts coming up is misleading (there are many). And to call the financial situation dire is touching on libellous.

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    Replies
    1. A harsh and untrue response.

      gl elite

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    2. Harsh? How?
      What is stated above is fact - the article fails to take into account the updated PFS, doesn't mention the likelihood of getting a JV and doesn't take into account most of the DFS has already been sunk cost wise.

      The resource in the ground is worth billions, Moz is a very friendly investment environment and we will get a good tax deal. We are surrounded by mining majors and Jindal are looking to set up an iron ore mine in the area.

      There are many catalysts for the share price coming up, and the financial situation isn't dire?

      Where are the lies in that?

      Delete
  6. Why not draw a support line at 14, seams to have hung around there as long as the 10 line. Plus it bounced off the 14 support recently.
    One piece of news will move it back to the 19 to 20 so you could say at the moment it is trendless or range bound between 14 and 19 which is the 61% fib level and retrace low of the first Elliott wave of the last rise. Good thing about reading charts for every one selling some one else is buying

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  7. a good an unbiased review

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  8. Hi Elite,

    Are you still neutral on this one?

    Thanks.

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