Matt Geiger’s Featured Investment – Ardea Resources (ASX: ARL, FRA:A91, OTCMKTS:ARRRF)

Matt Geiger August 4, 2017

Ardea Resources is the most recently added position to the MJG portfolio and our only cobalt investment. With a fully diluted Enterprise Value of ~A$65m, Ardea provides more leverage to the price of cobalt than any other public vehicle globally. Additionally, ARL offers significant relative value when compared to its nickel-laterite peers such as Robert Friedland’s Clean Teq.

The Partnership has established a position in ARL over the past 4 weeks, with an average cost basis of A$0.70 per share. As of August 2nd, Ardea shares were trading at A$0.865.

In this Featured Investment piece, I start by providing commentary on the three overarching categories that cobalt investments fall into. Depending on one’s geopolitical risk tolerance, opinion on the appropriate long-term price of cobalt, and comfort with optionality, each of these three categories may be suitable for different investors.

Next I present my investment thesis for Ardea Resources, starting with the company’s recent formation, a look at the management team, and details on the company’s share structure.

We then review two of Ardea’s assets: the flagship KNP nickel-laterite project and the secondary Lewis Ponds VMS project.

Next, we discuss how Ardea Resources offers tremendous leverage to the Co price as well as relative value when compared to peers.

We conclude with Ardea’s expected catalysts over the coming months, so readers can keep tabs on the company’s progress alongside me.

3 Ways To Play Cobalt

Cobalt assets fall into three main categories. Investors new to the space must determine which of these best fits their investment profile:

  1. DRC-based assets with exceptional economics
  2. Past producing mines in safe jurisdictions
  3. Optionality plays in safe jurisdictions

 

Every discussion about cobalt must start with the Democratic Republic of Congo, or DRC. Stunningly, this impoverished and politically unstable country accounts for as much as 65% of global supply. This simply comes down to grade – the rich sediment hosted copper-cobalt deposits found in the DRC are unrivaled anywhere else in the world. Despite the tremendous difficulties (and associated costs) of operating a mine in the Congo, these DRC based projects offer by far the most attractive economics of cobalt assets globally.

The downside of this first category, however, is the geopolitical risk that accompanies any investment in the Congo. While the situation has improved somewhat over the past decade, mining in the DRC has been synonymous with expropriations, bribery, and corruption ever since then-President Joseph Mobutu began using the state mining company (Gécamines) as a personal piggybank in the mid 1960’s.

Most recently, there is global worry that political instability might be right around the corner thanks to current president Joseph Kabila and his reluctance to step down after 16 years in power. Kabila, who has the lowest approval rating of any African leader, was constitutionally mandated to step down last December at the end of his second term. Instead, he resisted up until the last minute – before cutting a deal with an influential body of Roman Catholic bishops for a transitional government followed by elections at the end of 2017.

In recent months, Kabila has shown signs of reneging on his promise. This has the potential to throw the country into chaos and violence in the very near future. Some investors may be willing to take the risk, but until the Kabila situation is sorted out, we are steering clear of the Democratic Republic of Congo.

For those unwilling to touch the DRC, there are two other ways to gain exposure to cobalt assets. The first is to invest in past producing mines in historic cobalt districts – with the Cobalt, Ontario mining camp being a prime example. This mining camp was largely devoid of activity for decades but this has changed dramatically over the past 18 months where we’ve seen more than a dozen companies stake claims in the area. This pattern has repeated at other historic cobalt districts in Canada and Australia.

There are pros and cons to investing in past producing mines. On the plus side, these mines can be brought online much more quickly and cheaply than a typical greenfield project. Additionally, these historic projects are often very high grade and are likely economic at cobalt’s current price around US$30.

There are some distinct negatives as well. Due to the staking rush we’ve seen, these districts are currently fragmented amongst many companies – making it difficult and dilutive to build a cobalt resource of critical mass. Even ignoring the fragmentation, these historic mines are small in size and provide limited leverage if the cobalt price continues to climb.

The final category of cobalt investments encompasses the “optionality” plays, which take the form of large nickel-laterite deposits. By definition, optionality investments are NOT economic at the prevailing metal price.  This is a clear negative, as these projects will remain largely worthless as long as the cobalt price is at or below US$30. Additionally, given that optionality deposits are typically large and low-grade, capex requirements are substantial and construction timelines are rarely short.

It’s not all bad however. For those confident that cobalt prices have room to run to US$50 or more, the returns seen on these optionality plays will dwarf the returns from DRC-based assets or past producing cobalt mines. This is simply how optionality works – in a rising metal price environment, the valuation increases seen at large, low-grade assets trump the valuation gains seen at higher-quality projects.

Ardea Resources falls into this third category due to the immense size (and relatively low grade) of its KNP Project. While I typically eschew optionality investments and focus on projects economic at spot metal prices, I’m willing to make this specific bet due to my conviction that cobalt prices will continue to rise violently over the coming 2-3 years as the investment community slowly grasps the profound implications of the EV revolution.

Company Background

Ardea Resources is in fact a spin-off of ASX-listed Heron Resources Limited. Ardea only began trading in February 2017 after raising A$5.2m in an initial public offering. The company is headquartered in Perth, which is the closest major city to the KNP Project.

Ardea’s management team is headed by Managing Director Matthew Painter. Painter is a geologist with over 20 years of experience. Past employers include SRK Consulting and AngloGold Ashanti. Painter holds no other positions and has been focused exclusively on Ardea since November 2016.

Also of note is Non-Executive Chairman Katina Law, who joined the Ardea team on the same day as Painter. She has held senior positions at Newmont Mining Corporation’s head office in Denver and was recently CEO of Tanzania-focused East Africa Resources Limited.

The team is rounded out by mining industry veteran Ian Buchhorn, who serves as a Non-Executive Director. Buchhorn is also a director of Heron Resources Limited – providing continuity from Heron’s stewardship of the assets to Ardea’s.

Between the Ardea board and associates, the company’s insider ownership is just under 15%. This gives me sufficient confidence that Painter & co will make decisions that are in the best interest of all shareholders.

Ardea has just over 67m shares on issue. However, one knock I’ve heard against the company is that there is a decently sized warrant overhang.

More specifically, there are 12.3m IPO options exercisable at A$0.25 and 26.4m Loyalty Options exercisable at A$0.77. (These “Loyalty Options” were granted to shareholders with a listed address in either Australia or New Zealand as of May 22, 2017. Those who qualified received 1 free Loyalty Option for every 3 Shares held.)

Why doesn’t this warrant overhang concern me? There are a few reasons:

  1. The IPO options must be held in escrow until February 2020, which means that they will not cause any downward pressure on the ARL share price for at least 30 months.
  2. The Loyalty Options are only exercisable for one year after the issue date. This means that by June 2018, all 26m of these options will either be exercised or expired.
  3. At 77 cents, the Loyalty Options aren’t cheap. If all 26m end up being exercised, this would bring A$17m into the company’s till. This is a substantial sum of money that should be enough to bring the KNP Project to feasibility.
  4. Most importantly, even assuming that all IPO and Loyalty options are exercised tomorrow, the company would have a fully-diluted Enterprise Value of just over A$65m. This is still very cheap – for some context, KNP alone has seen over A$60m in historical expenditures.

Ardea currently has A$2.5m in the treasury. Assuming that no Loyalty Options are exercised, the company will have to raise money within the next 6-9 months. However, as mentioned above, there remains the distinct possibility that the company could advance the KNP Project to feasibility without coming back to market. This assumes that the ARL share price strength continues and that shareholders begin exercising their options in the coming months.

KNP

Ardea’s flagship project is the Kalgoorlie Nickel Project (KNP), located in Western Australia. Despite its relative obscurity, the KNP has the distinction of being the developed world’s largest cobalt project.

In total, the KNP has 805 Mt grading 0.05% Co and 0.7% Ni. This results in 386,000 tonnes contained cobalt and 5,600,000 tonnes contained nickel.

However Ardea management is focusing on the sections of the deposit with the highest cobalt to nickel ratio, which the company refers to as the “KNP Cobalt Zone”.  This Cobalt Zone should be viewed as a subset of the overall deposit.

The KNP Cobalt Zone is currently 49.7m tonnes grading 0.12% Co and 0.86% nickel. Note that the Co grade in the Cobalt Zone is 140% greater than the overall deposit. Additionally the cobalt to nickel ratio is 1:7 in the Cobalt Zone, versus 1:14 for KNP as a whole.

As seen in the above chart provided by Ardea management, the KNP is the largest cobalt deposit in Australia – with more than 230% more contained cobalt than the next closest development project (Glencore’s Murrin Murrin Mine has been in production since 1999). The KNP Cobalt Zone alone is larger than all but two projects.

The KNP, which is now 100%-owned by Ardea, has seen extensive work over the past decade from both Vale Inco and Heron Resources. Historical expenditures total US$50m, including over 400k meters of drilling and plenty of detailed metallurgical work. In addition, the KNP has an active granted mining lease and “all required infrastructure” according to management.

The KNP mineralization sits within 120m of the surface, with an average depth of 30-40m. This makes the project amenable to open-pit mining with a low strip ratio. With the mineralization hosted by iron-rich clays, mining will be free-digging, requiring no blasting, and is therefore low cost. Below I’ve included a couple cross-sections from Goongarrie South, which is one of three sections of the overall KNP deposit that form the Cobalt Zone. (Black Range and Kalpini are the other two.

In early July, the company released results from four holes drilled at Goongarrie South. The assays can be seen below. Notably, hole AGSD0001 ended in mineralization. While these holes were drilled primarily to provide material for metallurgical testing, the results demonstrate the thick intervals of high-grade mineralization found within the KNP Cobalt Zone.

If the KNP were to begin producing tomorrow, Ardea management estimates that revenue would be split 50-50 between cobalt and nickel at current metal prices.  This of course is subject to change, particularly if the cobalt price continues its relative outperformance of nickel over the coming years.

Management estimates that the initial capex at the KNP will lie anywhere between A$300m – A$700m. There are two variables to be considered. The first is scale – the company still needs to determine the optimal annual production figures. Secondly, the company needs to determine whether to go with HPAL or atmospheric acid leach in the flow sheet. In past metallurgical work at the KNP, HPAL resulted in better recoveries than atmospheric acid leach (99% Ni / 90% Co versus 90% Ni / 80% Co). However, it is significantly less expensive from a capex perspective to go with atmospheric acid leach. We will have a much better idea of the company’s thinking when the KNP Prefeasibility Study is released in Q1 2018.

It is also worth mentioning the potential for both scandium byproduct revenue and chyroprase production at the KNP. Scandium seems to be associated with the nickel-cobalt mineralization in the project’s Cobalt Zone. This obscure metal is poised to receive exponentially more attention in the coming years – as aluminum end users begin to recognize the wide-ranging benefits of “doping” their products with trace amounts of scandium. Robert Friedland’s Clean TeQ is seriously considering producing a scandium byproduct at its more advanced Syerston nickel-cobalt project. While I doubt we’ll see much attention paid to scandium in the KNP’s upcoming Prefeasibility Study, this will certainly be an area of interest for Ardea’s management in the coming years.

Additionally, a gemstone called chyroprase is found at the KNP. Commonly referred to as ‘Australian jade’, chrysoprase is a green semi-precious gemstone that, like opal, is located within cracks and crevices in weathered near-surface rocks. Profitable chrysoprase mining has been undertaken by small-scale tribute miners on the KNP mining licenses for many years. The chyroprase seen below comes from the KNP.

Although a different mineral to true jade, the distinction is not usually made in China. China-sourced supply of jade is for all intents and purposes exhausted. Supplies from India and Burma/Myanmar have been largely cut-off. Due to the strong cultural importance of jade in Chinese culture, there is presently very strong demand from Chinese jewelers to source jade and similar gemstones.

Since Ardea management does not have experience marketing gemstones to China, Ardea is seeking a suitable partner with knowledge of the downstream jewelry industry with which to further pursue opportunities for the large-scale mining of chrysoprase. The company plans to provide an update on this front by the end of the year.

Ardea has been busy at work at the KNP since going public in February 2017. In addition to the Goongarrie South drilling referenced above, the company also drilled 27 RC holes totaling 2000m at Black Range and 29 RC holes totaling 1500m at Kalpini. (Remember that Goongarrie South and Black Range are subsets of the KNP Cobalt Zone, which itself is a subset of the overall KNP. Kalpini is a 30km long, 75Mt deposit that is part of the KNP, portions of which are being assessed for inclusion into the KNP Cobalt Zone.)

In late June, Ardea announced an updated resource at the KNP Cobalt Zone. The aforementioned drilling was not included, as the focus of this updated resource was to look at the historical work through a “cobalt-first” lens.  This is the first time that cobalt cut-offs have been applied at the KNP – all previous modeling work used nickel cut-offs.

The next steps at the KNP are pretty simple – complete hydro-metallurgical testing on the Goongarrie South drill core and then incorporate the results into the upcoming PFS. We can expect to see an update on the metallurgical work within the next 60 days, while the PFS results should be announced in early 2018. Assuming the PFS numbers are satisfactory, the company will then move into Feasibility work – with the goal of completing a Feasibility Study in 2019.

Lewis Ponds

While Ardea’s clear focus is the KNP, management also sees potential at the company’s lesser-known Lewis Ponds project in New South Wales, Australia. Lewis Ponds is a VMS deposit that has a minimum of three lenses of zinc-gold mineralization. Past owners include TriAusMin Limited and Regis Resources, and it appears that that at least A$5m has been spent at the project. Ardea inherited a historic resource of 6.6 Mt at 1.5 g/t gold and 2.4 % zinc, estimated at a 3% ZnEq cut-off grade.

The previous operators at Lewis Ponds focused on a narrow high-grade underground mining model. However, due to the favorable strip ratios and consistent shallow high-grade occurrences, Ardea management is looking into the feasibility of an open-pit bulk mining scenario. Management believes that anything above a 1% ZnEq cut off may prove to be economic.

As stated in a February 10th press release, the initial Lewis Ponds Exploration Target is estimated at 15–25 Mt at 2.2–3.7 % ZnEq (1.2–2.0 g/t AuEq). The company has since drilled four diamond holes, and the results confirm that this Exploration Target is within the realm of possibility. Intercepts from the four holes can been seen below.

Ultimately the fate of Lewis Ponds will hinge on the metallurgy. Managing Director Matthew Painter indicated to me that the magic number is 80% recoveries. The company is in the midst of metallurgical testing and flowsheet design work. Results are expected before the end of the year. If positive, the company would then commence a Prefeasibility Study to be released in 2018.

Valuation

At the current ARL share price of A$0.865, the company has a fully-diluted enterprise value of ~A$65m.

Until Ardea releases the KNP Prefeasibility Study in early 2018, it is difficult to put a fair value on ARL shares. However, there are a few ways to put the company’s current valuation into perspective.

The first is to consider the value of the historical work at both the KNP and Lewis Ponds, and then compare this to the company’s enterprise value. Considering that KNP has seen ~A$60m in past work while Lewis Pond has seen at least A$5m, the historical expenditures between the two projects is roughly equal to the company’s current enterprise value.

What does this tell me? Keeping in mind that using historical expenditures as a valuation yardstick is far from an exact science, in my experience assets that are valued at or below historical expenditures are generally a bargain. (This assumes a competent management team and sufficient working capital behind the asset, and Ardea qualifies in both respects.)

At the very least, ARL has very little speculative premium baked into the current valuation. This is despite the fact that the cobalt space is hot right now, and there are more than a few juniors trading at $10-20m valuations with projects that have seen historical exploration work of well less than $5m. Investors seeking cobalt exposure through ARL shares can be assured that they are paying a reasonable price.

A second way to put Ardea’s valuation into perspective is a direct comparison between the KNP and Clean Teq’s Syerston Project. In the graphic below, you can see the similarities between the two Australia-based cobalt projects.

At Clean Teq’s current share price, Syerston has an Implied Project Value of roughly ~A$400m on a fully-diluted basis. This compares to a ~A$65m Implied Project Value for the KNP. (For the sake of argument, we’ll ignore Lewis Ponds and assume that Ardea’s valuation is due solely to the KNP.)

Syerston certainly deserves a higher valuation for the following reasons: (1) the Robert Friedland premium, (2) the project’s 18-month head start, and (3) the fact that Syerston has publicly known project economics. There is a good argument to be made that Clean Teq shares themselves are well undervalued.

That said, the current delta between the implied valuations is too extreme – the KNP should not be trading at an 85% discount to its closest peer. What is a fair discount?

Weighing Clean Teq’s advantages against the fact that the KNP has seen more historical work and contains significantly more cobalt, a discount anywhere between 50-70% seems more realistic. This suggests an ARL share price anywhere between A$1.38- A$2.14 (assuming that the company can stave off dilution for the foreseeable future through the exercise of IPO and Loyalty Options).

A final way to put Ardea’s current valuation into context is to look at the expected value of a best-case scenario. (We’ll ignore Lewis Ponds again and assume that Ardea’s valuation is due solely to the KNP.)

Here the best-case scenario is that we see US$50 cobalt or higher within the next two years. This would lead to some absolutely jaw dropping economics at the KNP – think after-tax NPV of A$1.5b and likely much higher.

Until we can look at the cobalt price sensitivity analysis in the upcoming Prefeasibility Study, we won’t know this exact number. However, when one considers that Clean Teq is projecting an A$1.1b after-tax NPV at Syerston using US$12 cobalt, this A$1.5b number isn’t an unreasonable expectation.

So what are the chances that we see US$50 cobalt prices in 2018 or 2019? While cobalt bulls will tell you that this is a near certainty due to the accelerating EV revolution, we’ll assume that there’s a 25% likelihood of this coming to fruition.

Multiplying the best-case outcome of A$1.5b by this 25% chance of success gives us an expected value of A$375m.

This number itself must then be discounted by 50% to account for the future equity dilution we’ll see if/when Ardea raises construction financing at the KNP. This results in an expected value of ~A$190m.

Assuming that the company can avoid equity dilution until the construction financing is raised, this suggests that ~A$2.00 is an appropriate share price for Ardea given the tremendous upside presented by further increases in the cobalt price.

As stated earlier, the chief risk for optionality plays such as Ardea is that the metal price doesn’t cooperate. Given the amount of past development work the KNP has seen as well as the impressive metallurgical results, there aren’t many company specific factors that concern me aside from excessive equity dilution. However, if the cobalt price reverses course and heads back towards US$10, investors in Ardea should understand that they are at risk of losing their entire investment.

Upcoming Catalysts

In conclusion, I’ve provided below the catalysts that ARL shareholders can expect over the coming months and years:

-Metallurgical update @ KNP by end Q3 2017

-Metallurgical update @ Lewis Ponds by end 2017

-Update on chyroprase potential @ KNP by end 2017

-Prefeasibility Study released @ KNP by end Q1 2018

 –Prefeasibility Study released @ Lewis Ponds by end 2018

 –Feasibility Study released @ KNP by end 2019

The most important of these is of course the KNP Prefeasibility Study expected in Q1 2018. This will be the first time that the project economics of the KNP have been assessed through a “cobalt-first” lens.

In addition, the pending metallurgical update at Lewis Ponds will indicate to Ardea management whether the VMS project warrants additional expenditures.

Ardea’s share price is beginning to show signs of life. Given the company’s progress at the KNP and the continued strength of the cobalt price, we may not be below A$1 for much longer. Prospective investors are advised to get involved soon (particularly given the 20% pullback we’ve seen in Ardea shares over the past 3 trading days), and then assess the investment once the KNP Prefeasibility Study is published in early 2018.

 

Matt Geiger has a diverse set of skills pertaining to early stage ventures – both in the world of natural resources and tech. He is currently General Partner of MJG Capital – a resource-focused investment partnership with 20+ LPs. He is also Cofounder/President of a venture-backed technology business with $10m in cumulative funding. Known for his exhaustive security analysis and intuitive grasp of contrarian investing, Matt is a rising star in the junior resource field.

Palisade Global Investments Disclaimer:

The views and opinions expressed in this article are those of the authors, and do not represent the views of Palisade Global Investments Ltd. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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