Description

1.        Summary

We recommend investing in KCN at a current market price of $1.10 AUD with upside potential share price upside reaching >$4 AUD. The company currently has a market cap of AUD $240m, AUD $10m cash, and no debt. We believe the business is trading at a significant discount to its realizable value based on a USD ~$1bn international arbitration claim by the company against the Kingdom of Thailand under the Thailand-Australia Free Trade Agreement (TAFTA) for the unlawful closure of the Chatree mine. As outlined in this note, recent announcements have given us confidence that a favourable resolution is around the corner.

Kingsgate Consolidated Limited (“KCN”) is an ASX-listed gold exploration and mining company that has two assets:

1)      Chatree Gold Mine – the largest gold mine in Thailand, owned via its Thai subsidiary Akara Resources PCL

2)      Nueva Esperanza – a high grade silver mine based in Chile’s highly prospective Maricunga belt (currently in a sale process)

The lack of analyst or brokerage research coverage together with Kingsgate being a small-cap listed on the Australian Stock Exchange, as well as language barriers making it hard to find information in Thailand has contributed to this compelling investment thesis being overlooked by the markets.

RECENT UPDATE

On 23-Sep-21 Kingsgate has released an update confirming that negotiations with the Thai government are nearing final stages and both parties have asked the arbitral tribunal hold the award until 31 October 2021, to allow the parties a short extension to conclude their settlement negotiations.

The negotiations include:

·         The grant of all operating licences and permit applications required to re-start and operate the Chatree Gold Mine

·         The renewal/approval of key exploration licence applications for surrounding areas

·         Improved processes around expediting approvals of mining leases and mine plans;

·         Royalty and tax relief for the re-start and continuance of operations

·         The ability to access development funding (if required) for plant refurbishment/expansion

·         The examination by Kingsgate of the feasibility of developing a local Thai gold refinery

·         Support from the Thai Government for the potential listing of Akara Resources on the Thai Stock Exchange

·         The successful resolution of all outstanding local legal issues

2.        Background

KCN has operated Chatree since 2004 and still holds valid mining licenses for Chatree, which expire in July 2028. Since inception, the company had invested AUD >$1bn dollars in the acquiring and developing the asset.

Before its closure by the Thai government in 2015 (with gold prices at around USD 1,150/oz.), the Chatree mine was highly cash generative, producing AUD $70m annual EBITDA  (AUD $80m the previous year) in the year leading up to its closure, with 11 years remaining on the mining licenses. In 2012, with gold transacting at USD 1,650/oz. KCN generated AUD $120m in annual EBITDA . Current dilution-adjusted stock price was AUD $3.74.

In May 2016, the government extended the metallurgical processing license for Chatree to 31 December 2016 instead of providing a 5-year renewal sought by the company.  At the time, Thailand’s Prime Minister (Prayut Chan-o-cha) stated at a press conference that “…by the end of this year, there will be no more gold mining ever again”.

On 13 December 2016, the National Council for Peace and Order (NCPO) issued an executive order under the temporary Constitution that prohibited the grant or renewal of gold mining, exploration or metallurgical processing licenses across Thailand until the National Mineral Management Policy Committee, chaired by the Prime Minister or Deputy Prime Minister, resolved otherwise. The order also suspended all gold mining and related operations from 1 January 2017. As a result, KCN had no legal recourse under the Thai legal system to challenge the basis of the government’s decision to only extend the metallurgical processing license for Chatree to 31 December 2016. The basis for the executive order was untested health and environmental concerns and resultant conflict in the community.

KCN and Akara have vehemently denied the impacts of the Chatree operations on the health of locals, with senior government officials also publicly acknowledging that there was no evidence of health impacts from the mine. Arsenic and manganese are naturally occurring and the company had found similar levels in people who were tested 50 km away from the mine. The contamination claims were tested by the Administrative Court in 2012, which found that the mine had not contaminated the environment. Moreover, according to the company’s own tests, cyanide levels were low and none had escaped the mine’s tailing pond, with KCN’s CEO noting that “A cigarette or a cup of coffee may contain similar levels of cyanide to what’s in our tailing facility .”

In 2015, the international mining industry consultant Behre Dolbear was commissioned by the Ministry of Industry to undertake a review of the impacts of Chatree operations. The review concluded “low arsenic/manganese impact” with “no negative impact” on the health of the community .  

In the months following the Chatree’s closure, KCN fruitlessly made several attempts to negotiate with the government for the reopening of the mine, along with compensation for lost earnings and capital investment. In August 2017, in an attempt to resolve the situation, the Thai government announced lifting the ban on granting or renewing the relevant licenses, without providing any reimbursement for lost earnings, restart capex, or other damages. Gold prices were still low back in 2017 and the company saw the Arbitration as the best course of action.

On 2 November 2017, KCN commenced arbitral proceedings against the Kingdom of Thailand under      TAFTA to recover the substantial losses that it has suffered, and continues to suffer, as a result of the unlawful expropriation of the Chatree Mine by the Thai Government.

3.        Basis for TAFTA Claim

The TAFTA was signed in 2004 to promote and improve the environment for bilateral services, trade and investment. Among other things, these provisions guarantee certain rights to Australian investors in Thailand, including the right to seek impartial resolution of disputes with the Thai Government relating to covered investments by way of arbitration before an international tribunal.

The TAFTA Claim results from a series of acts and omissions by Thailand against Kingsgate and its local subsidiary Akara Resources Public Co Limited, the Thai company that operates the Chatree Mine. The State acts that form the basis of the Company's TAFTA Claim include (but are not limited to):

·         an administrative decision in May 2016 that the metallurgical processing licence for Chatree only be renewed until the end of 2016, rather than a period of 3 or 5 years (as it had been renewed previously) and to proceed with the closure of Chatree; and

·         NCPO’s executive order of 13 December 2016 issued under section 44 of the temporary Constitution suspending all gold mining and related operations in Thailand from 1 January 2017.

Respected local law experts have been vocal in Thai press about the government’s breaches of TAFTA. Prominent Thai lawyers have noted that while TAFTA empowers the Thai government to suspend a project, the action has to be taken according to legal and other procedures stated in the bilateral agreement that ensure fairness to all the concerned parties. There must also be full disclosure of documents and other evidence to support the action. The section 44 order issued in December 2016 appears to have not followed the procedures established in the bilateral agreement. It can be concluded that there were insufficient scientific and academic documents to substantiate the order.

4.        Damages and Compensation under TAFTA

KCN incurred substantial loss as a result of the TAFTA breaches by the Thai government, making it entitled to compensation, and has been working with independent damages experts on a quantified amount due as a result of these breaches.

The TAFTA Tribunal has order proceedings to be kept confidential, but local media has reported the company is seeking damages in the range of USD $1bn.

Applying a DCF approach to the prospective 2017 performance (assuming gold prices at USD 1,350/oz.) of the Chatree mine (implied AUD $90m EBITDA), as mentioned above, results in a AUD $580m valuation. Including claims for sunk costs and the total amount invested into the mine, the total damages could easily be above the reported USD $1bn claim.

Local community support for the mine has been very high, with private and government surveys showing support levels of ~75% or greater for the mine to continue/-reopen.

The investment in KCN is not predicated on an Arbitration Award in favor of KCN. Whilst an award would still result in an attractive returns from current trading prices, an amicable settlement between the Thai Government and the Company as the most likely and most profitable scenario for shareholders. The TAFTA Arbitration/Claims simply give KCN an upper hand in the negotiation now at the last hinging of the game) which will likely results in a very favorable Settlement for the Company and its Shareholders.

5.        Probability of Settlement

The evolving economic and political situation in Thailand following the tribunal hearing in February 2020 has led us to conclude that there is a high probability of reaching a settlement with Thailand.

The COVID-19 pandemic has hit Thailand’s tourism-reliant economy hard, with Thai GDP decreasing by 6.1% in 2020. As a result, the Thai Government is looking to diversify the Thai economy by supporting regional areas and sectors unrelated to tourism. Social and political unrest has also increased with protesters calling for the reduced influence of the monarchy, dissolution of parliament and a greater democratization of the Thai Constitution. The Thai media and opposition parties have shown a keen interest in the case of Chatree’s closure. Given Prime Minister Prayuth Chan-o-cha (‘PM Prayuth’) was directly responsible for ordering Chatree’s closure, we believe an adverse TAFTA ruling would damage his political reputation greatly at the worst possible time for the Thai economy. These factors combine to put pressure on the Thai Government’s negotiation team to settle with KCN before the tribunal hands down its decision.

The bilateral relationship between Australia and Thailand remains strong with Australia being Thailand’s 7th largest export destination. Both countries also recently announced an elevation of the relationship to a Strategic Partnership and emphasized the importance of growing their trading relationship, especially as they recover from the COVID-19 pandemic.

6.        Chatree Mine – Outcome Scenarios

The Chatree Gold Mine (“Chatree”) is located in central Thailand, approximately 280 kilometers north of Bangkok. Chatree’s operations have historically been a large scale, low-grade, open pit gold mine.

Chatree was Thailand’s first and largest modern gold mine, and it commenced commercial operations in November 2001. Since then, Chatree has produced more than 1.8 million ounces of gold and more than 10 million ounces of silver. Chatree has extremely low cash costs. Total cash costs for 2015 were USD $690 per ounce (USD $595 per ounce exclusive of Thai royalties). Total production costs after depreciation and amortization were $US973 per ounce of gold produced.

In 2010, underpinned by the success of Chatree, KCN shares were worth AUD $12. The company had a market valuation of more than AUD $2.5 billion.

Until the order came to close Chatree in 2015, Akara (KCN wholly owned subsidiary) had been planning to invest a further $US 1 billion to continue mining on adjacent leases for another 20 to 30 years, raising several billion dollars in revenue, company executives said. This underpins the value of the Chatree Assets and indicates that Gold Reserves will increase over time as exploration continues. As we will outline below, we do believe that as part of the likely settlement between Thailand and KCN, KCN will receive permissions/licenses to expand the mine and continue to further explore the area.

Valuing the Chatree mine assets depends/is contingent on the outcome of the Arbitration or Settlement between the Thai government and KCN. We do see three possible scenarios with respect to the Chatree Assets:

Scenario A: (Highly likely / 85%) – Settlement between KCN and the Thai government in the very near term before any Arbitration decision is taken. Under this scenario we are of the opinion that the Thai Government will cover KCN legal expense and guarantee KCN to resume operation of the Chatree mine. KCN will likely obtain better conditions from the Thai Government such as licenses for new explorations etc. Given the age of the management team we believe that KCN will sell the Chatree and Nueva Esperanza assets after a successful settlement, distribute the proceeds to KCN’s shareholder and liquidate the Company.

The rationale behind this scenario being the most likely is the fact that even in Thailand the opinion has formed that the Thai Government is likely to lose the (AUD $1 billion) TAFTA dispute. This gives an upper hand to KCN in the negotiation and puts pressure on the Thai Government to settle.

Scenario B: (Possible but unlikely / 10%) – KCN and Thailand fail to find a settlement agreement before the Arbitration Award is given to KCN. Given the incentives of Thailand to settle, we see this scenario as unlikely. It is also in KCN best interest to settle because it would avoid the time consuming process of enforcing the Award. However, if this scenario were to materialize, we believe KCN’s management should sell the Arbitration Award to specialist litigation and distressed credit focused fund – the secondary market for arbitration awards is flourishing. Our discussions with brokers and investors who would purchase an award or fund enforcement lead us to believe that these awards trade for 50-75 cents on the dollar, keeping in mind that interest on unpaid awards accrues at 6-8%, The sale of arbitration awards or court judgements to hedge funds and litigation funders is not uncommon and companies like Cairn Energy and Exxon in the UK are actively pursuing monetization strategies with the arbitration awards they hold.

We believe that the award could also be pledged as collateral for financing or that an insurance policy could be purchased to ensure a minimum level of collection. Insurance brokers such as Arthur Gallagher also offer contingent policies to ensure payouts in a product called ‘Judgement Preservation Insurance’.

In either scenario – a sale of the award (partial or full) or to use it as collateral to borrow – we believe the company would pay out the proceeds to KCN’s Shareholders (+ Nueva Esperanza project sale proceeds) and liquidate the company.

Scenario C: (Very unlikely / 5%) – KCN loses the Arbitration dispute. Under this scenario we consider the value of the Chatree assets for KCN shareholders to be up to AUD $20 million. The company could liquidate all the physical assets of Chatree and sell its interest to a prospective operator who believed they could do a deal with the Thai government. Keep in mind that in 2016, Northern Gulf Petroleum (backed by the nephew of a Thai military general) attempted a hostile takeover for the company when the share price had been decimated by the forced closure. In 2017, a listed mine developer known as Metal Tiger Plc built close to a 7% stake in the company and attempted to take control of the board, ultimately losing the battle. With the run up in precious metals prices, we would see the same buyers and others turn up in this doomsday scenario at substantially higher valuations.

7.        Thoughts on Valuation (Chatree)

Under Scenario A listed above, we try to estimate how much would the Chatree asset be worth in current markets conditions after reopening with pre 2015 closure licenses/permits and then we apply a 25% premium to account for the fact that in a Settlement with the Thai Government new and more favourable mining and exploration conditions will likely be embedded. This 25% premium is justified by the fact that over time, the operator of the Chatree assets is likely to discover more gold resources in the area.

(Detailed calculations / graphics for the below methods can be provided on request)

Method A

We can start valuing the Chatree asset using a simple Net Present Value / Discounted Cash flow model. Applying a 25% premium to the obtained results we reach a valuation of AUD $897m or AUD $4.01 per share.

Method B

A second valuation approach we can use is to apply the multiples used in recent M&A transactions. Here we also apply the 25% premium for the same reasons illustrated before.  When it comes to Tier-1 jurisdiction gold producers with industry-leading costs (below $900/oz.). We’ve actually seen the price paid per ounce hit a new multi-year high in the past Q4. As shown below, suitors are willing to pay up significantly for Tier-1 jurisdiction gold producers with high margin operations, with an average price paid of $199.55/oz. since gold bottomed in 2015.

Prior to the most recent Northern Star & Saracen merger of equals, the highest price paid per ounce since 2015 for a gold producer was $239.13/oz. This company was high-margin junior producer Atlantic Gold (OTCPK: SPVEF). The fact that we've seen a new multi-year high of $256.47/oz. suggests that investors can feel comfortable paying above $200.00/oz. for gold producers in the best jurisdictions with industry-leading costs as suitors aren't hesitating to pay top-dollar for the best assets in the world.

To value the Chatree assets we utilize a conservative USD $ / oz. reserves price of $150. Using this valuation method, we reach a valuation for the Chatree asset of AUD $974, implying a value of approx. AUD $4.35 per share for KCN Shareholders.

Method C

A third valuation method could consist in applying to the Chatree asset the multiples of listed Gold producers. For convenience we used the peer set and multiples cited in the research note issued by JPM Asia Pacific Equity Research on September 7, 2020 titles “Gold Miners - A$ no longer a tailwind but valuations less stretched”.

Given that since September 2020 till today the NYSE Arca Gold Miners Index (NTX) has lost approximately 20%, we do not add the 25% premium to the Chatree assets to account for the multiples contraction (the two cancel out)

Using this valuation method, we reach a median valuation for the Chatree asset of AUD $962, implying a value of approx. AUD $4.30 per share for KCN Shareholders.

To sum up, the average valuation for the Chatree assets using 3 different valuation approaches is of AUD $944.78m or AUD $4.22 per share.

In Scenario B, we try to estimate for how much KCN could sell the Arbitration Award to a third party fund who will then take care of enforcing it. Without going into the details, we assume (subjective) that out of an AUD $1b claim Kingsgate gets awarded AUD $750m and then it sells the claim/credit to professional Hedge Funds at a 50% discount. Under this scenario, the worth the Chatree assets for KCN’s Shareholders is expected to be AUD $375m or AUD $1.68 per share.

8.        Nueva Esperanza Sale Project

Nueva Esperanza is 100% owned by KCN. It is a silver and gold project in Chile comprising several well-defined deposits hosted in a high sulphidation epithermal (hydrothermal) system and a number of undeveloped exploration targets with Mineral Resources inclusive of Ore Reserves estimated at 0.3m oz. of gold and 47.8m oz. of silver. 2016 Pre-Feasibility Study for the development of the 1.9m oz. gold equivalent (AuEq60) confirm the viability of an open pit operation with a 2 million tons per annum agitated leach process plant, which for the first 5 years, can deliver an average 135,000oz AuEq60 per annum production at an average cash cost (including royalty) of US$633/oz

On June 2021, Kingsgate announced it had signed a non-binding Letter of Intent with TSXV listed TDG Gold Corp outlining terms of the acquisition of Nueva Esperanza. Total value of the deal is c. AUD $69m, consisting of a combination of cash and equity in TDG Gold.

We believe that this transaction will significantly improve negotiations with Thais, as it will give Kingsgate necessary funding flexibility in order to restart the mine, rather than having to rely on getting cash funding from the Thai government. Management has stated that “Kingsgate is currently in the process of costing the refurbishment and restart of the [Chatree] operation.” and “[Nueva Esperanza Sale] would provide excellent optionality around the ongoing negotiations with Thailand to achieve a negotiated settlement under TAFTA. This may include the use of proceeds from Nueva Esperanza to refurbish and restart the Chatree Gold Mine if a negotiated settlement can be achieved and all licences and permits granted.”

Catalyst

Successful conclusion of negotiations between Kingsgate and the Thai government, announcing a restart of operations of the Chatree mine. As per guidance by the company, an announcement is expected ahead of 31 October 2021.