Description

Highlights

• Noranda Income Fund (“NIF”), owner of the Valleyfield zinc smelter, is poised to make significant cash flow as zinc treatment charges (“TCs”) are expected to rise dramatically and favor smelters
• At a zinc price of US$1.25 per lb and US$175 per tonne concentrate TC, we expect NIF to generate US$104.4 million in run rate EBITDA and US$44.6 million in run rate free cash flow
  • Current zinc price is $1.33/lb as of April 17 and benchmark TC announced by Korea Zinc and Teck at $245/dmt concentrate
• Despite a share price appreciation of 175% from a low of C$1.05 on September 12, 2018 to hitting a 52-week high of C$2.89 on April 17, given a shift in the zinc TC market dynamics, we believe there’s a huge upside
• We value the company today at C$6.16 per unit, based on 3.5x expected run rate EBITDA, a 113% premium to the current market price
• In comparison, pure play smelter companies Aurubis AG (XTRA:NDA) and Korea Zinc Co. Ltd. (KOSE:A010130) both trade at 5.7x 2019 consensus EBITDA estimates
• Using a 20% free cash flow yield, NIF’s price should be C$5.93 per unit
• The Company trades near its net working capital value net of ABL Facility, comprised of zinc concentrate and finished materials in inventory, accounts receivable from Glencore, net of payables to Glencore and ABL Facility
• As a trust, we believe NIF will resume paying meaningful dividends by March 2020; at an 80% payout ratio, NIF should provide a C$0.95 in dividend, representing a 32.9% dividend yield

History

Noranda Income Fund (“TSX:NIF-U”, “Noranda”, or “NIF”) owns a zinc smelter (the “Smelter”) located in Salaberry-de-Valleyfield, Quebec, Canada along the St. Lawrence River. The Fund was spun off from Noranda Inc. in 2002 and was created to take advantage of the unique income trust structure in Canada. Noranda Inc. received C$225 million in proceeds in exchange for 45% of the Fund; the IPO valued the Smelter at C$500 million. Noranda Inc. transferred the Smelter to NIF and signed an agreement to supply 100% of the Fund’s zinc concentrate requirements for processing for 15 years (the “SPA” or “Supply and Processing Agreement”) until May 2017. Since going public in 2002, NIF’s Agent (as defined in the SPA as one providing the concentrate and managing the Smelter) has changed hands multiple times. Since Glencore plc’s (“LSE:GLEN” or “Glencore”) purchase of Xstrata (who previously purchased Noranda Inc.), Glencore became NIF’s source of zinc concentrate, agent for the sale of its zinc products, and the manager and operator of the Smelter. After the expiry of the SPA, NIF entered into a five-year supply agreement with Glencore in January 2017, whereby the Smelter’s concentrate requirements would be fulfilled by Glencore, but Glencore would pay a “market” TC to the Fund, negotiated annually.

The zinc TC market in 2017 and 2018 strongly favored miners, not smelters, due to tightening zinc concentrate supply from miners and growing Chinese smelter refining capacity. Higher availability of smelter refining capacity resulted in miners having the ability to dictate the terms. Benchmark zinc TCs, set by Korea Zinc Co. Ltd. (KOSE:A010130) and Teck Resources Ltd. (TSX:TECK.B) each year, declined from US$243 per dry metric tonne concentrate ("dmt") in 2015 to US$147/dmt in 2018.  The spot TC price went as low as US$10 per tonne concentrate in January 2018.

By September 2018, NIF’s share price fell to as low as C$1.05 per unit and traded at 0.4x net working capital, despite generating US$41.6 million in EBITDA and US$4.0 million in free cash flow (before changes in working capital) in 2018. On December 31, 2018, NIF announced a C$0.03 in dividend, spending US$1.2 million.

Market Shifts to Favor Smelters... and NIF

When zinc concentrate supply tightened, new supply was bound to come online. Approximately 1.7 million tonnes in supply have come online since 2015, an approximately 14.4% increase. Wood Mackenzie forecasts mine production of approximately 13.9 million tonnes of mine production in 2019, effectively filling current zinc smelter capacity of 14.2 million tonnes. Wood Mackenzie’s mine production estimates are even higher for 2020 and 2021, at 14.8 million and 15.4 million tonnes, respectively. Thus, these increases have resulted in a very different negotiation between miners and smelters. On April 1, Fastmarkets announced that Korea Zinc and Teck Resources have signed a benchmark TCs at $245/dmt concentrate with price participation. Given higher expected supply in future years, pundits forecast even higher TCs for coming years and there’s an expectation that new smelter capacity will be needed to process new zinc concentrates.

Given this new market dynamic, on March 8, NIF announced that for the new period between May 1, 2019 and April 30, 2020, NIF and Glencore had reached a new pricing agreement whereby 50% of the concentrate feed would be priced at a fixed TC and the remaining 50% at a variable charge “that will reflect market movement during that period”. NIF also guided that “the terms under which zinc concentrate will be supplied to the fund… will reflect this more favorable market environment.”

While the terms weren’t disclosed and remain opaque, the equal blend of variable and fixed TC rate should bode well for NIF. With the fixed TC rate potentially being US$148/dmt (from the 2018 benchmark), the 2019 TC of US$245/dmt, and current spot TCs of US$285/dmt, we expect NIF to have TCs that are meaningfully higher than what it received in 2018. For our modeling exercise, our base run rate case uses US$175/dmt in TCs for NIF.

Figure 1 - Annotated Share Price Graph

A shift in the fundamentals, along with a change in sentiment toward NIF, caused the share price to bounce from its lows. The price has increased 44% to C$1.73 prior to the announcement on March 8 from December 2018 average of C$1.20, due to 1) C$0.03 dividend announcement and 2) a shift in change in Chinese spot TC. Upon the announcement by NIF on March 8, share price increased 15% that day, and share price continued to climb to C$2.89 on April 17. Despite the impressive 140.8% run since the December average, we note that the Smelter continues to be undervalued, given that its enterprise value, net of working capital and ABL facility values the Smelter at US$33.4 million.

How Smelters Make Money

Table 2 Breakdown of Smelter Revenue Sources

NIF generates revenues from four sources: 1) TCs, 2) excess production over payability (“Free Metals”), 3) zinc metal premiums, and 4) by-product sales. As explained above, TCs are paid by miners based on a charge per tonne of concentrate processed by the smelter. As an example, if NIF processes 522,500 tonnes of zinc concentrate — this would equate to US$91.4 million in TCs at US$175/dmt. Free Metals are composed of any excess production over payability. NIF, like other smelters, operates on 85% payability, which means that the Smelter pays the miner for 85% of the zinc metal that is contained in the concentrate. No smelter can extract 100% of the zinc metal contained in the concentrates, but any excess metal recovered over that 85% would be solely for the benefit of the smelter. The Smelter had a 97.5% recovery rate in 2018, ranking 7th out of 70 zinc smelters globally. Thus, this would mean that 12.5% of the 97.5% recovered metal, or 12.82% of the produced zinc, would be free metal to NIF, representing approximately 34,615 tonnes of zinc metal, or US$95.4 million (at US$1.25/lb zinc price). Third, smelters make a zinc premium based on their geographic location and the types of products they create. In 2018, NIF received US$0.07/lb for zinc product premium, which equated to US$41.7 million in total, based on its production. Lastly, smelters generate revenue from their by-product sales, which in NIF’s case are sulfuric acid and copper cake. In 2018, these sales equated to US$26.7 million. In total, this would indicate that NIF could produce US$255.2 million in revenues in the new TC environment. Since production levels and costs are expected to be similar to last year’s, we can expect all-in cash costs to be approximately US$150.8 million, implying an annualized run rate EBITDA of US$104.4 million, or C$138.9 million.

When we run an EBITDA sensitivity to the zinc price and TCs, we can see significant upside for NIF’s potential future cash flow generation. A ten-cent increase in the zinc price would increase NIF’s EBITDA by US$7.6 million to US$112.0 million, whereas a $25/dmt increase in TC would increase NIF’s EBITDA by US$13.0 million to US$117.4 million. See the sensitivity chart of EV/EBITDA multiples in Figure 4.

We also note NIF’s free cash flow generation. NIF’s capex of US$25 million, interest payment of US$8 million, and a tax rate of 35% would result in free cash flow of US$44.6 million, representing a 41.1% free cash flow yield. If 80% of the free cash flow were to be distributed to unitholders, NIF would provide a C$0.95 in distribution annually, a 32.9% dividend yield. A sensitivity chart on free cash flow yield is displayed in Figure 5.

Valuation

Figure 6 Illustrative Valuations with Various Methodologies

Using a 3.5x EBITDA multiple, a low multiple for a business of NIF’s nature, NIF should be valued at C$486 million in enterprise value. We believe that a 3.5x EBITDA multiple is lower than the market, given that Aurubis AG (XTRA:NDA) trades at 5.4x 2019E consensus EBITDA. Taking the current ABL Revolver at the Q4/2018 level, NIF’s shares should be trading at C$5.93 per unit. From cash flow perspective, NIF at 20% free cash flow yield would be C$6.16. If NIF were to provide C$0.95 in distribution per unit, at 12% yield, it should be valued at C$7.91.

From a replacement value perspective, NIF’s value cannot be further off from its current market valuation. Boliden AB (OM:BOL) spent US$55 million to increase capacity at its Odda zinc smelter by 30,000 tonnes, implying US$1,823 per tonne of additional capacity, valuing NIF’s asset at US$492 million (C$654.4 million), or C$9.39 per unit. We note that the last five new zinc smelters built have been in China and have had average capex of US$241 million for smelters that are less than half of the capacity of NIF, providing much higher multiple per capacity.

Summary

This time has come. Given an expected growth in zinc concentrate supply and the negotiating power shifting to the smelters, it is perfect timing to buy a pure-play, high-quality zinc smelter that controls 2.5% of the global zinc smelter capacity at a current valuation around its net working capital value, implying zero value for the smelter itself. NIF’s cash flow profile will dramatically improve, providing US$104.4 million in EBITDA and US$44.6 million in run rate free cash flow starting in May 2019. At 80% payout ratio, NIF should be able to distribute C$0.95 per unit, implying a 32.9% dividend yield.

Appendix: Working capital and Revolver

NIF has an asset-backed revolving loan facility (the “ABL Revolver”) with a total limit of US$180 million secured against its assets. The Revolver carries an average of floating Canadian or US rate plus margins of -0.25% to 2.25%, depending on excess availability and averaged 4.1% in 2016. As of December 31, 2018, NIF’s balance on the Revolver was US$133.7 million and last three years’ average of US$52.6 million.

Figure 7 - Comparable Days of Working Capital

Upon reviewing NIF’s working capital requirements, which the ABL Revolver is used to fund, its requirements are significantly higher than its comparables in the smelting industry. On an LTM basis, Aurubis AG and Korea Zinc Co. Ltd. both had similar days of inventory (76.2 and 72.7 days vs. NIF’s 75.3 days). However, days of receivable were much lower for them compared to NIF (12.2 and 18.5 days vs NIF’s 65.7 days). Since most of NIF’s accounts receivables are from Glencore, we also looked at Glencore’s LTM days of payable, which was at 17.6 days. Aurubis AG and Korea Zinc Co. Ltd.’s days of working capital of 57.6 and 80.1 days were much lower than NIF’s days of working capital of 100.8 days.

Based on December 31, 2018, NIF’s net working capital was US$208.9 million, and net of ABL Facility, it was US$75.2 million, approximately C$1.99 per share. (The company is indeed trading near 1x net book value of its net working capital less ABL Facility.) However, if we look at more of a normalized days of working capital of 73 days (18.5 days of receivables, 21 days of payables, and same days of inventory), NIF’s working capital requirements would reduce to US$145.1 million, a reduction of US$63.8 million or C$1.68 per share.

Catalyst

April 26, 2019: AGM in Toronto and release of Q1/2019 financials

May 2, 2019: Start of the new contract pricing