K92 Mining: Margin Pressure On Deck (TSX:KNT:CA)

Just over a month ago, I wrote on K92 Mining (OTCQX:KNTNF), noting that I expected a strong Q4 with tonnes processed likely to come in near the 120,000-tonne mark and quarterly production of ~35,500 gold-equivalent ounces [GEOs]. This ended up being right near where the actual results came in, with K92 Mining beating my estimate for tonnes processed (~121,700 tonnes) and production coming at my estimate of ~35,500 GEOs. Although this was an impressive finish to 2023, and key operating metrics continue to trend in the right direction, it missed its guidance mid-point for a second consecutive year, with ~122,800 GEOs vs. a mid-point of 127,500 GEOs.

Unfortunately, although margins will be stronger in Q4 2022 with a rebound in the gold price and higher sales volumes, all-in-sustaining cost [AISC] margins are expected to decline materially this year as the company invests in growth. This is because even if K92 Mining (“K92”) hits its FY2023 guidance mid-point of $1,240/oz, margins will be up 30% year-over-year vs. FY2022 estimates of $930/oz. Similar to B2Gold (BTG), this margin compression is temporary as the company spends heavily to set itself up for future growth. Still, with much weaker margins on deck, it’s possible the stock could underperform some of its peers in H1 2023 with lower production and elevated sustaining capital in the period. Let’s take a closer look:

Q4 & FY2022 Results

K92 Mining released its Q4 and FY2022 results last month, reporting quarterly production of ~35,500 ounces, a 2% decline from the year-ago period. This figure was in line with my estimates (~35,500 GEOs) and was the strongest quarter of the year, with production coming in just shy of the record levels achieved in Q4 2021 (~36,100 GEOs). However, although the strong finish to the year helped K92 to deliver into its FY2022 guidance range (115,000 to 140,000 GEOs), output came in below the guidance mid-point for the second consecutive year, though 2021 was a very challenging year so the company gets a pass here for several unplanned headwinds (shortage of bulk emulsion explosives, COVID-19 absenteeism).

Digging into the operations a little closer, annual production ended the year up 18% at ~122,800 GEOs, helped by a sharp increase in throughput with consistent outperformance vs. nameplate capacity. Progress toward its ongoing Stage 2A Expansion (400,000 to 500,000 tonnes per annum) helped with the increased production year-over-year, as did improved recovery rates despite slightly lower gold grades in the period (90.4% vs. 89.4%). In fact, tonnes processed were up 33% year-over-year to ~448,000 tonnes, ore tonnes mined hit a record of ~448,000 tonnes, and K92 is already processing at Stage 2A rates ahead of commissioning its floatation expansion which will double rougher capacity.

As noted in the preliminary Q4 results, K92 processed ~121,700 tonnes (1,323 tonnes per day) in the quarter, with a monthly record of 1,382 tonnes per day in November and a daily record of 1,714 tonnes per day on December 25th. These monthly and daily figures are outperforming the Stage 2A nameplate capacity of 1,370 tonnes per day, suggesting we should see a very strong Q2 through Q4 when the Stage 2A expansion is complete (setting the asset up for what should be consistent 1,400+ tonne per day processing rates and a 100 to 200 basis point lift in recovery rates) following the float cell hook-up later this quarter.

Finally, K92 also reported record mine development in Q4 of ~2,220 meters, a 45% increase year-over-year that has advanced incline #2 to 1,843 meters and incline #3 advanced to 1,811 meters. These development rates are 52% ahead of its annual budget, considerably de-risking the Stage 3/Stage 4 expansion and ensuring K92 Mining will have the tonnes to fill its new plant. The company noted that its consistent improvement in mining rates relates to its new replacement jumbos, improved ventilation/haulage, and improved maintenance/servicing with a new equipment workshop. So, how does 2023 look?

2023 Outlook

Although K92 Mining had an impressive year in 2022 and finished the year on a high note, the 2023 outlook is less robust than I expected, though there appears to be some conservatism in the annual guidance. Based on the company’s guidance released last month, K92 expects to produce 120,000 to 140,000 GEOs this year, translating to a 6% increase in output at the mid-point and likely a 9% increase year-over-year as I wouldn’t be surprised if the company didn’t beat this guidance mid-point (133,000+ GEOs). However, costs are expected to rise considerably, with cash cost guidance at $620/oz to $680/oz and AISC guidance at $1,180/oz to $1,300/oz.

The year-over-year cost increase is likely partially related to inflationary pressures affecting all producers and investments to prepare the Kainantu Mine for considerable growth planned post-2024. That includes accelerated sustaining capital and development expenditures to support its Phase 3/Phase 4 growth plans that were approved in December of last year and some planned expenditures from 2022 pushed into this year due to supply chain headwinds that led to delayed receipts. This means even if K92 delivers into the bottom third of cost guidance ($1,220/oz), AISC will soar over 30% year-over-year, with a 32% increase at the mid-point of guidance ($1,240/oz vs. ~$930/oz).

This wouldn’t be a big deal from a margin standpoint if the gold price were going to pick up most of this slack. However, with a quarter-to-date average realized gold price of ~$1,880/oz vs. a Q1 2022 average realized gold price of $1,769/oz and AISC likely to come in above $1,000/oz in Q1 2023, we should see AISC margins dip from $981/oz to sub $880/oz. Meanwhile, on a full-year basis and even assuming an average realized gold price of $1,900/oz (above year-to-date levels), AISC margins would slide from ~$820/oz to $660/oz at the mid-point. Using a $1,825/oz realized gold price for FY2023 (which is more conservative), AISC margins would plunge to $585/oz.

So, with a high likelihood of margin compression in 2023, while many other producers will enjoy margin expansion, it wouldn’t shock me to see K92’s short-term underperformance vs. peers continue from a share price performance standpoint. This is not a big deal for investors focused on the bigger picture, and it could open up an attractive buying opportunity if the weakness in the stock persists. However, this is one reason I did not see any reason to rush into the stock above US$6.00 when I wrote on my last update, with it extended above support and prone to a sharp pullback if we were to see any less favorable news. Let’s see if it’s priced into the stock:

Valuation & Technical Picture

Based on ~244 million fully diluted shares and a share price of US$5.17, K92 Mining trades at a market cap of ~$1.26 billion. If we compare this figure to an estimated fair value of ~$1.68 billion at $1,700/oz gold with $350 million assigned to exploration upside and $130 million in corporate G&A, this leaves K92 Mining trading at a P/NAV multiple of 0.75. For a producer with an industry-leading growth profile and a track record of exponential resource growth with multiple untested targets, I think the stock can easily command a multiple of 1.0x – 1.20x P/NAV, with the potential to trade at the higher end of this multiple when the Phase 3 Expansion is complete (Q4 2024).

If we use a 1.10x P/NAV multiple to derive its 12-month price target, I see a fair value for K92 Mining of ~$1.83 billion [US$7.50], translating to a 44% upside from current levels. Although this points to material upside, I prefer a minimum of a 40% discount for starting new positions in small-cap producers, but one could make an exception at 35% given K92 Mining’s unique investment thesis (near unrivaled growth). Still, at a share price of US$5.17, K92 Mining hasn’t quite reached its ideal buy zone, which is US$4.85 lower after applying this 35% discount.

Meanwhile, K92 Mining is still well above support from a technical standpoint, and we have a new short-term resistance level at US$5.95 after the stock failed near this level and saw momentum turn lower last month. Based on a share price of US$5.17 and support at US$4.50 with resistance at US$5.95, K92 Mining is in the middle of its support/resistance range, with the potential for a test of its long-term uptrend line in the US$4.50 – $4.65 range before it finds a durable low. So, while the stock could bottom, I don’t see a low-risk buy setup just yet, and the ideal setup from a technical/fundamental standpoint looks to be US$4.50 or lower.

Summary

If investors have grown weary of depending on the gold price to see a rise in their miners’ portfolio value, K92 Mining offers a unique investment thesis story that could appreciate meaningfully over the next three years. This is because we will see a meaningful increase in net asset value (exploration success), cash flow, and earnings per share as the company triples its annual GEO production looking out to 2026. That said, 2023 could be a softer year with margin compression on deck, and no matter how great a story is, I want to buy cyclical names when the sector is hated, and stocks are offering a significant margin of safety, not when we’ve seen a meaningful spike in optimism.

Currently, sentiment for miners (shown above) is still hovering in the ‘danger’ zone despite the recent pullback in the Gold Miners Index (GDX), and while many are suggesting they are seeing extreme pessimism, that is the opposite of what I see among proprietary sentiment indicators I track. This doesn’t mean that K92 Mining and the index must trade lower, but it does suggest an elevated risk of being aggressive at current levels, and when indicators are not flashing buy signals, I prefer to be pickier on entries. So, while I see K92 Mining as a top-12 producer and a solid buy-the-dip candidate, I am neutral short-term but would turn bullish at US$4.50.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.