Red 5’s early mover advantage as other miners wilt in WA’s hothouse economy

Cost inflation inside the isolated and overheated Western Australian economy is forcing mine developers to reassess projects as profits wilt, but there is an interesting example of a miner which dodged the costs bullet – Red 5 (reports Small Caps).
25th November 2021

The secret to the oddly named company’s success is largely one of timing.

It started the development process last year, locked in prices from suppliers and engineering contractors, and is expected to put the finishing touches to its King of the Hills project early next year at the original budgeted price of $226 million.

At any other time, Red 5’s success would not warrant a mention, but it does today because in simply doing what management promised highlights the problems faced by other mine developers as they struggle to source equipment and skilled labour.

For investors, Red 5 is the positive side of a tale about the importance of timing.

Essentially, the company knowingly (or unknowingly) followed the advice of legendary US investor Warren Buffett and bought when others were fearful.

Shortly after the Covid-19 crisis started to wash over the world last year, Red 5 raised capital and started placing orders for long lead times at the King of the Hills project, which is essentially the redevelopment of the old Tarmoola mine following a breakthrough in the geological interpretation of the large, low-grade, orebody, which is estimated to contain a resource of 4.12 million ounces of gold in 91 million tonnes of ore grading 1.4 grams a tonne.

When complete, King of the Hills will be Red 5’s primary source of gold, supported by an existing operation at Darlot about 100 kilometres to the north in WA’s Eastern Goldfields region.

Ore from Darlot will be trucked for processing at the new King of the Hills plant – reversing an existing arrangement.

When in production, King of the Hills is expected to yield 176,000oz of gold a year for the first six years of an initial 16-year life, generating annual free cash flow of $144 million in the first six years, for an internal rate of return on the investment of 50% at the current gold price of close to A$2,500/oz or 39.7% if the gold price falls to A$2,250/oz.

By moving quickly, Red 5 avoided the cost explosion which was always going to follow the pandemic and inflationary money-printing spree of central banks.

Rivals have not been so fortunate, whacked by soaring costs for everything from people to mine vehicles.

In a way, Red 5 is a WA mining sector anomaly with its difference emphasising the problems elsewhere in the same way a geologist uses anomalies in rock formations to find orebodies because they stand out from the broader background.

Over the next few months, Red 5’s achievement of simply delivering as promised should see it outperform rivals stuck in the WA hothouse with several broking firms, including Ord Minnett and Petra Capital, tipping a share price rise of up to 50% from the stock’s current $0.26 to around $0.40. Canaccord’s future price forecast is $0.35.

Three other WA mining projects are the flipside of Red 5 and examples of the problems caused by cost inflation in the state, which has erected high barriers to entry.

COVID-19 has resulted in shortages of equipment and workers, which is leading to construction delays as well as higher capital and operating costs.

When Fortescue Metals Group (ASX: FMG) started building its Iron Bridge magnetite processing project the capital cost estimate was US$2.6 billion.

Earlier this year it rose to US$3 billion, and by mid-year, it had risen to a target of between US$3.3 billion and US$3.5 billion – a blow-out of 35% which must hit future profits.

Liontown Resources (ASX: LTR) was last year hoping to build its Kathleen Valley lithium project for $325 million but recently lifted that estimate to $473 million. Albeit part of the cost increase was attributable to a decision to increase the tonnage of ore processed annually from 2Mt to 2.5Mt with the extra finished product helping offset the 45% cost increase.

Bardoc Gold (ASX: BDC) has been the hardest hit of the three cost blow-out examples, announcing in late September that it was undertaking a “strategic review” of its namesake project because of a $55 million (31%) increase in the pre-production capital cost estimate since the start of the year.

Fortescue, Liontown and Bardoc are not alone and serve as a reminder for investors that while the positive aspect of mining at a time of high commodity prices is the potential for strong profits there is another side to near-boom conditions, high and rising costs, which will still be there after the commodity price fades.

For Red 5 managing director, Mark Williams, there is a curious sense of satisfaction in being an outlier in the red-hot WA mining world even if it’s a result of simply doing what he said he would do, build a new project (out of two old projects) at the promised price.

“The key to what we’ve achieved so far is moving quickly and early,” he said this week.

“We got orders in for long lead time capital equipment in September last year and fixed the prices.”

“We also took what we regarded as a bold step in raising $125 million on development capital at the height of last year’s first wave of the COVID pandemic with that money enabling us to complete the final feasibility study, recruit high calibre people and get started before costs exploded.”

The impact of a cost blow-out can be seen in Bardoc’s share price which fell by 33% from $0.06 to $0.04 immediately after announcing the 31% capital cost increase.

Bardoc’s stock has since recovered, but the disclosure took investors by surprise, as did the comments of the chairman, Tony Leibowitz, who said there was worse to come.

“Cost pressures on new resources projects are likely to worsen over the next 12-to-18 months as the full impact of rising steel, materials and other input costs are factored in for new projects starting construction in the near term,” Leibowitz said.

How right he was and what a useful reminder for investors that even when a company looks appealing as an investment because of a discovery or when a resource calculation is reported there is always the other side of the good news, and that’s the cost of development at a time of rising prices.

Morgans, is one of the few local stockbroking firms to publish a costs alert for investors, singling out WA as being the region of primary worry.

“There are concerns that labour (availability) may worsen from 1 December, when WA’s vaccination mandate for the mining sector comes into effect,” Morgans in a note published last week.

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