Caledon Resources is an AIM-listed coal producer, primarily focused on mining coking coal in Queensland, Australia. The company was incorporated in the U.K. in 2000 and after a three year gold & precious metals exploration adventure in China, in 2006, its management transformed the company’s fortunes with a dramatic acquisition which has already catapulted it into the ranks of the coal producers. The transformational deal saw Caledon buy the Cook Colliery and related mining operations in Australia, from Xstrata. This was shortly followed by an additional coal-asset acquisition in the adjacent Minyango project, an area situated within the coal-rich, prolific Bowen Basin which contains many of Queensland’s premier coking and thermal coal mining operations.  Caledon is now rapidly ramping up production from Cook – at a time when pricing power is with the producers – while seeking to firm up the extent of the resource at Minyango to accelerate its move towards production.

On 24th April 2008, Caledon undertook a placement of 6.36 million ordinary shares which have been placed with Australian institutions at A$1.10 per share raising a total of nearly A$7 million which will be used to fund the final consideration payment of the Minyango acquisition. In addition, the Company intends to offer 13.64 million CDI’s at the same offer price of A$1.10.  Pursuant to the placement and public offer, Caledon hopes to raise a total of A$22 million which will be used for further improvements to the Cook Mine and for further exploration at Minyango.
The recent unprecedented demand for coking coal from Asian and Australian based utility companies and other end users has seen a sharp increase in prices and thus this capital raising looks well timed. This increased demand reflects the recent extreme weather events in Australia and China but also the strong underlying macro-economic growth story in the region. Continued question marks over South African coal exports caused by power supply disruptions have only added to the uplift in prices. These factors have consolidated power into the hands of coal producers and this is evidenced by recent contract negotiations over thermal/coking coal prices between producers and end users. The price of coking  has risen from $98 p/t in 2007 to a forecasted 2008 price of as high as US$225 p/t according to UBS.

Caledon has sought to exploit higher prices by recommissioning the Cook Mine and establishing a new workforce of around 160 personnel. At the end of December 2007, Caledon had mined 255,300 tonnes of coal of which 170,000 was coking coal while the remaining was thermal coal. Caledon fully commissioned its Magatar mining system at the end of January 2008 when the system began to cut its first coal. Initial unexpected problems were encountered with the installation of the new ABM25 continuous miner causing the company to miss its production targets. The problems have now been resolved and production has been ramped up.

We have valued Caledon Resources on a sum of parts basis. The majority of the company’s value derives from its principal producing asset, namely the Cook Mine. Using a detailed Discounted Cash flow model on an expected 20 year life mine and a discount rate of 8%, we arrive at a net present value of £148.2 million ($296.4 million) or 74p per Caledon share on a fully diluted basis.  We assumed modest production levels of 5.87 Mt of coal produced over the 20 year term, split 80% for coking coal and 20% for thermal coal. During the period 2009-2013, we forecast coking coal production of 0.96 Mt per year and 0.24 Mt per year of thermal coal production, rising to 1.36 Mt and 0.34 Mt per year thereafter respectively. We estimate the company to reach the 1 Mt coking coal and 0.8 Mt thermal coal production levels during 2008.   

Our DCF valuation is admittedly highly sensitive to thermal and coking coal prices, so bearing the coal price sensitivity, we have tried to be conservative with our coal price forecasts. Our coking coal price forecasts are $175 p/t (2008) falling on average by 5% for the first 10 years before they pick up again at a moderate 2%. Our thermal coal price forecasts are $120 p/t (2008) falling on average by 4% for the first 10 years before they pick up again at a moderate 1% increase. We consider these forecasts on the conservative side, bearing in mind that contract prices of coal for power plants and steel mills in 2008 have already increased due to the unprecedented tightness in global coal markets, following supply disruptions among key exporters.

The company’s other two projects add little to our group valuation. We value the Minyango lease at $10 million, and the legacy Mojiang gold project in China at $3.2 million. We estimate the company has cash and near cash resources of $18 million. Our sum of parts valuation comes to US$327.60 million or 81p per share on a fully diluted basis. Our valuation is underpinned by the possibility of a takeover bid by Caledon’s founder Steve Dattels who has in recent months accumulated a stake of 12% via his Polo company. At 75.25p we rate Caledon as an add with a target price of 81p.

Forecast Table Year to 31st December Sales (£million) Pre-Tax Profits (£million) Earnings Per Share (p) Price Earnings Ratio 2006A          - (1.690) (2.8) N/A 2007A 6.4 (18.88) (9.5) N/A 2008E 83.3 39.25* 13.7 5.49 2009E 93.0 47.70** 16.6 4.53 *£49.25m-£5m corporate SGA expenses + £5m unforeseen costs **£55.20m-£7.5m corporate SGA expenses

 

Background

Caledon Resources traces its roots back to Finelot Plc, a company incorporated in England and Wales in 2000 as one of many dotcom startups. The dotcom boom ended and so did Finelot’s business model. In 2003, the company turned itself into a mining investment company after raising £1.246 million through the issue of 124,559,285 ordinary shares at 1p (there has been a 1 for 5 consolidation since) and through the acquisition of Blackwatch Resources Ltd, a BVI incorporated company which was involved in exploration activities in China. The Company thus began trading on AIM under the new name Caledon Resources, focusing on precious metals exploration in China.

By the end of 2004, Caledon had managed to secure a strategic partnership with Dynasty Gold, the largest mineral title holder in China by acquiring a 15% stake in the company; a 19% investment in Toronto listed Afcan and a joint venture with Chenghua which gave Caledon access to explore its 20 gold mines and a joint venture with Mojiang Gold  which gave Caledon a 70% stake in the Mojiang project. The principal area of focus is known as the ‘Golden Triangle’ region of China and Caledon raised an additional £1.5 million to drill on a number of early stage properties. In September 2005, Afcan Mining was taken over by Eldorado Gold Corporation which allowed Caledon to generate £8.5 million from the disposal of its new Eldorado shares. Caledon reaped a 296% return on its original investment. With a significant improvement in its cash position, Caledon was able to pursue its desire to switch from an early stage explorer to a producer.

In line with this new strategy the Company set about searching for appropriate acquisitions and set its sights on the Cook Mine in Queensland. The decision to move into Australia was driven by a combination of the strong market outlook for coal and the low country risk. Caledon signed a Heads of Agreement in June 2006 with Xstrata Coal Pty Limited, a subsidiary of Xstrata plc, to acquire the Cook Coal Mine for a cash consideration of £18.5 million. The Company also targeted the adjacent Minyango coal property, a brownfield coking coal asset in Queensland which was purchased in September 2006 for a total consideration of A$42 million to be paid in instalments. The acquisitions were financed by an equity raising of £26.5 million from the placing of 331 million shares at 8p each. In November 2006, the Company announced a third acquisition of Mining Technology Partnerships Pty Ltd (MTP), the owner of certain intellectual property rights and revenue royalties arising from mining technology that Caledon intends to use at the Cook Mine. MTP is expected to become the exclusive representative of Magatar, the licence of the intellectual property in Australia, New Zealand and Indonesia. The purchase was for a sum of A$8.5 million financed by a combination of shares at 8p each and cash. The shares were temporarily suspended during the transformation and re-admitted to AIM in December 2006 at which point Caledon undertook the 5 for 1 share consolidation.

In November 2007, Caledon announced the disposal of certain Chinese projects in its portfolio to Indochina Minerals Limited. Indochina paid A$250,000 financed by the issue and allotment to Caledon of 1 million fully paid ordinary shares in Indochina at an issue price of A$0.2 per share. This marked the first sign of Caledon’s withdrawal from China.

 

Asset Review

Cook Mine

The Cook Mine is situated in the central part of the Queensland Bowen Basin, one of the world’s largest coal provinces which produces almost 50% of the world’s sea borne coking coal. Many mining majors already operate in the region including Rio Tinto, Xstrata, BHP Billiton and Anglo American, producing in total 115 million tonnes per annum. The area therefore has mining infrastructure already in place including a coal preparation plant  14 kilometres North of the Cook Mine as well as rail and port access all of which are available for Caledon to use.

The Cook Mine has two substantial seams: the Caster seam, 130 metres to 350 metres in depth and the Argo seam, 15 metres – 20 metres below the Caster seam. Cook was originally estimated to contain 126.5 million tonnes of resource but this estimate has been increased in an independent study conducted by SRK Engineering. The Mine is now estimated to hold a total of 176 million tonnes of resource of which 93 million tonnes is classified as a measured resource and 83 million tonnes is classified as an indicated resource. According to a JORC statement compiled by SRK Engineering, 17.08 million tonnes can be mined over a 10 year period and it is highly likely that adequate accessible resources are available to extend the 40 million tonnes of recoverable coal and increase the life of the mine by another 20 years.

Production commenced in March 2007 and Caledon planned to produce 900,000 tonnes in its first year of operations and 1.2 million tonnes in the second year and to increase output to 1.7 million tonnes from 2013 onwards, however, the mine encountered 2 problems that prevented it from meeting its first year targets. A spontaneous fire in an abandoned section of the mine and a lack of availability of hired equipment which was planned to be used in combination with owned equipment both had adverse effects on production. By end of December 2007, a total of 170,300 tonnes of coking coal and 32,700 tonnes of thermal coal had been produced. 149,500 tonnes of coking coal had been sold along with 18,900 tonnes of thermal coal. Going forward Cook will produce approximately 80% coking coal and 20% thermal coal.

The Cook Mine will be the first to use the Magatar Mining System which integrates a continuous miner/bolter paired with a continuous haulage system. The system eliminates the use of shuttle cars, providing a permanent link between the miner and the section conveyor. Government approval had to be gained for use of the equipment using the new mining method. The new Voest Alpine ABM25 continuous bolter/miner was commissioned underground to cut its first coal in November 2007 and in January 2008, commercial production from the Magatar system commenced.

Minyango

Minyango is located north of the Cook Mine in the mining town of Blackwater. Caledon’s initial strategy was to verify the existence of coal resources by extensive drilling. Caledon conducted a 15 hole drilling programme and then consulted with SRK to produce a JORC compliant resource statement identifying a total resource of 240 million tonnes comprising of 75 million tonnes of indicated resource and 165 million tonnes of inferred resource

A second drilling programme commenced in late July 2007 and was designed to advance the significant tonnage into JORC compliant Measure Resource in preparation for a pre-feasibility study. Caledon is now in the early stages of developing Minyango into a underground continuous miner operation, utilizing the same methodologies employed at Cook and utilizing spare capacity at the Cook wash plant.

Strategy

Caledon’s strategy is a clear one. The legacy Chinese assets will be sold in due course. The Company intends to work towards becoming a significant participant in the global seaborne coking coal market. It has refurbished the Cook Mine and put it into production quickly to realize near term cash flows. It is working towards completing a full feasibility study on the Minyango prospect to determine the economic viability of moving it into production over the medium term – this will engineer a massive ramp up in operational cashflows which will allow Caledon to develop other suitable Australian assets.

 

Risk and Opportunities

Any coal mining operation comes with clear industrywide operational risk. The spontaneous fire at Cook last year demonstrated that. The lack of suitable hire-in equipment – a factor beyond Caledon’s control – demonstrated that point a second time. There can be no guarantee that other factors without Caledon’s control will not in future mean that production targets will not be missed. Indeed, in January 2008, heavy rain in the Queensland Bowen Basin caused widespread flooding and property damage, disrupting the operations of many mining companies operating in the area. On that occasion Caledon was lucky, reporting only minor disruptions in the form of missing workers and a slight delay in the finalization of the second drilling program in Minyango. A positive effect of the rainfall was also reported as a result of the extreme weather conditions. The Company’s main water storage dam which supplies water for the Cook Mine and Cook coal wash plant was filled to capacity for the first time in 17 years.

At a company specific operating level, Caledon made an announcement on the 4th April concerning problems with the installation of the new ABM25 continuous miner. Caledon fully commissioned the Magatar system underground at the end of January 2008 when the system began to cut its first coal.  Since then Caledon has focused on ramping up the system to full operation. Implementation of the ABM25 miner encountered unexpected problems in February and March indicating that the company missed its monthly targets of 100ktpa. Caledon has been supplementing production with the continued use of one of the two hired ABM20 continuous miners. The problems have now been resolved after a substantial replacement of key components and the company is targeting to meet its monthly production, however the delays inevitably mean a reduction in expected production for the first half of 2008. As a result, Caledon expects the total saleable production for the full year to be in the range of 0.9Mt to 1.1Mt.

Despite the area’s long history of mining, the recent ramp up in production in the Bowen Basin means that there are infrastructure bottlenecks, notably at the ports, which can affect sales. Caledon’s production from the Cook Mine is exported through the port of Gladstone which, we believe, is relatively unaffected in this regard. Rail capacity allocated to Cook Mine have been decreased from 1.5 million tonnes to 1.1-1.2 million tonnes this year, thus constraining sales in the current environment, sales are expected to be constrained until 2012.

The short-term outlook for coal prices appears positive. However prices can fluctuate and with high fixed costs this can have a disproportionate effect on profitability. We have used what we believe to be conservative assumptions in our model and we believe that Caledon presents a robust investment case on that basis. Indeed we are modestly optimistic about the demand for coal in Australasia and Asia and therefore believe that the risks to our model are on the upside.
 
Caledon is in the process of seeking a dual listing on the Australian Stock Exchange to meet demand from Australian investors and increase sources of funding. On April 24th, Caledon filed a prospectus with the Australian Securities and Investment Commission to offer 13.64 million CDIs at a price of A$1.1 each. Each CDI is to represent a beneficial interest in one ordinary share in the company. Caledon has also undertaken a placement of 6.36 million shares which have been placed with Australian institutions at A$1.1 per share. The A$6.996 million (£3.3 million) raised will be used to fund the final payment of the Minyango acquisition. A total of 20 million shares will be issued pursuant to the placement raising a total of A$22 million for the company. Part of the money will be used for further improvements to the Cook Mine and for further exploration at Minyango. The company may require further funding to bring Minyango into production and investor appetite for resources stocks cannot be guaranteed.

A final potential upside opportunity for investors comes from  Steven Dattels’s stake building through his AIM listed Mongolian coal explorer Polo. The former chairman of Caledon has built a 12% stake in the Caledon which would entitle him to some power over the chairman and non-executive directors of the company. A potential takeover bid is possible. Dattels has not made his intentions clear at this stage.

 

Management

Robert J Alford, Chairman, aged 57. Alford joined the board of directors of the Company at the time of its original admission to trading on AIM in 2000. Alford became non-executive Chairman of Caledon in February 2005 and from September 2006 has held the role of Executive Chairman in order to manage the Company’s transition from China focused gold explorer to coking coal producer. Previously, Alford held a variety of senior positions in the Nelson Hurst Group including responsibility for Mergers and Acquisitions. In 1989 he negotiated the sale of the Nelson Hurst Group to Citibank NA. In May 1991 the then much-enlarged financial services group was reacquired by management. Alford is a member of Lloyds, registered as a Non-Executive Director with the FSA and is recognised by The Guernsey Financial Services Commission and The Bermuda Monetary Authority (as a director of regulated businesses).

Mark Trevan, Managing Director, aged 51. Prior to joining Caledon in September 2006 he spent 25 years with Rio Tinto where he held senior executive roles in the areas of coal marketing, general commercial, corporate strategy and project feasibility. He joined Rio Tinto’s Queensland coal subsidiary in 1997 as General Manager Marketing and through various corporate reorganisations also became responsible for the marketing of Rio Tinto’s Coal and Allied subsidiary and its Indonesian Kaltim Prima operations. Trevan brings extensive coal industry contacts both within Queensland and the international arena.

Peter Seear, Chief Operating Officer, aged 55. Actively engaged in the coal mining industry since 1977. He commenced his career immediately upon graduation from Coventry University in 1977 as Engineering Manager for a drill rig manufacturer engaged in the design and development of exploration drill rigs. He became a Chartered Engineer in 1983. Seear worked for coal mining equipment manufacturers including Joy Mining Machinery Ltd and an Anglo American subsidiary, Coalequip in Johannesburg in South Africa and transferred to Joy in North America responsible for new project development after completing his studies at Harvard Business School where he attained a PMD. Seear brings a wealth of international contacts in the equipment design, development and manufacturing business.

Graham Mascall, Non-Executive Director, aged 61. Over 35 years of commercial, financial and transaction experience in mergers and acquisitions, business development and project management in mining and mining finance. Over the course of his career he has worked as an executive for a number of companies in the mining and mine finance sector, including Billiton plc where in 2000, as chief executive for mergers and acquisitions, Base Metals and New Business, he led the US$2.1 billion acquisition of Rio Algom Limited. He has also worked for BHP Billiton plc, Deutsche Morgan Grenfell, Outokumpu Metals and Resources and Barclays Bank. Mascall is a graduate in mining engineering from the Camborne School of Mines and holds a Master of Engineering in Mineral Economics from McGill University.

George Salamis, Non-Executive Director, aged 41. One of the founding shareholders of Caledon and held the position of Managing Director and Chief Executive Officer from 2003 until September 2007. Salamis is currently the President of a junior gold producer, Rusoro Mining Limited, with operating gold mines in Latin America. Prior to this, he held senior management positions with well-established mining companies most notably Placer Dome Inc. and Cameco Corporation. His career in the mining industry spans over 20 years involving assignments in many different regions of the world, on various resource commodities. In recent years, he has also played integral roles, both executive and non-executive, in several large M&A transactions and major financing initiatives in the mining industry.  Salamis holds a graduate degree in Geology from the Universite de Montreal/Ecole Polytechnique.

Nicholas Clarke, Non-Executive Director, aged 55. Clarke has been involved in the mining industry since 1974 in a number of production and service capacities. He worked in South Africa, Ghana and Saudi Arabia on mines for a period of some 17 years. In 1992 he commenced working in the consultancy industry and in 1996 was made Managing Director of CSMA Consultants Ltd. During this period he managed numerous technical studies on mineral projects in Africa, Europe and the Former Soviet Union. He was author and project manager on a number of AIM and TSX CPR’s during this period and was most specifically involved in the economic valuation of mineral assets. Clarke has extensive experience in managing feasibility studies and how they interrelate to finance requirements. In 2004 he joined Oriel Resources plc, an AIM and TSX quoted natural resources company with nickel and chrome assets in Kazakhstan, as Director of Mining, and was appointed Managing Director in 2005.

Shareholders

Caledon Resources’ total issued share capital is 176,985,128 shares. The major shareholders with 3% or more holding in the Company are.

 

Ingalls & Snyder LLC	20.92%
Polo (Steve Dattels)	12%
Watami Trading	7.35%
JP Morgan Fleming Asset Management	5.65%
Capita Group Companies	3.87%
Hermes Pensions Management	3.86%
Astaire & Partners	3.63%
ABN AMRO Asset Management	3.14%

 

Recent Results, Balance Sheet and Cash Flow

Calendar 2007 was the first revenue generating year for the company, with turnover hitting £6.4 million from the sale of 150 kilotonnes and 19 kilotonnes of coking and thermal coal respectively at an average price of $75 per tonne. Caledon generated a loss of £14.5 million compared with a loss of £2 million in calendar 2006. The loss per share was 9.5p up from 2.8p. The loss for the period was primarily due to the costs associated with the recommencement of mining operations at the Cook mine including the introduction of the Magatar mining system. Costs totalling £1.3 million were incurred in connection with the company issuing and listing £27.5 million convertible loan notes on the Luxembourg Stock Exchange. The interest paid on convertible loans during the year amounted to £1.2 million. Administrative cost increased, as budgeted, from £3.5 million to £10.5 million due a combination of increases in salary costs, marketing, rent and overheads.

Delays to commissioning the Magatar system resulted in an increase in working capital and the below forecast production placed additional pressure on cash resources. We believe Caledon’s current cash position is around £9 million. As noted above, Caledon will be using the £3.3 million raised from the placement of shares with Australian institutions to fund the final payment of the Minyango acquisition.

 

Valuation and Conclusion

We have valued Caledon Resources on a sum of parts basis. The majority of the company’s value lies in its principal asset, namely the Cook Mine. We have put together a detailed Discounted Cash flow model on an expected 20 year life mine using a discount rate of 8%. Our DCF valuation is sensitive to thermal and coking coal prices, so bearing in mind the coal price sensitivity, we have tried to be conservative in our coal price forecasts. Our coking coal price forecasts are $175 p/t (2008) falling on average by 5% for the first 10 years before they pick up again at a moderate 2% per annum. Our thermal coal price forecasts are $120 p/t (2008) falling on average by 4% for the first 10 years before they pick up again at a moderate 1% increase per annum. We consider these forecasts on the conservative side, bearing in mind that contract prices of coal for power plants and steel mills in 2008 have increased due to the unprecedented tightness in global coal markets, following supply disruptions among key exporters. Investment bank UBS forecasts coking coal price to rise to a record high of $225 a tonne in 2008, an increase of 130% from the agreed price of US$98 p/t in 2007.

We assumed modest production levels of 5.87 Mt of coal produced over the 20 year term, split between 80% coking coal and 20% thermal coal. During the period 2009-2013, we forecast coking coal production of 0.96 Mt per year and 0.24 Mt per year of thermal coal production, rising to 1.36 Mt and 0.34 Mt per year thereafter respectively. We estimate the company to reach the 1 Mt coking coal and 0.8 Mt thermal coal production levels in 2008. Our operating costs per tonne of coal produced start at around $90 per tonne, falling to a level of around $65 per tonne coal as economies of scale and operational efficiencies kick into the project. We expect that the capital investment and working capital requirement to be around the $70-75 million, funded equally by debt (50%) and equity (50%). We expect debt repayment to occur fairly early in the project, say by 2009-2010, depending on the company’s policy of managing its cost and source of capital and capital structure. We make the assumption that the company will be raising around £18 million in equity at 60p per share, raising 30 million new shares in the process. Taking into consideration a marginal tax rate of 30%, we arrive at a net present value of £148.2 million ($296.4 million) or 74p per Caledon share on a fully diluted basis (170.625 million plus 30 million new shares).  

If we take into consideration the company’s other two projects, namely the Minyango lease, valued at $10 million, and the Mojiang gold project at $3.2 million. We estimate the company has cash and near cash resources of $18 million. Our sum of parts valuation comes to US$327.60 million or 81p per share on a fully diluted basis. On that basis, at 75.25p and with the added interest provided by the Polo stakebuilding we rate the shares as an “add” with a price target of 81p.

Forecast Table Year to 31st December Sales (£million) Pre-Tax Profits (£million) Earnings Per Share (p) Price Earnings Ratio 2006A          - (1.690) (2.8) N/A 2007A 6.4 (18.88) (9.5) N/A 2008E 83.3 39.25* 13.7 5.49 2009E 93.0 47.70** 16.6 4.53 *£49.25m-£5m corporate SGA expenses + £5m unforeseen costs **£55.20m-£7.5m corporate SGA expenses