SouthGobi tries to reverse recent market slide

Large losses and re-aligning an open pit mine have dampened the recent market enthusiasm for SouthGobi Resources (SGQ-T) and its Ovoot Tolgoi coal project in Mongolia.

The Vancouver-based company’s shares closed as high as $20 in early January on the back of an improved regulatory environment in Mongolia and renewed faith in global economic growth, but since then the market has soured on the company and in Toronto on May 21 SouthGobi shares closed at just $10.24.

On a May 14 conference call, company chief executive Alex Molyneux addressed some of the fundamental issues that could have been the cause of market concern.

Molyneux explained that the lower than anticipated production levels from the mine were due to the company being in the midst of a mine re-alignment which necessitated it moving little more than waste for the month of January.

When mining coal did resume, the strip ratio of 6.8:1 was a tad higher than the stated life- of-mine average of 4.1:1, and considerably higher than last year’s strip ratio of just 2.2:1.

But Molyneux explained that as the re-alignment nears completion – it should be finished by the end of the second quarter – strip ratios are moving back towards the life-of-mine average.

The need for re-alignment came from the mine’s initial set-up that saw waste being piled along strike. The set up was beneficial in the early stages of the mine’s life because the configuration allowed for customer trucks to drive right into the mine and be loaded with coal directly, eliminating the need for stock piling.

But in the long run the set-up wasn’t sustainable, Molyneux says, because customer trucks would be blocked both by the growing depth of the open pit and greater congestion that was to come from more mining equipment in the pit.

“As of November last year we stopped the practice (of letting customer trucks into the pit),” Molyneux said. “Now access to the pit is on a north south access which also gives us better access and better quality control on the coal being mined.”

Indeed operational results from the month of April show the re-alignment to be progressing well as the company shipped 200,000 tonnes of coal for US$44 per tonne at a strip ratio of around 5:1.

Molyneux says the re-alignment will be done by the end of the second quarter, allowing the run rate on production to climb to 300,000 tonnes a month at a strip ratio of roughly 4:1.

And while operationally things are trending in the right direction, investors must also consider the project’s exposure to fluctuating coal prices.

While the mine did increase its average realized price for the quarter – it shipped 426,000 tonnes at US$36 dollars per tonne compared to 130,000 tonnes at US$29 dollars per tonne for the year previous – the company cannot lock into longer term pricing contracts at this point.

Molyneux said the company would like to have contracts in place 2011 but that to get such contracts SouthGobi would need two things: licences from China – which is where the coal is being shipped to — and a higher quality of coal.

To secure the first element, Molyneux said the company would likely have to joint venture with a company that had access to such licences.

As for the second component, the type of larger Chinese end-users that offer long term contracts demand that the coal be washed and SouthGobi currently does not have the ability to do that.

But that will change in the future.

The company says it plans to build a coal handling facility which should be commissioned in the first quarter of next year.

Another element of the company’s financial statement that the markets may have had a hard time digesting was a net loss in the quarter of US$168.3 million compared to a loss of just US$10 million for the same period last year.

SouthGobi’s chief financial officer, Terry Krepiakevich, said most of that loss – roughly US$154.5 million of it – was a non cash loss, and further, US$162.3 million of the loss could be chalked up to the US$500 million in convertible debt it issued to China Investment Corp. (CIC).

The convertible debt deal was done in lieu of a straight up equity issue in connection with the company listing on the Hong Kong stock exchange earlier this year.

The losses on SouthGobi’s balance sheet had to do with the interest expense on the bonds – which is 8% — and par value changes on the embedded derivatives which must be marked-to-market.

While that last component may sound complicated to the average investor, Molyneux put it in plainer terms.

“We have to re-value the option that the bondholder’s hold,” he said. “If our share price goes up then the option price goes up and we have to report a loss. If the share price goes down, then the option value goes down and we report profit.”

Going forward, Molyneux says while the convertible debt situation will still result in losses on the company’s balance sheet, such losses won’t be as “dramatic” as they were in the first quarter.

So far, half of the bonds held by CIC have been called in by SouthGobi. That move gave CIC a 13.4% stake in the company’s equity. SouthGobi, however, does not have a right to call anymore bonds until 2014.

The strike price on the rest of the debt is $11.88 and can be exercised at CIC’s option.

Turning away from the convertible debt and focusing on operations, SouthGobi’s losses don’t look so damning.

Operating losses from continuing operations for the quarter came in at US$6.5 million which was US$100,000 less than what the company reported for the same period last year.

Molyneux said once the realignment of the open pit is completed higher production and improved quality will significantly improve on those numbers.

Ovoot Tolgoi has proven and probable mineral reserves of 114.1 million tonnes, measured and indicated resources of 249.8 million tonnes and an inferred resource of 33.5 million tonnes.

Those estimates come from the summer and fall of last year, and with some $20 million being put into its exploration budget this year, investors may well be anticipating improvement on those numbers shortly.

But Molyneux explained that because the government of Mongolia prefers resources to be calculated using the old Soviet standard, the company will do its resource estimates in that method first so that it can secure any licences or permits it may need. Once that is done, it will then proceed with an NI 43-101 compliant resource update, which would be ready for dissemination towards then end of the first quarter in 2011.