Update: Ivanhoe to sell SouthGobi stake to Chalco

 Ivanhoe Mines (IVN-T, IVN-N, IVN-Q) says it will sell its stake in Mongolian coal producer SouthGobi Resources (SGQ-T) to Aluminum Corp. of China (Chalco) and use the proceeds to fund development of its massive Oyu Tolgoi mine, where it says initial production is expected to start in the third quarter of 2012 with commercial production following in the first half of 2013.

Chalco—the second-largest alumina producer and third-largest primary aluminum producer in the world—announced on Apr. 2 that it intends to make a proportional take-over bid for up to 60% of SouthGobi’s issued and outstanding shares.

Ivanhoe owns 104.81 million shares or about 57.6% of SouthGobi and estimates that it could receive up to $889 million from the sale. A sale of 60% of its current holding would net proceeds of about $533 million. Chalco’s $8.48 offer price for SouthGobi shares is a 28% premium to its most recent closing price on the Toronto Stock Exchange of $6.62, and a 32% premium over the volume-weighted average price of $6.41 over the past ten trading days on the TSX.

The Chinese company has also signed a cooperative agreement with SouthGobi that includes an off-take clause. Under the agreement SouthGobi will have the right to offer up to 100% of its saleable coal to Chalco and Chalco will have the obligation to purchase the coal at market prices for a 24-month period. Chalco will also assist SouthGobi to procure electricity for its Mongolian business operations either through a direct connection to grid power or through the development of a power plant. Chalco will also provide support to SouthGobi’s coal-haul highway project.

SouthGobi’s flagship coal mine, Ovoot Tolgoi, produced about 4.57 million tonnes of coal last year, up from 2.79 million tonnes in 2010. In 2011 SouthGobi posted record annual gross profit of US$51.7 million, up 424% from 2010, and record annual revenue of US$179 million, an increase of 124% over 2010.

Selling its stake in SouthGobi will help Ivanhoe develop Oyu Tolgoi, the world’s largest undeveloped copper-gold project in the South Gobi region of Mongolia, about 550 km south of the capital, Ulaanbaatar, and 80 km north of the Mongolia-China border.

In a research note to clients, mining analyst Alec Kodatsky of CIBC said that 72.7% of the overall construction of the first phase of Oyu Tolgoi was completed at the end of February; pre-stripping of the open pit was ahead of schedule; and pre-commissioning of the primary crusher, overland conveyor and coarse-ore stockpile circuits will likely start in April. Ivanhoe owns a 66% stake in the copper-gold mine project. Kodatsky believes Ivanhoe shares “are at a favorable entry point for investors seeking exposure to OT” and said that the company’s “effort to daylight the value of its non-core assets should help narrow the discount implied by current share prices versus our NAV.”

Kodatsky has a “sector outperformer” rating on Ivanhoe and a 12-month price target of $26 per share.

In addition to SouthGobi, Ivanhoe’s other non-core assets are its 59% interest in Ivanhoe Australia (IVA-T), a copper-gold-uranium-molybdenum, rhenium exploration and development company, and a 50% interest in Altynalmas Gold, a private company that is developing the Kyzyl gold project in Kazakhstan.

Kodatsky outlined the near-term catalysts for Oyu Tolgoi as the approval of a cross-border power supply agreement, interim project financing and possible asset sales. While ongoing delays in securing the cross-border power supply agreement present a risk to development timelines, Kodatsky says, he sees “encouraging signs that this dialogue is heading in a constructive direction including the commencing of construction of the transmission towers on the Chinese side of the border (with the Mongolian towers already complete).”

The Toronto-based analyst also points out that the project “has significant connections to Chinese enterprise (including two smelters holding off-take rights to the produced concentrate)” and notes that Chinalco (ACH-N) is a significant shareholder of Rio Tinto (RIO-L), the majority owner of Ivanhoe.” And while Ivanhoe has provided a Phase I construction capex update demonstrating that the budget has risen 3% to $6.2 billion, Kodatsky says, that is still an “admirable performance given the levels of cost inflation observed elsewhere in the mining industry.”

The major overhang is uncertainty about the proposed $4 billion project financing facility, he says, which continues to face delays but is expected to be finalized in the third quarter of this year. “With a $2.1 billion project expenditure budget for 2012 and roughly $700 million of cash available on the balance sheet to be deployed at OT (as of the end of 2011), Ivanhoe is under near-term pressure to raise interim financing,” he writes.

Adam Graf, managing director of Dahlman Rose & Co. in New York has a buy rating on Ivanhoe’s shares listed on the New York Stock Exchange with a 12-month target price of US$22.42 per share.

Toronto-based mining analyst Tom Meyer of Scotia Capital has lowered his 12-month target price on Ivanhoe’s Toronto-listed shares from $18 to $15. Meyer points out that total capex for Oyu Tolgoi is now estimated at US$13.2 billion, up from an earlier estimate in 2010 of US$9.6 billion, while operating expenses are estimated at a cash cost including by-product credits of US$0.81 per lb. of copper for the life of reserve, compared to a previous estimate of US$0.62 per lb. copper.

 “Our NAVPS estimate declines to $14.53 from $19.01 after updating project parameters and assuming SouthGobi is sold for $850 million,” Meyer writes. He also notes that Ivanhoe shares trade at a price to net asset value of 1.07 times versus the peer average of producing companies at 0.62 times.

At presstime in Toronto Ivanhoe was trading at $14.29 per share within a 52-week range of $12.85-27.82. In New York Ivanhoe was trading at US$14.41 per share within a 52-week range of US$12.11-28.97.

In Toronto SouthGobi shares were trading at $7.31 apiece within a 52-week range of $5.54-14.75.