Major Nickel Miner Down but Not Out

TORONTO ( -- Shares of LionOre Mining [TSX:LIM] have dropped to levels not seen since last autumn, following the release of disappointing second quarter results.

The Toronto-based nickel miner reported Q2 earnings of $0.10 per share (EPS) and cash flow of $0.29 per share (CFPS), well below analysts' consensus of $0.17 EPS and $0.32 CFPS. The company said that EPS does not include $0.05 in profit tied-up in inventory awaiting shipment. However, included in the earnings was a foreign exchange gain of roughly $0.06 per share.

Production was 5,968 tonnes at a cost of $3.67 per pound. Management reported that cash costs escalated in the second quarter due to lower-than-expected production.

The main drag on nickel production was the Black Swan operation in Australia where LIM switched to owner mining during the quarter after its mining contractor went bankrupt. Underground mining production was also hampered by continuing rehabilitation and development, according to Barry Allan and Shelton Yip at Research Capital in an August 15 report. As a result, a higher proportion of ore came from the lower-grade open pit.

LIM received an 80% stake in the open-cut Black Swan and underground Silver Swan mines, as well as an 80% interest in the Honeymoon Well project, following its purchase last December of Australian nickel producer MPI Mines Ltd. for A$285 million in cash and shares. In an August 15 report, Greg Barnes and Bonita To at Canaccord Capital wrote that they believe operations at the Swan mines will return to more normal levels by the fourth quarter at the earliest.

At LIM's Phoenix operation in Botswana, production was 1,913 tonnes at a cash cost of $4.45 per pound, compared to 2,918 tonnes at a cash cost of $2.34 per pound in the second quarter of last year. The company has an 85% interest in the Tati Nickel Mining Company, which is exploiting the Phoenix nickel deposit.

A Plethora of Projects

Overall, LIM plans to boost its nickel output to 80,000 metric tonnes a year by 2008 and has outlined an ambitious plan of expanding existing mines and opening new ones. Yet as Canaccord's Barnes and To wrote: "Sometimes it is enough to make our heads spin trying to stay on top of all of the different initiatives."

Management is considering expansion at Tati to five million tonnes per year and to increase throughput at the Black Swan operation to two million tonnes per year.

A feasibility study on the Honeymoon Well project is expected later this year or in early 2006. Annual nickel production is expected to be at a rate of 35,000 to 40,000 tonnes starting in 2008. Previous estimates have placed a price tag of $400 million on the project.

At Lake Johnston in Australia, where LIM has a 100% stake in the Emily Ann mine, management continues to study the potential for bulk underground mining at the Maggie Hayes deposit. This would include the expansion of the Lake Johnson mill to 1.5 million tonnes per year, up from the recently expanded annual rate of 500,000 tonnes per year. A decision on this project could come in the third quarter, though production would not start until 2007 at the earliest.

LIM believes that there is substantial resource upside at the Nkomati operation in South Africa, in which the company acquired a 50% interest in January through its investment in Nkomati Nickel. Management had originally expected that the resource was large enough to support a rate of 16,000 tonnes per year, but now believes the operation could support a 20% to 30% higher production rate.

Activox to Start at Avalon?

According to analysts, it now appears that the Avalon project will probably host its first commercial scale Activox plant. Avalon is the former Bulong nickel smelter/refinery that LIM bought for A$15 million and believes it can convert it to an Activox facility. Compared with smelting, the low-pressure oxidation Activox process promises significantly lower capital costs and similar power costs and metal recoveries. Capital costs for a 40,000 tonne per year nickel plant at Avalon are estimated at $220 to $250 million.

Canaccord's Barnes and To believe that the company's goal of having a commercial scale plant in operation by the end of 2006 is optimistic. The analysts also say that it remains to be decided whether Avalon will process third party concentrate or receives the bulk of its feed from the Honeymoon Well Project, and that it is not clear if decisions on the Avalon and Honeymoon Well projects are mutually exclusive. In a report dated June 15, Raymond Goldie at Salman Partners wrote that Avalon could have the potential to treat feedstock from all of LIM's operations in Western Australia.

Correlation to Nickel Prices

There's no question that LIM has the potential to significantly grow production, but the company will have to navigate numerous logistical and operational challenges to achieve its ambitious goals, especially in Western Australia where a tight construction market and a shortage of water and skilled labor are acute.

In a report dated February 2, 2005, Raymond Goldie of Salman Partners wrote that "the most appropriate way to project the company's future share price" was to treat them as a proxy on nickel prices. The analyst then wrote on June 15 that following BHP's takeover of WMC Resources, such nickel 'pure plays' are even scarcer, and that LIM could benefit as a result.

Spot nickel prices on the London Metal Exchange (LME) have tripled since the fall of 2001 and are currently trading around the $15,000 a tonne level. Since the end of 1999, shares of Inco [TSX:N] have had a higher correlation (R2 = 0.8074) to spot nickel prices than LIM shares (R2 = 0.5715).

This is partly because LIM shares have performed better, posting an annualized return of 29% from December 31, 1999 to July 31, 1999, compared to 10% for spot nickel on the LME and 7.5% for Inco.

Since January 3, 2003, Inco shares have had an even higher (R2 = 0.8402), and LIM shares a lower (R2 = 0.2848), correlation to spot nickel prices.

LIM has a lot on the go. The potential payoff in increased production is high, but there are a lot of operational hurdles (too many to affect management's focus on individual projects?) that could trip up the company along the way.

No doubt, LIM shares have had a great run, even including the recent downturn, but if one is only looking to replicate the performance of nickel in an equity investment, Inco's past performance indicates it could be a better bet. Of course, Inco will be hoping to better its performance with the development of Voisey's Bay and Goro.

As of July 31, LIM had a short position of 5,068,088 shares. Following the Q2 release, Barry Allan and Shelton Yip at Research Capital downgraded LIM from 'buy' to 'accumulate' with a C$7.76 target. Greg Barnes and Bonita To at Canaccord Capital downgraded the stock from 'buy' to 'hold' and lowered their target price from C$7.50 to C$7. Cliff Hale-Sanders at TD Newcrest also downgraded the stock from 'buy' to 'hold' and has a 12-month target of C$8.

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