The Noranda Income Fund (TSE: NIF.UN) set big expectations with impressive cash guidance and new contracts prior to 2019 Q2 earnings. Unfortunately, production challenges came from left field and led to downward-revised guidance.
These revisions have caused Noranda’s share price to fall 14% as of this writing. While there was an initial sell-off at the opening, the stock price appears to have leveled off around $2.25.
Bad News First
Based on earlier guidance, the Noranda Income Fund was not a 2019 Q2 story. However, worse than expected operational performance has dampened the fund’s overall outlook.
Management revised production guidance from an initial midpoint of 275,000 tonnes down to 260,000 tonnes, a reduction of approximately 5%. Cash flow forecasts saw a larger drop from an initial range of $55 to 17 million down to $37 to 4 million, or an approximate 40% midpoint reduction with the revision. The discrepancy between these two adjustments is discussed below.
As expected, Noranda’s revised guidance significantly alters the expected yields for the next twelve months. Specifically, assuming the stock price adjusts to represent a 12% yield and cash flows are distributed to shareholders, the base case (guidance midpoint) represents potential returns of 44% from the current stock price of $2.25. If the stock price changes meaningfully from this value, the potential returns will be different.
Challenges Ahead, But Things Not As Bad As Recent Quarter Suggests
During the earnings conference call, management stated the production reduction was caused by two primary challenges: impurity concentrations in the zinc concentrate leading to filtration capacity limitations and a one-time unplanned maintenance event.
The unplanned maintenance negatively impacted production volumes, driving up unit production costs and leading to an increase to $617 from $504 quarter over quarter. It also created unexpected capital costs for Noranda, as reflected by the substantial decrease in their cash flow guidance. Fortunately, management stated capital expenses are back on track for the rest of the year.
The higher unit production costs also stem from the loss of an electricity rebate. Management noted in the conference call that they only received one month of an energy rebate from the province of Quebec for Q2. While the language around why the rebate was lost for two months was unclear, they stated that they expect the rebate to return in July. This appears to be another one-time operational challenge that weighed on Noranda in the quarter.
Noranda also delayed the expected start of the benefits from their new treatment charge contract with Glencore Canada to the end of the year. This delay stems from a small reduction in concentrate throughput, 7% quarter over quarter, delaying inventory turnover.
They previously stated they will only realize these benefits once all inventory purchased prior to May 1st, 2019 is processed. This suggests the cash flow from their 12-month guidance will be back-loaded to the first half of 2020.
Our Take – Fundamentals Remain The Same
As of this writing, the stock is off on operational challenges. We believe the fundamentals are still there – Noranda still has the potential to provide a solid distribution over the next twelves months. If the price declines further, it could provide an excellent buying opportunity.
Even with the operational challenges, Noranda was able to pay down a portion of their ABL revolving facility while generating positive cash flow for the fund.
Guided capital expenditures remained the same at $30 to 35 million. In Q1, it was noted the guidance for CapEx was higher than in previous years. This suggests Noranda has already planned and accounted for the necessary upgrades to deal with the higher impurity levels in the zinc concentrate feed.
Currently, Noranda has received very favorable treatment charges with spot prices reaching as high as $270 per tonne in June of 2019 according to Wood Mackenzie. Analysts expect treatment charge pricing to remain favorable for zinc processing facilities for the remainder of 2019. This should help them minimize the damage from the production challenges.
Looking further out, the exact pricing environment is less clear. However, Noranda has the Glencore Canada contract to fall-back on for the first half of 2020. Beyond that, even a significant reduction in treatment charges for 2020 would leave Noranda significantly better off than 2018 prices of $90 per tonne.
In the end, we see the operational challenges reducing the total upside, but not changing the fundamentals of the company. This was always a Q4 story, but now positive returns appear to be pushed back into the first half of 2020.
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