Due Diligence Guidelines –
7. Financial: Cash Costs, Working Capital, Commodity Prices and Path to Profitability
7.1.1 A Mineral Company must, … if it has commenced production, [(1)] provide an estimate of cash operating costs … [and] … [(2)] disclose an estimate of the operating cash cost per appropriate unit for the Minerals and/or Petroleum produced. [Listing Rules 18.03(3), and 18.06]
7.1.2 Regarding the preparation of a listing document, a sponsor should perform, without limitation … assess the business performance, financial condition, development, prospects and any financial projection or profit forecast. [Paragraph 17.6(d)(vi) of the Code of Conduct]
7.2.1 For projects which are in production, the sponsor’s diligence should be based on the actual financial results of the project, and management estimates of costs should be cross-checked against underlying financial information.
7.2.2 Sponsors should also understand how costs may be apportioned between different processes. For example, if a mine produces a number of different products, the basis of cost allocation between these products should be understood and disclosed.
7.2.3 Where costs are based upon current production and (due to the mine plan or field development plan) it is expected that costs are likely to increase throughout the life of the project, this should be properly understood by sponsors and the likely cost increases should be disclosed. For example, this would be relevant where a mine begins production by mining relatively higher grade ore or where the stripping ratio (waste to ore) ratio increases over the course of the mine plan.
7.2.4 Regard should also be had to other costs which may increase over time or where additional costs may be incurred. Examples are given in FAQ 5 of the Exchange’s Frequently Asked Questions Series 12.
7.3 Recommended Steps
7.3.1 The sponsor should request management estimates of costs and discuss with management the basis of estimates and cost allocation and check the estimates against underlying financial information. The sponsor should also discuss the assumptions relied upon by management and reasonableness of the assumptions.
7.3.2 The sponsor should examine the presentation of costs data and ensure that it adequately explains which costs are included – for example, the impact of non-cash costs such as depreciation or depletion charges; and the impact of non-mine costs such as corporate expenses, royalties and costs involved in sales, logistics and marketing. Further, if a single project or process produces a number of different products, the basis of cost allocation between these products should be disclosed. Known price increases should also be accounted for.
7.3.3 The sponsor should review mine/field development plans and identify together with management areas of, and likelihood of, increased costs over time although the sponsor’s diligence steps cannot be expected to predict the extent of future cost increases or provide any assurance such increases will not occur.
7.3.4 The sponsor should also discuss with the Competent Person the cost estimates and the findings from the sponsor’s discussion with management.
If a Mineral Company has not yet begun production, it must disclose its plans to proceed to production with indicative dates and costs. [Listing Rule 18.07]
7.5.1 The Listing Rules do not prescribe the nature of development plans for pre-production projects as it is recognised that such plans may only be indicative by nature. However, its plans must be supported by a scoping study as these preliminary evaluations outline the parameters of a project and provide indicative estimates of capital and operating costs and would provide comfort to investors that the Mineral Company’s plan to proceed to production is supported by an independent opinion.15 This scoping study should not include inferred resources.
7.5.2 For pre-production projects, the Exchange may require disclosure of the estimated cost per unit (assuming production had commenced) in order for the Mineral Company to demonstrate a “path to commercial production”. This is particularly relevant for Mineral Companies applying for the waiver under Listing Rule 18.04, and Exchange Listing Decision LD74-2013 makes it clear that these plans must be plausible and credible.16
7.5.3 With regard to the prospective costs per unit for the project, the costs assumptions for projects yet to commence production are more difficult to determine by their very nature than those already in production. The data should be included as part of the Competent Person’s Report, but where the data is reproduced from management’s estimates or is merely a stated assumption to the technical economic model, this should be made clear in the disclosures.
7.6 Recommended Steps
7.6.1 With regard to the development and capital expenditure programme, the sponsor should discuss with the Mineral Company (and review feasibility studies) to determine the most likely timetable and costs of the programme having regard to the expertise of any third party who has assisted with the feasibility studies.
7.6.2 Where there is an identified Engineering, Procurement and Construction (“EPC”) contractor or other third party responsible for the development programme, such party should be interviewed and the capex schedule analysed, including an analysis of the risk of time or cost overruns or other material uncertainties.
7.6.3 The sponsor should request management estimates of costs, discuss with management the basis of estimates and cost allocation and check the estimates against underlying financial information, where available.
7.6.4 The sponsor should examine the presentation of costs data and ensure that it adequately explains the extent to which costs are presented – for example, the impact of depletion and depreciation charges, and non-mine costs such as corporate expenses, royalties and costs involved in sales, logistics and marketing.
7.6.5 The sponsor should discuss with the Competent Person and the Mineral Company what methodologies have been used to arrive at the cost estimates and whether the assumptions on which the disclosures are based appear to be consistent with the Mineral Company’s circumstances. Where the Mineral Company has comparable projects already in production or there is publicly available data from a neighbouring or comparable third party project, the sponsor should consider whether these are likely to provide useful points of reference.
7.6.6 The sponsor should also review and check any sensitivity analyses on the costs and discuss with the Competent Person and management the economic viability of the project(s) at various cost/price points.
7.6.7 The sponsor should also discuss with management the Mineral Company’s financing plans for the mine/project if not already obtained/available and consider the reasonableness and adequacy of such fund-raising plans.
7.6.8 Where there are outstanding permits or rights to be acquired by the Mineral Company, the sponsor should discuss with management steps taken so far and the likelihood of obtaining such outstanding permits or rights. The sponsor should also discuss with lawyers in relevant jurisdictions the process for obtaining such permits and rights and the Mineral Company’s compliance with such process and the further procedures and steps required.
A Mineral Company must … demonstrate to the Exchange’s satisfaction that it has available working capital for 125% of the group’s present requirements, that is for at least the next 12 months. [Listing Rule 18.03(4)]
7.8.1 Listing Rule 18.03(4) does not require capital expenditure to be included in working capital requirements but does require costs of proposed exploration and/or development to be included. FAQ 5A of the Exchange’s Frequently Asked Questions Series 12 draws a distinction between, on the one hand, costs of proposed exploration and/or development related to the Mineral Company’s daily operations (e.g., contracting fees for excavation and/or transportation costs) and, on the other hand, the capital expenditures associated with development of infrastructure and expansion of processing facilities. This might not necessarily be consistent with the accounting treatment of costs as being either capitalised or expensed. Accordingly, the sponsor should review a breakdown of expenditure to determine whether, consistent with the FAQ, the requirement for working capital of 125% of the Group’s requirements is met.
7.8.2 The sponsor should assume for the purposes of its working capital analysis that the project is developed on a timetable consistent with the development plan described in the listing document.
7.9 Recommended Steps
7.9.1 The sponsor should review financial information and working capital analysis and consider its sufficiency.
7.9.2 The sponsor should discuss with management the assumptions and basis for the working capital analysis and their reasonableness.
7.10 In addition, sponsors should note that the Exchange would expect the following financial information to be disclosed in the listing document:
(a) sensitivity analysis on changes in the price of Mineral or Petroleum Assets, contracting fees, utility expenses and transportation costs, where material, during the track record period and the forecast period;
(b) breakdown of production costs and total cash operating costs;
(c) the amounts of exploration expenses during the track record period and up to the latest practicable date, and how they were accounted for in the applicant’s financial statements; and
(d) the major assumptions adopted for the forecast operating costs.17
HKCFEF Limited and the contributing law firms, accountants and sponsors are not offering these due diligence guidelines as legal, financial or professional advice or services and they should not be relied upon as such. These due diligence guidelines should not be used as a sole basis for any decision, action or inaction and are not meant to serve as a substitute for the advice of qualified professionals. See here for the full terms and conditions.