SGQ.V · 2014-08-11

SouthGobi Resources announces second quarter 2014 financial and operating results

Management Changes Production Results Financials

August 11, 2014

SouthGobi Resources announces second quarter 2014 financial and operating results

HONG KONG - SouthGobi Resources Ltd. (TSX: SGQ, HK: 1878) (the "Company") today announced its financial and operating results for the three and six months ended June 30, 2014. All figures are in U.S. Dollars unless otherwise stated.

Significant Events and Highlights

The Company’s significant events and highlights for the three months ended June 30, 2014 and subsequent period to August 11, 2014 are as follows:

The Company continues to operate under difficult market conditions. Coal prices in China declined further in the second quarter compared to the first quarter of 2014 in response to excess seaborne and Chinese domestic supply. The decline in coal prices has been partially offset by the increase in the Company’s volumes in the second quarter compared to the seasonally slow first quarter.
Production decreased to 0.55 million tonnes of raw coal in the second quarter of 2014 compared to production of 0.64 million tonnes of raw coal in the first quarter of 2014. This decrease in production is due to the Company’s decision in June in response to current market conditions to reduce its production and place approximately half of its workforce in furlough. This furlough is anticipated to remain in place until the end of August subject to market conditions.
On May 25, 2014, the Company announced it obtained a $10 million revolving credit facility from Turquoise Hill Resources Ltd. (“Turquoise Hill”) to meet its short term working capital requirements with a maturity date of August 30, 2014. At June 30, 2014 the Company had drawn down $3.8 million under this facility.
The Company completed the sale of Tsagaan Tolgoi mining license in the second quarter of 2014. The net proceeds generated for the Company after taxes and disposal costs was $1.3 million and was received in April 2014.
The trial date for the tax investigation case against the Company’s Mongolian subsidiary SouthGobi Sands LLC and three of its former employees as detailed in the Company’s announcement of June 24, 2014 has been deferred until August 25, 2014.
On June 19, 2014, the Takeovers and Mergers Panel of Hong Kong’s Securities and Futures Commission determined that the Company should be considered a public company in Hong Kong for the purposes of the Codes on Takeovers and Mergers and Share Purchases in Hong Kong (the “Takeovers Code”). The Takeovers Code now applies to the Company.
On July 30, 2014 the Company announced Turquoise Hill entered into an agreement with National United Resources (“NUR”) to sell shares representing 29.95% of the Company’s total common shares.

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The closing of this transaction is subject to certain conditions, including the approval of both the Hong Kong Stock Exchange (“HKEX”) as well as NUR’s shareholders. Turquoise Hill expects the closing to occur no later than November 30, 2014.

The Company announces Mr. Brett Salt, Chief Commercial Officer, has resigned with an effective date of October 1, 2014. Mr. Salt has accepted a new role with another company. The Company will announce its new sales and marketing structure in due course.

OVERVIEW OF OPERATIONAL DATA AND FINANCIAL RESULTS

Overview of Operational Data

Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Sales Volumes, Prices and Costs

Premium semi-soft coking coal Coal sales (millions of tonnes) - 0.21 - 0.29 Average realized selling price (per tonne) ⁽ⁱ⁾ $

$ 32.46 $
- $ 35.82

Standard semi-soft coking coal Coal sales (millions of tonnes) 0.12 - 0.41 - Average realized selling price (per tonne) ⁽ⁱ⁾ $ 20.33 $

$ 21.52 $ -

Thermal coal Coal sales (millions of tonnes) 0.51 0.11 0.61 0.31 Average realized selling price (per tonne) ⁽ⁱ⁾ $ 10.72 $ 13.98 $ 10.94 $ 13.78 Total

Coal sales(millions of tonnes)	0.63	0.32	1.02	0.60
Average realized selling price(per tonne) (i)	$12.52	$26.26	$15.22	$24.70
Raw coal production (millions of tonnes)	0.55	0.17	1.19	0.19

Direct cash costs of product sold (per tonne) ⁽ⁱⁱ⁾ $ 8.23 $ 11.49 $ 9.08 $ 10.90 Mine administration cash costs of product sold (per tonne) ⁽ⁱⁱ⁾ $ 2.49 $ 7.14 $ 3.00 $ 4.53 Total cash costs of product sold (per tonne) ⁽ⁱⁱ⁾ $ 10.72 $ 18.63 $ 12.08 $ 15.43

Other Operational Data

Production waste material moved (millions of bank 2.17 2.71 4.72 3.10 cubic meters)

Strip ratio (bank cubic meters of waste material per tonne of 3.97 15.55 4.00 16.40 coal produced)

Lost time injury frequency rate (iii) 0.15 - 0.15 -

(i) Average realized selling price excludes royalties and selling fees.

(ii) A non-IFRS financial measure, refer to “Non-IFRS Financial Measures” section. Cash costs of product sold exclude idled mine asset cash costs.

(iii) Per 200,000 man hours and calculated based on a rolling 12 month average.

Summary of Operational Data

The Company continues to operate under difficult market conditions which have affected the Company’s results for the second quarter in respect of sales prices, mix and volumes.

During the second quarter of 2014, the Company shipped 0.91 million tonnes of coal. Revenue was recognized in respect of 0.63 million tonnes with the remaining 0.28 million tonnes expected to meet all revenue recognition requirements in the second half of 2014.

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In light of the current market, the Company continued to pace its production with current demand. As a result, the Company operated significantly below its operating capacity in the second quarter of 2014. In June 2014 following a review of operations, the Company further reduced its production and placed approximately half of its workforce in furlough.

The production in the second quarter of 2014 was higher than the second quarter of 2013 as the Company primarily moved waste material (overburden) and exposed coal in pit in preparation for sales anticipated in subsequent quarters of 2013.

On June 26, 2014, the Ovoot Tolgoi mine site region experienced torrential rain and flooding which temporarily interrupted mining operations. The region was subject to further rainfall in July. The impact on the Company’s operations is not expected to be material.

The Company continues to maintain a strong safety record. It recorded one lost time injury on April 8, 2014 and has at June 30, 2014 a lost injury time frequency rate of 0.15 per 200,000 man hours based on a rolling 12 month average.

Summary of Financial Results

Three months ended Six months ended June 30, June 30,

$ in thousands, except per share information 2014 2013 2014 2013 Revenue (i),(ii) $ 6,691 $ 6,129 $ 11,828 $ 10,527

Cost of sales(ii)	(20,086)	(17,477)	(38,452)	(38,783)
Gross loss excluding idled mine asset costs	(8,497)	(5,593)	(18,699)	(6,087)
Gross loss including idled mine asset costs	(13,395)	(11,348)	(26,624)	(28,256)
Other operating expenses	(1,776)	(14,925)	(2,849)	(15,356)
Administration expenses	(2,253)	(4,024)	(4,490)	(7,757)
Evaluation and exploration expenses	(107)	(221)	(279)	(494)
Loss from operations	(17,531)	(30,518)	(34,242)	(51,862)
Finance costs	(5,215)	(5,617)	(10,240)	(10,608)
Finance income	127	3,366	1,134	4,136
Share of earnings/(losses) of joint venture	(3)	44	(29)	27
Income tax (expense)/recovery	(546)	(416)	(546)	1,500
Net loss	(23,168)	(33,141)	(43,923)	(56,807)

Basic loss per share $ (0.12) $ (0.18) $ (0.23) $ (0.31) Diluted loss per share $ (0.12) $ (0.18) $ (0.23) $ (0.31)

(i) Revenue is presented net of royalties and selling fees.

(ii) Revenue and cost of sales relate to the Company’s Ovoot Tolgoi Mine within the Mongolian Coal Division operating segment. Refer to note 4 of the condensed consolidated interim financial statements for further analysis regarding the Company’s reportable operating segments.

Royalty regime in Mongolia

During a trial period from October 1, 2012 to March 31, 2013, the royalty imposed on coal sales was determined using the actual contracted sales price per tonne. The Government of Mongolia changed the royalty regime effective April 1, 2013. From April 1, 2013 to March 31, 2014, the royalty on all coal sales exported out of Mongolia was based on a set reference price per tonne published monthly by the Government of Mongolia. As a result, in the second quarter of 2013, the Company was subject to an average 7% royalty based on a weighted average reference price of $70.83 per tonne while the Company’s average realized selling price was $26.26 per tonne.

The Government of Mongolia changed the royalty regime effective April 1, 2014. Under the new “flexible tariff” royalty regime, the royalty per tonne for export coal sales will be calculated based on the actual contracted sales price per tonne, whereby the contracted sales price includes the costs of transporting the coal to the Mongolia-China border. If transportation costs are not included in the contracted sales price

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between a buyer and seller, the following costs are required to be included in the contracted sales price for purposes of calculating the royalty per tonne: transportation costs and costs associated with transportation such as customs documentation fees, insurance, loading and unloading costs. In the event the actual contracted sales price calculated as described above differs by more than 10% from the contracted sales price of coal products with the same classification and quality being exported by other legal entities in Mongolia through the same border crossing, the calculated contracted sales price shall be deemed nonmarket under Mongolian tax law and the royalty per tonne will be calculated based on a reference price that will be determined by the Government of Mongolia.

The Company currently sells coal from the Ovoot Tolgoi Mine ex mine gate and the coal is exported through the Shivee Khuren Border Crossing. The Company’s average realized selling price excludes transportation costs.

On July 4, 2014, the Government of Mongolia made further amendment to the royalty regime. From July 4, 2014 onwards the royalty is to be initially calculated and paid monthly based on the Government reference price. On a quarterly basis the royalty amount would be adjusted to reflect the contracted sales price and additional documentation would have to be submitted to the Mongolian Tax Authority. Once the quarterly statement has been approved by the Mongolian Tax Authority, any adjustments between the monthly payments for the quarter and the quarterly submission are adjusted in the next months’ royalty calculation.

Overview of Financial Results

The Company recorded a $17.5 million loss from operations in the second quarter of 2014 compared to a $30.5 million loss from operations in the second quarter of 2013. The second quarter of 2014 was impacted by continuing difficult market conditions which resulted in lower sales prices compared to the second quarter of 2013. This reduction in prices was offset by higher sales volumes, lower royalty expenses, lower idled mine asset costs and lower impairment losses in the second quarter of 2014 compared to the second quarter of 2013.

Revenue was $6.7 million in the second quarter of 2014 compared to $6.1 million in the second quarter of 2013. The Company sold 0.63 million tonnes of coal at an average realized selling price of $12.52 per tonne in the second quarter of 2014 compared to sales of 0.32 million tonnes at an average realized selling price of $26.26 per tonne in the second quarter of 2013. Revenue increased in the second quarter of 2014 compared to the second quarter of 2013 primarily due to higher sales volumes. The average realized selling price was impacted by the product mix in the second quarter of 2014. The product mix in the second quarter of 2014 primarily consisted of thermal coal with limited Standard semi-soft coking coal compared to a mix of Premium semi-soft coking coal and thermal coal in the second quarter of 2013.

The Company’s revenue is presented net of royalties and selling fees. Following the change in the Mongolia’s royalty regime starting April 1, 2014, the Company’s effective royalty rate for the second quarter of 2014, based on the Company’s average realized selling price of $12.52 per tonne, was 8.1% or $1.00 per tonne. In the second quarter of 2013, the Company was subject to an average 7% royalty based on a weighted average reference price of $70.83 per tonne. As a result, the Company’s effective royalty rate was 18.4% or $4.82 per tonne based on the average realized selling price of $26.26 per tonne in the second quarter of 2013.

Cost of sales was $20.1 million in the second quarter of 2014 compared to $17.5 million in the second quarter of 2013. Cost of sales comprises operating expenses, share-based compensation expense, equipment depreciation, depletion of mineral properties, coal stockpile inventory impairments and idled mine asset costs. Operating expenses in cost of sales reflect the total cash costs of product sold (a non- IFRS financial measure, see “Non-IFRS Financial Measures” section) during the period.

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Three months ended Six months ended June 30, June 30,

$ in thousands 2014 2013 2014 2013

Operating expenses Share-based compensation expense Depreciation and depletion Impairment of coal stockpile inventories	$ 6,754 127 2,061 6,246	$ 5,988 (153) 2,037 3,850
Cost of sales from mine operations Cost of sales related to idled mine assets	15,188 4,898	11,722 5,755
Cost of sales	$ 2 0,086	$ 1 7,477

$ 1 2,317 143 4,540 13,527	$ 9,209 (153) 2,587 4,971
30,527 7,925	16,614 22,169
$ 3 8,452	$ 3 8,783

Operating expenses in cost of sales were $6.8 million in the second quarter of 2014 compared to $6.0 million in the second quarter of 2013. Total cash costs of product sold were $10.72 per tonne in the second quarter of 2014 compared to $18.63 per tonne in the second quarter of 2013. The decrease in total cash costs per tonne sold primarily relates to an increase in tonnage sold as the Company focused on pit preparation in the second quarter of 2013.

Cost of sales in the second quarter of 2014 and the second quarter of 2013 included coal stockpile impairments of $6.2 million and $3.9 million, respectively, to reduce the carrying value of the Company’s coal stockpiles to their net realizable value. The coal stockpile impairments recorded in both 2014 and 2013 reflect the challenging coal market conditions and primarily related to the Company’s higher-ash products.

Cost of sales related to idled mine asset costs primarily consisted of period costs, which were expensed as incurred and primarily included depreciation expense. Cost of sales related to idled mine assets in the second quarter of 2014 included $4.9 million related to depreciation expenses for idled equipment (2013: $5.8 million). Idled mine asset costs decreased in the second quarter of 2014 compared to the second quarter of 2013 as a result of the recommencement of mining operations at the Ovoot Tolgoi Mine on March 22, 2013. However, the second quarter 2014 production plan did not fully utilize the Company’s existing mining fleet, therefore, idled mine asset costs continued to be incurred throughout the second quarter of 2014.

Other operating expenses were $1.8 million in the second quarter of 2014 compared to $14.9 million in the second quarter of 2013.

The Company’s investment in Aspire is accounted for as an available-for-sale financial asset and carried at its fair value. In the second quarter of 2014, Aspire’s market capitalization increased with the gain for the Company being recorded in other comprehensive income. This compares to an impairment loss of $3.1 million recognized in other operating expenses in the second quarter of 2013 as a result of a decrease in Aspire’s market capitalization during that period.

The Company recognized an impairment loss of $3.4 million in the second quarter of 2014 related to prepaid toll washing fees under the contract with Ejinaqi Jinda Coal Industry Co. Ltd. (“Ejin Jinda”). The impairment charge is a result of the continued delay in starting the commercial operations at the wet washing facility and the continued soft coal market in China. In the second quarter of 2014 the Company recognized an

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impairment charge of $0.3 million in respect of surplus construction materials. In the second quarter of 2013, the Company recognized a total of $11.2 million in impairment in respect of material and supplies ($6.9 million) and property, plant and equipment ($4.3 million).

In the second quarter of 2014 the Company completed the sale of the Tsagaan Tolgoi mining license. The gross proceeds of the sale were $2.0 million, indirect taxes and costs totaled $0.2 million and a withholding tax totaling $0.5 million was incurred. The net proceeds generated for the Company after taxes and costs were $1.3 million.

Administration expenses were $2.3 million in the second quarter of 2014 compared to $4.0 million in the second quarter of 2013.

Administration expenses were lower in the second quarter of 2014 compared to the second quarter of 2013 primarily due to lower professional fees. Professional fees in the second quarter of 2013 included $1.6 million of fees related to the internal investigations led by a tripartite committee referred to section “Regulatory Issues and Contingences”. The tripartite committee substantially completed the investigative phase of its activities during 2013, therefore additional professional fees were not incurred in the second quarter of 2014.

Corporate administration costs were also lower in the second quarter of 2014 compared to the second quarter of 2013 as a result of the Company’s cost-cutting initiatives.

Evaluation and exploration expenses were $0.1 million in the second quarter of 2014 compared to $0.2 million in the second quarter of 2013. The Company continued to minimize evaluation and exploration expenditures in the second quarter of 2014 in order to preserve the Company’s financial resources. Evaluation and exploration activities and expenditures in the second quarter of 2014 were limited to ensuring that the Company met the Mongolian Minerals Law requirements in respect of its mining and exploration licenses.

Finance costs were $5.2 million and $5.6 million in the second quarter of 2014 and 2013 which primarily consisted of interest expense on the $250.0 million CIC convertible debenture.

Finance income was $0.1 million in the second quarter of 2014 compared to $3.4 million in the second quarter of 2013 primarily consisting of unrealized gains on the fair value change of the embedded derivatives in the CIC convertible debenture ($0.1 million and $3.3 million respectively for the second quarter of 2014 and second quarter of 2013). The fair value of the embedded derivatives in the CIC convertible debenture is driven by many factors including: the Company’s common share price, U.S. Dollar and Canadian Dollar exchange rates and share price volatility.

Income tax expense was $0.5 million in the second quarter of 2014 compared to an expense of $0.4 million in the second quarter of 2013. The $0.5 million recognized in the second quarter of 2014 relates to taxes paid in respect of the sale of the Tsagaan Tolgoi mining license.

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Summary of Quarterly Operational Data

	2014		2013				2012
Quarter Ended	30-Jun	31-Mar	31-Dec	30-Sep	30-Jun	31-Mar	31-Dec	30-Sep
Sales Volumes, Prices and Costs Premium semi-soft coking coal Coal sales (millions of tonnes) Average realized selling price (per tonne) (i) Standard semi-soft coking coal Coal sales (millions of tonnes) Average realized selling price (per tonne) (i) Thermal coal Coal sales (millions of tonnes) Average realized selling price (per tonne) (i) Total Coal sales (millions of tonnes) Average realized selling price (per tonne) (i) Raw coal production (millions of tonnes) Direct cash costs of product sold (per tonne) (ii) Mine administration cash costs of product sold (per tonne) (ii) Total cash costs of product sold (per tonne) (ii) Other Operational Data Production waste material moved (millions of bank cubic meters) Strip ratio (bank cubic meters of waste material per tonne of coal produced) Lost time injury frequency rate (iii)	- $ - 0.12 $ 20.33 0.51 $ 10.72 0.63 $ 12.52 0.55 $ 8 .23 $ 2 .49 $ 10.72 2.17 3.97 0.15	- $ - 0.29 $ 22.00 0.10 $ 12.07 0.39 $ 19.54 0.64 $ 10.43 $ 3 .80 $ 14.23 2.55 4.02 -	0.21 $ 37.54 1.40 $ 24.49 0.11 $ 12.60 1.72 $ 25.30 1.73 $ 11.13 $ 1 .39 $ 12.52 3.77 2.18 -	0.04 $ 37.50 0.87 $ 21.67 0.03 $ 13.07 0.94 $ 22.05 1.13 $ 9 .41 $ 2 .20 $ 11.61 1.57 1.39 -	0.21 $ 32.46 - $ - 0.11 $ 13.98 0.32 $ 26.26 0.17 $ 11.49 $ 7 .14 $ 18.63 2.71 15.55 -	0.08 $ 45.81 - $ - 0.20 $ 13.67 0.28 $ 22.75 0.02 $ 10.22 $ 1 .46 $ 11.68 0.40 26.21 -	0.03 $ 47.86 - $ - - $ - 0.03 $ 47.86 - $ 11.67 $ 5 .08 $ 16.75 - - 0.1	- $ - 0.01 $ 49.91 0.31 $ 15.87 0.32 $ 16.98 - $ 9 .56 $ 3 .75 $ 13.31 - - 0.2

(i) Average realized selling price excludes royalties and selling fees.

(ii) A non-IFRS financial measure, refer to “Non-IFRS Financial Measures” section. Cash costs of product sold exclude idled mine asset cash costs.

(iii) Per 200,000 man hours and calculated based on a rolling 12 month average.

Summary of Quarterly Financial Results

$ in thousands, except per share information	2014		2013				2012
Quarter Ended	30-Jun	31-Mar	31-Dec	30-Sep	30-Jun	31-Mar	31-Dec	30-Sep
Financial Results Revenue (i), (ii) Cost of sales (ii) Gross profit/(loss) excluding idled mine asset costs Gross profit/(loss) including idled mine asset costs Other operating expenses Administration expenses Evaluation and exploration expenses Loss from operations Finance costs Finance income Share of earnings/(losses) of joint venture Income tax recovery/(expense) Net loss Basic loss per share Diluted loss per share	$ 6,691 (20,086) (8,497) (13,395) (1,776) (2,253) (107) (17,531) (5,215) 127 (3) (546) (23,168) $ ( 0.12) $ ( 0.12)	$ 5,137 (18,366) (10,202) (13,229) (1,073) (2,237) (172) (16,711) (5,025) 1,007 (26) - (20,755) $ ( 0.11) $ ( 0.11)	$ 32,457 (40,359) (4,141) (7,900) (109,682) (3,668) (489) (121,740) (5,167) 1,301 (15) (13,109) (138,730) $ ( 0.75) $ ( 0.75)	$ 15,652 (33,486) (13,323) (17,834) (1,003) (4,204) (186) (23,227) (5,382) 124 (66) (13,377) (41,928) $ ( 0.23) $ ( 0.23)	$ 6,129 (17,477) (5,593) (11,348) (14,925) (4,024) (221) (30,518) (5,617) 3,366 44 (416) (33,141) $ ( 0.18) $ ( 0.18)	$ 4,398 (21,305) (494) (16,907) (431) (3,733) (273) (21,344) (4,996) 775 (17) 1,916 (23,666) $ ( 0.13) $ ( 0.13)	$ 1,186 (32,229) (12,601) (31,043) (19,282) (6,080) (508) (56,913) (4,718) (116) 144 5,040 (56,564) $ ( 0.31) $ ( 0.31)	$ 3,804 (31,454) (8,719) (27,650) (18,315) (5,178) (958) (52,101) (5,164) 12,947 288 (2,383) (46,413) $ ( 0.26) $ ( 0.26)

(i) Revenue is presented net of royalties and selling fees.

(ii) Revenue and cost of sales relate to the Company’s Ovoot Tolgoi Mine within the Mongolian Coal Division operating segment. Refer to note 4 of the Company’s condensed consolidated interim financial statements for further analysis regarding the Company’s reportable operating segments.

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FINANCIAL POSITION AND LIQUIDITY

Liquidity and Capital Resources

The Company has in place a planning, budgeting and forecasting process to help determine the funds required to support the Company’s normal operations on an ongoing basis and its expansionary plans.

On May 25, 2014, the Company announced it had obtained a $10 million revolving credit facility from Turquoise Hill to meet its short term working capital requirements (the “Turquoise Hill Loan Facility”). The terms and conditions of this facility were filed on SEDAR (www.sedar.com) on June 2, 2014. The key commercial terms of the facility are as follows:

maturity date of August 30, 2014;
interest rate of one month US dollar LIBOR Rate in effect plus 11% margin per annum;
commitment fee of 35% of interest rate payable quarterly in arrears on undrawn principal amount of facility;
front end fee of $0.1 million;
draws subject to customary closing conditions and the Company’s cash requirements in the ordinary course of business;
facility is subject to certain mandatory prepayment and termination provisions; and
the Company to continue to seek other funding alternatives.

As at June 30, 2014 the Company had drawn down $3.8 million under this facility. Notwithstanding the provision of the $10 million shareholder loan facility, the Company continues to experience negative impacts on its margins and liquidity and there can be no assurance that the Company will have sufficient funding for the balance of 2014 to be able to continue as a going concern.

The Company anticipates that coal prices in China will remain under pressure through the end of 2014, which will continue to impact the Company’s margins and liquidity. Therefore the Company is actively seeking additional sources of financing to continue operating and meet its objectives, while continuing to be focused on minimizing uncommitted capital expenditures while preserving the Company’s growth options. The Company is in discussions with various parties regarding potential funding solutions; however, there is no guarantee that an agreement will be reached. As of the date hereof, the Company expects to be able to secure such funding in order to pay the interest due under the CIC convertible debenture on November 19, 2014. If it does not do so, or if it fails to secure additional capital or otherwise restructure or refinance its business in order to address its cash requirements through June 30, 2015, then the Company is unlikely to have sufficient capital resources or cash flows from mining operations in order to satisfy its ongoing obligations and future contractual commitments, including cash interest payments due on the CIC convertible debenture. As a result, the Company may not be able to continue as a going concern. Refer to section 11 “Risk Factors” of the Company’s MD&A for the six months ended June 30, 2014 which is available at www.sedar.com for further analysis. Therefore, the Company is actively seeking additional sources of financing to continue operating and meet its objectives.

Several adverse conditions and material uncertainties cast significant doubt upon the going concern assumption. The Company had cash of $8.8 million and working capital (excess current assets over current liabilities) of $16.7 million at June 30, 2014. The Company’s consolidated financial statements have been prepared on a going concern basis which assumes that the Company will continue operating until at least June 30, 2015 and will be able to realize its assets and discharge its liabilities in the normal course of operations as they come due; however, in order to continue as a going concern, the Company must generate sufficient operating cash flows, secure additional capital or otherwise pursue a strategic restructuring, refinancing or other transaction to provide it with additional liquidity. If the Company fails to generate sufficient operating cash flows, secure additional capital or otherwise restructure or refinance its business in order to pay the interest due under the CIC convertible debenture on November 19, 2014, or if it fails to generate sufficient operating cash flows, secure additional capital or otherwise restructure or refinance its business in order to address its cash requirements through June 30, 2015, it will not have adequate liquidity to fund its operations and meet its obligations (including its debt payment obligations), it

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may not be able to continue as a going concern. If for any reason, the Company is unable to secure the additional sources of financing and continue as a going concern, then this could result in adjustments to the amounts and classifications of assets and liabilities in the Company’s consolidated financial statements and such adjustments could be material.

While the Company intends to secure additional sources of financing as soon as possible, a continued delay in securing additional financing could ultimately result in an event of default under the $250.0 million CIC convertible debenture which, if not cured within applicable cure periods in accordance with the terms of such debenture, may result in the principal amount owing and all accrued and unpaid interest becoming immediately due and payable upon notice to the Company by CIC.

Factors that impact the Company’s liquidity are being closely monitored and include, but are not limited to, Chinese economic growth, market prices of coal, production levels, operating cash costs, capital costs, exchange rates of currencies of countries where the Company operates and exploration and discretionary expenditures.

Cash Position and Liquidity

As at June 30, 2014, the Company had cash of $8.8 million compared to cash of $21.8 million as at December 31, 2013. Working capital (excess current assets over current liabilities) was $16.7 million as at June 30, 2014 compared to $41.7 million as at December 31, 2013. As at August 11, 2014, the Company had cash of $6.2 million and there have been no further amounts drawn down under the Turquoise Hills Loan Facility since June 30, 2014.

As at June 30, 2014, the Company’s gearing ratio was 0.20 (December 31, 2013: 0.19), which was calculated based on the Company’s long term liabilities to total assets. As at June 30, 2014, the Company is not subject to any externally imposed capital requirements.

Mongolian IAAC Investigation

In the first quarter of 2013, the Company was subject to orders imposed by Mongolia’s Independent Authority against Corruption (the “IAAC”) which placed restrictions on certain of the Company’s Mongolian assets. The orders were imposed on the Company in connection with the IAAC’s investigation of the Company. The Mongolian State Investigation Office (the “SIA”) also continues to enforce the orders on the Company.

The orders placing restrictions on certain of the Company’s Mongolian assets could ultimately result in an event of default of the Company’s CIC convertible debenture. Following a review by the Company and its advisers, it is the Company's view that this does not result in an event of default as defined under the CIC convertible debenture terms. However, if an event of default of the CIC convertible debenture occurs that remains uncured for ten business days, the principal amount owing and all accrued and unpaid interest will become immediately due and payable upon notice to the Company by CIC.

The orders relate to certain items of operating equipment and infrastructure and the Company’s Mongolian bank accounts. The orders related to the operating equipment and infrastructure restricts the sale of these items; however, the orders do not restrict the use of these items in the Company’s mining activities. The orders related to the Company’s Mongolian bank accounts restrict the use of in-country funds. While the orders restrict the use of in-country funds pending outcome of the investigation, they are not expected to have any material impact on the Company’s activities.

Ovoot Tolgoi Mine Impairment Analysis

Unchanged from the assessment made as at December 31, 2013, and March 31, 2014 respectively, the Company determined that an indicator of impairment existed for its Ovoot Tolgoi Mine cash generating unit as at June 30, 2014. The impairment indicator was the continued weakness in the Company’s share price

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during the second quarter of 2014 and the fact that the market capitalization of the Company, as at June 30, 2014, was less than the carrying value of its net assets.

Therefore, the Company conducted an impairment test whereby the carrying value of the Company’s Ovoot Tolgoi Mine cash generating unit was compared to its “value in use” using a discounted future cash flow valuation model. The Company’s Ovoot Tolgoi Mine cash generating unit carrying value was $397.2 million as at June 30, 2014.

Key estimates and assumptions incorporated in the valuation model included the following:

long term real selling price of $104 per tonne for semi-soft coking coal FOB Australia;
life-of-mine coal production and operating costs; and
a pre-tax discount rate of 14.9% based on an analysis of market, country and company specific factors.

Key sensitivities in the valuation model are as follows:

for each 1% increase/(decrease) in the long term real selling price of semi-soft coking coal FOB Australia, the calculated value of the cash generating unit increases/(decreases) by approximately $24.1/($24.1) million; and
for each 1% increase/ (decrease) in the pre-tax discount rate, the calculated value of the cash generating unit (decreases)/increases by approximately ($22.1)/$23.9 million.

The impairment analysis did not result in the identification of an impairment loss and no charge was required as at June 30, 2014. A decline of more than 2% in the long term real selling price of semi soft coking coal or an increase of more than 2% in the pre-tax discount rate may trigger an impairment charge on the cash generating unit. The Company believes that the estimates and assumptions incorporated in the impairment analysis are reasonable; however, the estimates and assumptions are subject to significant uncertainties and judgments.

REGULATORY ISSUES AND CONTINGENCIES

Regulatory Issues

Governmental and Regulatory Investigations

The Company is subject to investigations by the IAAC and the SIA regarding allegations against the Company and some of its former employees. The IAAC investigation concerns possible breaches of Mongolia’s anti-corruption laws, while the SIA investigation concerns possible breaches of Mongolia’s money laundering and taxation laws.

While the IAAC investigation into allegations of possible breaches of Mongolian anti-corruption laws has been suspended, the Company has not received formal notice that the IAAC investigation is completed. The IAAC has not formally accused any current or former Company employees of breach of Mongolia’s anti-corruption laws.

A report issued by the experts appointed by the SIA on June 30, 2013 and again in January 2014 has recommended that the accusations of money laundering as alleged against the Company’s three former employees be withdrawn. However, to date, the Company has not received notice or legal document confirming such withdrawal as recommended by the experts appointed by the SIA.

A third investigation ordered by the SIA and conducted by the National Forensic Center (“NFC”) into alleged violations of Mongolian taxation law was concluded at the end of January 2014. The report with conclusions of the investigations by the NFC has been provided to the Prosecutor General of Mongolia. The Prosecutor General has issued criminal charges against the three former employees and the Company’s Mongolian

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subsidiary SouthGobi Sands LLC may be held liable as “civil defendant” for alleged violations of Mongolian taxation law. The case was transferred to a Court of Justice for review by a judge in April 2014. On May 12, 2014, the Company was advised that the appointed judge has concluded that the investigation on the case was incomplete and has ordered to return the case to the General Prosecutor for additional investigation. As announced by the Company on June 24, 2014, the Company has been informed that the additional investigation has been completed and the case was transferred back to the First Instance Second District Court which set the trial date to June 30, 2014. Following the initial appearances before the court by all concerned parties, the trial date for the case has been deferred until August 25, 2014.

The likelihood or consequences of an outcome or any action taken against SouthGobi Sands LLC as “civil defendant” are uncertain and unclear at this time but could include financial or other penalties, which could be material, and which could have a material adverse effect on the Company.

The Company, including its Mongolian subsidiary SouthGobi Sands LLC, has prepared its financial statements in compliance with IFRS, and lodged all its tax returns in the required format under Mongolian tax law. During the investigative period, which has been ongoing since May 2012, the Company devoted considerable internal resources in reviewing and responding to the allegations raised through the investigations by the relevant authorities. The Company views these accusations as unfounded. It disputes these accusations and the procedures and conclusions of the investigations that led to these accusations and will vigorously defend itself and its former three (3) employees against these charges.

At this point, the three former employees continue to be subject to a travel ban. SouthGobi Sands LLC is designated as a “civil defendant” in connection with the tax evasion allegations, and may potentially be held financially liable for the alleged criminal misconduct of its former employees under Mongolian Law.

The SIA also continues to enforce administrative restrictions, which were initially imposed by the IAAC investigation, on certain of the Company’s Mongolian assets, including $1.5 million held in local bank accounts, in connection with its continuing investigation of these allegations. This $1.5 million is included within the cash balance in the Company’s financial statements. While the orders restrict the use of incountry funds pending the outcome of the investigation, they are not expected to have a material impact on the Company’s activities in the short term, although they could create potential difficulties for the Company in the medium to long term. The Company will continue to take all appropriate steps to protect its ability to conduct its business activities in the ordinary course.

Internal Investigations

Through its Audit Committee (comprised solely of independent directors), the Company has conducted an internal investigation into possible breaches of law, internal corporate policies and codes of conduct arising from the allegations which have been raised through the investigations in Mongolia. The Chair of the Audit Committee has also participated in a tripartite committee, comprised of the Audit Committee Chairs of the Company and Turquoise Hill and a representative of Rio Tinto, which focused on the investigation of a number of those allegations, including possible violations of anti-corruption laws. The tripartite committee substantially completed the investigative phase of its activities during the third quarter of 2013. There have been no significant developments in respect of the internal investigations since the completion of the investigative phase during the third quarter of 2013.

The investigations referred to above could result in one or more Mongolian, Canadian, United States or other governmental or regulatory agencies taking civil or criminal action against the Company, its affiliates or its current or former employees. The likelihood or consequences of such an outcome are unclear at this time but could include financial or other penalties, which could be material, and which could have a material adverse effect on the Company. Refer to the Company’s MD&A for the year ended December 31, 2013, which is available at www.sedar.com, section 14 “Risk Factors”, “the Company is subject to continuing governmental, regulatory and internal investigations, the outcome of which is unclear at this time but could have a material adverse effect on the Company”.

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Mining Prohibition in Specified Areas Law

Pursuant to the Mining Prohibition in Specified Areas Law, the Government of Mongolia has defined the boundaries of certain areas in which exploration and mining is purportedly prohibited. A list of licenses has been prepared that overlap with the prohibited areas described in the law based on information submitted by water authority agencies, forest authority agencies and local authorities for submission to the Government of Mongolia.

Portions of the Company’s Ovoot Tolgoi mining license and exploration licenses pertaining to the Zag Suuj Deposit and the South Biluut and Jargalant Fields within the Soumber Deposit are included on the list of licenses published by the Government of Mongolia, potentially affecting the status of those licenses under the Mining Prohibition in Specified Areas Law.

In regard to the Ovoot Tolgoi mining license, the potential area which may be affected is a relatively small area which represents approximately 3% of the entire area of the mining license and does not contain any of the Company’s NI 43-101 reserves or resources or immovable assets. Accordingly, the loss of the potentially affected area would not materially and adversely affect the existing operations.

Activities historically carried out on the other licenses referred to above include drilling, trenching and geological reconnaissance. The Company has no immovable assets located in any of the potentially affected areas of these licenses and the loss of any or all of these potentially affected properties would not materially and adversely affect the existing operations.

The Company understands that the status of the Mining Prohibition in Specified Areas Law is unclear and it has not been enforced to date. Reports from Mongolia suggest that the law may be amended. The Company will continue to monitor developments and will ensure that it is fully compliant with Mongolian law.

Other Corporate Information

Prior to the listing of the securities of the Company on the HKEX in 2010, the Company applied to Hong Kong’s Securities and Futures Commission (the “SFC”) for, and was granted, a ruling that the Company is not a public company in Hong Kong for the purposes of the Takeovers Code (the “2009 Ruling”). Consequently the Takeovers Code has not applied to the Company since the time of its Hong Kong listing.

In June 2014, the Company made an application to the SFC for a confirmation of the SFC’s prior ruling that the Company is not a public company in Hong Kong for the purposes of the Takeovers Code. The Company made this application so it could assess, with a greater degree of certainty, its options for sourcing the additional financing it requires to continue operating and meet its obligations.

Following the application to the SFC, the Takeovers and Mergers Panel of the SFC (“Takeovers Panel”) determined on June 19, 2014 that the Company should be considered a public company in Hong Kong for the purposes of the Takeovers Code. The Takeovers Code now applies to the Company.

The Takeovers Panel’s decision was based primary upon the material change in the greater number of Hong Kong shareholders as reflected in the proportions of shares held on the Hong Kong and Canadian register, in particular the relative proportions held by the public (excluding Turquoise Hill and CIC). The Takeovers Panel was also of the view that there is a material change in relation to the extent of trading in the shares in Hong Kong as reflected in the proportionate trading volumes on the HKEX and in Canada. As a result, the Takeover Panel has concluded that the 2009 Ruling which considered that the Company should not be a public company in Hong Kong for the purposes of the Takeovers Code is no longer valid and the Company should be considered a public company in Hong Kong within the meaning of section 4.2 of the Introduction to the Takeovers Code.

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