Even though we aren't huge fans of John Maynard Keynes, he has a simple but profound quote that we stick to, "When the facts change, I change my mind." In this case, we believe that there has been a material change in the facts surrounding our previous analysis of Midas Gold (OTCQX:MDRPF) and thus we're writing an updated piece with the new and updated numbers, and our conclusion has changed.
In our previous piece about Midas Gold, we believed that the shares were slightly undervalued. At that point, they were trading around $.95 USD per share, but we believe there would be a better entry point based on our analysis of the NPV and the recently issued warrants. All of this was based on an extremely conservative model where we used a 10% discount rate and we assumed the project would be sold off at a fraction of the NPV valuation.
But now we have access to the most recent financials, and more importantly, we've corrected one of the assumptions we've made in our previous model regarding the costs to mine the deposit. We'll get into these things in more detail, but first let us outline our modeling method. For investors who are unfamiliar with Midas Gold, you can read our aforementioned piece for a quick outline of the company.
Our Modeling Method
When it comes to explorers and developers with preliminary and initial resource estimates, we tend to take an extremely conservative approach towards evaluating the future cash flows from a project and the inputs that go in to determine those future cash flows. These companies are high risk companies, and thus investors need to keep that in mind when determining the price they would pay for a share of any particular company.
So the first thing we will do is construct a model based on the company's Preliminary Economic Assessment (PEA) to come up with a sum of the discounted future cash flows. We also will tweak some of the inputs to make them more conservative, because PEAs can often be a little optimistic. This sticks to our philosophy of de-risking the project by using more conservative inputs - we would rather overestimate risk than underestimate it. After doing this we will have a conservative valuation of what the share price should be based on the future cash flows.
Finally, if this is a project we believe that a company cannot develop on its own and that it will need to be acquired, we will take that share price and discount it a further 25-50% to come up with a fair acquisition price. This is essentially the highest amount an acquirer should pay to acquire the company that will still allow the acquirer to have a 33-100% upside on the NPV of the project.
The last thing we do is discount that another 35% to allow the acquirer to incorporate a premium into the acquisition price of the company - without that premium (or a premium high enough); existing shareholders would have no reason to sell.
You can see all of this for a generic company in the table below.
As investors can see, this valuation method is extremely conservative and allows an acquirer a price that would incorporate a large amount of risk into the acquisition.
This is something many investors forget when buying "acquisition target-type" companies - the acquirer must not only buy shares trading at a discount to whatever their acquisition premium is, but they must also have upside to make the acquisition accretive to their own shareholders. It would be silly for a company to acquire another company based on fair price, or even a slight undervaluation.
One major take away from this is that a company that is able to come up with the financing to fund construction will command a much higher price since it should not lose the discount to its fair price that is needed for another company to acquire it. Of course that isn't easy when we're talking about hundreds of millions of dollars, but it should definitely be noted.
Finally, in our modeling we take a different approach to many other analysts in that we believe that the gold price can be assumed to increase at a rate similar to the rate of inflation, and thus we usually assume a 5% rise in gold, as well as all other expenses. The reason why we do this is because gold has demonstrated that it will (on average) rise at a rate similar to or higher than official inflation (it has averaged a little over 8% per year since its 1971 demonetization) and this rise acts like a time-value of money compensator for investors. Though this is not traditional, we believe it is logical and makes much more sense from an analytical point of view than discounting future cash flows and then assuming a static gold price 5 and 10 years in the future (does anybody think gold will be under $2000 per ounce in 2024?).
Inputs for Our Midas Gold Model
We will now detail the inputs that we used to model the company's future cash flows, which are based on the company's published PEA, available on the company's website or at www.sedar.com. One bit of housekeeping that is important to mention, in our previous piece we made the erroneous assumption that the cost of mining waste material was not included in the cash cost per ounce and thus we added that into the cash costs of the project. The result of this is that the cash costs were higher than they should have been since the costs to mine the waste tonnes were double counted - we've corrected that in this piece and the current cash cost should be accurate.
Additionally, we've used both the newest financials (as of December 31st, 2013) and the recently issued warrants to calculate the estimated enterprise value of the company, which is shown in the table below.
As investors can see, at the current price and shares outstanding, the company's approximate fully diluted enterprise valuation is 100 million US dollars. Any difference between the enterprise valuation, and our current fair share valuation is the discount or premium that is attached to the current share price.
Next let's go into some of the assumptions we used in our model.
As we stated earlier, we use an aggressively conservative valuation method to assess these projects, not because we assume the PEA is wrong, but because we want to make sure there is quite a bit of leeway. That means if grades are lower than expected, recovery isn't as good, or expenses rise, our investment will still be an investment we want in our portfolio - and of course if things meet or beat expectations then we have quite a bit of upside by being aggressively conservative.
- For payable gold we subtracted the Franco-Nevada (NYSE:FNV) royalty (assuming Midas would buy back 1/3 of it before production) and we also subtracted a 5% gold risk rate, which is simply a way for us to account for lower expected grades and recoveries.
- For initial capital expenditures we used a 25% contingency rate to standardize it with other company PEAs that we research.
- We used a 10% discount rate for our modeling, which is pretty conservative as most PEAs use a lower discount rate (5% or 7.5%).
Finally, we assume all costs will rise by about 5% per year and thus costs far in the future may differ from those assumed in the PEA. For example, the PEA estimates the closure costs to be around $53 million, but around 20 years from now we highly doubt the closure costs will be anywhere close to $53 million with inflation - it will be much higher than that. Thus we think it is responsible to increase all costs by 5% per year.
Let us now put all of this together to find a valuation for the company.
Base Case Cash Flows
Notes about Cash Flows Table: Most of these numbers are based in part of the company's PEA filed on www.sedar.ca, but in our model we escalate the costs at a 5% rate and we use a base gold price of $1300. We need to remind investors that this base case gold price is not the current gold price, but instead should be a gold price that is neither a spike nor dip - more along the lines of a price where gold can grow at a healthy rate, and not necessarily the price of gold at any particular day.
Finally, we've also included a few other things in our model:
- Cash flows are discounted at a 10% discount rate.
- The gold price is assumed to grow at 5% per year.
- All expenses are expected to grow at 5% per year.
- Corporate overhead and expenses are estimated at a base $10 million per year before production.
- $25 million additional expenses are estimated in Year 1 and 2 for definition drilling, feasibility study, metallurgical testing, EIS work, and permitting (as per PEA).
- Franco-Nevada's NSR (currently 1.7%) is assumed to be bought back for $9 million during Year 3.
- Sustaining capital expenses are taken from the PEA and then increased by 5% per year.
- In Year 5, $33 million in working capital is expected to be needed, and then returned in Year 20.
Putting a Value on Midas Gold's Stock
Now, with our complete model we are ready to come up with a valuation for Midas Gold's stock based on the value of the estimated cash flows.
As investors can see, based on our model, inputs, a base $1300 gold price, and a discount rate of 10%, the after-tax NPV is around $368 million. This may not seem particularly high, but it is actually very good because we're using a model that is extremely conservative - many other gold projects would be negative based on this aggressive model.
Additionally, the IRR for the project based on our aggressive modeling is 17.3% (above our minimum 15%), which is very good considering that we've worked in quite a bit of leeway into our cash flows with the 5% gold risk discount.
Finally, what is the estimated fair valuation for the stock? Based on this aggressive modeling of the cash flows, $3.69 would be a fair valuation for the stock that would incorporate all of the future cash flows at $1300 gold and a 10% discount rate. This would be the fair valuation of a company that was "shovel-ready" and had all the necessary permits and financing in place, but of course Midas Gold is not in that position yet so we cannot recommend this valuation at the current time.
For a company like Midas Gold that owns a project that is significantly larger than its current market capitalization ($100 million versus close to $900 million in initial capital requirements), we like to look at it from the perspective of an acquirer - what would be the maximum price an acquirer would want to pay for the company?
Selling the project would mean that an acquirer needs to see value in the project beyond fair value - after all we're talking mining and nobody buys a project at its project cash flow price. In this case we assume an acquirer will only pay 50% (for riskier projects) or 75% of the total NPV of the project since they need to be able to add value - which is difficult to do if you are paying full NPV for a project.
In this case we consider Golden Meadows a risky project and so we assume an acquirer will pay no more than 50% of the project's after-tax NPV, so instead of $3.69 per share, an acquirer will probably pay no more than $1.84 per share.
Finally, we also have to take into consideration the acquisition premium that an acquirer will need to pay to get shareholder approval. This is something Goldcorp (NYSE:GG) found out the hard way as it tried to acquire Osisko Mining for a mere 15% premium - which is being fought aggressively by Osisko management and shareholders. No acquirer wants to go through a failed acquisition, so they need to be able to pay a premium and still not overpay for the shares.
In our opinion, Midas Gold investors should be looking for a buyout - and for that to happen the potential acquirer will need to pay a premium (we use 35% as our "fair" buyout premium) on the current share price to get investors to accept the deal. So even though we believe a buyer would be getting a good deal on the company with plenty of upside at a price up to $1.85, they would be willing to bid on Midas shares up to $1.37 per share ($1.37 + 35% buyout premium equals $1.85).
Thus we believe a fair valuation for Midas Gold at a base $1300 gold price is around $1.37 per share. This $1.37 price would allow an acquirer to add a 35% acquisition premium and enough after-tax NPV flows to make it worth their while. We want to emphasize this price is based on our aggressively conservative model in which we have:
- Used a 10% discount rate.
- Used a gold "risk-rate" that removed 5% of their expected gold production to account for lower grades and recoveries.
- Cut the NPV by 50% to give an acquirer significant upside on the acquisition.
- Added an additional 35% to account for a premium that would be paid to buyout the company's shareholders.
All of these things make our model extremely conservative and allow for a considerable amount of upside. Based on this, Midas Gold still stacks up impressively with an estimated $1.37 top-line acquisition price - which leaves investors more than 50% upside. Investors should remember that this is not a fair valuation, but rather the top price an acquirer would BEGIN to bid for the company - that means it's BEFORE the 35% acquisition premium that would bring the share price to $1.84 per share (more than double the current share price).
We also want to emphasize that the beauty of our model is that it allows for a considerable upside for the acquirer even with these premiums - almost double the expected NPV AFTER the full acquisition price of $1.84. It would make an excellent deal for an acquirer with significant upside, if the project receives a regulatory green light - it could be one of those rare times that the share price of both the acquired and acquirer rise on the acquisition.
Of course, as with any gold miner or explorers, the gold price is absolutely critical to determining the value of the company and so we've included in the table below some different base gold prices and the suggested value of the company based on these different values.
Conclusion for Investors
Based on our model, we think a fair value for the Golden Meadows project where an acquirer could acquire it with a nice premium and still have plenty of NPV left over to make it a worthwhile transaction is $1.37 per share (based on $1300 gold) or up to $1.58 per share (based on $1350 gold).
Since the current share price is around $.83 per share, we believe that Midas Gold has significant upside to get close to the valuation based on these inputs. We also want to remind investors that we used a very conservative model that offered investors significant leeway if production or recoveries are below estimated levels.
One of the main reasons why we believe that the shares are not priced higher is because of the risks associated with the environmental permitting process. We are not going to get into the specifics of this project's environmental needs (others are more learned in this than us), but investors are always nervous about open-pit mines in environmentally conscious countries. That's obviously why it is one of the priorities of management to de-risk the environmental aspects of this project. If they can successfully do that then we can easily see the shares valued at levels 50% higher even with a gold price lower than current levels.
Of course, just as with any other explorer, there are plenty of risks here (especially if there are environmental concerns) and so investors should make sure they carefully follow events with Midas Gold (or outsource it to a firm or analyst who does). We will be monitoring the company and its Preliminary Feasibility Study (due in mid-2014) and the gold price (obviously higher gold prices make this a much more valuable stock).
One last thing for investors to remember is that Teck Resources Limited (NYSE:TCK) already owns 9.9% of the company and chose to participate in Midas Gold's recent financing. That obviously means that Teck Resources is interested in keeping its eye on the development of Golden Meadows, and for investors that is definitely a positive.
But for now, based on the new information that we've pointed to earlier, we've changed our position on the company and we recommend that investors consider initiating a position in Midas Gold at the current price with a multiple tranche dollar cost averaging strategy. Even though there are significant risks with the company, the valuation is just too compelling to turn down initiating a position in Midas Gold and see how the company progresses in its 2014 goals of de-risking the Golden Meadows project.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MDRPF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The only reason why we don't have a long position is because we've changed our analytical position on the company and to be fair to our readers we will wait at least 24 hours after the article is published to initiate a long position - which we currently plan on doing.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.