- Klondex Mines released a PEA on April 29th.
- While the report shows less production than I anticipated the potential for additional production is still there while production costs will remain low. .
- The company is ultimately overvalued on a DCF basis using the cash-flow that we can accurately calculate, but the unknowns dramatically improve the upside potential. .
- Therefore Klondex Mines remains a compelling speculation stock for gold bulls.
To summarize my argument, Klondex Mines has one of the highest grade underground gold resources to my knowledge at its Fire Creek property. While the company has delineated its resource a couple of ways, its most recent resource estimate from September is over 700,000 ounces of gold at over 20 grams per tonne. Given this unusually high grade resource there was an excellent probability that the gold could be extracted inexpensively.
Furthermore, the Fire Creek property is located in Nevada, which is one of the friendliest mining jurisdictions in the world. According to the Frasier Institute's policy potential index Nevada ranks 8th out of 112 countries, states and provinces. This means that mining executives are confident in Nevada's government and in its policies insofar as they encourage investment in Nevada by mining companies. Companies that operate in Nevada have an easy time getting permits, and the procedures that they must follow are straightforward and predictable.
Finally, in December Klondex Mines purchased the Midas mine and mill, which is nearby Fire Creek, from Newmont Mining (NYSE:NEM). While the company had to issue stock and debt, and while it had to sell a royalty to Franco Nevada (NYSE:FNV), the purchase put Klondex Mines in an enviable position whereby the aforementioned low cost production appeared to be right around the corner.
Since my December article was published Klondex Mines has admittedly underperformed the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) by about 4%. In part this is likely due to the fact that Klondex Mines issued stock in order to help pay for the Midas mine and mill. But I think a large part of this underperformance can be attributed to the fact that Klondex Mines was one of a handful of gold mining stocks that rose in 2013. While the beginning 2014 is generally a good market for investors to use to compare the performance of various gold miners given that this is when the sector turned positive, we must acknowledge the substantial outperformance of Klondex Mines on a longer time frame.
This outperformance reflects the company's high grade resource, its low risk geography, and its meaningful strides towards positive cash-flow.
Since then the company has confirmed my suspicion that it will be able to produce gold at a very low cost in the near future--it released the results from its preliminary economic assessment. This report shows that the company will be able produce gold at just over $600/ounce at its Fire Creek mine. Although its current mine plan estimates just 280,000 ounces of production over a five year period there is still a strong possibility that this mine plan can be extended to include the roughly 440,000 ounces that aren't included in the mine plan.
As we will see the company is going to increase production every year from the present through 2017 before it is scheduled to cease in 2018. However, given the size of the mineral resource, and given the company's ongoing exploration success there is no reason to assume that production is going to cease in 2018. In all likelihood investors should anticipate the release of an updated resource estimate and an updated mine plan in a couple of years, and we should expect production to continue at around the 2017 rate--88,000 ounces--for years to come.
88,000 ounces of production at $700/ounce assuming a $1,300/ounce gold price and a 35% corporate tax rate means that the company will be able to generate $34 million in annual cash-flow--not bad for a company that is valued at just under $200 million!
It gets better considering that the company will be producing gold and silver at the Midas mine and considering that the company plans to use its extra milling capacity to process ore from the Washington Mine owned by the French Gulch Nevada Mining Corp. Milling is a "turn-key" operation that adds no overhead expenses--these revenues fall straight to the bottom line. While these two added revenues sources aren't readily quantifiable it is clear that Klondex has a lot of potential to generate revenue beyond its Fire Creek operation.
Ultimately Klondex is still a speculative investment. While the Fire Creek operation will be low-cost, the effective cost rises given the company's obligations to Franco Nevada. Furthermore, the mine's current life is just 5 years. While there is a strong possibility that this life will be extended we cannot prudently make this assumption without qualifying our investment thesis--Klondex is speculative so long as we are paying a price that exceeds the current PEA's NPV estimate, which I have qualified from Klondex's numbers to incorporate a more conservative discount rate and the Franco Nevada royalty.
However considering that Klondex is a high grade mine in a low-risk jurisdiction with minimal overhead costs and additional sources of revenue, Klondex is still a company worth investing in.
The Fire Creek PEA
On April 29th Klondex Mines released the highlights of its much anticipated PEA. While production cost estimates fell within my December expectations--$636/ounce (AISC)--annual production fell short, as did total production. This drastically impacts the mine's cash-flow potential during the first few years of production, especially sine the Franco Nevada royalty stipulates an exact number of ounces due rather than a percentage of ounces produced in the first 5 years of the agreement.
Let us look at the specifics of the mine plan's cash-flow potential, keeping in mind that total production falls well short of the total Fire Creek resource--i.e. we should expect more production beyond the 5 years estimated in the PEA mine plan.
1--5 years of production as detailed in the following chart (note that I am omitting silver, which at the current gold/silver ratio of 66.7 is negligible).
|Year||Gold Production||Gold Due To Franco Nevada||Net Attributable Gold Production|
Note that the gold due to Franco Nevada is due either from Fire Creek or from Midas, but since we are looking at a "floor" valuation scenario, and since we don't have specific production metrics from the Midas mine we will assume that Midas production is 0 until we have clear data pointing to a specific number.
2--Cash costs are $459/ounce net of silver by-products. AISC average $636/ounce. We can get a more specific year-by-year estimate by looking at the company's actual anticipated expenditures. They are given on the following chart which can be found in the aforementioned April 29th press release.
Given this data we can now calculate the year-by-year production costs for Fire Creek for the ounces attributable to Klondex Mines (assuming that the cost of producing the gold attributable to Franco Nevada is evenly distributed (on a year-by-year basis) among the remaining ounces).
|Year||Production Attributable to Klondex||Total Cash Costs ($459*Total Fire Creek Production) In Millions||Total Sustaining Costs In Millions||Effective Total Production Cost For Attributable Ounces|
Given this data we can calculate the value of the discounted cash-flow from the estimated 5 years of production after the royalty is paid to Franco Nevada. All amounts are in millions of dollars and taxes are included. I must stress that these figures are valuation floors, and I will detail the many ways in which the mine life can be extended and the potential for Klondex to generate additional cash-flow.
|Discount Rate/Gold Price||$1,000||$1,300||$1,600|
Given these figures compared with the company's $195 million valuation the stock is overvalued.
However, as I emphasized above Klondex is speculative, and the bet that we are making is that the company will be able to continue mining beyond the five years at approximately the 2017 rate. So let's assume another five years of production at 75,000 ounces per year and with production costs at a slightly higher $700/ounce. Since Franco Nevada has a 2.5% NSR royalty on the gold produced after 2018 Franco Nevada's share comes to 1,875 ounces per year. This means that Klondex will have 73,125 ounces of attributable production at $718/ounce. Given these assumptions we get the following updated NPV matrix for this optimistic scenario.
|Discount Rate/Gold Price||$1,000||$1,300||$1,600|
This additional production doesn't include the additional resources that the company is exploring for all the time. In fact just recently the company announced extremely positive drill results showing uncanny ore grades of 75 grams of gold per tonne on a new promising vein.
Furthermore this additional production doesn't include the lower grade ore that was omitted from the most recent resource estimate. Readers of my last article will recall that I provided a comparison of the two resource estimates. These two charts are worth reprinting.
Note that, providing the additional gold is readily accessible, the resource estimate using a 7 gram per tonne cutoff grade still yields an incredibly high ore grade, and the 1.2 million ounces of measured and indicated resources at 17.6 grams per tonne can likely be produced at a relatively low cost. Since investors interested in Klondex Mines will almost certainly be bullish of gold, the added cost of mining the slightly ore grade ore should be more than offset by the presumed increase in the gold price.
Valuing Klondex Mines
As I have stressed an investment in Klondex Mines is speculative. There are too many moving parts in order to accurately value all of the company's assets, and the discounted cash-flow from Fire Creek's 5 year mine plan isn't sufficient to justify an investment in the stock.
However we have seen that the value of Klondex increases markedly when we use relatively conservative assumptions for the future of Fire Creek beyond 2018. Depending on the discount rate we use the value goes up to $168 million or $146 million. If we add the $83 million that the company paid for the Midas mill we get valuations of $251 million and $229 million for 8% and 12% discount rates, respectively. This doesn't include any of the upside potential from exploration at Fire Creek. It also doesn't take into consideration production from the Midas mine, and the fact that I am assuming that the Franco Nevada royalty detracts solely from the value of Fire Creek while the royalty agreement is on both Fire Creek and Midas. Thus my valuation assumptions for Fire Creek are almost certainly too conservative.
Given these points Klondex Mines probably isn't "cheap," but it certainly offers a lot of value relative to its potential upside. Considering that management continues to find zone of high-grade mineralization there is a strong likelihood that we will see more production at Fire Creek than I anticipate even in my more optimistic scenario. Furthermore, I arrived at a valuation of $229 million - $251 million without considering the cash-flow from the company's mining operations at Midas, or its milling agreement with French Gulch.
Given these points, and given the potential I have already outlined in my previous articles I think Klondex continues to be a compelling story that more aggressive gold bulls should buy into.
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