- High 9% Average Annual Return in Canadian Dollars, with a short September 2017 Maturity!
- Convertible feature of this note lowers the default risk while offering a potential for higher returns if the stock price appreciates sufficiently.
- The company’s 2013 sales of 135,550 ounces were up 62% from 2012!
Each week we screen corporate bond listings to find offerings with high yields and the lowest risk possible relative to projected returns. Sometimes we are attracted by a high yield on a bond issued by a solid-but-undervalued company. At other times, what catches our eye is a good yield on a bond that has the potential to convert to the common stock of a growing company.
And once in a great while, we find bonds issued by a company that has made itself profitable despite a difficult environment for its main product. We consider these to be great opportunities, because a company that can do well in tough times has a high likelihood of doing very well when the market for its main product improves.
This is exactly the case with this week's recommendation of Lake Shore Gold (NYSEMKT:LSG) 6.25% convertible bonds, selling at a discount and indicating a yield to maturity of about 9%. In the past two years, Lake Shore Gold has completed a major mill expansion, increased its processing capacity by 50%, and made its operations free cash flow positive - all while the price of gold was declining by $300/oz.
These developments greatly increase our confidence in the safety of principal represented by these bonds. And, should the price of gold return to previous levels, the convertibility feature of these bonds presents an opportunity for significant gain.
About Lake Shore Gold
Lake Shore Gold was formed in 2002 as an explorer for gold and base metals in the Canadian Shield. It is now a production gold mining company, operating three wholly owned, multi-million ounce gold complexes in the Timmins Gold Camp. The company also has a number of prospective projects and exploration targets located in and around the Timmins Camp.
(The Timmins area is located in northern Ontario, Canada. It has produced over 70 million ounces of gold to date, making it one of the most productive gold camps in the world.) Lake Shore Gold's common shares trade on both the TSX and NYSE under the symbol LSG.
Increasing Gold Resources
Lake Shore Gold's operations involve three multi-million ounce gold complexes located in the century-old Timmins Gold Camp in northern Ontario:
The Timmins West Complex is located 18 kilometers west of Timmins and hosts the Timmins West mine, as well as a development project and an exploration property.
On the east side of Timmins, the Bell Creek Complex hosts the company's milling facility, as well as the Bell Creek Mine and a number of exploration properties.
The company's third gold complex is the Fenn-Gib project, located approximately 60 kilometers east of Bell Creek. Fenn-Gib is an advanced-stage exploration project, which hosts a large, near-surface, potentially open-pittable resource and has excellent potential for further growth.
Over the last several years, the company has increased its "Measured & Indicated" and "Inferred" estimates of the gold available for production at Timmins West and Bell Creek, and the mine life expectancy is currently 9 to 10 years.
In addition, during the third quarter of 2013, the company completed a 50% expansion of its milling facility, increasing processing capacity from 2,000 tonnes per day to 3,000 tonnes per day. The expansion was immediately reflected in a record 51,700-ounce production for the fourth quarter of 2013.
We like companies that produce more…
In 2013, Lake Shore Gold produced 134,600 ounces of gold, a 57% increase over 2012.
In the fourth quarter of 2013, the company produced 51,700 ounces, more than double the production for the fourth quarter of 2012.
While lowering their cost of production…
In 2013, cash operating costs were US$766 per ounce sold, a 23% improvement on cash operating costs for 2012.
In the fourth quarter, cash operating costs were US$609 per ounce sold, a 38% improvement from the fourth quarter of 2012. "All-in" costs were US$1,139 for the year (a 37% improvement from 2012), and US$849 for the fourth quarter (a 52% improvement over the same quarter a year earlier). This compares quite favorably with other major gold producers, such as Goldcorp (NYSE:GG), which had cash costs of $687 per gold ounce for 2013 and all-in sustaining costs of $1,031 for all of 2013. Low cost leader Barrick (NYSE:ABX)'s all-in sustaining costs guidance for 2014 was $920-980.
And selling more of what they produce
The company's 2013 sales of 135,550 ounces were up 62% from 2012.
Even more impressively, the company's fourth quarter sales of 49,600 ounces represented an increase of 149% from the fourth quarter of 2012.
We like companies with increasing cash flow from operations
The processing capacity available after the completion of the mill expansion significantly increased cash flow from operations.
The table compares LSG's increasing cash flow to the price of gold from 2011 through the first quarter of 2014:
Gold Prices, Start of Period ($US)
Gold Prices, End of Period ($US)
% Change, Gold Prices
Cash Flows from Operating Activities (CAD$000s)
% Change in Cash Flow from Previous Year
*percent change from corresponding quarter in 2013
Lake Shore Gold consistently increased its cash flow from operating activities in each successive year, despite a fluctuation in the price of gold (and a substantial fall in that price throughout 2013). A company that does well when the price of its main product ((NASDAQ:GOLD)) is falling is likely to do even better if the price of that product recovers.
We like companies with substantial amounts of cash, and decreasing amounts of debt
As of May 6, 2014, cash and bullion stood at CAD$48 million, or about 37% of total debt.
Lake Shore Gold repaid CAD$3.7 million of debt in the first quarter, and forecast debt repayment to be CAD$20-25 million for the year.
We like companies with significant upside potential
We think that Lake Shore Gold has performed admirably during a difficult period for the price of gold. The company estimates that every US$100 rise in the price of gold increases its free cash flow by CAD$16-18 million. A recovery in gold prices, should it occur, would improve the company's cash position significantly, and bring the convertibility feature of these bonds into consideration.
The bonds allow the holder to convert to shares of LSG stock at CAD$1.40/share. At the time of this writing, LSG's stock price stood at ~CAD$0.77/share. But should the price of gold recover at any time before the maturity of these bonds, we think Lake Shore Gold is positioned to profit handsomely. Meanwhile, investors can enjoy the 8-5/8% return presented by the bonds' current market price.
The default risk is Lake Shore Gold's ability to perform. Considering their recent performance, increased processing capacity, substantial mineral resources, and increasing cash flow, it is our opinion that the default risk for this 39 month bond is minimal relative to its return potential. An option that further reduces the default risk of this convertible bond, should at its maturity the company decide not to pay off or roll over the debt, is a conversion of the principal (at par) to LSG common stock at a 5% discount to the stock's 10 day average price at maturity on 9/30/2017.
There is also an inherent currency risk in bonds denominated in other than US dollars. However, in the case of the Canadian dollar, we think this risk is minimal. Canada has the eleventh-largest economy in the world and is one of the world's wealthiest nations. According to the International Monetary Fund (IMF), the 2013 forecast for Canada's debt puts it at 87% of GDP, well below the estimate of 108.1% of GDP that puts the United States 7th highest out of the 30 most advanced economies. With 2% GDP growth and less debt, Canada is one of only 11 countries in the world with stable AAA ratings. Three quarters of its exports go to the U.S. Canada is the U.S.' single largest supplier of energy (oil, natural gas, uranium, and hydroelectricity). Considering its energy contribution and its large automotive and technology industries, it is no surprise that Canada's economy mirrors that of the U.S.
The company's performance is highly dependent on the price of gold as it directly affects the company's profitability and cash flow. The price of gold is subject to volatile price movements during short periods of time. Gold prices can be affected by numerous factors, such as the strength of the US dollar, global economic conditions, supply and demand, interest rates, and inflation rates, all of which are beyond the Lake Shore Gold's control. Slow global growth is expected to continue into 2014, reflecting the compounding effect of a number of factors, most notably increasing fiscal belt-tightening in many advanced nations, prior credit restraint in some key developing countries, and the cascading effect on international trade, credit, and financial conditions associated with the euro zone's lingering sovereign debt issues. In this environment, however, precious metals are likely to represent an attractive investment alternative.
Lake Shore Gold also has execution and market risks as a relatively young and fast-growing junior mining company; such companies often encounter unforeseen issues. But even in case of a default, Lake Shore Gold has highly marketable assets in the form of Measured & Indicated and Inferred reserves. Estimating ore reserves and resources is not an exact science. Estimating ore reserves requires a high degree of professional accountability and experience. In the past, we have found estimates of ore reserves from companies that we have investigated to be reasonably accurate.
This issue has similar risks and rewards to our previous Brigus Gold - recently bought out by Primero Mining (NYSE:PPP) - reviews. The Brigus offering proved to be very successful for our investors. (Here are links to our first, second, third, and fourth previous articles about Brigus.) We have had a very high degree of success with Canadian-based convertible bond issues, with over half receiving buyout offers. We have found that firms that are highly skilled in execution and have increasing cash flows often become acquisition targets for major resource companies.
We believe that Lake Shore Gold has demonstrated superior execution in a difficult environment for gold prices, far above most other gold companies we have followed in the last three years. The company has improved its cash flow, lowered its production costs, and increased its resources. They have demonstrated that they can excel, even in a declining market. While it would not surprise us to see gold prices fluctuate, we believe this issue offers excellent return from a company that enjoys an increasing cash position and better interest coverage. This bond appears to be a rare opportunity to obtain a high yield with significantly lower default risk than is typically associated with an unrated medium-term bond. In addition, its convertibility feature offers the potential for additional capital gains. As a result, we see this convertible debenture as a savvy opportunity for investors, and have added Lake Shore Gold to our Fixed-Income2.com and Fixed-Income3.com portfolios.
Lake Shore Gold
TSX: 0.86 (6/17/14)
Conversion Price: 1.40 (CAD)
Price: 92.25% (6/17/14)
Yield to Maturity: ~9.0%
Disclosure: Some Durig Capital clients may currently own Lake
Shore Gold stock and/or its bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients. The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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.