As gold stocks were declining last fall I began to put my “shopping list” together for 2007. My strategy was to focus on production. It was pointed out by Steve Saville, at TSI, that producing companies tend to lead the pure exploration companies after significant market corrections. Producing companies are also less likely to be raising equity capital, which dilutes shareholders and pressures their stock.
It also seemed that everything I read pointed to three dynamics for precious metal stocks in 2007.
1) Mine construction costs are escalating while the availability of equipment, supplies and labor are getting very tight. This is not only causing budgets to increase, but construction delays are becoming the norm, further straining project economics. While capital may be available, it is becoming increasingly difficult for junior mining companies to attract skilled workers and make the transition from explorer to producer.
2) Despite all the exploration throughout the world, gold and silver production has not kept up with the declines at existing mines since 2001. Roland Watson has written some very interesting reports regarding “peak gold”.
3) After the very robust M&A activity in 2006, there is no reason to believe that it will slowdown in 2007, especially considering 1&2 above. Major and mid-tier precious metal companies are finding it far easier, and cheaper, to buy current (or near-term) production/reserves. In fact, if gold and silver prices remain at current levels, M&A activity could increase this year. If metal prices increase, 2007 could turn into a “feeding frenzy”. It would not surprise me to see private equity get involved in precious metals this year.
On my list, I focus only on companies with existing production for 2007 or companies with “fully funded, fully permitted mines” that are on schedule for 2007 production. Then, I put together a very simple model to compare valuations. I calculate enterprise value using fully diluted shares outstanding, plus debt. I subtract “in the money” warrant/option value and cash/liquid investments. I use the company’s projections for 2007 production and NI 43-101 reserves. I only use the reserves from producing (or soon to be producing) mines. I use measured and indicated plus 50% of inferred resources. From this, I calculate the dollar value for an ounce of annual production and an ounce of mineral reserves.
This spreadsheet acts as my first screen. I then look at the individual companies and consider some other important criteria. Production history and cost is a prime consideration. I also evaluate political risk, hedging, by-product credits and management’s development track record. All things being equal, I then consider the “blue sky” of a company’s project pipeline, stock ownership or joint venture partners. I use $3000 per ounce of annual production and $200 per ounce of reserves as fair value ($3000/$200). I try to buy companies below these levels.
My October “shopping list” included Gammon Lake Resources (GRS), Minefinders (MFN), Minera Andes (OTC:MNEAF) and Yamana Gold (NYSE:AUY). In December, I added IAM Gold (NYSE:IAG) and this week I added Hecla (NYSE:HL) and Richmont Mines (NYSEMKT:RIC).
The price to earnings ratio is usually not a metric that precious metal investors use to value stocks. Production expenses typically tend to accelerate as fast, if not faster, than gold prices. This has been true for the last few years as energy, equipment and labor costs have been on a tear. This is compounded by increased exploration budgets driven by higher metal prices and declining production. The large mining companies tend to sell at above market multiples and are supported more by the value of reserves in the ground. This year, however, could be unusually profitable for most gold miners, as it appears that at least some costs have stabilized. It could be a boom time for some of the mid-tier companies ramping up production with years of loss carry forwards and tax credits on their books. If gold/silver prices cooperate, we could see some real earnings surprises in the precious metals sector.
Bill Cary wrote a piece last week that really drove this point home so I added PE ratios to my valuation model. Using the BMO Research estimates, the majors are still looking at above market multiples. They range from Newmont (NYSE:NEM) at 19 to Goldcorp (NYSE:GG) at 33. However, some of the emerging and mid-tier producers are sporting price earnings ratios in the low teens for 2007.
Yamana is the most expensive stock in my matrix. However, the stock price was $8.50 in October so the numbers looked more like $5000/$200 when I purchased the stock. AUY has assumed the role of #1 Wall Street “darling gold stock” vacated by Glamis Gold when Goldcorp acquired them last year. To say that GG overpaid for Glamis, according to my, model is an understatement (and Rob McEwen’s). At the time of the merger, GG paid $8.6B for Glamis. That equates to $12,286 for projected 2007 production. However, they paid about $250 per ounce of reserves based on increased resources at the monster Pensaquito development. Kevin McArthur and his team at Glamis have a unique combination of skills that helped constantly keep their stock overvalued. They delivered on their projects and they effectively communicated their story to the investment community.
Peter Marrone and his crew at Yamana have those skills, as well. They have three mines in construction, which will increase production to 800,000 ounces in 2008, and 1MM ounces in 2009. They will probably use their expensive stock to make another acquisition this year. The PE ratio for AUY is one of the lowest in the group at 11 times 2007 earnings of $1.17. Due to some very timely copper hedging at $3.50, cash costs for gold production will be (-$114). Yamana has a great story and they tell it very well. And of course, Cramer loves them.
None of the rest of the stocks on my list is as “silver-tongued” with the investment community. But, with strong earnings and low valuations, most are buyout candidates. Gammon Lake Resources (GRS) has risen about 60% since October and is no longer cheap in my matrix. The company has two producing mines in Mexico. After some startup problems at their Ocampo Mine, they are now on track to produce 480,000 gold ounce equivalent [GOE] this year. Current improvements should increase production by 10% for 2008. Ocampo made Jim Letourneau’s list of the top 20 undeveloped silver deposits. While the resource is actually more gold than silver, Ocampo now also has the distinction of being the first on the list to move into production. GRS management is working on their story and will do a road trip to Europe with BMO Nesbitt this spring. Meanwhile they are very focused on their two mine operations and expanding reserves on these properties. Ocampo is an open pit and underground mine. The underground production will increase over the next two years. GRS should produce 600,000 GOE in 2009. Ocampo was financed through a credit facility (about $87MM) with no hedging requirements.
Hecla (HL) made my list and is an interesting turn around story. After years of losses Hecla was solidly in the black in 2006. Since 2001, they have continuously issued stock to cover losses and doubled their outstanding shares. In 2007, they will produce over 7MM ounces of silver. Their two producing silver mines are very long life and have significant lead and zinc credits. Their cash cost in Q3 was $.59 for silver. Hecla’s stock has been pressured by its mining operation in Venezuela and the threat of nationalization. The mine produces about 130,000 ounces of gold per year. But the reserves are less than 500,000 ounces and are not a significant part of their resource base. Their silver business is so good that while Venezuela represents over 50% of revenue, it accounts for less than 10% of gross profits. All their other assets are in North America and they have a project on the Carlin Trend in Nevada that could be in production by 2008.
Drilling programs at their producing mines are significantly increasing reserves. Their Green Creek Mine in Alaska (HL-30%), operated by Rio Tinto (RTP), has significant exploration potential. They have a mine in Mexico that is on “care and maintenance” but 2006 drilling has found a new vein that could be brought into production very quickly. They have $86MM in cash and $300MM in tax loss carry-forwards. Hecla has been in the mining business for 115 years.
IAM Gold is undervalued in my model. Production this year should be about 1.1 MM ounces and reserves are over 12MM ounces. Cash costs are high at about $300, but not so high as to warrant the current discount of $2174 for production and $200 for reserves. Using BMO’s earnings number, from Bill Cara’s report, the PE is 21. However, their IAG estimate is at the low end of all analysts. Using the high-end estimate of $.60, the PE drops to 14. They should be helped more than most from lower fuel costs and a weaker Canadian Dollar.
IAG merged with Cambior last year. The Cambior merger brought some proven technical talent and attractive development projects to IAG. Projects in development could add another 12MM ounces to reserves. Cambior has a proven track record for bringing mines into production. The market remains unimpressed and the stock has been under selling pressure since the merger. My model makes IAG a likely buyout candidate for a major company looking to add 1MMoz of production, a huge reserve base and an excellent development pipeline. IAG has over $200MM in cash and gold bullion.
Aurizon Mines (AZK) has a motto; “The best place to find gold, is in a gold mine”.
There is probably a lot of truth to that. AZK had their first pour at their Casa Berardi Mine in November 2006. They are now on track to produce 185,000 ounces of gold in 2007. The mine produced over 600,000 ounces from 1988-1997. AZK purchased the property, in 1998, with much of the mining infrastructure in place including the mill and process facilities. They then found the additional resources to bring the mine back into production. They continue to increase reserves on the property and are finding higher-grade ore. They expect to more than double the current resource at Casa. Berardi.
AZK has about $60MM in debt from financing the mine. They are hedged via put/call options for an average of 71,000 ounces per year through 2010. The hedge allows AZK to receive $813/oz in 2007, increasing to $908 in 2010. They are also hedged against currency risk for $60MM through 2010. AZK thwarted a hostile takeover bid from Northgate Minerals (NXG) in 2006. They have $23MM in cash and $150MM in loss carry forwards/tax credits.
Minefinders’ (MFN) Delores Mine in Mexico also made the top 20 list. If things go according to plan, it could also be the second in production. Delores is fully funded, fully permitted and construction is on schedule. The resource is 50/50 gold and silver. However, the gold equivalent M&I reserves are calculated using 63:1 for silver. At the current ratio of 50:1, reserves are over 6MM GOE and production increases to 220,000. Bank financing was available for the project, but the Company opted to issue $85MM in convertible bonds. The bonds lowered interest to 4.5%, were issued at a 36% premium and eliminated all hedging requirements.
In my model, MFN is very cheap at $1628 per ounce of production and $55 per ounce of reserves. Part of this discount reflects the fact that production will not start until late 2007 and startup problems are a risk. The mine is only 80km north of Ocampo and Agnico-Eagle’s Pinos Altos project. Also in this area is Goldfield/Glamis with their El Sauzal mine, and Alamos Gold’s Mulatos mine. The Delores Mine would be a great addition to any of these company’s portfolios. At today’s prices, MFN is my numero uno buyout candidate for 2007.
The last company I am going to feature in this report is tiny Richmont Mines (RIC). This is a small company ($40MM EV) with nothing but past production problems. They currently have three producing mines and had hoped to increase production to 100,000 ounces in 2007. That is not to be. They are pulling the plug on their East Amphi Mine this year and their Beaufor Mine continues to have head-grade problems. Their new Island Gold project (55% RIC) had its first pour last fall and is projected to produce 65,000 ounces this year.
RIC also owns the Camplor Mill on the Cadillac Break in Quebec. The mill processes the ore from their Beaufor and East Amphi mines. They also process ore for several other mines. The mill is centrally located on Break and is only a few kilometers from Aurizon’s Joanna prospect. The mill operation is probably worth $30MM and should also allow RIC to pursue some interesting joint venture opportunities along the Break.
What also makes RIC interesting is the BMO earnings estimate of $.22 for 2007. First of all, no one has covered this little company more diligently than Craig Miller at BMO. Despite their problems, RIC was profitable through Q3 2006. Q4 will probably reflect the East Amphi write-off, so they will probably show a loss for the year. But next year they will have tax credits and receive most of the cash flow from the Island Mine. They get 70% of all cash flow until they recoup their $10MM capital costs. They also funded the JV Partners interest ($4.5MM) and will recoup that over the next several quarters.
Richmont has a market cap of $50MM with $10MM in cash and a mill worth $30MM. They are buying back stock and selling at 10 times 2007 earnings estimates. At today’s price, the market is predicting more problems. They are un-hedged. They are leveraged to gold prices and the Canadian Dollar. In early 2007, both are going their way.
Q4 earnings should give us a pretty good idea of what is in store for this year. With oil prices down and a weaker Canadian Dollar, 2007 could be the “perfect storm” for many mid-tier producers.
Disclosure: The author is long AUY, GRS, HL, IAG, MFN, RIC, MNEAF and GFI. He has no positions in any other stocks mentioned in this report.