As documented in Part 1 of this article, Novagold (NG) has had a sordid past. The company should have gone bankrupt in 2008 under the weight of management's stunning errors. Instead, the company was able to issue tons of new shares and keep the lights on for another day. Despite no longer being a gold producer after the fatal accident that shut down Rock Creek, Novagold shares have surged even as the company has returned to being a nearly revenue-free exploration company with no hopes of positive cash flow for many years.
Several allegedly positive catalysts have emerged that have renewed interest in the Novagold story. For starters, the price of gold has gone up. This isn't breaking news, yet the company seems to think it is:
What a difference a year can make! 2010 was a remarkable year for commodities, with gold increasing 25%, copper gaining 30% during the year and silver rallying an astounding 78%. Indeed, gold reached new all-time highs in 2010, trading through US$1,412 on December 29. The average closing price in 2010 was US$1,225 compared to US$972 in 2009, a 26% increase.
You have to read through all this drivel before getting to the latest depressing financial statements in Novagold's year-end financial results press release. The important thing to remember is that Novagold investors can take advantage of that huge surge in gold, silver, and copper prices with the zero ounces of all three metals that Novagold mines annually. The company's only revenue is the $650,000 a year or so it generates selling sand and gravel, putting Novagold's Price/Sales ratio at a rather lofty 4,937.
The company consistently continues to lose more than $60 million a year. (Last year's nearly $200 million loss is exaggerated by the fact that Novagold wrote off the Rock Creek project from its previous valuation of more than $100 million to its new valuation of nil.) The company has less than a dollar a share in cash (and an equivalent debt load to the meager cash supply) and the book value clocks in at under $2 a share. So why are shares trading at more than $13?
The answer is Novagold's perceived potential. Despite the overwhelming previous failures of the present management team, the market has inexplicably decided to give CEO Rick Van Nieuwenhuyse and his team the benefit of the doubt. And it is indeed true that if Novagold's two main projects, Donlin Creek and Galore Creek, ever get built, they will provide large supplies of gold and copper. However, the price tags for the two projects combined have soared to $9 billion, leaving Novagold's 50% obligation at more than $4 billion.
Novagold has less than $200 million in cash and it has nothing substantial to back large credit lines against. And while the company can dilute itself yet again, it isn't going to raise anywhere near enough money to fund even one of the huge projects. Some analysts have suggested that Novagold could sell Ambler, a smaller project, to raise funds. However, Novagold paid a mere $29 million for the remaining half of the project two years ago from Rio Tinto (RIO). Rio Tinto, a highly respected miner, either drastically screwed up in practically giving away Ambler, or Novagold is hyping up the potential of another marginal asset. Given Novagold's history, I wouldn't bet against Rio Tinto's judgment.
Any sort of mineral production is five or more years away (probably further, as Novagold has been on the verge of starting construction for years now on both mines) and even CEO Rick Van Nieuwenhuyse admits the company will take longer than that to become cash flow positive. As such, the company will run out of financing options long before any minerals are profitably mined.
The company's best option is to sell itself to somebody else. In fact, this appears to be what Novagold investors have been assuming will be their exit strategy. However, it's hard to see that math adding up either. Barrick Gold (ABX) offered $1.6 billion for Novagold in 2006 when Galore Creek had a better reserve profile and lower cost estimates. When the company's errors in assessing Galore Creek became clear in 2007, Novagold stock got cut in half in a single day.
With that in mind, it is hard to justify the $3 billion market cap Novagold has today. In fact, it is hard to even justify that $1.6 billion Barrick originally offered given the overoptimistic assumptions that were cooked into that offer. Novagold's management will tell you Donlin Creek and Galore Creek are more valuable than they were in 2006, but I see no reason to trust their assessment.
Also, as noted in Part 1, Novagold was a difficult deal partner previously, making life miserable for suitor Barrick. Novagold appears to have misled and obscured facts from shareholders to successfully poison the atmosphere against the Barrick offer. With tons of development stage gold companies on the market, I can't imagine Novagold is one of larger mining companies' preferred targets. Why risk another headache?
Also, the amount of debt needed to finance the acquisition and subsequent mine development would be substantial. Novagold's share of the two mines' development costs are more than $4 billion, and acquiring Novagold itself, at a premium, would cost another $4 billion or so. Even for a large player like Newmont (NEM), that $8 billion would be a fairly heavy strain on a balance sheet that contains less than $5 billion of debt currently. Additionally, any potential buyer can simply wait for Novagold to run out of cash and max out its credit lines before buying. Since Novagold has no prayer of bringing its projects to completion on its own, any potential buyer can patiently wait until the price is right (i.e. much lower) before bidding.
Bulls have also taken solace in the fact that John Paulson and George Soros have taken stakes in Novagold. However, both of these stakes were acquired at well below then-current market prices and both Novagold blocks were purchased under $6 a share. Rounding out the celebrity endorsements, Jim Cramer has recently touted Novagold the best call option on gold.
This argument is true to a degree but significantly flawed. Certainly if gold rises far enough, Novagold's projects will be clearly economically feasible to the point that they justify the massive up-front costs. However, Novagold will perform much less like a call option than it would first appear. This is due to the fact that the same inflationary forces lifting the prices of gold, silver and copper, also lift the costs associated with building and operating the mines.
In particular, three issues stand out. The price of energy, particularly for remote mining operations, presents a great problem; one that was cited in the decision to shelve Galore Creek in 2007. This problem may be alleviated somewhat by plans to incorporate natural gas power at one of the mines. However, there is no guarantee natural gas will stay cheap by the time the mine is well into its lifecycle. The cost of labor is also rising as there is a fairly small pool of both mining experts and of people willing to work in the harsh remote mines of northern Canada, and ever-more mining companies chasing after this limited labor supply.
Also, if the sort of U.S. dollar collapse occurs that Novagold proponents such as Steven Leeb anticipate (Leeb has a bold 5-year price target of more than $5,000/oz for gold), the Canadian dollar will surge in comparison with the U.S. dollar. This will raise Novagold's costs further. The strong Canadian dollar was mentioned as a problem when the Galore Creek project was shelved in 2007.
Since Novagold is far from an ideal buyout candidate and is trading at nearly double the market cap of when Barrick tried to acquire it previously, it is hard to imagine a happy outcome to Novagold's story. The company certainly can't self-finance either of its large mines through to fruition, and it is looking to sell Ambler -- the mine it actually could afford to bring to production. Either the company faces an endless string of dilutive share offerings or it will have to throw itself to the mercy of the market and publicly ask for a buyout.
Should the strong gold and copper bull market continue, it's possible that somebody will come along and offer somewhere in the neighborhood of $4 billion ($17 a share) for Novagold. It's more likely that the precious metals bull will take a breather or taper out and with prices at current levels, it is hard to see anyone offering more than Barrick did. $1.6 billion at today's share count only works out to around $7 a share, certainly not a good result for investors. And if the gold bull should reverse and gold fall to around $1,000/oz or lower, it is likely that Novagold's projects would again become economically unfeasible. This would lead shares to return to their 2008 valuation and leave Novagold in penny stock land.
To top it all off, Novagold is still led by the same dubious management team that fatally bungled its one and only operational mine, Rock Creek. While there is competition, it appears safe to say that for now, Novagold is indeed the most overvalued well-known precious metals company available on an American stock exchange today. If you are interested in buying a call option on gold, just go buy call options on a gold ETF such as GLD.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.