DGSE's Reverse Merger: Home Run Trading Opportunity

| About: DGSE Companies, (DGSE)

Momentum traders and long-term growth investors have been piling into DGSE Companies Inc. (NYSEMKT:DGSE). The stock is up 85% since March, and 220% since September. To understand present and possible future trading action, it's necessary to learn about the company's development.

For years, DGSE languished as a moribund operator of two wholesale and retail jewelry stores/pawnshops. The company rarely turned much of a profit. Margins were tiny. A few years ago, DGSE merged with Superior Galleries, an auction and retail rare coin operation that had not turned a profit in five years. Nothing came of it.

DGSE had long been controlled by its primary shareholder, Dr. Len Smith, a man with a talent for creative dealmaking, thanks to many years as a bankruptcy specialist. He struck a complex deal with the now-infamous Stanford Bank to provide DGSE with $11.5 million in credit so the company could attempt to grow, and Stanford swapped out $8.4 million in Superior debt for equity.

Then Stanford blew up. Dr. Smith worked out a brilliant deal. The Stanford Receivor converted $11.5 million in debt and all the equity into 3 million DGSE shares, and sold them for $3.6 million - essentially taking 15 cents on the dollar.

Yet DGSE didn't pay a dime.

Enter NTR Metals

The tab was picked up by NTR Metals, DGSE's primary gold scrapper, which also took control of the 3 million shares. NTR Metals is privately-held, a premier precious metals conglomerate, generating $2 billion in annual revenue. Attached was a clause allowing NTR to purchase 1 million DGSE shares directly from Dr. Smith for $6 per share within the next two years. At the time, the stock was trading at $2.50.

This presented three puzzling questions.

1) Why would NTR want to purchase a million shares far above the present stock price?

2) How could it unload the shares it already purchased? I could see why it would buy DGSE shares at $1.20 a share and recognize an instant 100% paper gain. But at the time, DGSE was a thinly-traded microcap, and it never was able to unload the shares.

3) Given NTR's powerhouse stature in the industry, what possible operational synergies could it have with DGSE that it didn't already have or couldn't create itself?

The answers came as NTR began buying shares in the open market. At the time, but no longer, DGSE shares were so thinly traded with such large spreads that a few hundred shares moved the stock significantly. It wasn't long before the stock broke $5, and NTR exercised its $6 option. That answered the first question.

In addition, NTR now owned nearly 40% of DGSE. This was when the reverse merger concept hit me, along with the answers to the two remaining questions.

Reverse Merger in Play

This piecemeal reverse merger would be a way for NTR to offload parts of its business into the public market without the complexity of an IPO. The deal had Dr. Smith's fingerprints all over it. But a reverse merger from which NTR could see its investment value increase made no sense unless: 1) the stock became more liquid, 2) the share price continued to increase, and 3) shareholders were getting something of value, which so far they hadn't. So, $3.6 million had gone to the Stanford Receivor and $6 million directly into Dr. Smith's pocket.

Then the other shoe dropped last month.

DGSE purchased Southern Bullion Trading (SBT), a part of NTR's domestic business, in exchange for up to 600,000 shares of DGSE restricted stock. SBT would also put up a $2 million equity investment to be dedicated to SBT's expansion. That gave NTR even more control of DGSE while giving shareholders a viable bullion operation from which significant earnings would be generated. SBT's unaudited 2010 revenues were $35 million, generating $1.5 million in operating income. However, this was only based on a few stores and didn't include the full complement of revenues for the 12 new stores they opened during 2010, or the six they've opened so far this year.

Trading volume is now routinely over 30,000 shares. I believe volume will increase significantly as DGSE has finally found a growth vehicle. With increased volume comes tighter trading spreads, and less stock volatility. With all of these factors combined, NTR is successfully transitioning DGSE into a company deserving of analyst, mutual fund, and journalist coverage - thereby creating a liquid market for the stock it holds. Question No. 2 was answered.

As for question No. 3, it's moot. NTR did not need DGSE for any of this. DGSE may have more experience dealing with the public directly, but NTR has so much expertise in the precious metals field that they didn't need to spend $11.6 million for DGSE's expertise. They also could have easily sold SBT to any number of other entities for a boatload of money, but that would've capped their upside.

NTR is in this because it wanted a public vehicle through which it could expand, and it fully intends to transform DGSE into a stock that is on everyone's radar.

And they are succeeding. Here's why DGSE is not only going to be a great momentum trade, but a solid growth play.

What It Means for Investors and Traders

It's all about the gold. Gold prices will remain high for quite some time. Diamonds, watches other metals-- they will all provide income for DGSE, but it's the gold that will drive the growth.

Thanks to the weak economy, pawnshops and retail gold purchasing are on fire. First Cash Financial Services (NASDAQ:FCFS) has seen mid-to-upper single digit increases in scrap volume over the past two years. Why do you see all the "we buy gold" signs? Because buyers like First Cash, EZCorp, (NASDAQ:EZPW) and Cash America (NYSE:CSH) generate 40% gross margins buying from the public and selling to refiners like NTR.

As a refiner, NTR and SBT) make their money refining the gold, and reselling it via their dealer desks. They make a net spread of 2 - 2.5% (4.1% on the operating income level). In addition, demand for physical gold bullion is rising. DGSE is opening its Bullion Express stores, where any person or firm can purchase physical bullion. The company can now play the market both ways, enjoying spreads on both the purchase, and resale (after refining).

From Fundamental Analysis to Price Target

DGSE reported an operating loss last year, and a $.05 profit in 2009 - pretty typical for the company. However, Q1 showed a 40% revenue increase and DGSE earned $.03 a share. Half the profit came from gold sales, half from jewelry sales. At the same run-rate, DGSE is looking at $0.12 per share for 2011. This does not include the SBT contribution. What might that be? We won't know until financials are released in a few weeks. But let's assume the 2010 numbers are based on six stores. In 2011, SBT will have at least 20. So figure $115 million in 2011 revenue, and $5 million in operating income. But factoring in taxes, possible interest expense and just to be super-conservative, let's transfer just $3.5 million to the bottom line, or about $0.35 per share.

That gives DGSE $0.47 per share in earnings for 2011, and a 17x earnings multiple.

One sector I would use to make comparisons are the gold miners. The Market Vectors Gold Miners ETF (NYSEARCA:GDX) trades at a P/E of 15, Newmont Mining (NYSE:NEM) is at 12.5x, Barrick Gold (NYSE:ABX) is at 13.4x, Kinross Gold (NYSE:KGC) trades at 18x, Goldcorp (NYSE:GG) is at 19.5x, and El Dorado Gold (NYSE:EGO) trades at 19x. The average of these six securities is a 16 P/E, suggesting DGSE is fairly valued.

I might also compare it to the jewelry sellers. Tiffany and Company (NYSE:TIF) (which also does B2B sales, like DGSE, and is seeing strong jewelry-driven growth) sells at 19x earnings, Signet Jewelers (NYSE:SIG) (which saw a 1-% increase in same stores sales in Q1, which bodes well for DGSE) sells for about 16x earnings, and Harry Winston Diamond (HWD) (which had 26% revenue increases, driven by jewelry sales) is hovering around 18x estimates. Again, DGSE seems fairly valued from this perspective.

Back to gold miners. Newmont (with operations and assets in the U.S., Australia, Peru, Indonesia, Ghana, Canada, New Zealand and Mexico) trades 10% below analyst median estimates of $73. Kinross (with operations and assets in the Americas, Africa and Russian Federation) trades 15% below analyst's median target of $22.50. Goldcorp (with multiple precious metal deposits in the America, Canada and Mexico) trades 15% below the median target of $66. And Barrick (with operations and assets in North and South America, Australia Pacific region, and Africa) is 12% undervalued.

This suggests DGSE may be 13% undervalued. And given the attention the stock has received from momentum traders, I think a 15%-20% trading upside from here is absolutely possible, giving the stock a $9.60 price target in the short term, and possibly as high as $12 as the company makes it onto traders' radars.

Going forward, as a growth play, I think there is enormous potential due to the opportunity afforded by rapid SBT store expansion in the U.S., the Bullion Express concept expansion, and the long-term secular trend of strong gold prices. This alone should justify a 20% annualized growth rate.

Next, I doubt this is the last transaction we'll see between NTR and DGSE. NTR will want controlling ownership, meaning at least 51% of the shares. It will certainly move more assets into DGSE in exchange for more stock. I think that could push the company to 30% annualized growth.

Add in the momentum trading, and I would project a $12 stock price by year end, followed by 30% annualized growth over the next three years, giving a 2015 price target of $26. We'll know more as the story unfolds.

Disclosure: I am long DGSE.

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