DGSE Offers A Gold Play Without Gold's Volatility

| About: DGSE Companies, (DGSE)

There has been tons of attention surrounding gold. If you're been a gold bug who got in early, you are rejoicing. However, if you've been on the sidelines watching gold soar and are kicking yourself -- yet are uncertain about jumping in considering the metal's huge gains -- don't despair. I found a very compelling play on gold that I believe will outperform owning the metal itself, ETFs that trade in it, or even gold miners ... and it can be done without being exposed to the same volatility the metal experiences on a daily basis.

A Special Relationship

There's been an interesting quasi-reverse merger going on with a company called DGSE Companies (NYSEMKT:DGSE) and a private entity known as NTR Metals. As I've written, DGSE was a moribund operation dealing in jewelry, bullion, and rare coins for many years. However, the inclusion of NTR's Southern Bullion Trading (SBT) into DGSE has altered the complexion of its operation.

Normally, if you walk into a "We Buy Gold" shop and sell your gold, you'll get paid well below market price. That buyer will sell it to a middleman who sells it to a refiner like SBT. However, with SBT having numerous locations around the country and in the process of rapid expansion in the form of DGSE's "Bullion Express" stores, customers can sell their gold directly to SBT, which then sells it to NTR Metals. Why NTR specifically? Because NTR was DGSE's primary buyer in the past, and now DGSE and NTR have a good reason to be in an exclusive relationship.

As part of this quasi-reverse merger, NTR owns 36% of DGSE and continues to buy more stock in the open market. I believe NTR will eventually own at least 49%. NTR will want to increase revenues in its publicly-held entity as much as possible to help boost the stock price, so it will pay much more for bullion than it would to any other seller -- maybe even close to spot. NTR won't care as much about its private net margins as it will about its public ones.

Smoothed Volatility

Why isn't this secret gold play subject to the volatility of daily gold prices? Because NTR has a specific incentive to shower DGSE with as much money for gold sales as it can, given that it owns so much of DGSE. It's effectively a transfer of revenue from privately-held NTR to publicly-held DGSE, of which NTR owns a large chunk. This helps transition DGSE into a company deserving of analyst, mutual fund, and journalist coverage, thereby creating a more liquid market for the stock it holds and making NTR's ownership more valuable than it would be as a private entity.

Part of this process means that no matter what happens to the price of gold, NTR can continue to pay close to spot for DGSE's gold, and all DGSE/SBT has to do is pay the public just a tiny bit less for its gold if gold prices drop in order to maintain its own margins.

Here's an example (not using actual numbers, but to illustrate the point): Say gold is trading at $1700. A customer sells an ounce of gold to DGSE and gets $1000. DGSE sells to NTR for $1683. It has a 68.3% gross margin on the sale and make $683 profit.

Gold falls 10% to $1530 an ounce. A customer sells an ounce of gold to DGSE and gets 11% less, or $890. DGSE sells to NTR for $1515 an ounce. It has a 70% gross margin on the sale and collect $625. By passing the decreased price in gold on to the customer in the form of a lower purchase price, DGSE can actually increase its margins yet not suffer the full 10% decrease in revenue.

Still, that may sound like exposure to volatility. But stick with me. If you are directly invested in gold via an ETF like SPDR Gold Shares (NYSEARCA:GLD), you are directly exposed to the daily volatility of gold prices. Every bit of news, or lack thereof, moves the price of gold and this hits you directly. That means you are going to be subject to your own emotions about whether to sell or buy or sell short on a moment-to-moment basis. We all know emotion will kill returns, because emotional decisions are often bad decisions.

However, as a holder of DGSE stock, any volatility is smoothed out over time. DGSE's earnings will reflect the average price of gold during any given period. In addition, since the transactions involving DGSE/SBT and their clients involve percentages of the price of gold, and not the whole 100%, this will further dampen the volatility.

Revised Valuation

Here's the icing on this cake: DGSE is already undervalued in the market, which means investors not only are going to reap the benefits of the stock's capital appreciation to catch up to its fair value, they will also enjoy the benefits of its growth strategy, all the while without experiencing the volatility of investing in gold directly.

My previous article did not consider the higher prices NTR would pay for DGSE/SBT's gold. Now I am factoring in that effect. In addition, DGSE reported second quarter earnings that increase its 2011 run-rate. 2011 run-rate earnings are now $1.74 million, or 17 cents per share.

I assumed $5 million in operating income on $115 million in 2011 SBT revenue last time, or a 4.3% margin. I'm going to bump these margins to 5%, reflecting my thesis above. That brings SBT revenue to $5.75 million. I transferred 70% to the bottom line to be conservative last time, and I'll keep that assumption, giving net SBT earnings of $4 million. Total DGSE 2011 earnings are thus $5.74 million, or 57 cents per share. At a stock price of $8.20, DGSE thus trades at 14 times 2011 earnings.

One sector I would use to make comparisons are the gold miners. The Market Vectors Gold Miners ETF (GDX) trades at a P/E of 15, Newmont Mining (NEM) is at 13.9x, Barrick Gold (ABX) is at 13.2x, Kinross Gold (KGC) trades at 18x, Goldcorp (GG) is at 21x, and El Dorado Gold (EGO) trades at 31x. The average of these six securities is a 19 P/E, suggesting DGSE is 27% undervalued.

I might also compare it to the jewelry sellers. Tiffany and Company (TIF) (which also does B2B sales, like DGSE, and is seeing strong jewelry-driven growth) sells at 19x earnings, Signet Jewelers (SIG) sells for about 12x earnings, and Harry Winston Diamond (HWD) (which had 26% revenue increases, driven by jewelry sales) is hovering around 24x estimates. Again, DGSE seems 25% undervalued with these comparisons.

Last time I suggested the stock might see a 25% trading bounce as the market started to discover the company. I was right as the stock went from $8 to $10. Since then, as the market got hammered with the S&P downgrade; the stock is back down to $8.20, giving traders and long-term value and growth investors another opportunity to buy in.

The difference is that this time, my $10.50 near-term price target isn't just based on trading -- it's based on a fundamental valuation. DGSE should hit $10.50 and stay there, if not go as high as $12 as traders discover this new play. (By the way, NTR continues to buy stock in the open market. It purchased 2,000 shares at $8.48 on August 18. Even it thinks it's undervalued.)

Beyond that, I stick by my 30% annualized growth rate projections, giving the stock $1.25 per share in earnings in 2014. At a 30x P/E, that gives a $37 three-year price target, or a triple from here. Meanwhile, even if gold manages to go parabolic and stay at $2,500, you're only looking at a 50% total return and you get the stomach-churning volatility along with it. To me, the choice is clear. Buy DGSE.

Disclosure: I am long DGSE.