By Joung Park
We believe Eldorado Gold (EGO) has earned a narrow economic moat. While little has changed in recent years with regard to Eldorado's position within the gold mining industry, we have gradually developed a greater appreciation for the firm's ability to generate economic profits in a normalized gold price environment (which we presently assume to be roughly $1,200 per ounce).
Economic moats in mining are almost entirely predicated on sustaining a low-cost position, which in turn depends on three major factors: low production costs, long reserve lives, and prudent capital allocation.
We believe Eldorado scores near the top of the industry on all three of these metrics, which should help the firm to generate economic profits throughout most of the gold price cycle.
Enviable Cash Costs Relative to Peers
Eldorado Gold boasts the lowest cash costs within our gold mining coverage universe, with total cash costs of $423 per ounce in 2010. This figure includes direct mining costs and overhead expenses, as well as royalties paid to various governments. The firm's cash costs compare favorably with the gold mining industry average of $579 per ounce in 2010. We attribute Eldorado's low cash cost to the firm's high gold grades and easy ore access.
Eldorado's total proven and probable gold reserves grade sits at 1.1 grams per ton--higher than the industry average, but certainly not a remarkable figure. However, the firm's average gold grade is weighed down by lower grades at Kisladag (0.74 grams per ton), which comprise over half of the company's entire gold reserves. Gold reserve grades at Eldorado's other mining assets tend to be very high, such as the Efemcukuru mine at 9.1 grams per ton. Higher gold grades mean fewer tons of ore need to be mined and processed to yield the same amount of gold, which helps lower cash costs. Even Kisladag, which seems to exhibit mediocre gold grades, enjoys rock-bottom production costs because it produces the yellow metal through heap leaching, a mining technique that relies more on large volumes of ore throughput rather than on high gold grades.
In addition to its above-average gold grades, Eldorado's low-cost position is also supported by easy access to the gold ore. The majority of Eldorado's gold comes from surface open-cut mining, which is simpler and cheaper than extracting gold from underground. And the firm's underground mines are either a combination of open pits and underground tunnels, or very shallow underground holes by industry standards, which again helps minimize mining costs.
While almost all of Eldorado's mines exhibit below-average costs, we think the firm's favorable cash position is anchored in particular by Kisladag, which is the firm's largest producing asset and attained exceptional cash costs of just $351 per ounce in 2010. Eldorado recently released initial studies on the Phase IV brownfield expansion project at Kisladag that would double gold production at this mine from its 2010 levels by 2015 while keeping unit cash costs essentially flat. The Phase IV expansion, which we think will almost certainly be completed, would further cement Eldorado's low-cost position. In addition, we think that as high-grade deposits at the aforementioned Efemcukuru and Eastern Dragon assets come on line, this would also help lower the firm's average production costs going forward.
Long Reserve Life Ensures Sustainability of Low-Cost Position
While Eldorado certainly benefits from owning cost-advantaged mining assets, such advantages cannot last forever given that gold is a nonrenewable resource that is eventually depleted over time. Once that happens, Eldorado would have to replenish its gold reserves in order to continue production, either by acquiring mining assets on the market or through internal exploration and development efforts. Neither method guarantees that Eldorado will be able to procure mining assets that are as economically attractive as its current portfolio of mines, which would undoubtedly hurt future returns.
Fortunately for Eldorado, the firm's current mines have exceptionally long lives. Assuming our projected 2011 production forecast for the company, Eldorado's total gold reserves of 18.7 million ounces should last roughly 26 years. Moreover, over half of the firm's gold reserves are housed at Kisladag, which exhibits production costs even lower than the company's average. Even after the firm doubles its production at Kisladag as a result of Phase IV, Kisladag's reserves would not be depleted for another two decades, ensuring that the firm's ability to generate economic returns will remain intact for many years to come.
Prudent Capital Allocation
While maintaining low cash costs is certainly important for generating economic profits in the gold mining space, miners must also minimize capital spending on acquisitions, development projects, and existing mines in order to generate high returns. We think Eldorado can accomplish this. The company has low sustaining capex requirements, which we estimate to be less than $100 million per year, or less than 10% of projected 2011 sales. The firm also enjoys various brownfield growth opportunities that will not be very capital-intensive. For example, the Phase IV expansion at Kisladag is estimated to require an initial capex of only $354 million, a very modest sum considering that Phase IV would boost Eldorado's annual gold production by almost 250,000 ounces per year.
We like the fact that many of Eldorado's senior managers, including CEO Paul Wright, were former geologists or mining engineers with extensive experience in developing and operating mines. As a result, the company has built a good track record of developing mining assets on time and on budget, including the Kisladag, Tanjianshan, and Efemcukuru mines. This gives us greater confidence that Eldorado will be able to do a good job in controlling its capital spending going forward, helping to keep returns on invested capital high.
A common destroyer of returns on invested capital in the gold mining space is large, dilutive acquisitions. Fortunately, Eldorado prefers to grow through either internal expansions or small purchases of early-stage exploratory companies, generally eschewing big-ticket purchases. The company has made only one major acquisition during the past five years: its purchase of Sino Gold in December 2009 for total consideration of roughly $1.9 billion. At the time the acquisition nearly doubled Eldorado's gold reserves and also helped to consolidate the firm's operations in China by adding two operating mines in the country to complement Eldorado's existing Tanjianshan mine. Consequently, we view this transaction as an accretive and strategically sound transaction. While we cannot forecast with certainty that management will completely avoid dilutive acquisitions going forward, Eldorado's prior track record suggests that the company is less likely than its peers to dent its returns on capital through misguided capital allocation decisions.