Two Undervalued Gold Stocks In The Sweet Spot

by: Don Durrett

Summary

I define "the sweet spot."

One undervalued gold stock is Jaguar Mining - an undervalued mid-tier producer.

Another is Exeter Resources - an undervalued late-stage development project.

I provide a "3 P's" analysis of each stock.

Last month, I posted an article on Seeking Alpha titled SILJ: Currently The Best Risk/Reward Silver Stock. This month I'll give you two stocks that can both beat SILJ or GDXJ. These stocks are in what I call the sweet spot, with fully diluted market caps between $100 million and $150 million. Once a stock reaches the $100 million level, the risk reduces because investors have recognized its value. Conversely, once a stock exceeds $150 million, the upside potential begins to diminish.

This range of $100 to $150 million does not apply to all miners. Often a company displays extraordinary value well before it reaches $100 million and long after it exceeds $150 million. However, most companies are in the sweet spot from $100 to $150 million. That is usually the ideal time to buy them from a risk/reward viewpoint.

This range is where you will find late stage development projects, near term producers, or mid-tier producers. What you are really investing in are emerging mid-tier producers. Most mid-tier producers are valued over $100 million, so buying in this range is catching an early mid-tier producer. These are the companies that can grow quickly. At this valuation, most of these companies will only have one producing mine, or their first mine under development. Thus, you are getting in early. Remember, you usually don't make your big money on the first mine, but their second and third.

Whereas the risk is substantial for Junior gold and silver mining stocks, the upside is also substantial. My current focus is on both undervalued producers and companies with solid projects that are advancing toward production. My range is wider than $100 to $150 million market cap, but if a company falls into that sweet spot, I am more likely to buy it.

I consider all Junior development companies as high risk speculation stocks, because you can never know if they will make it into production. If they have trouble with financing, or if the geology is analyzed incorrectly (e.g. Rubicon Minerals), or if any number of issues arises, these stocks can drop like a rock. Also, management is crucial and can disappoint investors with poor decisions and bad execution. Lastly, quality projects tend to get taken out by larger companies, which generally do not have the upside potential that I am looking for.

I think now is a good time to look for undervalued companies with growth potential. If we are in another gold bull run that could see new highs above the 2011 level of $1935 (see historical prices), then it would be wise to spot the potential winners. The biggest winners are likely to be those that are currently valued under $150 million, and are either producing or sitting on development projects that have all of the factors needed to be successful.

My investing style is to focus on potential future cash flow in conjunction with higher gold prices. For instance, what is the future value of XYZGoldStock if they develop a 5 million oz project and produce 300,000 oz annually at $2,000 gold? If you just do a quick and dirty analysis using potential future cash flow, you get 300,000 oz x $500 (estimated cash flow per oz) = $150 million in annual cash flow. If you multiply that by 10 you get a $1.5 billion valuation. Note that some companies were valued at 30x cash flow during the last mania in stocks in 1980, and a 10x cash flow valuation is quite common today for strong mining companies. A conservative method is to use 5x cash flow.

It's amazing how valuable a mining company could become when it owns large profitable projects. There are many development stocks today with solid projects. Not all of them will be successful in building their mines, so it is a crapshoot picking the winners early. The smart play is to watch these stocks and see who is going to get financing. Of course, the longer you wait the higher your entry price will be.

The most ideal stock is an undervalued company that is either financed to build its first project, or is an undervalued producer with growth prospects. The only way you can understand the risk of an undervalued stock is to do your own due diligence. Below I will go step-by-step and show you what to look for when analyzing a mining stock. But even with this data in hand, you should do your own due diligence to confirm what I have written.

Even if you think you know a stock intimately, the data will change. If there is one constant in the story of a stock, it is change. And the higher the risk, it seems like the data changes more frequently. Whereas a Major or a strong mid-tier producer can weather a data change, a Junior can drop in value a significant percentage on small changes. The volatility can be staggering, and sometimes Juniors do not survive these changes.

The two most important rules to follow to limit your risk exposure are: 1) Only invest in company that has the goods. In other words, do not chase drill results. Make sure that your company has at least one very good project. 2) Do not invest more than 1% of your portfolio cost-basis into a high risk stock. Thus, if your invested dollars total $100,000, then your max is $1,000 for a high risk stock. This may seem too low, but you have to stay humble and acknowledge the high risk. If you think the stock is low risk, then you can double this total to a maximum of $2,000. You may be thinking that you could end up with 80 stocks. Perhaps, but this won't happen if you buy bullion and/or ETFs as a foundation. With bullion and ETFs you can go over the $2,000 limit.

The following analysis is based on data from the www.goldsilverdata.com database.

Stock Name

Symbol (US)

Type

Risk

Share Price (US)

FD Shares

FD Mkt Cap (7/8/2016)

Jaguar Mining

JAGGF

Gold

High

.41

317M

$132M

Click to enlarge

Jaguar Mining (OTC:JAGGF) (analysis on 5/29/2016) is a mid-tier producer in Brazil with 3 operating mines at 90,000 oz annual production. Recently they went bankrupt from high costs and high debt. They have now restructured the debt and re-listed their shares. Original shareholders got wiped out and the bond holders now own most of the company. They cleared $260 million in debt from their balance sheet. Currently they have $30 million in debt and $18 million in cash.

Management hurt shareholders again in late 2015, when they borrowed $21 million using convertible debt at .15 cents a share Canadian. It matures in 2018, and at today's exchange rate of 11.5 cent US, that would be 190 million shares. Thus, we have huge dilution looming in 2 years.

They have 7 million oz at 1.2. gpt, with 2.5 million oz of reserves. In 2016, they plan to produce about 90,000 oz with cash costs at $750. Their breakeven is about $1150 gold. They have very good properties in Brazil on 500,000 acres. Their open pit project (Gurupi) is ready to be built, although the capex is $280 million and probably cannot be financed at $1300 gold prices. With their resources, they should be producing 200,000 oz in about 5 years. However, that can't happen unless gold prices rise and they can get financing. This is a company that is extremely leveraged for higher gold prices. Once they get some solid cash flow they can become a growth focused company.

The 3 Ps

Properties

Do they have a flagship project? Yes, long life mine.

Do they have a pipeline of projects for growth? Yes, several additional projects.

Do they exploration potential to expand resources? Yes, 500,000 acres to explore.

Is the grade and recovery rate satisfactory? Yes, but requires higher gold prices for growth.

Is the location satisfactory? Yes, Brazil is currently mining friendly. They have no infrastructure issues.

Do they own it? Yes, 100%.

People

Is it an exploration or production team? Both.

Do they have experience? Yes, it is a highly experienced team.

Do they have a track record for building mines? Yes.

Are they investor friendly and not always diluting? They recently severely diluted.

Is the team large enough to build a mine? Yes.

Have you listened to a CEO interview? Their new CEO seems to be executing after their recently bankruptcy.

Are they cash focused? They appear to be keeping debt low and cash in the bank.

How much stock does management own? Unknown.

Do the website and company presentation provide adequate guidance and details? Yes.

Projects

What are the resources? 5.8 million oz at 1.2 gpt.

What documentation has been released (PEA, Pre-feasibility Study, Feasibility Study)? N/A.

What is the capex? N/A. What is the after-tax IRR? N/A.

What are the estimated cash costs and all-in costs per oz? $750 cash costs.

Can it be financed? N/A.

How will it be financed (debt, equity, streaming)? N/A.

Share Structure

Is it highly diluted? Yes. They have 317 million fully diluted shares.

Timeline Risk

N/A.

Market Cap Size

It's in the sweet spot.

Stock Chart

Is this a good entry point? Yes.

Balance Sheet

What is their cash/debt situation? $18 million in cash and $30 million in debt.

Valuation

What is their future market cap growth rate at $2500 gold? 1100% at 200,000 oz. (see below).

What is their future free cash flow at $2500 gold? $160 million annually at 200,000 oz. (200,000 x $800).

What are their future reserves valued at today? $29 per oz at 4.5 million oz. ($132 million / 4.5 million oz).

Future market cap growth:

Current Market Cap: $132 Million. Future Market Cap: 200,000 oz x $800 = $160 million annual cash flow x 10 = $1.6 billion Compare the two values and you get a 1100% increase.

Is Jaguar Mining highly undervalued? Yes, with a potential increase of 3000% and future reserved valued at $8.70, it is highly undervalued. If you consider share dilution to pay for the feasibility study, engineering, and financing the mine, the upside is considerably lower. If they build the mine, perhaps it will be a 10+ bagger.

You can check the data included in this article at Jaguar Mining's website and my own.

Stock Name

Symbol (US)

Type

Risk

Share Price (US)

FD Shares

FD Mkt Cap (7/8/2016)

Exeter Resources

XRA

Gold

High

1.36

96M

$130M

Click to enlarge

Exeter Resources (NYSEMKT:XRA) (analysis on 6/4/2016) has a huge gold project in Chile. Undeveloped giant gold deposits are rare and Exeter Resources has one (20 million oz, although low grade at .5 gpt, but 80% recovery rate). And it is in the right location, next to a large producing mine that has infrastructure. Plus, it is a low cost surface mine that includes 6 billion pounds of copper and 40 million oz of silver (1 gpt), which will reduce costs. Cash cost for gold equivalent production (gold, silver, and copper) will be around $600 per oz. For gold only, cash costs will be very low.

Originally they were going to mine 700,000 oz (gold equivalent) per year for 19 years (13 million oz). They have abandoned that plan because the capex was $5 billion. Instead they are going to start small and expand production over time. They will end up building the mine in phases. They have three starting options under consideration. Option 1 will likely be used, which is a small open pit oxide mine. The initial capex will be around $240 million, with production at 125,000 oz (gold equivalent). Once they get into production, they will become a growth company. Production should eventually reach 350,000 oz annually, and perhaps much more.

There are significant risks with this stock. First is the long timeline risk until production ramps up. They still need a pre-feasibility and final feasibility studies, as well as permitting. Second, they could easily get taken out by a Major once gold prices rise and their 15 million ounces suddenly become very valuable. Third, they need to acquire financing, which could cause dilution or hurt their balance sheet. My guess is that once they de-risk the project with a final feasibility study and final permits, they won't be able to hold off a takeover attempt. Their gold in the ground is currently being valued at $5 per oz. I'm sure a major would pay up to $50 per oz for this project ($750 million) once gold prices take off and it is de-risked and ready for construction. But I doubt they will have to pay that much. As investors, we will be lucky if we get half that amount. These big projects usually always go to the big boys.

The 3 Ps

Properties

Do they have a flagship project? Yes, long life mine.

Do they have a pipeline of projects for growth? Yes, additional mines are possible from current project.

Do they exploration potential to expand resources? With 20 million oz they don't need to explore.

Is the grade and recovery rate satisfactory? Yes, but requires higher gold prices.

Is the location satisfactory? Yes, although Chile is not ideal. They have no infrastructure issues, other than potential water issues at higher production levels.

Do they own it? Yes, 100%.

People

Is it an exploration or production team? Both.

Do they have experience? Yes, it is a highly experienced team.

Do they have a track record for building mines? First mine.

Are they investor friendly and not always diluting? Yes.

Is the team large enough to build a mine? Yes.

Have you listened to a CEO interview? Yes, he is very impressive. He talks about the important issues and is comprehensive.

Are they cash focused? This is unknown until they make some money.

How much stock does management own? Unknown.

Do the website and company presentation provide adequate guidance and details? Yes.

Projects

What are the resources? 20 million oz at .5 gpt.

What documentation has been released (PEA, Pre-feasibility Study, Feasibility Study)? PEA.

What is the capex? $240 Million

What is the after-tax IRR? 28% at $1300 gold.

What are the estimated cash costs and all-in costs per oz? $600 cash costs.

Can it be financed? N/A.

How will it be financed (debt, equity, streaming)? N/A.

Share Structure

Is it highly diluted? No, 96 million fully diluted shares. However, they will need to dilute to pay for the feasibility and engineering studies, as well as to finance the mine.

Timeline Risk

Yes, risk exists because there will be no production until around 2022.

Market Cap Size

It's in the sweet spot.

Stock Chart

Is this a good entry point? Yes, but it has made a big run in the last two months. Perhaps it's better to wait for a pullback.

Balance Sheet

What is their cash/debt situation? $15 million in cash and zero debt.

Valuation

What is their future market cap growth rate at $2500 gold? 3000% at 500,000 oz. (see below).

What is their future free cash flow at $2500 gold? $400 million annually at 500,000 oz. (500,000 x $800).

What are their future reserves valued at today? $8.70 per oz at 15 million oz. ($130 million / 15 million oz).

Future market cap growth:

Current Market Cap: $130 Million. Future Market Cap: 500,000 oz x $800 = $400 million annual cash flow x 10 = $4 billion Compare the two values and you get a 3000% increase.

Is Exeter Resources highly undervalued? Yes, with a potential increase of 3000% and future reserved valued at $8.70, it is highly undervalued. If you consider share dilution to pay for the feasibility study, engineering, and financing the mine, the upside is considerably lower. If they build the mine, perhaps it will be a 10 +bagger.

You can check the data included in this article at Exeter Resource's website and my own.

Disclosure: I am/we are long XRA, JAGGF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.