Junior gold and silver miners do not often tempt us at Pounce. Large upfront capital requirements to fund aggressive exploration and mine development often portend stretched balance sheets, dilutive secondary offerings, and years of deeply negative cash flow - all for an uncertain payoff.
However Canadian gold miner Primero (PPP) recently caught our eye precisely because of its opposite characteristics:
- The company runs the already fully operational and highly profitable San Dimas mine in Mexico.
- Its balance sheet currently carries almost no net debt with plenty of available cash.
- Most importantly, Primero's existing mine operations generate significant free cash flow.
Primero acquired the San Dimas mine from Goldcorp (GG) in mid-2010 for $510 million - paying $216 million in cash, issuing Goldcorp $110 million in convertible and term notes, and the balance in Primero common shares currently equivalent to 36% of the company. Primero has used its cash flow since the acquisition to pay down $35 million of the acquisition-related debt, and expects to pay down another $30 million within the next two quarters.
So with gold (GLD) trading in a volatile sideways range, predictions of a deeper correction in gold rampant in the financial media, and the gold miners' ETF (GDX) already at lows last seen in 2010 - why take a chance on Primero now? Put simply - the price has already traded down to fabulously cheap levels, even if gold prices were to retreat to $1300/oz.
In recent comments on February 29, at the BMO Capital Markets Global Metals and Mining Conference, Primero CEO Joseph Conway commented that the company could generate $90 million in 2012 after tax cash flow with gold above $1600/oz. Subtract the planned $30 million in 2012 capex, and Primero could net $60 million in 2012 free cash flow. Using the March 22, closing price of $2.28 and the September 30, 2011, share count of 88.25 million, PPP is a stock trading at a free cash flow multiple to enterprise value (EV/FCF) of 3.4. In today's stock market it's rare to see sustainable EV/FCF multiples under 10, let alone 3.4. Hypothetically Primero could generate the necessary cash to repurchase all of its currently outstanding common shares in a little over three years!
Of course the fear driving the gold miners' poor stock performance is that gold prices will break down below the current range and retreat further - perhaps to $1500, $1400, even $1300/oz. So how might such a correction impact Primero's operational performance?
Primero forecasts 2012 mine production exceeding 100,000 gold equivalent ounces, after producing 102,200 gold equivalent ounces in 2011. Total 2012 cash costs per gold equivalent ounce are forecast to be $660/oz at the high end. Using these figures, if gold falls to $1300/oz Primero will generate ~$130 million in sales and incur ~$66 million in total cash expenses. We can approximate the difference of $64 million as operating cash flow. Subtract $20 million in planned exploration expenses and $10 million in maintenance capex, and Primero would net $34 million in free cash flow. The EV/FCF multiple in this pessimistic scenario rises to 6, still dirt cheap by nearly any standard.
Normally any stock that trades at such low EV/FCF multiples reflects a company whose cash flow is shrinking. In contrast Primero appears fully capable of maintaining its current production rate of 100,000 gold equivalent ounces for years to come, and is currently considering an expansion of its mill capacity to double the current production rate going into 2014. The current prospective total cost of the project? $15 million, an amount Primero can easily fund from its current cash flow.
One company-specific reason that Primero's stock has traded under pressure recently is the uncertainty surrounding the company's ongoing independent review of its reserve and resource estimation methods, which may result in downward revisions to the Primero's gold reserve figures. The company initiated the review in January 2012 after encountering variations in ore grades, which impacted mine operations in the latest quarter. However according to Primero's press release, "it is not expected that any potential change in estimates will change the level of confidence management has in the ultimate mineral potential of San Dimas ... the review of estimation methodology is being driven by a desire to determine if greater operating predictability and improved mine planning can be achieved." The completion of the review will heavily influence future decisions on the mill expansion project, as well as the focus of exploration.
Even if the review results in lower gold reserve figures for the developed areas of the San Dimas mine, CEO Conway commented at the BMO conference that Primero expects its exploration efforts at San Dimas will result in reserve additions that will more than make up the difference. Both the review of estimation methods and the confidence in exploration results point up the reason Primero saw opportunity in acquiring San Dimas in the first place - that San Dimas has remained underexplored precisely because of its prolific 100-year history of gold and silver production. Certainly Primero and its 36% shareholder Goldcorp still believe that plenty of potential remains to be uncovered.
At the March 22, closing price of $2.28, our view is that PPP offers an excellent contrarian opportunity with a large margin of safety. With Primero set to announce earnings on March 28, our strategy is to buy half of our intended position now and look to buy the remaining half following the earnings report.