As Wall Street grapples with the mining industry's persistent string of earnings misses, the monolithic declines across the group have presented an unprecedented opportunity to extract alpha. The confluence of peak gold production, rapidly depleting grades, and substantial escalations in cash mining costs has been supportive of higher commodity prices. Such trends, however, have had a significant adverse impact on the industry's margins. The key to making a fortune in the mining realm going forward is to invest in unique high quality assets with stable cash mining costs, clean balance sheets, and flat or rising production and reserves. Coeur d'Alene Mines (CDE) fits this profile perfectly and perplexingly trades at a significant discount to NAV, close to 3X EBITDA, and an 18% FCF yield despite having almost $100 million of net cash on its balance sheet. Coeur is buying back stock after recently implementing the first repurchase plan in the history of the company, and the resulting accretion could be significant.
Speaking from the sidelines of the 2012 African Mining Indaba conference, AngloGold Ashanti (AU) CEO, Mark Cutifani, made the astonishing claim that at a price of $1,650 per ounce of Au, gold miners are "only just returning the weighted average cost of capital for the industry." He also argued that "the average cost to produce an ounce of gold, all up, everything loaded in, is about $1,200 to $1,250." IAMGold (IAG) CEO, Steve Letwin, recently told Mineweb that a floor has developed in and around the $1,400 - $1,450 level as a result of increased costs across the industry. "I think you hit peak gold three or four years ago. You cannot find the large deposits any more. Most of it being lower grade and in more remote locations, so it's going to be difficult for anybody to produce gold at less than $1,200/oz in terms of new discoveries," Letwin said. The magnitude of Goldcorp's (GG) recent negative preannouncement demonstrates the severity of the production declines and cost increases that have ensued across the globe. The company, which is perceived as one of the best operators in the industry, increased its annual cash cost guidance by ~11% and reduced its silver byproduct production guidance for the year by almost ~11.5%.
While rapidly escalating costs, falling production and depleting grades have been construed as a negative development for the entire mining industry, these trends will enable Coeur d'Alene Mines to differentiate itself from the precious metals group and rapidly transition from trading at a substantial discount to the group to a significant premium.
CDE is the largest U.S.-based primary silver producer and a pure play precious metals producer with a mix of approximately a 65%:35% silver to gold ratio. The company was run by Dennis Wheeler between December 1986 to July 2011, and during this period it pursued an acquisitive strategy to grow its production. In 2007, CDE made its largest acquisition ever of the Palmarejo silver project in Chihuahua, Mexico for $1.1 billion, nearly equivalent to CDE's entire current market cap despite only comprising an estimated 40% of the company's current NAV! When CDE acquired Palmarejo, silver prices were less than $15/oz vs. >$27/oz today and the mine's operating costs were expected to be below $2.00/oz of silver after by-product credits vs. last quarter's costs of only -$2.29/oz. Subsequent to CDE's acquisition of Palmerejo, the company suffered from recurring missteps in ramping up production at the mine. Also, its Kensington underground gold mine in Southeast Alaska was on put hold in mid-2007 until a the U.S. Supreme Court sided with Coeur Alaska in 2009, paving the way for tailings mine waste from Kensington to be dumped into Lower Slate Lake.
CDE's 5-year performance is down 62% while that of the GDX is down only 3% in the same period. Under the company's new management team led by CEO Mitch Krebs, its results have improved markedly and its mine portfolio is now firing on all cylinders. The market just hasn't recognized it yet. The primary argument for purchasing the equity of miners rather than the underlying metals revolves around the optionality associated with miners' cash flow growth exceeding metals' price appreciation. Rising costs, however, have dampened operating leverage for the industry and resulted in significant underperformance for precious metals equities.
While cash costs have been increasing for precious metals producers, CDE's cash costs declined last year from $7.05/oz Ag in 2011 to $6.32/oz of Ag and Palmerejo's cash costs declined from $4.10/oz in 2010 to -$2.27 last quarter. The industry is suffering from depleting grades in its world class deposits, but CDE has been able to defy this ominous trend by ramping production in some relatively nascent high-grade mines. Its Kensington gold mine, for example, will generate substantially improved throughput as the year progresses and cash costs for the mine should settle below $800/oz of Au from $2,709/oz of Au in the most recent quarter. The company's stable cash costs have enabled it to generate significant operating leverage as metals prices have appreciated. In 2011, for example, average gold prices were up 28% and silver increased 74% while CDE's gross profit increased 124%. Also, the company's low cash costs of less than 25% of current silver prices provide significant downside protection if precious metals prices plunge.
CDE's cost advantage over other precious metals producers, however, is understated based simply on contrasting cash costs. The real total cost per ounce (RTC) includes both expenses from the income statement and capx, which is an integral component of a miner's production (RTC is defined as Total Cash Cost + G&A Expense + Other Expense + Exploration Expense + Tax + Capex). For the senior gold producers, RTCs are estimated to be approximately $1,700 per ounce, which is in excess of the current price of gold. CDE's estimated RTC for 2012 is <$17 per ounce of Ag, which is 38% lower than current spot silver price. With the major capital expenditures for Kensington and Palmerejo having already been spent, CDE's free cash flow is now being significantly bolstered by its declining capx profile. CDE's capx was $365 million in 2008, $219 million in 2009, $156 million in 2010, $120 million in 2011, and the company's 2012 capx guidance was $90 - $120 million, $33 - $42 million of which is growth capx.
CDE believes that its annual production of 18.5-20 million oz of silver and 210,000 - 250,000 oz gold is sustainable between 2012 and 2014 and that its reserves and resources will grow in 2012. Though the market may be concerned about CDE's production profile declining beyond this period, the company has several low cost sources of production and reserve growth that investors are currently overlooking. Coeur is implementing an aggressive spending program on Palmerejo this year to advance the Guadalupe and La Patria deposits located near the primary deposit and to expand existing ore bodies through the operation of 6 core drills. As the core assays are released to the market in the months ahead, investors could begin to contemplate a significant upside scenario in which Palmerejo's production growth potential amounts to millions of additional ounces of silver. Past exploration at Palmerejo had been focused on only 10% of Coeur's >12,000‐hectare land position.
Coeur's Joequin mine in Argentina is essentially a satellite to its Martha Mine. Joaquin's property package is more than twice the size of Palmarejo. Drilling in 2012 (over 23,000 meters) will result in increased resources at the La Negra and La Morocha deposits, which are just north of Martha. An updated mineral resource estimate is expected to be completed and released imminently. Coeur also has an opportunity to increase production at Rochester through the expansion of its $13/oz Ag cash cost heap leach mine, a potential high return project that could add 4 million ounces of annual silver production.
One risk factor that has unjustifiably resulted in CDE's trading at less than half of the silver mining industry's P/CFPS multiple is its exposure to Bolivia through its ownership in the San Bartolome mine, which comprised 26% of the company's metals sales in 2011. Bolivia has nationalized a string of assets in the energy, mining and power-generation sectors since President Evo Morales took office in 2006, including having recently taken control of Spanish Red Electrica Corp.'s power-grid operations (TDE) in May and Glencore's Colquiri zinc and tin mine in June. The consistent causes of these nationalizations have been underinvestment, underproduction, and labor unrest. Joao Augusto de Castro Neves, Latin America analyst at political risk consultancy Eurasia Group, argues that Bolivia's TDE takeover should not be seen as "a harbinger of a new wave of Bolivian nationalization" but instead "as the tail end of a cycle of nationalizations." Also, after Spain's initial criticism, the country acknowledged the legitimacy of Bolivia's nationalization decision, which includes a promise of fair compensation. Red Eléctrica expects to strike a friendly agreement with Bolivia on the value of its investment, and the parties have agreed to retain a joint appraiser. In the case of the Colquiri mine, the nationalization ended a standoff between workers at Glencore's Bolivian subsidiary and co-operative miners who had been disputing ownership of the site's mining rights. Bolivian Vice President Alvaro Garcia Linera informed a local news agency that the mine will be run by the Bolivian national mining company, Comibol, and that the government will calculate Glencore's compensation within 120 days. While these developments have caught the attention of the press and the stock market over the past several months, President Morales' policies have been more balanced towards foreign businesses than most investors have contemplated. In an effort to reduce Bolivia's dependency on fuel imports for domestic consumption, for example, the government instituted a new policy on April 19 boosting incentives for crude oil production from $10 to $40 per barrel.
Comibol is the underlying owner of virtually all the mining rights relating to the San Bartolome project and these mining rights have been leased to Coeur. Unlike the contentious relationships in projects that have been subject to government scrutiny, CDE and Comibol enjoy a very benign and synergistic partnership. The productivity and union relations associated with CDE's Bolivian project are very strong. In April of last year, Coeur announced it received assurances from the Morales Administration that San Bartolome was not targeted for any proposed mining nationalization in Bolivia. The company said "the labor unions working with management at San Bartolomé have openly denounced any nationalization and expressed their support of Manquiri (the subsidiary that operates San Bartolomé) as have the mining cooperatives in Potosi, who are a strong social and political influence in Bolivia." Coeur's management team expects new mining legislation to be enacted in Bolivia this year and provide increased transparency and comfort that San Bartolome's mining rights will remain in the company's hands. Also, mining at San Bartolome is conducted using specialized free-digging surface mining techniques that do not require drilling or blasting, and Coeur contributes significantly to the efficiency of the operation, making its relationship with Comibol very synergistic.
With CDE's unprecedented decision last month to repurchase its shares through an initial authorization of up to $100 million, investors should feel more comfortable that the company's cash flow will be deployed on high return investments under its new management team. If the stock were to increase 3-fold from current levels to ~$50 per share, it would still be trading at a 6% FCF yield, which is relatively close to that of the S&P 500! With the race to devalue fiat currencies in full swing and the continued US dollar appreciation adversely impacting net exports in an economy with an output gap that is already unacceptably high, the Fed will have no choice but to ease further. Also, Congress' stagnant progress in implementing new stimulative fiscal policy is a best case scenario for gold and silver, as it shifts the burden onto the Fed's money printing machine in order to fulfill its dual mandate.