Ian Cassel's  Instablog

I’ve been invested in Gold Resource Corporation (sym: GORO) since its IPO in 2006. Gold Resource Corporation anticipates gold production by year end 2009. Since day one, management has been positioning the company to be in the elite class of low cost gold producers. Companies such as Agnico-Eagle (AEM), Yamana Gold (AUY), and Goldcorp (GG) operate in this group and trade at PE’s that are two-three-four fold higher than average cost gold producers. The reason their gold cash costs are so low is that these companies not only produce gold but produce other by-products such as silver, copper, zinc, lead, etc that they sell and use as a credit against costs.  Several times Agnico-Eagle (AEM) actually had a negative gold cash cost due to by product sales being so high.  The pitch for low cost producers is simple: The lower the cost, the higher the margin and EPS. At $1,000+ gold, a company that can produce gold at a sub $200/oz level has almost Microsoft (MSFT) or Google (GOOG) margins. Gold Resource Corporation anticipates producing 70,000 ounces of gold in Year one at a $100 cost in Year 1, 110,000 ounces at $0 cost in Year two, and 177,000 ounces at $0 cost in Year three. 
 

If GORO is successful in being a low cost gold producer, the reward for investors is going to be very high. Let’s look at Gold Resource Corp’s first year production dynamics (estimated grade, recovery rate, mill up time, etc) to see if they can produce gold sub-$200/oz. 
 

Any projection involves calculations that rely on certain assumptions. The following assumptions are used to determine possible cash flows:

 

(1) The El Aguila open-pit ore will average 7.45g of gold a tonne.

(2) The El Aguila open-pit ore will average 63.0g of silver a tonne.

(3) Recovery rate for gold will be ~94%.

(4) Recovery rate for silver will be ~90%.

(5) Amount of recoverable gold a tonne is 0.94 X 7.45 = 7.003g

(6) Amount of recoverable silver a tonne is 0.90 X 63.0 = 56.700g

(7) The cost to excavate open-pit ore is $2 a tonne.

(8) The cost to mill a tonne of ore is $26. This cost is consistent with other Mexican miners processing ore through a mill. Total cost (mining plus milling) is $28 a tonne.

(9) Mill commercial production capacity is 1,150 tonnes a day.

(10) Mill up-time will be ~90% or 328 days a year.

(11) There are ~31.1 grams to a Troy ounce.

(12) Use a gold price of $1,000 an ounce.

(13) Use a silver price of $17 an ounce.

 

Using these metrics, it is relatively easy to calculate the expected first production year cash flow once full commercial production is achieved.

 

Gold production should equal 1,150t/d X 7.003gAu = 8,053g a day. Dividing by 31.1 to convert to ounces gives us 259 gold ounces a day. Multiplying by 328, we get 84,937 gold ounces a year. Dollar value of gold = 84,937 X $1,000 = $84,937,000.

 

Silver production should equal 1,150t/d X 56.7gAg = 65,205g a day. Dividing by 31.1 to convert to ounces gives us 2,097 silver ounces a day. Multiplying by 328, we get 687,693 silver ounces a year. Dollar value of silver = 687,693 X $17 = $11,690,781.

 

The combined value of gold and silver = $84,937,000 + $11,690,781 = $96,627,781.

 

The next step is to calculate and apply the cost to mine and mill the ore.

1,150t/d X $28/t X 328d/y = $10,561,600. Subtracting this from the combined value of the extracted gold and silver: $96,627,781 - $10,561,600 = $86,066,181 net.

 

An interesting fact is that the cost to mine and mill El Aguila ore ($10,561,600) is less than the value of the silver ($11,690,781) by $1,129,181. Dividing the $1,129,181 surplus by the number of gold ounces produced (84,937) we get $13.29 per gold ounce. In other words, if we apply silver as a credit against the cost of producing the gold, the silver should pay all mining and milling costs, and in addition, add $13.29 a gold ounce in profit. Another way to view it is that gold would be produced at a negative cost of $13.29 an ounce.

In fact, even if El Aguila ore didn't contain any silver at all, the cost would be $28/tonne X 4.44 tonnes = $124.32 an ounce to produce gold.  How is this possible?  Because 7g of recoverable gold per tonne is incredibly rich ore by industry standards and that's especially true for open-pit operations.  The average ore grade for South Africa gold mines is 4.5g / tonne.

 

The assumption is that this gold and silver will be in the form of dore bars which will be sold to refiners at a discount of ~3% to the spot price of gold. Correcting the net of $86,066,181 for the 3% discount, we have $86,066,181 X 0.97 = $83,484,196 in free cash flow. Assuming a fully diluted issued share count of 50 million, the free cash flow per share would be $1.67. Applying the 1/3 for taxes, 1/3 for exploration and development, and 1/3 for dividend that GRC has mentioned as a possibility, the dividend per share will be $0.55 a share.

 

Earnings would be 2/3 of $1.67, or approximately $1.11, which, if we assume a PE ratio of 20, would yield a possible share price of $22.

Please note that these calculations depend on GRC being able to supply high grade ore from the El Aguila open-pit mine for a full 12 months. The recent new discovery at El Aguila of 904g (29 ounces) of gold per tonne of ore certainly increases the probability that there are 12 months of high grade ore supply at El Aguila. GRC has said that they only anticipate that El Aguila would supply enough ore to produce 70,000 gold ounces. If that proves to be the case, then running at a rate of 259 gold ounces a day, the ore would only last 270 days or about 9 months.
 

In conclusion, Gold Resource Corporation WILL be a low cost gold producer. This peer group is currently trading at 20x forward EPS. Gold Resource Corp and its shareholders look to have a very rewarding future. 

Disclosure:  LONG GORO

Unfortunately, as investors all we have is past performance to judge future performance. To buy low and sell high you need many things to happen in your favor that you have no control over. The most important one, the company needs to execute and execute well, so the premise of this article is now that you have a winner, when do you start taking profits.   A strategy for selling high is as important as one for buying low. It has taken me way too long to figure out that a profit is booked after the sell transaction and not before. I’ve seen seven figure profits in stocks slip away into losses more than once because I did not have a selling strategy. Just like many things in life to define the ending (how to sell) you need to define the beginning (how to buy).

 

One of the keys for me in finding OTCBB winners is finding them when they are undervalued given current and future growth prospects. I try to invest in stocks that in my estimation should be 4x+ higher RIGHT NOW, and then buy up to 50% of my fair value price. Let’s use EGMI as an example. I stumbled on this gem in April 2008 at $0.60. The stock earned 6c in 2007, 10c in 2008 and gave guidance for 14c in 2009 thus having EPS growth of 40%+ for three years. Not only that but the company had no financing risk as they were producing roughly $2 million a qtr in operating income thus adding to its pile of cash (~$11 million). When I found EGMI it had no business being so low except for a few idiot hedge funds that tanked the stock because of redemptions. I felt the stock should at least be trading at 20x 09’ guidance short term, so $2.80/share was my fair value price given no new deals/contracts. Additional deals would likely add to the multiple and increase the fair value price. My buying strategy was to buy all the stock that I could up to $1.40/share or roughly up to 50% of my fair value estimate at the time. I have since bought stock higher than $1.40 as I’ve paid as high as $1.70 for the remainder of my position. 

 

Since I take rather large positions in companies it’s even more important that I have some sort of selling strategy. I normally wouldn’t share this but what the heck. I normally start taking some profits off the table when the stock gets above my initial fair value price. The amount I sell really is more of a feel game. If the company is continuing to hit on all cylinders, then I might only sell a little bit, but the key is to take some profits. This isn’t rocket science I know, but it is very harmful to your net worth to fall in love with a stock. I also don’t claim to know everything, as I will likely continue to take losses from time to time but it’s a game of averages. The difference between a .200 and .320 batting average in baseball is about $10 million a year. 

 

Again, Life is too short not to take profits. Enjoy the money you make and buy a depreciating asset or two, but don’t spend too much. The whole point is to keep your net worth snow balling. The next cheap stock you find you’ll be able to buy more stock and make more profit (hopefully). I try not to spend more than 5% of my net worth on “stuff” in a given year, which can be scaled back to 0 if I hit a bad streak which I will. The main thing is to get out of debt, keep fixed costs low, stay lean, make money and always pay cash for “stuff”. If I can’t pay cash for something I don’t buy it. It’s been a practice that has served me well over the years and lets me sleep soundly at night.  Okay, enough of my ranting as I’m starting to turn into Suze Orman ;)

When deciding to invest in a micro cap stock, the most important thing outside of a company’s business itself is their share structure. I’m not going to go into too much detail, but there are certain elements which are crucial to understand before making an investment. The elements of a share structure that I pay careful attention to are outstanding shares (OS), fully diluted outstanding shares (FD OS) which include options and warrants (in and out of money), insider ownership, and convertible preferred shares. A company’s share structure is a complete reflection of management’s ability to create shareholder value. Management’s #1 goal should be to get off the OTC bulletin board, and a company’s share structure is usually the main deterrent or facilitator. 
 

OS and FD OS: These two terms are highly important because they are the key component in deriving a company’s market cap.   The OS can always be found in quarterly and annual reports, 10Q’s and 10K’s or by calling the company’s transfer agent. The FD OS can be found by taking the OS + warrants/options + convertible notes/shares. Also, I add all the warrants and options including “In the money” and “Out of the money”. If they add dilution they are getting added. The most detailed account of options/warrants is always found in the 10K (annual report) usually buried way down in the report.   Make sure that when you are adding up a company’s FD OS you pay careful attention to any outstanding preferred shares/convertible preferred shares. Many preferred shares have a conversion feature that convert into common shares at some ratio. For example, company XYZ might have 100,000 preferred shares outstanding which seems small so you don’t pay attention to it, but in reality they may convert 1:100 into common shares. In other words company XYZ’s FD OS is actually 10 million (100,000 preferred shares x 100) shares more then what you thought. Always use FD OS when evaluating a stocks market cap and while doing EPS and PE analysis.  
 

As an investor my sweet spot is between 10 million – 60 million FD OS. I normally don’t look at anything outside those parameters unless there is absolutely no financing risk and/or the fundamentals warrant it, as in Electronic Game Card Inc’s (EGMI) case {62m OS outstanding, 70m FD OS}. ZAGG Inc (ZAGG) fell right in the sweet spot {20m OS, 25m FD OS}. The reasons for not getting involved with companies with high FD OS’s are obvious. If company XYZ has 200 million OS and the stock is at $0.50/share it already has a market cap of $100 million. You know how much money a company with 200m shares out has to make to make 0.10 EPS thus warranting $1-2 stock price? $20 million, Good luck but I’ll pass.   However, a company like ZAGG only has to make $2.5 million net to make 0.10 EPS. Other reasons to stay away from high FD OS stocks are that it takes a lot of volume to move them and each incremental move higher has a much bigger effect on market cap.  For example, ZAGG going from $4 to $8, is the same as company XYZ going from $0.50 to $1 when looking at market cap. More importantly, a company trading under a buck with 100 million+ OS just shows that management either didn’t do their job or isn’t doing their job. A point I made earlier is that every CEO’s #1 goal should be to get off the OTC Bulletin Board and quite honestly it won’t happen with a high FD OS companies.    
 

ZAGG Inc really was a perfect situation. I found the stock in October 2008 during the economic crisis. At the time the company was at $0.60/share, trading 18,000 shares a day on average, and had a market cap of $15 million (25m FD OS x .60). Up to this point the stock was in a trading range of 55c – 90c over the prior year. The company just reached an inflection point ie profitability and announced the product entering Best Buy (BBY). ZAGG’s run up in recent months was only attainable because of the tight share structure which I found to be a great reflection on management.  Between October-December 2008, I and few other investors bought up every share we could since I thought this was a $3 stock in the making. With only 25 million FD OS and 6-7 million shares in the float there came a point in time where the scarcity of shares and the 100% net income growth lead to high PE multiples {Disclosure: also signed onto be an advisor to ZAGG in December 2008}. My point being that a stock with a good share structure like ZAGG will always trade at a higher multiple (PE) due to the scarcity of shares, when compared to the same business model inside a company with 200 million FD OS. I still believe to this day that ZAGG is one of those rare situations where both business growth and share structure are in perfect harmony, thus creating a perfect storm that leads to sustained stock price accelleration. 

On the other side of the spectrum, a problem occurs when a company has too few OS as there is little liquidity in the market place for the stock. I could list 50 different companies with 1-4 million OS and the problem is that they don’t trade enough volume for any serious investor to get involved. As a retail investor, I’m looking for stocks that will go to the next level and that means attracting institutional investment.  Someone needs to buy my shares off me at a higher price ;) A small fund isn’t going to buy a stock that trades 1,000 – 10,000 shares a day. How will an institution ever be able to pick up a meaningful position (or get out of a position) without moving the stock price quite significantly, so most funds will just pass. This is a problem and one to stay away from. For me the sweet spot for FD OS is around 20-30 million.  
 

Insider ownership is an important qualitative component in any stock. I normally like to see insiders owning between 20-60% of the FD OS. Too little insider ownership might show not enough alignment with shareholders meaning management doesn’t have enough skin in the game to do what’s right for shareholders. I can sometimes overlook lesser insider ownership under certain circumstances, such as when a new management team takes over a company, etc. In my experience it is also bad to see insiders owning too much of the company such as when the CEO owns 70%+ of the FD OS. I’ve found that in these situations the CEO acts too much as a dictator and not as a shareholder advocate.
 

I’m going to stop writing now as I hate reading long blog posts and this for some reason is turning into one of those. I wanted to make a few more points but am tuckered out and quite honestly I don’t want to disclose all my secrets ;) There is no greater motivator and educator than losing money. I learned from making investments and losing money just like many others, and it is amazing how many investors continue to overlook the importance of a good share structure. Through the years my batting average continues to increase and I hope yours will too. We are only in this for the money. 

 

Disclosure: Long EGMI and Long ZAGG. No affiliation with EGMI. I am an advisor to ZAGG. http://iancassel.com/disclaimer/