Luna Gold - Waxing Or Waning?

| About: Luna Gold (LGCUF)
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Luna Gold (OTCPK:LGCUF) is a junior gold mining company operating the Aurizona mine in the coastal region of Northern Brazil. The company achieved commercial production from an open pit mine in early 2011 and produced over 74,000 ounces of gold in 2012, the first full year of commercial production. Since the beginning of this year an expansion program is underway that is scheduled to take the average annual life of mine output to 135,000 ounces of gold. This expansion program is still on time and on budget for commissioning in the fourth quarter of this year. This expansion is termed "Phase I" and the release of a preliminary feasibility study for "Phase II" targeting 200,000 to 300,000 ounces per year production is scheduled for release also in the fourth quarter.

Luna Gold has listings on the Toronto and Lima Stock Exchanges and trades in the US via the pink sheets. During the past three months an average of 12,000 shares have changed hands per day on the pinks sheets OTCQX exchange and 190,000 shares per day on the Toronto Stock Exchange providing sufficient liquidity for most retail purposes. At the time of writing the market capitalization sits at $152M and shares are trading for $1.45 resulting in a P/NAV ratio of less than 0.4. The share registry is tight with only 105M shares outstanding, insider ownership of 14.4% and negligible institutional ownership. Luna Gold had a moderate long-term debt of $30M. A high percentage of operating cost is incurred in Brazilian Real, which has moved favorably against the dollar in the past few months.

Operational results were reported below expectations for the first quarter this year, mainly due to severe drought conditions restricting water supply for the process plant. At the time we contacted the company and received a detailed response which we summarized in a past article. The results for the second quarter of this year have now been released and production has increased only slightly from Q1, necessitating a 2013 guidance reduction by a hefty 15,000 ounces to a range from 80,000 to 90,000 ounces for the year. The new guidance forecasts the mine operating as initially guided for the second half of the year, with first half shortfalls essentially accounting for the reduction of the original guidance. At the same time the company announced a reduction of the cash cost target for the year to $670 to $690 per ounce. In response to depressed gold prices the company also initiated a number of cost-cutting measures.

(Aurizona mill. Photos taken from company website)

We felt that it was time again to ask the company a couple of questions and proceeded to contact Mark Halpin, Vice President Corporate Development, who was helpful as always to provide some color.

When asked for the reasons for the production shortfall in the first half of the year Mark Halpin provided the following list:

  • "Continuation of a 1 in 100 year drought from mid-2012 to the end of February 2013 which restricted the water supply to our processing plant resulting in lower plant throughput
  • Luna was mining a newly cleared section of the Piaba pit that hosts lateritic ore for the whole quarter. The laterite has a higher work index that requires a longer milling time to reduce the ore to the required particle size for the metallurgical process. On the other hand, laterite has a higher grade than the life of mine average grade
  • Longer than expected downtime for SAG maintenance
  • Delay in spare parts delivery for our mining fleet which resulted in a lower mining fleet availability. Measures have been put in place with our suppliers to reduce a reoccurrence of delayed parts delivery."

With water supply back to normal levels since the end of February and measures put in place to get through the next possible drought, a new service agreement with suppliers plus the SAG mill back in normal working conditions three of these reasons can be considered resolved.

The mention of laterite mining led to our next query. We were wondering how the reduction in cash costs will be achieved. Some gold miners tend to high-grade their mines in tough times which can lead to un-economical low-grade portions of the reserve left behind and creating a shortfall later on. We prompted Mark on this concern and received the following reassuring explanation:

"Historically during the first half of a year we are able to remove more waste which opens up the ore deposit for greater saprolite ore mining in the second half. [...] The average expected grade processed for second half 2013 is 1.20 g/t [which] is lower than the 1.53 g/t grade processed and mined during the first half of 2013. Our main lever to increase ounces in the second half is an increase of plant throughput and access to the softer saprolite ore."

The MD&A for the second quarter report lists a number of cost cutting initiatives. Mark Halpin reiterated these measures and provided additional color in our communication as follows:

"The Company's priority to continue maximizing margins and cash generation, the current lower gold price environment has motivated Luna to implement several initiatives including: eliminating non-essential expenditures; continuous improvement throughout the supply chain, contract review and negotiations, and internal process controls; changing the phased commissioning of Phase I expansion to commissioning all equipment in the fourth quarter 2013; placing exploration on care and maintenance until further notice.

The depreciation of the Brazilian Real against the US dollar has also helped with reducing our costs as around 90% of our costs at Aurizona are Real-denominated.

Recently the fixed cash compensation of Executive Management and Board members has been reduced by 20% for a 12 month period."

With this initiative Luna Gold joins a growing group of gold miners that have put similar cost-cutting measures in place. The salary reduction of the company executives is substantial and will resonate with investors and general staff alike. However, we note with some regret the complete mothballing of Luna Greenfield exploration. Beyond the mentioned Phase II expansion and a potential underground mine at Piaba, organic growth will presumably come from the vast prospective land package adjacent to the existing mine. We certainly hope that putting exploration on hold will not impact on further growth when the time comes, however Luna Gold may take the opportunity to acquire operating and development stage projects to fuel future growth.

(Flooded artisanal pit, Luna Greenfields)

If realized these measures are impressive, but in the light of the production shortfall so far this year, they are also necessary considering the cost of the ongoing Phase I expansion program. Phase I expansion is budgeted with $50M. Just over half of this budget has been spent, leaving $24M to be paid for in the second half of this year with $12.6M already committed.

The balance sheet for the second quarter indicates only $3.9M in cash, but this has been supplemented already by $8.4M worth from gold sales resulting in a current cash balance of $12.3M. Sandstorm Gold (NYSEMKT:SAND) has a streaming agreement with Luna Gold allowing them to purchase a portion of gold production for a discounted price in exchange for a portion of the initial development capital. In order to finance the remainder of the Phase I expansion plan Luna Gold has announced it will draw down $10 million of its subordinated debt facility with Sandstorm Gold which has also been acknowledged in the last earnings call by the streaming company.

"The Company intends to draw down the Sandstorm Subordinated Debt Facility in Q3 2013, to provide assistance in funding the completion of the Phase I Expansion. In addition, the Company continues to receive a 17% contribution of capital from Sandstorm for the Phase I Expansion on a timely basis." (from the Q2/2013 MD&A)

This plan will work comfortably if the new operational goals for the second half are achieved and the associated cash flow eventuates. However, it is important to note that failure to do so would put noticeable financial strain on the company. Luna Gold is now under pressure to perform very well for the remainder of the year.

Having said that we feel that it is worth analyzing the projected production costs. The World Gold Council has recently published guidance for calculating All-In Sustaining Costs. Luna Gold uses a different terminology and definition and we asked Mark Halpin about cost measures used by the company. Here is the explanation he gave:

"We use "All-in Operating Costs" to show the costs incurred at site level to produce an ounce of gold and include the following expenses; mining, processing, site G&A, transport and refining, royalties, sustaining capital, Aurizona exploration, interest and income taxes. In our Investor Presentation we show "Total Production Cash Costs" which includes our "All-in Operating Costs" plus corporate and Luna Greenfield exploration expenses.

The "All-in Sustaining Costs" guidance published by the World Gold Council is less comprehensive than our "All-in Operating Costs". For example, the WGC "All-in Sustaining Costs" doesn't include income taxes or interest expense where the Luna "All-in Operating Costs" includes both."

In a recent survey of 13 companies reporting All-In Sustaining Costs as defined by the WGC Luna Gold would rank in equal fourth position, considering projected All-in Operating Costs of $938 for the second quarter. We find this a very encouraging sign for the time after completion of the Phase I expansion when economy of scale can be expected to lower cash costs further and the necessities of funding capital expenditure from cash flow will cease.


LGCUF data by YCharts

For the time being we remain tentatively optimistic. The company has implemented measures to achieve the prime goal of implementing Phase I expansion without shareholder dilution. If successful Luna Gold should return to outperforming peers in due time. We note that there is not too much room for errors. The next quarterly report will need to show the effectiveness of the announced measures.

Disclosure: I am long OTCPK:LGCUF, SAND. 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.