Argonaut Gold Is A Buy Without San Antonio, And A Steal With It

| About: Argonaut Gold (ARNGF)
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Argonaut Gold shares plummeted when it learned that the MIA rejected its appeal to build the San Antonio Mine.

While this was a large blow there is very little chance that the project won't be developed--it will just take a while.

Nevertheless the market is pricing this long-life, low-cost gold mine out of the stock.

The stock is a good buy even if we assume that San Antonio is worthless, especially if you are bullish on gold.

The stock is a steal if we assume production at San Antonio, even if we discount it out 3 years.

Back in February I wrote an article in which I argued that the selloff in shares of Argonaut Gold (OTCPK:ARNGF) was too dramatic considering the diminished valuation resulting from the company's forward guidance at its El Castillo and its La Colorada projects. I attributed this investor fear to the fact that weak guidance seemed to be worse considering that it impacted the company's near-term cash flow. Investors who saw that a great deal of the company's true value was found in its non-producing assets, and in the long-term cash flow potential from its producing assets were able to see beyond the weakness in the stock and realize that Argonaut Gold was a great company with a lot of growth potential trading at a good valuation. I concluded by suggesting that investors pick up shares on weakness in the gold mining sector, which at the time was overdue considering the run-up in mining shares during the first 7 weeks of 2014.

The weakness I anticipated has come, but I didn't expect it to take such a toll on Argonaut Gold shares. Since my initial piece on Argonaut Gold was published on February 21st the Market Vectors Junior Gold Miner ETF is down 14%, whereas Argonaut Gold shares are down 36%. This underperformance was sustained from February 21st until today, although it became especially acute around April 10th, when the company announced that its appeal of the MIA (Medio Impacto Ambiental--the Mexican equivalent of the EPA) ruling regarding permitting of its San Antonio mine was rejected.

This is undoubtedly bad news. But with the company valued at $566 million now investors have virtually priced the project at $0. While the risk that the project won't get built at all has certainly escalated the fact that investors are getting it for free, along with the fact that the company has several other projects as well as $150 million in working capital versus just $14 million in debt means that the sell-off is a buying opportunity.

What Has Changed Besides San Antonio?

My February analysis of Argonaut's other assets is largely unchanged. The only update we have seen is that first quarter production figures were released for the company's El Castillo and La Colorada mines. We also got financial results for the fourth quarter of 2013 and for the first quarter of 2014.

Regarding the latter, in Q4 the company reported a $14 million loss due to lower gold prices, lower production, higher production costs, and an $18 million tax liability. In Q1 the company reported a $3 million profit which was down year over year due to a lower gold price and higher production costs partially offset by a production increase.

Regarding the former, production was down in the first quarter as was expected.

Let us review and update the company's assets, excluding San Antonio.

1: El Castillo

The El Castillo project is Argonaut Gold's largest producing mine. Back in February I estimated that this mine was worth about a fourth of the company's total NAV depending on the gold price, the discount rate, and how optimistic one's projections for future production were.

According to the mine plan released in 2010 the mine was supposed to produce about 115k ounces of gold annually. Instead last year it produced just 95k ounces and 2014 guidance was for 90k-100k. This was due to a lower recovery grade, not to fewer tonnes of ore being milled, and so this meant that total production costs would rise as well while gold production fell, increasing production costs on a per-ounce basis.

Depending on the gold price I estimated that this reduction in guidance was worth about $73 million in market cap at an 8% discount rate, or $55 million at 12%. A great deal of the opportunity I spotted back in February was the fact that the market had shaved nearly $200 million in value after the poor guidance was released.

Q1 production figures came in at 22,278k ounces, which annualizes out to 89k ounces. This is slightly below the 90k-100k ounce guidance, but investors need to keep in mind that there was a production trough in January and that the Q1 production figures do not contradict management's prior 2014 estimate.

In my February analysis of El Castillo's NPV I offered two scenarios:

  1. The Pessimistic Scenario: Production would come in at 90,000 ounces at $900/ounce for the estimated life of the mine, or 8 years. This last figure was based on management's initial mine plan extending out 8 years, although that was based on 115,000 ounces of production per year.
  2. The Optimistic Scenario: This scenario assumes 100,000 ounces of production in 2014 with 115,000 ounces for 10 years afterwards at $90/ounce. This assumes that all of the mine's mineral reserves are produced plus some of the measured and indicated resources. This optimistic scenario was just that, although assuming all of the mine's measured and indicated resources were produced this scenario isn't optimistic enough.

Looking back the pessimistic scenario was probably too pessimistic given that I should have assumed that all of the mine's mineral reserves were mined. This assumes more than 2 more years of production at 90,000 ounces. But given that the Q1 production figures nearly annualize to 90,000 ounces, and given that January was especially weak, we can probably remain conservative and assume the middle to the upper end of the 90,000-100,000 ounce range provided for 2014.

So if we assume 95,000 ounces of production for 10 years at $900/ounce we get a fairly conservative outlook of El Castillo's value. I include taxes, all amounts are in millions of dollars.

Discount Rate/Gold Price $1,200 $1,300 $1,600
8% $134 $179 $313
12% $117 $156 $273

2: La Colorada

The La Colorada project saw production nearly double year over year, but it fell short of the company's annualized goal of 50,000 ounces due to an upgrade of the mine's crusher. Thus the weak production of 7,500 ounces shouldn't concern investors. The mine has about 1 million ounces of resources if we subtract the ounces that were mined already from the 2011 resource estimate. However, considering that these are indicated mineral resources that have not yet been deemed economical to mine assuming that all of these ounces will be mined is overly optimistic. If we conservatively assume half are mined then the mine has about 10 years worth of production left.

Accounting for silver credits, the mine should be able to produce at about $650/ounce conservatively. Assuming 50,000 ounces of production at $650/ounce for 10 years the mine has the following post-tax value matrix.

Discount Rate/Gold Price $1,200 $1.300 $1.600
8% $129 $153 $224
12% $113 $134 $196

3: The Magino Project

Little has changed except that the company saw positive results from its heap leach metallurgical testing results, which has prompted management to explore processing lower grade ore.

This is good news, but I will not alter my initial assumptions of 185,000 ounces of average production for the first 7 years and 58,000 ounces for the subsequent 6 years. Initial capex should be $356 million and AISC should come in at about $734/ounce. Given these assumptions we get the following valuation matrix for the Magino Project.

Discount Rate/Gold Price $1,200 $1,300 $1,600
8% $82 $150 $364
12% $23 $82 $266

4: San Agustin

The company has drilled some 13,000 meters here, and it has announced plans to release more specific figures regarding this newly acquired exploration property, but otherwise there is no change to my assessment of San Agustin, which is worth repeating here verbatim:

The San Agustin project was recently acquired from Silver Standard Resources (NASDAQ:SSRI) in exchange for $15 million in up front cash, $30 million in stock, future payments totaling $30 million, and a 2% net smelter royalty. The project has no economic assessment so it is difficult to put a price tag on it. Nevertheless it has sufficient resources to be an economical mine. Since the deal has a total value of $85 million (roughly assigning $10 million to the royalty) we can conservatively assign $50 million of value to it. It will be interesting to see what the company ends up finding when it releases a PEA towards the end of the year. If it is positive then this will add to my thesis that investors need to look more at the company's project pipeline and less at its near-term cash flow and production in order to appreciate its value.

While $50 million is well below the acquisition cost, and while the company has added value to San Agustin, I will still assume it is worth $50 million.

5: Other Assets

Counting the company's working capital, its other non-mining assets, and its liabilities, we must add an additional $74 million to Argonaut's value.

Argonaut Gold's Value Ex-San Antonio

Recall that the thesis I am putting forward is that Argonaut Gold is a worthwhile investment even if we assume that its San Antonio mine has no value. In all likelihood this is not the case; we will probably see the project get the necessary approval, and the extent of the damage is more likely delayed production than no production altogether.

Accounting for the companies remaining four mine's and the net value of its non-mining assets we get the following valuation matrix.

Discount Rate/Gold Price $1,200 $1,300 $1,600
8% $469 $606 $1,025
12% $377 $496 $859

Given the company's valuation of $566 million it is evident that the market is assigning virtually no value to the San Antonio project. Furthermore, even though the current valuation falls within the range given by NPV estimates at 8% and 12%, as I have already hinted Argonaut potentially has significantly more value than what the above matrix indicates. To review:

  • The El Castillo project can potentially produce much more gold than I am assuming, both on a per-year basis and in total. The mine plan I assume produces roughly 1 million ounces, but the project has more than 3 million ounces. While some of these ounces are in the more speculative "inferred resource" category, I think there is a reasonable possibility that the mine's life can be extended beyond my assumption.
  • The same can be said about my La Colorada estimate, which accounts for about 500,000 ounces of production when the potential is double this.
  • The Magino mine also has a lot of potential. The mine plan given in the company's assessment estimates just 1.7 million ounces of production whereas the mine has 6 million ounces of estimated gold. I suspect that going forward the project will be able to produce at the 185,000 ounce level for more than 7 years.
  • Due to uncertainty I shaved of $30 million in value from the acquisition price of San Agustin. But that is a huge 37% discount, perhaps merited by the fact that the project has no concrete valuation estimate. But while we have seen some problems this year Argonaut's management has a track record of finding quality assets and bringing them into production. It is unlikely that it would have paid $80 million for San Agustin if it didn't see much more potential than this in the project, especially since Silver Standard was a motivated seller.

Given these points I think one can justify taking a position in Argonaut now considering the current valuation and the various ways in which this value can be enhanced. This is the case even if San Antonio is worthless. That is, if the company were to come out tomorrow and say that it is forfeiting the asset one could still buy the stock.

The San Antonio Project

Of course San Antonio is not worthless. Even analysts who lowered their price targets on the April 10th decision (e.g. Ciara Sawicki of Scotia Bank) believe that the project will be built, albeit after some time passes as Argonaut Gold works things out with the MIA. After all, San Antonio isn't a large project whose construction threatens an entire ecosystem (e.g. Taseko's (NYSEMKT:TGB) New Prosperity). Mr. Sawicki believes that the recent MIA decision could delay production by 12 months or longer.

That's bad, but it hardly merits the sell-off that we saw upon the news. To be conservative let us assume a 3 year delay. At an 8% discount rate this means that the project is worth 21% less. At a 12% discount rate the project is worth 29% less.

With these points let's look at the actual valuation of the project. The mine is expected to produce 70,000 ounces annually for 15 years, and it will do so at an incredibly low cost of less than $600/ounce. Furthermore the project will cost just $84 million to build. With these assumptions we get the following valuation matrix for San Antonio.

Discount Rate/Gold Price $1,200 $1,300 $1,600
8% $140 $163 $260
12% $90 $106 $176

So it is evident that the San Antonio project still has a lot of value despite the fact that we have discounted the estimated cash flow three years.

If we add this to the above valuation matrix for Argonaut ex-San Antonio we get the following:

Discount Rate/Gold Price $1,200 $1,300 $1,600
8% $609 $769 $1,285
12% $467 $602 $1,035


From the above valuation scenarios it is clear that investors are assuming the worst-case scenario for the San Antonio mine. However there doesn't seem to be anybody who holds this conviction. As is often the case investors panicked on the negative announcement. For those who appreciate the value found in Argonaut Gold's various assets this presented a buying opportunity even for those who are pessimistic on longer-term prospects of the San Antonio mine.

At the current valuation a rather pessimistic scenario is being built in. I already demonstrated above how the company is fairly valued even if we assume rather pessimistic scenarios for the company's other projects. Considering that these other four projects can easily be worth more than the scenarios I put forth, and considering that the San Antonio project is probably going to get built, albeit some time in the future, Argonaut Gold offers investors a fairly compelling opportunity to get exposure to the gold market through a company that has a strong balance sheet, growth potential, and a management team with a proven track record of creating shareholder value.

Disclosure: I am long SSRI. 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.