An Overview of Luna Gold
Luna Gold (OTCQX:LGCUF) owns and operates the Aurizona Gold Mine in Brazil. It currently produces around 90,000 ounces of gold per year, and this figure is expected to rise to 135,000 oz. next years. Given the mine's massive resource base of nearly 5 million ounces the company should be able to produce at this level for an extended period of time, and it even has plans to expand production even more (in its phase two expansion).
However there is a caveat. In the depths of the financial crisis Luna Gold sold a large gold stream to Sandstorm Gold (NYSEMKT:SAND) that affords the latter company the right to purchase 17% of the gold produced at the Aurizona Project at $400/oz. As a result Luna Gold's average realized gold price is significantly lower than the prevailing market price. For instance at $1,300/oz. gold Luna Gold only realizes $1,147/oz. Now considering that the company had production costs of about $1,000/oz. this means that the Sandstorm stream is eating up about half of its cash-flow.
Back in April I argued that this was a serious issue. It not only meant that the company's immediate cash-flow was compromised, but it meant that the phase two expansion plan didn't make much economic sense in most reasonable scenarios unless the gold price rose substantially.
The problem was exacerbated as the company recently announced lower production and higher costs due to heavy rainfall, which forced the company to process low-grade stockpiled ore. Production fell to just 14,300 ounces for the quarter and the stock immediately fell by nearly 20%, and it continued to fall throughout the rest of July and into early August.
The Sandstorm Gold Deal
Sandstorm Gold took a significant hit as well. Luna Gold was expecting to produce about 90,000 ounces in 2014 or 22,500 ounces quarterly, meaning that the 14,300 ounce figure was more than 8,000 ounces short, or 1,400 attributable ounces. Granted this only adds up to a little more than a $1 million in lost cash-flow, but for a company that generated $15 million in sales last quarter and that reported a gross profit of $5 million this is a significant figure for one quarter.
Sandstorm Gold also realized that Luna's cash-flow troubles may not be just a 1-off. With this in mind it would have trouble financing the phase two expansion, which as I've mentioned is already a questionable endeavor considering its potential cost to shareholders versus the company's reduced realized gold price.
As a result Sandstorm Gold just increased its equity position in Luna Gold to 20%. Now on the surface this might seem bad for Luna Gold, which is diluting shareholders as its stock is down 35% for the year and is trading at a multi-year low. But investors should note that in the press release announcing the deal there is mention of a potential restructuring of the streaming agreement.
This might seem unlikely prior to the deal--why would Sandstorm agree to this when it is basically agreeing to reduce its streaming income? But now that Sandstorm has an interest in Luna Gold it could benefit by amending the terms in order to favor Luna Gold. Such an amendment would not only give Luna Gold an immediate cash-flow boost, but it would also make an expansion far more economical.
The Investment Thesis
While Luna Gold's production costs will probably be higher than expected for 2014 they are still likely to come in at my initial estimate of about $1,000/oz, which is slightly higher than the Q1 figure of $921/oz. Now in April we weren't sure how much an Aurizona phase 2 expansion would cost, and so I came up with 2 estimates--$100 million and $200 million. Now with production rising to 300,000 ounces per year as a result this seems cheap. But keep in mind that the company's effective realized gold price was far below the actual gold price--$1,147/oz. at $1,300/oz. gold. As a result the company's (then) $128 million valuation only made sense if we assumed an expansion cost of $100 million and an 8% discount rate, and this made an investment in Luna Gold risky. You can see the downside risk on the following table, which is my April estimate of Luna Gold's valuation.
|Discount Rate/Gold Price (Effective Gold Price)||$1,200 ($1,064)||$1,300 ($1,147)||$1,600 ($1,396)|
|$100 Million Capex|
|$200 Million Capex|
*Note that the numbers in parentheses in the "gold price" row reflect Luna Gold's actual cost of production when we take the Sandstorm streaming deal into consideration.
While the stock offered leverage to a rising gold price it also had a lot of downside risk should the gold price remain flat or decline, and since pretty much every gold stock offers leverage to the gold price I didn't see the logic in owning Luna Gold.
Now, however, a restructuring of this deal seems likely, and that means that Luna Gold's effective realized gold price is going to increase. If you look at the above table you see that the stock offers tremendous leverage to the upside should Luna Gold's effective gold price rise. Thus, despite the dilution it appears that Luna Gold is a big winner in this deal--it only takes a minor restructuring in order to catapult the NPV of Aurizona higher.
In what follows I will look at a few restructuring scenarios that keep in mind that the deal needs to be mutually beneficial to both Luna Gold and Sandstorm Gold. With the latter now owning a 20% stake in the former this shouldn't be too difficult to accomplish. I will then refigure the above table, which should demonstrate the value added to Luna Gold, and why the negative market reaction makes no sense.
Restructuring the Streaming Deal
Unfortunately it is impossible to know how the deal will be restructured except that it will favor Luna Gold. Right now Sandstorm Gold has the right to buy 17% of Luna Gold's Aurizona production at $404/oz with the extra $4 being an inflation adjustment.
There are two ways in which the deal can be altered in Luna Gold's favor--the amount of production allotted to Sandstorm Gold can decrease or the amount that Sandstorm pays can increase. We can also see some combination of both.
The following table provides various scenarios for this restructuring. The columns show a reduction in the royalty size and the rows show an increase in the sale price. Each box has 3 figures reflecting Luna Gold's "effective" production cost at $1,200/oz., $1,300/oz., and $1,600/oz., respectively. Note that since the inflation adjustment has been relatively negligible I will ignore it for now for the sake of simplicity.
|Percentage Attributable To Sandstorm/Sandstorm's Cost||$400||$475||$550|
These changes may not seem like that big a deal. For instance in my "middle" scenario where the stream is reduced to 14% at $475/oz. the company's realized gold price at $1,300/oz. gold only increases by $38/oz. But that $38/oz. increase compared with a $1,000/oz. production cost means that the company's realized gold price net of of costs increases by 26%! The project's NPV increases by even more because of the fixed expansion costs.
Re-valuing Aurizona Under the Restructuring Assumption
On the one hand this might seem pointless--why not just wait for the restructuring to take place so that we can reassess the project's new value and make an informed investment decision? There are two reasons for this. The first is that the restructuring will have an instant and substantial positive effect on the value of the Aurizona Project even if the restructuring doesn't appear to be so substantial. We just saw this by looking at the "middle" scenario. The market is going to react strongly to this news, and I think if investors wait it will be too late.
The second is that we can already assume that the restructuring is going to be mutually beneficial. It is going to be substantial enough to relieve Luna Gold of its cash-flow troubles while not so large as to hurt Sandstorm Gold. But since Sandstorm Gold is now a 20% shareholder in Luna Gold we can see a more substantial restructuring hurting Sandstorm, and this is decidedly favorable for Luna Gold.
With this in mind let's recalculate the NPV of Aurizona. Note that in April I assumed 90,000 ounces of production in 2014, 135,000 in 2015, 230,000 in 2016-7, and 300,000 in 2018 - 30. The one change I am making is that production in 2014 will be 75,000 ounces reflecting the aforementioned Q2 production issues. I will still use $1,000/oz. keeping in mind that this figure is higher than "normal" but also that we need to be conservative to account for the possibility that the company will experience production problems in the future. I will also use the "middle" scenario from the above table. Amounts include taxes (34%).
|Discount Rate/Gold Price (Effective Gold Price)||$1,200 ($1,099)||$1,300 ($1,185)||$1,600 ($1,443)|
|$100 Million Capex|
|$200 Million Capex|
Valuing Luna Gold
Assuming that the company essentially broke even in the second quarter, its non-mining assets essentially equal its liabilities prior to the secondary offering. After the secondary offering we need to add $31 million to the above numbers. Looking at our 4 scenarios for the current gold price of $1,300 we get valuation estimates for Luna Gold of $248 million, $180 million, $182 million, and $115 million vs. a market capitalization of $137 million ($0.90/share and 152 million shares outstanding after the secondary offering).
While there is still downside risk if we assume that the expansion capex is high we see that in 3 of the 4 scenarios the stock has upside, and in one of these it has substantial upside.
This in itself is sufficient to make the stock compelling, although it gets better if we assume that the company will be able to secure financing for all or part of the phase 2 expansion. While I don't explore the details here, it only improves the investment case for Luna Gold considering that a financing deal would mean that some, if not all of the company's expenses are discounted out into the future and they consequently have a dampened negative impact on the project's NPV.
While Luna Gold has had a rough 2014 both in terms of its share price performance and its underlying business I think that the worst is over. This is in large part due to the fact that Sandstorm Gold has increased its stake in the company, and the fact that it is now incentivized to restructure its streaming deal with Luna Gold. As we have seen in the figures presented above a small restructuring goes a long way.
With this in mind, and given the fact that the stock has fallen 15% since I expressed caution in April, I think the risk/reward is decidedly more favorable. While it is still speculative in that we don't know what the Aurizona expansion will cost, and we don't know the details of the stream restructuring, the stock appears to be at or near a bottom, and I think it is a compelling investment for long-term gold bulls.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in LGCUF over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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