Asset Disposal Makes Kingold One Of The Cheapest Ways To Own Gold In The World

| About: KINGOLD JEWELRY (KGJI)

Summary

Kingold just sold their entire Real Estate Development investments for a price substantially above all expectations.

Book Value per Share will climb north of $5 per share.

The Book Value massively understates the Net Asset Value. Gold bullion is valued at cost. Valued at market, the NAV is over $7 a share.

With the real estate gone, the NAV is almost entirely gold and cash. It's the Gold Stupid!

The core operating business of jewelry manufacturing is highly profitable and thrown in for free.

Background

For background on Kingold (NASDAQ:KGJI) and our original investment thesis, which we wrote when the stock was selling at $1.40, please refer to our original SA article on May 2nd.

Kingold is China's largest independent gold jewelry manufacturer. The core manufacturing business is highly profitable and growing.

However, it is the accumulated reserves of gold bullion that has caught the eye of savvy gold investors looking for hidden value. Kingold owns 15.8 million grams of gold bullion built up over 10 years. At least 12.5 million grams are surplus to the inventory needs of the business. The book cost of their gold bullion reserves is $503 million but the market value is closer to $680 million. Prior to this announcement, the value of gold and cash accounted for 69% of the company's assets. This announcement means that 90%+ of the company assets will be gold and cash.

In our previous article, we carefully set out our calculations for a base case NAV of $5.53 per share and an aggressive case for $6.54 per share. We were too low on all counts.

We also identified four potential catalysts that could cause the share price to reflect underlying value over the next two years. We set a year-end target share price of $1.90 and a longer-term target of $6. We were too conservative on our timing and we missed altogether a rather obvious fifth catalyst (a rising gold price!).

Since last May, the Net Asset Value has risen substantially due to:-

1. The rising gold price.

2. Retained earnings from the jewelry business (this is the smallest of the three)

3. Last Friday's unexpectedly large gain as they exited their real estate investment

At $2.00, the stock is much cheaper now than it was at $1.40.

The Disposal of their ENTIRE Real Estate Development transforms the company

In our May note, we described how Kingold's real estate interest in the Jewelry Park Development (JPD) was highly unpopular with investors. Nevertheless, we wrote that "There is light at the end of the tunnel"... "We think the value of the asset is understated in the books and value will be unlocked over the next 18 months." We pointed to more optimistic language from company management.

We noted reports of the values of real estate transactions recovering in the region. Then we used a range of assumptions based on reported pre-sales and local real estate values to calculate a range of values for the JPD. Our conservative estimate was that the JPD was understated by 54 cents per share. Our aggressive estimate was as much as 90 cents per share.

Our aggressive estimate is doing a victory lap. But it was low.

Last Friday, Kingold announced that they had sold their entire interest in the development for $171 million, representing a gross profit of $75 million on their investment to date of $96 million. The profit amounts to $1.14 per share.

As we recalculate the impact of the transaction, we need to take account of capitalized interest associated with the development. At end March, capitalized interest was $10.7 million which would bring the profit after interest to 97.5 cents per share.

The real estate development, which investors hated, and most thought would be barely break-even, has just netted the company an unexpected profit equal to 50% of the company's market capitalization.

However, the impact of this transaction far outweighs the raw numbers. At a stroke, this deal transforms the company. Investors had long been turned off by the diversification into real estate. Heng Ren, the activist fund described the previous situation poignantly in a letter to the board as "The only thing investors hate more than a company investing outside their expertise is investing in Chinese real estate." *

This transaction de-levers and de-risks balance sheet.

Most important of all, the company returns to its core business of gold jewelry and THE COMPANY'S ASSETS ARE ALMOST ENTIRELY GOLD AND CASH.

We believe that many investors have not digested this news yet:

A. The transaction was complicated. You will have to read the disclosure three or four times before you figure it out.

B. The company quietly released an 8-K without a splashy press release.

C. The stock remains uncovered by any research from the sell side. We checked in with the only institutional broker we are aware of who follows the stock and we can best describe his response to the deal as "Fantastic."

*(We would be remiss at this point not to congratulate Heng Ren on their activist position in the company.)

A rising gold price has had a levered impact on the share price

Kingold has a seat at a table that most hedge funds can only dream of.

Two of the biggest macro plays this year have been... Long Gold.... Short the Chinese Currency.

Stan Druckenmiller eloquently delivered the case for gold at the Sohn conference earlier this year. The speech is here and the slides here. If you have not seen or read Druckenmiller's presentation, it is a "must read."

Kingold's assets are gold. Kingold's liabilities are RMB denominated debt. Kingold is effectively long gold and short the RMB.

The only RMB denominated asset that they held was $96m invested in real estate, which they just sold... for $171m.

Kingold has a cost and information advantage over any other long gold, short RMB position. Kingold has no expensive cost of borrow to short the RMB and buy gold. They are a Chinese manufacturing company borrowing at competitive interest rates from the Chinese banks to fund gold "inventory." The company is at the nexus of information regarding Chinese retail gold demand, seeing orders from retailers and wholesalers well in advance of the published statistics that gold bugs so eagerly wait for. The company has a history of adroitly managing their inventory levels, building up gold inventory in troughs and trimming inventory ahead of peaks. For example, they substantially increased their gold inventory in Q4 2015.

As a result, the rising gold price since the start of this year and the declining RMB has had a substantial beneficial impact on the NAV of Kingold.

We show later in this note how we have calculated the revised NAV of Kingold benefiting from both the rise in the gold price and the profit on disposal of the real estate.

Hidden Value - The Book Value of the Gold inventory is substantially understated.

As we described in our May note, the company values its owned gold inventory in the balance sheet at the lower of cost or market value. Gold acquired above market value at quarter end is written down to market value. Gold acquired below market value is left at cost. Over time, the company has used this accounting policy to build up gold bullion reserves where the book value is substantially below the market value.

In our May recommendation, we calculated that valuing the end December gold inventory at market, rather than lower of cost or market, would add between 96 cents and $1.61 to the NAV.

Since December, the gold reserves of Kingold have risen substantially and the gold price has risen.

The amount of gold and the book cost of that gold is shown in note 3 in the Q1 10-Q

From this, we can see that Kingold owns 15,759,816 grams of gold with a book cost of $31.97 per gram. The current price of gold is $1360 per troy ounce, equivalent to $43.72 per gram.

If we revalue the entire inventory at market, this would add $185,203,343 {15,759,816* ($43.72-$31.97)} to the assets of Kingold equivalent to $2.81 per share.

If we limited the revaluation just to the raw material, this would add $2.17 to the NAV per share.

Revised NAV

In May, we calculated a base case NAV of $5.53.

Since then, the company announced Q1 results and the disposal of the real estate. Here is our revised NAV calculation

Base Case Aggressive Case
Book Value 3/31/16 $4.29 $4.29
Disposal of Real Estate +0.97 +0.97
Revaluation of Gold Inventory +2.17 +2.81
Estimated NAV $ 7.43 $ 8.07

In May, we also looked at the potential impact of a share buyback. We have refined our model to incorporate the impact from taxation (there will be a tax bill due on the disposal of the real estate and although it is unlikely that the company will ever recognize all the gains on gold, for tax purposes, we assume the unrealized gains are fully taxed). We have also incorporated dilution from options and warrants. We incorporate all three of these adjustments because if there is a buyback, it will likely accompany the exercise of options and realizing gains on the undervalued assets.

Base Case Aggressive Case
Estimated NAV $7.43 $8.07
Tax Impact -0.75 -0.90
Dilution Impact -0.27 -0.30
Impact of Buyback +1.58 +1.78
Adjusted NAV after Share Buy Back $8.00 $8.65

The Share Buyback calculation is based upon a transaction where the company spends $40 million (23% of the proceeds from the real estate disposal) at an average buyback price of $2.50. We are not forecasting this transaction; this is just for illustrative purposes.

We previously based our long-term "blue sky" price target on a 25% probability of a share buyback. The potential for a share buyback has increased with the real estate disposal and the accompanying reduction in leverage. We thus base our long-term price target at 67% base case weighting and a 33% probability of a buyback. (0.67*7.43 +0.33*8.65) for a target price of $7.83

Our short-term target for the stock is raised to $3.00. Since May, the gold price has risen from $1,215 to $1,360 adding over a dollar a share to the NAV. On top of this, the real estate disposal improves transparency and added a further 97 cents per share.

Our worst-case scenario for the NAV would be a fully taxed, fully diluted base case NAV of $6.41. At $3.00, investors would be buying gold and cash for 46 cents on the dollar.

After selling the real estate, Kingold is effectively a gold asset (each share owns 0.24 grams of gold) with a high-quality jewelry manufacturing business thrown in for free. Investors should consider Kingold as part of their gold exposure. For investors looking for gold exposure, Kingold is equivalent to a contract on gold at under $700 per troy ounce financed by RMB leverage. We have looked around, but we cannot find a cheaper way to back Stan Druckenmiller's call.

At $2, KGJI is cheaper after this transaction than it was when we recommended it at $1.40.

Disclosure: I am/we are long KGJI.

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.

About this article:

Expand
Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here