- Recent events have reduced much of the risk associated with the Fruta del Norte project.
- The degree of perceived risk is overbaked leaving Lundin Gold undervalued.
- Lundin Gold's market cap is significantly less than what the Fruta del Norte mine is worth once it enters production.
All figures contained in this article are in U.S. dollars unless otherwise noted.
Gold is whipsawing wildly because investors are reacting sharply to every piece of news whether it be good or bad that has the potential to affect markets. While it has pulled back sharply in recent days because of growing optimism over the strength of the economy, rising geopolitical and economic uncertainty means that its outlook remains positive.
While I am not an enthusiastic fan of gold as an investment, there are some very interesting prospective mining investments that have the potential to deliver outsized returns for investors. My top pick at this time is a gold mining project I have been monitoring for some time, the Fruta del Norte operations owned by Lundin Gold Inc. (FTMNF).
Over the last year, it is down by almost 11%, providing investors with a handy entry point. Notably, it has fared better than the majority of junior gold miners as represented by the VanEck Vectors Junior Gold Miners ETF (GDXJ) which is down by 34% over that period.
Source: Yahoo Finance.
I expect Lundin Gold to significantly outperform that ETF over the medium to long term.
Nevertheless, regardless of this performance, Lundin Gold in the past has attracted considerable attention for all the wrong reasons. This primarily stems from the fact that the project is located in Ecuador which is viewed as an extremely high-risk jurisdiction.
There have, however, been several recent economic and political events which, when combined with the solid underlying fundamentals for the project, make it a very attractive investment despite the perceived high degree of risk.
What is Fruta del Norte?
Fruta del Norte is one of the world’s most recent and largest gold discoveries located in the impoverished South American nation of Ecuador on the south-eastern border with Peru.
Source: company filings.
It has attracted considerable negative attention ever since Kinross Gold (KGC) was unable to get the project off the ground and sold it to Lundin Gold for $240 million in 2015.
Source: Minergia: Fruta del Norte site.
The deposit is considered to be one of the largest high-grade discoveries made in recent times. It has been assessed to have indicated gold resources of 7.4 million ounces and 4.8 million ounces of gold reserves at a grade of 9.7 g/t, making it one of the highest-grade projects under development at this time globally.
Source: company filings.
Because of the high ore grades, the project was initially estimated upon commencing production to have low all-in sustaining costs (AISCs) of $623 per ounce making it one of the lowest cost mines in the industry as the chart shows:
Source: company filings.
The breakdown of Lundin Gold’s AISCs are shown in the graphic below:
Source: company filings.
The AISCs for the project in the latest project update have been revised downwards to $609 per ounce, further highlighting the quality of the deposit and the potential that the operation holds once production commences.
Based on these figures, clearly this is an ore body worth developing, but that said, there are a range of risks surrounding the project which need to be thoroughly understood before making an investment.
The primary reason that Kinross disposed off the asset is because it was unable to secure favorable terms on which to develop the project; the major sore point being a 70% windfall tax. Nevertheless, Lundin, because of the conflation of a range of factors, has been able to secure appropriate terms on which to develop the project.
Political risk is declining
What many pundits have failed to come to terms with is the changing position of Ecuador’s government with respect to foreign investment and mining. The country has rightly gained a reputation as a high-risk jurisdiction among foreign investors, miners and energy companies due to non-cooperative jurisdiction with opaque regulations and the real risk of the nationalization of projects.
Nevertheless, Ecuador, which is one of the poorest nations in South America, is in the process of repositioning itself as a mining friendly jurisdiction.
OPEC member Ecuador has been among those long-suffering members that has been particularly vulnerable to the prolonged slump in oil. This is because it is highly dependent upon oil as a driver of government revenue and much needed export income. Prior to the sharp decline in crude in late 2014, it was responsible for generating roughly 15% of the Andean nations' GDP and the protracted weakness has created a massive fiscal shortfall.
As a result, in a country lacking any other major industries to fill the gap, Quito has settled upon mining in the mineral rich country to generate the much-needed revenue it requires.
Way back in 2015, then minister of strategic sectors Rafael Poveda said:
We want mining to constitute the axis which will allow us to improve living conditions for communities and 15 million Ecuadorians...
This certainly illustrates the government’s desire to promote mining in the impoverished country.
Recently, closely contested presidential elections which saw ruling party candidate Lenin Moreno secure victory after allegations of electoral fraud, protests and a subsequent recount underscores the fragile domestic environment.
Since 2015, Quito has targeted $5 billion of investment in mining by 2020 and this has certainly aided Lundin in its bid to secure favorable terms (superior to those held by Kinross), environmental permits and licensing.
Lundin has secured the EIS and environmental license, exploitation agreement and investment protection agreement. It has been granted the authority to develop and produce gold from the location for 25 years with royalties, windfalls and sovereign taxes all clearly quantified. This includes fixing the income tax rate at a favorable 22%, flat royalties fixed at just under 5%, exemption from Ecuador's 5% capital outflow tax on interest and principal payments to entities outside of the country as well as the transfer of funds abroad and the ability to assign all or part of the project to external parties.
For these reasons, the project from a regulatory point of view is on a solid footing, and when coupled with Quito’s dire need to generate additional income from mining to replace lost oil revenues, mitigates much of the regulatory and geopolitical risk.
Secures financing package
The next key risk for the project was the ability to gain financing. In a recent announcement, Lundin Gold confirmed that it had secured a finance package of $400 to $450 million with the Orion Mine Finance Group and Blackstone Tactical Opportunities. The agreement is comprised of a $150 million secured loan facility repayable in 19 fixed quarterly principal and interest installments equivalent to the value of 11,500 ounces of gold starting in December 2020.
Notably, Lundin Gold can defer repayments by up to four quarters but at the cost of increasing the deferred repayment by 1,000 ounces of gold for each deferred quarter.
If we run some rough numbers on that part of the package and assume that none of the buyback or deferred payment options are exercised while using the assumed base case price of $1,250 per ounce, we find:
- On an undiscounted basis, the lenders are buying a total of 218,500 ounces of gold (being the 19 equal quarterly payments of 11,500 ounces mentioned earlier) for $686 per ounce.
- Total repayments when using the $1,250 per ounce assumed in the base case for the project are valued at $273 million giving the lenders a total gain of just over $123 million (after deducting the $150 million loan) which yields 82% and comes to an annualized return or ROI of 13.4%.
The second part of the package is a $150 million streaming deal, where in exchange for $150 million, Lundin Gold will deliver 7.75% of gold and 100% of silver production starting in December 2020 to the lenders, up to a maximum of 350,000 gold ounces and six million silver ounces.
When looking at some rough numbers on that part of the package, I have come up with the following:
- On an undiscounted basis, the lenders are buying 350,000 ounces of gold for $429 an ounce.
- With the mine forecast to produce 300,000 ounces annually, 23,5000 ounces will be paid each year to meet the required repayments for a total of 15 years.
- When using the assumed base case price of $1,250 per ounce, it means that the lenders will receive a total of $437.5 million. After deducting the $150 million principle, they will receive a total return of $287.5 million giving a yield of 192% which is an annualized ROI of 7.4%.
The lenders have also committed to participating in any further equity raisings by Lundin Gold for up to $150 million along with the right to purchase up to 50% of Fruta de Norte production to a maximum of 2.5 million ounces.
Using the existing assumptions for the project, notably the base case price of US$1,250 per ounce, no mine life extensions beyond 15 years and average annual production of 300,000 ounces, the financing package sees the lenders receiving around $74 million of the post-tax NPV(5%) of the project. This represents a big chunk of the value of the project but is representative of the risks involved. The return received by the lenders will grow considerably if the project can realize the considerable exploration upside that is available.
Lundin Gold has drawn $75 million from the prepayment facility and $75 million from the stream and has a contractor working on mine development at this time.
Source: El Ciudadano: Fruta del Norte mine under construction.
All work is on schedule and the mine is expected to commence first production during fourth quarter 2019 with a productive life of 15 years and annual production of over 300,000 ounces. There is every likelihood that life-span will expand given the tremendous exploration upside available from the project.
Substantial exploration upside
One of the core strengths of the project aside from the high ore grades as well as the size and scope of the ore body is the significant exploration upside that exists. There are 70,000 hectares of prospective exploration acreage and there are 7.4 million ounces of inferred resources along with an additional 2.1 million ounces of indicated resources.
Source: company filings
While there is no guarantee that those inferred and indicated resources will be economically recoverable, the reduction in AISCs and revised earlier date for first production (brought forward to 2019) as part of the latest project update highlights the quality of the ore body.
Because of Ecuador’s reputation as a difficult jurisdiction in which to operate, there has been a dearth of precious metals exploration, meaning there are considerable greenfield and brownfield opportunities available in the vicinity of the Fruta del Norte deposit. Those opportunities are illustrated by the unique characteristics of the ore body which are highlighted in the graphic below:
Source: Economic Geology: ‘Discovery, Geology, and Origin of the Fruta del Norte Epithermal Gold-Silver Deposit, Southeastern Ecuador’
It is reasonable to expect that the gold reserves will grow over the life of the mine and that production could easily exceed the 300,000 ounces annually forecast in the project update.
Finding Lundin Gold’s indicative fair value
To gain a better understanding of Lundin Gold’s fair value per share, I have reviewed the original NPV-5 calculations and updated valuation to determine its fair value. I have taken that data and used an industry standard NPV-5 methodology along with the following assumptions to calculate Lundin Gold’s value per share:
After considering these assumptions and valuing its cash flows over a 15-year period, representing the life of the mine, I have determined an indicative value of $5.96 per share as the table shows.
This indicates that Lundin Gold is currently 47% undervalued highlighting the considerable upside on offer for risk tolerant investors.
Nonetheless, that valuation is sensitive to a range of factors, key being the assumed price of gold. That sensitivity is illustrated in the table below:
Clearly, if the average price of gold falls below the $1,250 per ounce assumed for the base case, then Lundin Gold’s fair value also decreases, although the opposite occurs should it average a higher price.
The high grade Fruta del Norte deposit coupled with recent developments, including lower estimated AISCs, earlier than expected commencement of operations and significant exploration upside, makes Lundin Gold an attractive investment. Even more so when it is considered that it offers investors considerable upside given that it is 47% undervalued after applying a relatively conservative valuation methodology.
Furthermore, the fundamentals for gold remain favorable which means that it may exceed the assumed target price used for that valuation creating further upside. For these reasons, it is one of my top picks for playing higher gold.
Investors should note that Lundin Gold trades on the TSX under the listing of LUG which is far more liquid than its U.S. OTC stock with an average volume of around 51,000 shares traded over the last three months.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FTMNF over the next 72 hours. 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.
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