Gran Colombia Gold: Extremely Deep-Value Gold Miner

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About: Gran Colombia Gold Corp. (TPRFF)
by: Harris Perlman, CFA

Summary

The stock trades at less than 3x forward earnings.

Investors have ignored the company due to earlier financial trouble and no sell-side coverage.

Dramatic valuation divergence from other gold miners, coupled with ongoing growth, creates a setup for huge returns.

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(Note: all ‘$’ figures are USD, not CAD, unless stated otherwise.)

Gran Colombia is a long-forgotten, profitable and growing gold miner that is trading below 3x forward earnings.

Why does this opportunity exist? I believe the reasons are:

  1. Small size (<$100mm market cap before warrant dilution)
  2. No analyst coverage
  3. Old shareholders were wiped out by high debt, lower gold prices, and failure of a major development project
  4. Improved operating results are obscured by one-time financial expenses from balance sheet restructurings
  5. New shares in the hands of former convert holders are likely weighing on the stock
  6. Underground operations preclude useful NAV analysis
  7. Co-chairman's image was tarnished after his oil company blew up
  8. Fear of Colombia exposure

Segovia and Marmato Assets

The company has two main assets, both in Colombia, called Segovia and Marmato. Segovia is a high-grade underground operation that includes three primary mines and has been producing since 1852; it represents ~90% of current production. Marmato makes up the remainder. Gran Colombia went public via reverse-merger in 2010, when the company paid $200mm to acquire Segovia. The idea was to modernize the mines, increase production, and reduce costs. In 2011, the company completed a merger of equals with Medoro Resources, owner of Marmato.

Marmato is a huge deposit, which Gran Colombia planned to develop as an open-pit mine, and thereby catapult into the ranks of major gold mining companies. Marmato’s NPV was thought to be around $1 billion at $1200/oz gold. Unfortunately, to develop Marmato required re-locating the local population, who literally lived on top of the deposit. Massive local opposition to the project has prevented Gran Colombia from developing the open pit; Marmato's current production comes from its small underground operations. Although management perhaps deserves blame for under-estimating the difficulty (or impossibility) of developing an open pit mine in a populated area, they aren't the only ones in Colombia to have made that mistake. AngloGold Ashanti, the third-largest multinational gold miner, was recently forced to halt development of its huge La Colosa open-pit project due to local opposition. AngloGold has sunk $900mm into its three Colombian projects (of which La Colosa is the largest), and the company still has nothing to show for it.

Challenges and Dilution

As Gran Colombia struggled in vain to push the Marmato development forward, it also struggled to reduce costs quickly at Segovia. When the company acquired Segovia, the operations were producing ~55k oz/year at a high cash cost of around $1300/oz. The mines had poor infrastructure and minimal automation, the result of decades of under-investment and under-management. In 2013, as the gold price was crashing, Gran Colombia was going into debt to invest in mine upgrades and a new mill complex. In 2015 the company started to benefit from its investments, as well as a weaker Colombian peso and a renegotiated agreement with some mining contractors, but by that time it had already defaulted on its debt. Debtholders turned the screws, and the company was forced to restructure its notes as highly dilutive convertible debentures.

Turnaround

Despite the financial turmoil, the company was successful in turning Segovia into a sizable (and growing) low-cost operation; production has increased from ~55k oz/year to ~200k oz/year, and cash costs have fallen from ~$1300/oz to less than $650/oz. Segovia’s current expected mine life is 2026, which was already extended by four years in 2017. Since underground mines (as compared to pit mines) typically explore and book new resources only as they expand, I expect that mine life will be continuously extended. This year the company has already made multiple announcements (here and here) of encouraging drill results at Segovia.

Source: Author based on company filings

Since Gran Colombia’s first debt restructuring in early 2016, many investors have ignored its equity due to the presence of its highly dilutive (and also potentially more attractive) debentures. However, the company has cleaned up its capital structure in the past year, and completed a major refinancing in May. Subsequent to the end of Q2, its last convertible debt was all converted into equity. The only remaining debt is $93mm of gold-linked notes, due 2024, which provide upside to noteholders at gold prices above $1250/oz. The notes are structured such that the noteholders get upside exposure to 23k oz of production in the first year, and lower amounts as the principal is paid down; because this represents only around 10% of the company's production, the equity retains 90% of the upside to the gold price. The company has ~$25mm of cash, which will increase by a further $20mm after eventual exercise of in-the-money warrants. Net debt is now comfortably below 1x EBITDA. In my opinion, the equity is now very investable.

Forward Estimates

To estimate forward earnings, I assume the following:

  1. Production will increase to 240k oz/year, from a ~230k oz run-rate in September; management expects to reach 300k oz in a couple of years (according to this recent video presentation, 14:10).
  2. AISC (All-In Sustaining Cost) will decline slightly to $900/oz, from $905/oz in 1H18, due to increasing scale and a weaker Colombian peso.
  3. The fully-diluted share count of 63mm assumes exercise of all outstanding warrants and options, excluding those with strike prices above $30/share.

Source: Author based on company filings and author's own forecasts

Although the P/E output from my income statement forecast may seem surprisingly low, I do not believe that any of the inputs are aggressive; in fact, they may prove to be too pessimistic. Segovia's production has grown at an annualized pace of around 18% over the past seven years, and yet my production forecast (of which Segovia is around 90%) is only 5% above September's run-rate. Moreover, the Colombian peso is down against the US dollar by approximately 10% since the first half of this year, and yet I assume that AISC will drop by less than 1%. Because there is no analyst coverage and the company is not widely followed, it is hard to say how these forecasts differ from the market's current expectations.

Interestingly, the company’s current accounting looks conservative. Generally, gold miners’ stated AISCs are misleadingly low because large amounts of capex are bucketed as exploration/development activities (excluded from AISC), even though such activities are necessary to offset production declines at other mines. However, Gran Colombia is currently including almost all of its capex in AISC. Thus, while the company is growing production via ongoing exploratory drilling and mine expansion, these growth investments are being counted as if they are part of normal day-to-day operations. I wouldn’t be surprised if this overstates the real steady-state cost structure by $10mm or more (equivalent to >$0.10/share of free cash flow).

Management

The company is led by Co-Chairman Serafino Iacono, a well-connected entrepreneur with a history of making natural resource deals in Latin America, particularly Colombia. Unfortunately, he may be best-known for building Pacific Rubiales (later renamed "Pacific Exploration") which became the largest independent oil company in Colombia before eventually imploding as a result of the oil crash;a WSJ article suggests that management's overly aggressive deal-making was also partly to blame. Before Pacific Rubiales, Serafino managed an early-stage Venezuelan gold mining company called Bolivar Gold, which was successfully sold to Gold Fields in 2006 for C$450mm. My sources suggest that Serafino is a good guy, although I haven’t personally met him. According to Gran Colombia’s IR, Serafino and his family/associates together own roughly 10% of the stock, and the company is currently Serafino’s main focus.

Risk Considerations

Colombia exposure is a risk, but one that I am willing to underwrite. In addition to management’s long history in Colombia, the board includes one former Minister of Justice and one former Minister of Mines and Energy. One of the company’s challenges is that most of Colombia’s gold has historically been mined by independent “artisanal” miners operating without licenses. Gran Colombia has had increasing success in signing those people as contractors, but there is still some tension as the company (with support from the government) cracks down on unlicensed mining on its properties. In 2017, production at Segovia was shut down for over a month as artisanal miners went on strike; the result was that the company cut deals with more illegal miners and turned them into contractors.

Additionally, there is always some chance of gang/guerrilla-related violence. Last month Continental Gold, another company with mines in Colombia, suffered a setback when some of its geologists were murdered in the field. In 2015, Gran Colombia's Segovia operation was targeted by a paramilitary gang that murdered one miner and sought protection money from the company. Despite death threats, the company's miners pleaded with the company not to close the mines, since no production meant no income; in the end, operations were affected for less than two months (with no mention of whether any protection money was paid). To really get into the weeds and better understand the local security situation, I recommend reading this report, which includes the following excerpts:

"While extortion and control of mining areas continues for artisanal and small scale mining, extortion of large-scale mining companies seems less prevalent. According to local miners interviewed for this study, large-scale mining companies are no longer systematically paying extortion to guerrilla groups, as they used to (e.g. Mineros S.A.). However, other sources suggest that illegal armed groups still resort to the use of force, threats or intimidation when it comes to large-scale mining companies." (p.15)

"Large-scale companies in Antioquia [the region in which Segovia is located] are, to some extent (see section above regarding extortion), insulated from illegal armed groups because of the protection provided by private security companies and state security forces." (p.15)

I think it is fair to say that maintaining security is a constant component of mining in Colombia, as in some other developing countries. While Colombia’s security situation has improved significantly over the years, it is still an overhang.

Valuation

The stock is dramatically undervalued relative to comps. The largest, most liquid gold miners like Barrick Gold and Newmont Mining trade at over 20x forward earnings. Big gold miners generally own assets in a mix of low-risk (Nevada/Canada/Australia) and higher-risk (Latin America/Africa) geographies. Unfortunately, I don’t believe there are any other US or Canada-listed Colombian gold miners with producing mines (Continental Gold’s mines are still in development). I also took a look at the Bogotá stock exchange; the sole listed miner there is Mineros SA, which was the largest gold miner in the country until it was overtaken by Gran Colombia. Mineros actually looks kind of cheap at first glance, trading at ~9x my estimate of run-rate earnings. However, production at Mineros’ low-cost alluvial operation in Colombia is declining (-18% in 1H18, per company filings), while its Nicaraguan mine is barely breaking even and is subject to increasing political risk. Besides Mineros, I looked through a couple dozen Colombian stocks and wasn’t able to find anything below 10x earnings.

Given Segovia's growth profile and low production cost, I believe the stock is worth 15x forward earnings, or approximately $10/share, representing close to 500% upside. If the company continues to execute, then fair value should increase over time. Importantly, the company is now funding its growth from operating cash flow; that eliminates the need for financing, which is commonly a problem for junior miners. The greatest risk to the thesis is the price of gold. If gold were to fall to $1000/oz then I estimate that the company would earn only around $0.10 of EPS; at a 10x earnings multiple (reflecting thinner margins), the stock would be worth $1/share, or ~40% downside. Additionally, there remain operational tail risks, such as a prolonged conflict with artisanal miners or gangs/guerrillas, which could seriously impair the value of the company's assets. Overall, I believe the very large upside potential more than compensates investors for bearing these risks.

Disclosure: I am/we are long TPRFF.

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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