Victoria's Royalty Is A Sign Of Enhanced Interest In Kirkland Lake Gold's Success

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About: Kirkland Lake Gold Ltd. (KL)
by: Vitaliy Gromadin, CFA
Summary

The recent headwind from the possible implementation of 2.75% royalty on Australia-based mine looks manageable for the company.

Some investors are more focused on limited growth in the foreseeable future as a grade of Australia-based asset has already got to the unbelievable level in the 2018 report (above 30 g/t).

It is time for investors who value experienced management, cash flow generation (FCF yield 7% in 2020) and attractive balance (net cash = $266mn).

It seems, Australia's state Victoria wants a bigger piece of the golden pie with its new 2.75% royalty. Kirkland Lake Gold's (KL) CEO was clear in Financial Review's article last week, the company's answer on that will be lower exploration and capital expenditures, hence production will be also lower in the future. The dollar amount of new taxes (about $25 mn per year) is substantial for the asset with about $50 mn per year of investments in exploration.

According to the article, a spokeswoman for Victorian Treasurer Tim Pallas said on Monday the royalty would take 2.75% of "the net market value, which is effectively revenue minus allowable deductions".

Beside the fact there has been no consultation, we are not fully understanding how the tax is going to be calculated, so that is something we need to understand. If it was simply a 2.75% net smelter return on [roughly] 600,000 ounces at $US1300 gold price, it would be $25 mn to $30 mn per year additional,

the company's CEO Tony Makuch said.

Fosterville needs these investments in exploration, and Tony Makuch knows how to invest successfully. By the end of 2018, Fosterville's reserves have jumped by 1 mn Ozs to above 2.7 mn Ozs. Though that is enough for only 4.5 years of 2019 production volumes close to 0.6 mn Ozs.

Source: Company's site

For instance, the second by importance asset, Canada-based Macassa mine, has got more than 8 years of 2019 production volumes close to 0.3 mn Ozs.

Production at Fosterville will rise from 356,000 ounces in 2018 to between 550,000 and 610,000 in 2019, and Mr. Makuch said the mine could maintain that rate of production for about three years.

Sources: Company's data, estimates

This year was the first time when the management gave positive guidance: getting to 1 mn Ozs of gold production for all company (mostly from Fosterville). From the start, their expectations had been cautious.

Source: Company's data

However, further spending on exploration and development would be required to maintain or grow production beyond the next three years, and Mr. Makuch said the royalty could affect those decisions:

If we continue to explore at the levels of about $50 million per year and capital investments in the order of magnitude of $150 million to $200 million per year back into the area, we expect we will be able to maintain that," he said. ''We have a very high grade resource at Fosterville, but as you are exploring into other areas you don't find those sorts of grades. You may still find things that, at different cost structures, could still be profitable and you could still grow from it. It is going to affect the economics of these other areas... it potentially sterilises parts of the resource.

Fosterville is easily Australia's most profitable ''pure'' gold mine, and its recent success has sparked a wave of new investment in Victoria's previously moribund gold sector. Mr. Makuch said Kirkland Lake would try to win an audience with the Victorian government in the near future to discuss the royalty, which is scheduled to take effect on January 1, 2020.

Valuation

Having analyzed Kirkland Lake Gold at the beginning of the year, I was impressed. However, the company's valuation was likely limited below $40 per share unless higher gold price levels were assumed even after more marvelous than expected IQ19 results. Then was a long period of markets in the risk-on mode while gold had gone on the sidelines... before last week.

In times when President of the United States acts sometimes like there is no tomorrow, you'd better be invested in something that has got defensive value. Kirkland Lake has got:

  • Exceptional management, experienced in geology, development and production.
  • The prime assets. Production in Canada- and Australia-based mines has got ore grade close to 30 grams per tonne. Hence, production costs are the lowest in the industry.
  • The shares look fairly valued at the current level of gold pricing but will follow all the appreciation in case of favorable.

It could be argued that the high grade of production is just temporary. The production is backed by reserves only through 2023. This new royalty gave food for thoughts about the company's future beyond the time frame. Suddenly, recent short thesis with $17 target by Lakewood Capital on limited reserves and low grade of resources at Fosterville (only 4.4 g/t compared to 31 g/t of reserves) is not looking so utterly strange.

I agree with the conclusions in the article about this short position, that NAV's calculation is a long way from share price's fair valuation. Given higher taxes in Victoria, the company will likely discover another place for its investments. Experienced in geology management can successfully focus on the company's assets in Canada or some new mines.

Below are presented the two cases for the company's valuation to assess the negative effect of the royalty. Given adjustments to exploration, CapEx, and production, the result is a negative effect of about 2% to the share price.

Excluding Victoria's royalty

Including Victoria's royalty from January 1, 2020

Sources: Company's data, Estimates

Gold Price

A stronger probability of lowering interest rates makes gold more attractive to investors. The escalation of trade wars lowers economic outlook, which in turn promotes an increase of analysts' expectations about Fed Rate cut. This is how the market works these days.

The yield of TIPS (Treasury Inflation Protected Securities) has been going lower. The $1300 per Oz pricing level for gold looks now strongly supported by this dependence.

Source: Bloomberg

Gold ETF holdings stayed at an elevated level, despite this prolonged period of higher-risk appetite in the markets. Investors have not lost interest in gold. In my opinion, it might easily get to $1,400-1,500 per Oz range this year in a favorable to the precious metal scenario.

Source: Bloomberg

Bottom Line

At the current price level of gold, the company looks fairly valued due to the recent rally in shares. However, investing in Kirkland Lake Gold makes much sense, especially given possible gold price appreciation in the near future. The recent headwind from Victoria's royalty, if implemented from 2020, seems manageable for the company. For the shares to surpass the $40 level gold price should be at $1500, which is not an unreachable price level for the precious metal this year.

Disclaimer: This article is for informational purposes only. Please do your own due diligence before making any investment decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.