This article was originally published at miningWEALTH.com on March 1, 2016.
We first looked at Goldsource Mines (OTC:GXSFF) back in 2014 but have only now decided to write it up as a stock we think is worth owning. The company offers essentially everything we are looking for in a gold miner:
- A seasoned management team with skin in the game.
- Low (anticipated) production costs.
- A simple operation.
- Local and government approval to operate.
- Compelling valuation.
Shares have begun to move-they've more than doubled since bottoming at the end of 2013 (a time when several gold stocks bottomed). The company has begun to receive attention from some analysts (e.g. Peter Spina, Jay Taylor). We think the strength can continue despite the >50% move the shares have displayed in the past three months: the company is becoming a small-scale producer, and while it isn't extremely cheap on a price to NPV basis relative to many of its peers, this is an especially low-risk project given the simplicity and low-cost of the operation.
Furthermore, current NPV projections only reflect a fraction of the NI 43-101 compliant resources, and we believe that the latter, in turn, provide a poor indication of Eagle Mountain's true cash-flow potential. Ironically, this "hidden value" is a result of management's prudent strategy of starting production on a small scale to finance exploration internally, as opposed to diluting shareholders to do so. The ore body-that is, the saprolite ore only (there is non-saprolite ore that management is currently not planning to mine given the ease with which saprolite is processed)-extends beyond the resource in almost all directions. Growth can be augmented by acquisitions-artisanal mining (restricted to easy-to-mine saprolite) is a common occupation in the region, and Goldsource can acquire some of this land or act as a toll miller to artisanal miners. Thus we see this as a one-project growth story that can grow in several ways. Shares trade at a discount to the NPV stated in the PEA, and at a very low multiple to its current cash-flow potential. In a market that is willing to pay 15-20X operating cash-flow (or more!) for "growth stocks" we see Goldsource's valuation as very attractive. We also believe the gold price can rise considerably from here, although Goldsource Mines can perform well at the current gold price and even at lower gold prices.
Strong Management With Skin In The Game
CEO Scott Drever and COO Eric Fier have worked together in the past. They have extensive experience and a proven track record with their recently sold SilverCrest Mines. Eric Fier oversaw the development of that company's flagship mine-Santa Elena. This is a cash-flowing asset, and given its low production costs we had gotten behind SilverCrest Mines before it was bought out by First Majestic Silver. Note that this is also a company we like, and believe that its management made a good acquisition with SilverCrest.
Given management's past success we're confident in its ability to develop the Eagle Mountain Project, especially considering that it should be an easier project to develop than Santa Elena given that it is near-surface high grade saprolite ore. We not only like strong management teams, but we like it when they take on projects that are simple. In fact, we think that the best management teams-despite their being able to develop complex projects-are able to find and exploit easy projects, and this is the situation we have here. Note that this theme fits other investments that we've backed such as Great Lakes Graphite, which has a very strong management team and the simplest project currently under consideration by a graphite junior.
We should also note that management has skin in the game. The following table provides readers with insider ownership information of all of the company's senior officers and directors. Note that we didn't include the Donald Smith Value Fund, which holds 20 million shares and 10 million warrants despite the fact that this makes the fund an insider by virtue of being a 10% owner.
We should note that most of the options and warrants are in the money, and so we count this data towards insider ownership whereas we haven't in the past when the options and warrants were well out of the money (e.g. Commerce Resources). The following is from the company's "share structure" page on its website:
Options and Warrants
The fact that most of the options and warrants are in the money means there is a higher likelihood that the company will be able to raise additional money, which could be useful towards augmenting cash-flow in financing expansion. If there are start-up issues that don't merit putting off expansion, or if the gold price weakens, this money could be very useful.
The subsequent two charts are from the company's latest financial statement showing data as of 9/30/2015:
We note that while option/warrant converters may do so and retain shares they often finance the share purchases by selling some of the newly obtained shares onto the open market. This risk is mitigated in Goldsource's case given that it has seen strong volume-a shareholder looking to divest, for instance, 500,000 shares, could fairly easily do so in this market. Should all warrants and options be exercised this should generate ~C$13 million in cash.
Goldsource Mines is focused on the Eagle Mountain Project in the Guyanese jungle. While it might seem risky this is a mining friendly jurisdiction that has been a home to mining and exploration for the better part of the last 130 years. More importantly it is a home to mining today. The following statement can be found in the Eagle Mountain PEA: "Employment is dependent on local artisanal mining and mining-related activities." Artisanal miners often don't have access to the most advanced and efficient mining equipment and techniques, and they can be successful only when the ore is simple to extract (e.g. in the case of near-surface saprolite). This increases the likelihood that Goldsource Mines will find attractive acquisition targets near Eagle Mountain. Permitting is very simple for the kind of operation that GoldSource wants to start with, which qualifies it as a "medium-scale" operation. The company received its medium scale mining permit in 2014 through its business arrangement with Kilroy Mining Inc., a local Guyanese entity. .
The current deposit is currently ~1 million ounces of indicated and inferred resources.
However, as we will see when we discuss the project the company is really only interested in the saprolite, which is weathered ore and effectively already partially processed. This gives it 380,000 oz.-mostly inferred. Thus unless you use your imagination to expand the deposit Goldsource isn't so cheap if we value it based on the number of ounces it is claiming to be of value-$66/oz., and this rises to more like $100/oz. when we consider recovery rates at initial estimated levels. Keep in mind that a company like First Mining Finance is looking for high quality in-ground gold for <$10/oz., and it's buying them!
Why should we pay $66/oz. when there are considerably cheaper ounces for sale? There is a good reason, although we emphasize that we're hardly against complementary investments that offer cheap in-ground ounces, so long as they are quality ounces.
These are very high quality ounces. Saprolite ore is effectively partially processed, making it easier and less expensive to extract gold from saprolite relative to extracting gold from hard rock deposits.
Goldsource's Eagle Mountain ore is among the least expensive in the world to process. We will see that excluding capital costs, which are high in the first few years due to the company's scaled approach, the company produces gold at ~$500/oz.
According to the PEA the saprolite ore lies just 10-40 meters below the surface, as you can see on the following image there is plenty of saprolite containing gold. The subsequent image displays the series of pits the company envisions based on the location of the mineralized saprolite and localized grades (the deposit is somewhat inconsistent at depth, which does pose a small risk, although the PEA takes this into consideration).
Finally, the company's resource expansion efforts stopped not because it reached the border of the ore zone, but because it had drilled out a large enough resource to sustain a small operation such as that described in the PEA. We note that the resource is open in "most directions," and again emphasize the nearby artisan mining as suggestive that there is more gold-rich saprolite nearby that is, at the very least, available for toll milling. We further note that when a mining company is deciding where to place infrastructure it first makes sure it isn't blocking access to valuable ore, and that Goldsource's efforts in this regard had to be abandoned because it couldn't find a near-by spot that did not contain valuable ore.
The Eagle Mountain Gold Project Strategy
The main strategy here is that Goldsource wants easy-to-generate cash-flow, and every decision that management has made goes towards achieving this as opposed to maximizing the project's NPV or the number of ounces mined/discovered. We've seen that the deposit consists of saprolite ore that sits on top of hard rock ore. The mine plan only incorporates saprolite ore given that it is relatively easy to mine-no drilling/blasting is required . The ~600,000 oz. of gold found in hard rock ore may be processed at a later date, but it is not a priority.
In order to minimize start-up costs-and the company reached project commissioning on just $5 million in pre-production capex-Goldsource's management is starting small at just 1,000 tpd. Furthermore, the company is only going to be using simple gravity separation. This last point means the company will achieve low recoveries-estimated at 60%-but these will be easy-to-recover ounces. Over the first four years management plans on increasing production to 4,000 tpd.
It can achieve this by expanding the mining operation and processing plant, and these are included in the PEA capex estimate (see the second set of numbers).
Not included in the PEA is the possibility for the company to add a second shift. Right now the mine is scheduled to operate 1-10 hr. shift per day. This could feasibly be doubled, and the project's peak production could double as well (although the resources don't exist yet for 8,000 tpd. to be sustained for very long).
While there is a 4-year plan to grow production to 4,000 tpd. of ore management will only move forward with the expansion if the initial concept works well. The phased development approach effectively works in parallel to de-risking the project, stage by stage. In fact, we were told that the initial 1,000 tpd. mine is a "proof-of-concept" operation, and that adding production through a shift or added processing capacity will come only once the concept is proven out. Note that, despite the fact that adding a shift is not included in the PEA this is the simplest way for the company to increase its production, meaning that it will likely be implemented before the processing plant is expanded or the recovery-rate is optimized.
Ideally, management will finance the expansion using the company's internally generated cash-flow, which we will see is feasible even at lower gold prices assuming the company's figure are accurate. Yet the company has other sources of capital as well. First, recall that we will likely see some money come in through the exercise of options and warrants that are already in the money. Most of this should come in towards the beginning of next year and at the end of next year. Second, the company's pre-production capex came in under budget at ~$5 million, meaning the company has nearly $1 million more than its $400,000 working capital allowance. This doesn't surprise us considering management's experience and the fact that the company is pursuing a simple project that minimizes capex unknowns. Finally, the company has a $1 million line of credit, although the interest rate on this is high at 12% meaning management would have to see a very promising opportunity in order to draw it down. Each of these mitigates the risk of further shareholder dilution, although we note again that when options and warrant are exercised that we could see near-term selling pressure.
Capex going forward is low and management can improvise with respect to future capital expenditures given the aforementioned mine plan flexibility. Opex will be low as well since we are looking at relatively high-grade gold (1-1.2 gpt. for RoM ore) near the surface. Cash-costs are expected to be ~$480/oz., which is incredibly low. Recall that capex is high in the first few years given the expansion plans, but the company can still generate positive cash-flow if we include expansion/sustaining capex, even if the gold price falls. Here is a pre-tax scenario based on the PEA mine-plan at $900/oz. gold. Note that capital expenditures that will grow the project are included.
(We note that the company's costs include a royalty owed to the Guyanese government, and cost estimates from the PEA assume a gold price of $1,250/oz. Thus in the above scenario we would see the company's effective production costs decline, althoug hwe didn't factor this into our estimates.)
With gold trading considerably higher than $900/oz., and given the aforementioned sources of captial available to Goldsource, it is evident that the company should have no trouble financing its expansion organically, and that the economics will be sufficiently favorable to do so.
Formulating an exact valuation assessment of a project such as Eagle Mountain is very difficult. So we've decided to look at a few scenarios based on the assumptions made above. It will become clear that these assumptions lead to some very optimistic figures that make Goldsource shares extremely attractive. Even in our "worst-case" scenario, or the PEA scenario, shares have considerable upside.
Note that our "base case" gold price is $1,170/oz., or ~$80/oz. below the current market price.
1: The PEA Scenario
We don't think this is the best way to value GoldSource and Eagle Mountain, yet the PEA is the data given to us by the company. This an operation that will be developed in stages over a period of years, so there will be regular capital costs during the early years as management scales up production. But the company will be producing gold at a very low cost as it scales up its project, and we calculate that by the second year (as in the PEA) the company will be cash-flow positive if we include the regular capital costs the company will be incurring, particularly in the first three years of production. The following table uses data from the company's PEA-Table 22.3-and assumes a gold price of $1,170/oz.
Note that these are pre-tax numbers, and that there are sunk costs from ~$5 million of pre-production capex plus incurred exploration expenses. Cash-flow substantially outweighs sunk costs, and we can easily estimate the post-tax cash-flow and NPV by just correcting for the Guyana corporate tax-rate, which is 30%. This gives us net cash-flow of ~$64 million and an NPV (10%) of ~$38 million, or more than 50% higher than the company's current market valuation. Note also that "year 1" is 2015 and that the company is a few months behind the schedule outlined in the PEA.
The NPV figure provided here shows us that the company's ~$25 million valuation is too low. Assuming the $38 million figure is a better reflection of the company's valuation then the shares are worth US$0.30 each, or C$0.42/share assuming a CADUSD exchange rate of 0.72.
2: Beyond The PEA
We have no intention of amending the above PEA to incorporate a ramp-up to 8,000 tpd. of production because this would simply move some cash-flow forward and reduce the value lost in time decay. We might be able to bump up our estimated value-based on the PEA-by ~25%. Considering the upside potential in Goldsource shares this is akin to a rounding error.
Given our assessment of the project, we think that rather than looking at NPV we should instead consider a multiple of the company's projected cash-flow at "full production," which is what we expect in years 4-7 here, and that investors should expect the share price to reach this multiple over a period of 2-3 years sa the company scales its operation. With average annual cash-flow at just over $17 million pre-tax ($12 million post-tax) during these years we would expect the company's valuation to reach a figure considerably higher than $25 million. At 6X operating cash-flow it would be ~$100 million or 4-times higher. Again, it would take a couple years to reach this point as the company grows its production (according to the PEA-schedule), but the projected capital gain is sizable.
Note again that the second shift is not included in the PEA, and if we use a multiple of peak-PEA cash-flow as our target valuation we can double the figures discussed above. That means at $1,170/oz. gold Eagle Mountain can generate $24 million in post-tax cash-flow. And that doesn't take into consideration that the second shift will be less costly than the first. Thus shares can rise 8-fold over the intermediate term.
This scenario requires some added effort on the part of management in order to increase its saprolite resource through either exploration or acquisitions, and the cost of that would erode this 8-fold gain somewhat. Even if it fell to a 6-fold gain the upside is substantial, although we note that exploration should be inexpensive given that these are shallow holes drilled into weathered rock.
To give you an idea of the NPV of such a project we've decided to draw out the calculations for a scenario similar to the PEA-scenario but with (1) a 2nd shift and (2) 10-years of full production (the PEA scenario has 6, with years 1 and 8 being incomplete). We have assumed that the company adds the 2nd shift after the first year, which we've left untouched. We've taken a rough average of the full production years and assume 50,000 oz. of production in the last full years of production. This means we are also assuming the company is able to expand the saprolite resource so that we can see both expanded production on a daily basis and overall. Of course, making this assumption is risky, but given the long-term goals of the company we see this scenario as something close to what we think management has in mind. We assumed $500/oz. production costs-higher than the figure used by the company in later years. We also assumed $1 million per year in capital costs during these years. Finally, we added $500,000 in capital costs per year starting in year 4-the first "full year of production to account for additional exploration and possible acquisitions.
If we were to value the company based on this scenario the project is worth ~$115 million after taxes assuming no recuperation of sunk costs or depreciation. Assuming all of the warrants and options are exercised there will be ~177 million shares outstanding, and in the exercise process the company would bring in ~C$13 million or ~$10 million. This would give us a valuation of ~$125 million or a share price of $0.71 or C$0.99, meaning there is considerable upside in the company's optimal development scenario, even at the current gold price.
3: Gold Price Leverage
We've demonstrated that the stock can achieve sizable gains in a gold-neutral environment. These gains can be even greater should the gold price rise, and we are gold bulls at miningWEALTH. Here are a couple of variations on the PEA scenario at different gold prices. These NPV numbers are rough estimates given the variable impact of the royalty and the fact that a changing gold price will influence management's plans, but they do provide an idea of the potential annual cash-flow this company can generate..
So we don't get the torque that we've seen with some other projects but at $2,000/oz. gold and a 6X pre-tax cash-flow multiple we could see the shares trade ~10X higher than they do today, and 20X higher should we see a second shift. Note that most of the relative upside we perceive in Goldsource shares is a function of the company's ability to grow its production, and not its ability to leverage the gold price. However we note the company could expand further in a higher gold price environment, as management may feel justified in processing stockpiled or hard rock ore should the gold price rise to $2,000/oz.
While these numbers become outrageous after a while we've also calculated the NPV of Eagle Mountain using our optimistic scenario at $1,300/oz. and again at $2,000/oz.
These are, of course, optimistic scenarios, but they are not unreasonable based on the assumptions that we've made. In fact they could be conservative given the fact that a higher gold price means Goldsource will generate more cash-flow with which it can expand its operation.
The Bottom Line
Investors are beginning to wake up to Goldsource Mines. Recent market strength could prompt some selling, but we think the smart money will be buying the dips. The company remains undervalued when compared with the valuation estimates put forth in the PEA, and this $38 million valuation is our near-term price target: one that can be reached in fairly short order simply as a matter of this story gaining investors' attentions.
But we're more interested in the company's longer-term cash-flow potential, and believe that the current deposit can be expanded so that in a few years the company can trade based on an 8,000 tpd. mine that lasts longer than the current mine plan. Assuming a valuation based on a multiple to cash-flow, we estimate the latter to be $34 million pre-tax or $24 million post-tax, and these are big numbers compared with the company's current $25 million valuation. Even in our NPV-estimate for the 8,000 tpd. operation and 10 years of "full production" we get a valuation in excess of 3-times the current market capitalization. In reaching full production the company will generate more cash than it needs to expand its operations, meaning that it can pad its balance sheet, drill out the deposit in order to expand the mine-life, or even purchase additional nearby projects with similar geological attributes. As this reality materializes, it has the potential to change investor sentiment: we believe shares can re-rate to a much higher valuation as investors realize that this is a cash-flow growth company rather than a development company with limited resources. The extent of future gains are largely unpredictable-except in that these projected gains are extraordinary-and for now we would focus on the near-term potential as a price-target for now (remember $0.30/share or C$0.41/share) and reassess this figure as the company progresses.
But the fact that we can manipulate these numbers to show tremendous potential gains in the share price means little if the company cannot execute. And so we close by reiterating that Eagle Mountain is a simple project with well-understood geology being operated by a management team with a proven track record and skin in the game.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GXSFF over the next 72 hours.