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El Dorado Gold (EGO) vs. Yamana Gold (AUY)

|Includes: ABX, AUY, Eldorado Gold Corporation (EGO), NEM

If you are the kind of person who rigorously scans through the produce aisles looking for healthy organic food you might want to start doing the same with your stock portfolio. This might not only keep your skin looking radiant but also prevent from uncomfortable heart burn. In this article I will talk about two stocks in my favorite sector, the gold mining sector, one which has pursued organic growth and another which has not.  
In one extreme we have El Dorado Gold (NYSE: EGO), a stock that has been injected with the growth hormone of public media and touted frequently on TV as a high growth company. On the other side, the one for health conscious investors, we have Yamana Gold Inc (NYSE: AUY) a stock perhaps not as widely known or followed but which delivered solid Q3 2010 results and is less likely to result in digestive tract problems.
First let’s look at their similarities.  By the way, the shared characteristics of these two stocks summarize my bullish sentiment on owning the sector and specifically my recommendation on owning gold mining companies over the commodity itself.
As mining operations both AUY and EGO profit from the difference between gold prices about $1,390 per ounce as of the date of this article and the cost of extracting mineral from the earth, roughly mid $400s; which is to say both companies enjoy phenomenal gross profit margins. Both Yamana Gold and El Dorado Gold are Canadian companies trading on NYSE (AUY, EGO)  and TSE (YYRI/ ELD).   They are both mid tier miners. Mid tier companies can attract higher multiples because it’s easier to grow volume. starting from a smaller base than it is for the lager mining companies like Barrick Gold (NYSE:ABX) or Newmont Mining (NYSE:NEM). Thus mid tier miners can deliver the one-two punch provided by rising commodity prices and fast volume growth. Throw low cost operations from emerging markets into the mix and you end up with a dynamite free cash flow formula which can be reinvested in exploration & development or returned to shareholders in the form of dividends or stock buy backs. Both companies are strong in all these points.  Finally AUY and EGO do not hedge future gold sales so they are fully levered to upward trending commodity prices giving them a similar investment profile. 
Those are the similarities now let’s look at the differences.
First I would point to location. Mining operations for AUY are located in South America including Brazil, Chile Argentina and Mexico whereas EGO has mines in Turkey, Brazil North America and China. At the end of 2009 EGO significantly increased its investment in China by acquiring Sino Gold. It is an accepted fact in this industry that scarcity of the yellow metal has driven exploration to more remote places and mining companies to look for the lower production costs in emerging markets. Without claiming to be a political analyst, if given a choice I’d rather have my investments in jurisdictions that are stable and tested mining markets in Latin America (save for Venezuela and Cuba) than in China. Let’s be clear, location alone is not a deterrent for investing in either of these companies but it does call, in my view, for a slight bias towards AUY.   
But let’s move on to the crux of this article which is about growth and valuation.
Looking at the results, in Q3-10 EGO delivered yr/yr revenue growth of 130% with 190mm in revenue compared to 80mm in Q3-09. Lion share of volume growth, however, came from the acquisition of Sino Gold which was funded by issuing stock. Earnings per share on the other hand increased a paltry 12% to $.09 from $0.08 in Q3-09, lackluster compared to top-line growth. The reason is shareholders were severely diluted by the acquisition with the number of outstanding shares going from 392mm in Q3-09 to 547mm in Q3-10 or a 39% dilution
Now let’s look at AUY: In Q3-10 AUY delivered 36% yr/yr revenue growth with $453mm in revenue compared to $333mm in Q3-09. This was organic growth. Most notably earnings per share grew 142% to $0.17 from $.07 in Q3-09. Management reiterated yearly volume guidance of 1.03-1.145 GEO (gold equivalent ounces) production for 2010 which means AUY will have at least an equally strong fourth quarter provided commodity prices hold. An important disclosure: While there was modest volume growth driven by higher production and efficiencies from mine operations; most Q3 yr/yr revenue growth was achieved by selling off inventory built up in Q2-10 and through commodity price appreciation. In fact,  no significant production volume gains are expected until 2012 when new projects will come on line increasing volume to 1.5mm GEO and then to 1.7mm GEO in 2013. This is from a base of 1.1mm GEO (which is why we like mid tier mining companies). Again all this growth is predicated from internally funded projects without dilutive acquisitions. In 2012 AUY will start to deliver the mentioned one- two punch.  
Now let’s look at the valuation: Based on market prices of AUY $11.47 and EGO $18.89 as of Nov 4th  AUG had market cap of 8.5bn and EGO of 10.3bn.
Comparatively EGO seems to be richly priced especially since AUY generated $485mm in operating cash flow (before changes in working capital) for the 9 month period compared to $269mm by EGO in the same period.  AUY has current production capacity of 1.1mm GEO and EGO has about 65% of that capacity even after the Sino Gold acquisition.
On a P/E ratio basis; assuming 0.56x in earnings per share for FY-10 for AUY (the company generated $0.39 in the first 9 months of 2010 ) P/E ratio is 20.4x;  while EGO’s  $0.40 FY-10 earnings per share ($0.30 YTD) results in a P/E ratio of 47x.
I can justify AUY’s valuation based on production growth which will accelerate in 2012 when the new mines will begin to kick in. In my view AUY is a better investment than EGO, larger in absolute terms, with clearer growth prospects in more stable jurisdictions and has at least comparable reserves. I believe AUY is a buy here. EGO not so much. I would wait until there are indications of organic growth to justify EGO’s valuation. Right now there is too much dilution in the water. Now don’t get me wrong, I believe EGO is a great company with a great management and the acquisition of the mines in China might prove to be a good long term investment, but the stock has become over exposed to the media. This is exactly what happens when you put the words “Gold” and “China” in the same sentence and repeat it a few times on TV. They simply have driven the price too high for EGO.
So, don’t eat the blubber. Stay lean. If you are looking for a mid tier mining company with good growth prospects and a reasonable valuation pick AUY.

Disclosure: Long "ABX" Long "AUY"