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Gran Colombia Gold Corporation Undervalued, But Highly Speculative

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Colombia is shaping up as not only one of the hottest destinations for oil exploration and production, but also for the production of a range of other basic materials, including gold and other precious metals. This has seen a surge in interest among gold miners with a number of foreign domiciled miners establishing operations in the country. This explosion in interest can be attributed to a number of factors including Colombia's improving internal security environment and the favorable business environment established by the Colombian government. This surge in interest has seen Colombia become the fifth largest gold producer in Latin America.

Among these companies currently exploring for and producing gold in Colombia is micro-cap gold miner Gran Colombia Gold Corporation (OTCPK:TPRFF). At this time, I believe that Gran Colombia is significantly undervalued by the market, with its share price falling by around 28% over the last year. This sell down has come about with international mining juniors falling into disfavor with investors because of a perceived increase in political and market risk across the basic materials sector. This I believe has created a deep-value investment opportunity with Gran Colombia for patient, risk-tolerant investors and in this article I will explain why, including the risks investors face.

The Company

Gran Colombia is a Canadian domiciled gold and silver exploration, development and production company, which is primarily focused on developing its operations in Colombia. Despite being a micro-cap with a market cap of around $100 million at the time of writing, it is currently the largest underground gold and silver producer in Colombia. The company has several underground mines at its Segovia and Marmato operations, located in the departments of Antioquia and Caldas respectively, as illustrated by the map below.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

The company has a high quality asset base with its Segovia operations rated 7th in Colombia by grade, while its undeveloped Marmato deposits are rated 18th by grade as illustrate by the chart below.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

The Segovia operations consist of 16 concessions across 6,000 hectares with a total indicated and inferred gold resource of 113,000 ounces with an average grade of across the total resources of just over 6 grams of gold per tonne. The Marmato operations have a total measured, indicated and inferred gold resource of 14,377,000 ounces, with an average grade of 0.91 gold per tonne.

The company has total gold reserves of 15.9 million ounces broken down between measured, indicated and inferred as set out in the table below.

Source: Gran Colombia Management's Discussion and Analysis for the Quarter Ended September 30, 2012.

In addition, Gran Colombia has 90,000 ounces of proven and probable reserves, which makes it in comparison to many of its peers that are operational producers in Latin America quite small. These peers such asBarrick Gold (NYSE:ABX), Compañía de Minas Buenaventura (NYSE:BVN) andNew Gold (NYSEMKT:NGD), have considerably higher proven and probable reserves as the chart below illustrates.

Source data: Gran Colombia, Barrick Gold, Buenaventura and New Gold Annual Reports 2011.

This indicates that Gran Colombia is a far riskier investment opportunity because the majority of its gold reserves are more speculative because they are defined as measured and indicated and inferred.

It also underscores the small size of the company and the obvious risk that come with investing in a micro-cap gold producer and explorer. These risks include; the unproven nature of their operations, lower proven gold reserves, and smaller production prevents them from accessing economies of scale and the inability to weather any sustained downturn in the gold price.

Financial Snapshot

Gran Colombia's financial performance over the last five quarters has continued to be disappointing with revenue declining for the last two successive quarters. For the third quarter 2012, revenue fell by 16% QoQ and almost 32% YoY to $217 million. For the same period, net income also fell by around 12% QoQ and 56% YoY to $58 million as the financial snapshot below illustrates.

Source data: Gran Colombia Financial Filings 3Q11 to 3Q12.

As would be expected from a junior gold producer and miner, Gran Colombia has a high COGS to revenue ratio, which has been close to 80% over the last two quarters. This indicates that it is a higher cost producer than many of its peers as the chart below illustrates.

Source data: Gran Colombia, Barrick Gold, Buenaventura and New Gold 3Q12 Financial Filings.

The higher cost of the company's operations can be attributed to its small size and inability to access the same degree of economies of scale of its larger peers. It is also a direct result of the increased need for the company to spend considerable financial resources on developing its existing assets so as to bring them on line for production.

The company's EBITDA margin is also not particularly impressive but this is to be expected from a junior gold producer and explorer and should improve as it is able to bring more of its projects to production and further access its reserves. As the chart below illustrates, this EBITDA ratio at 11% for the third quarter 2012, is also inferior to its gold producing peers that operate in South America.

Source data: Gran Colombia, Barrick Gold, Buenaventura and New Gold 3Q12 Financial Filings.

However, on a more positive note as the chart illustrates, Gran Colombia's EBITDA has continued to improve over since growing by 4% QoQ and 25% YoY. As the company's operations continue to mature, I expect to see a significant improvement in its EBITDA margin.

Production Continues to Grow

Gran Colombia has continued to grow production, with total production up by 5% QoQ and 23% YoY to be almost 27,000 ounces for the third quarter 2012 as the chart below illustrates.

Source data: Gran Colombia Financial Filings 3Q11 to 3Q12.

This indicates that the company's revenues should continue to grow over the near term and that it is well placed to take advantage of any increase in the gold price over the next year. This significant YoY increase in production can be attributed to continued mine development and increased mill throughput resulting from plant upgrades including the installation of four new flotation cells. The plant's throughput capacity should continue to rise with two new flotation cells being installed over the remainder of 2012.

I am also expecting this production to further increase over the near future with the company continuing with significant capital development activities at its Providencia and Sandra K mines. The company is also continuing with de-watering activities at its El Silencio mine to open up access to the lower levels.

However, one aspect of the company's production during the third quarter 2012 that is of some concern is falling ore grades at Segovia. This has come about because of the depletion of higher grade zones in the levels being mined, along with the processing of lower grade stockpiles in the ramp up of the new mill. But it is expected that these ore grades will improve as new mining areas are opened up at Segovia during the fourth quarter 2012. All of which bodes well for increased revenue and profitability with the forecast increase in the price of gold.

Production Cost per Ounce Continues to Fall

Another positive aspect of Gran Colombia's operations is that production costs per ounce continue to fall. For the third quarter 2012 they are down by almost 1% QoQ and almost 6% YoY to $1,261 as the chart below shows.

Source data: Gran Colombia Financial Filings 3Q11 to 3Q12.

This falling production cost per ounce should further assist Gran Colombia to improve its EBITDA margin and reduce its cost of goods sold seeing its COGS to revenue ratio improve, particularly with the positive forecast outlook for gold.

But in comparison to its peer, production costs per ounce are still quite high at $1,261 per ounce, which is more than its peers Barrick Gold at $793 for the third quarter 2012 and New Gold at $443 for the same period. This as illustrated by the chart below indicates that Gran Colombia is a high cost producer and it is also far higher than the first half 2012 industry average of $727.

Source data: Gran Colombia, Barrick Gold and New Gold 3Q12 Financial Filings.

*NB: Barrick Gold's fourth quarter production cost was $584, a substantial decrease from its third quarter results.

This is somewhat concerning because at the time of writing, gold is trading at $1,608 per ounce, which is only a $347 or 27.5% premium on the third quarter 2012 production cost per ounce. This means that any sustained or significant fall in the gold price will significantly impact the company's profitability and profit margins. It also means that any significant increase in costs will have the same effect and while it is unlikely based on the current outlook, a 28% drop in the gold price or increase in cash production costs would make continued production unprofitable.

There is a Positive Outlook for the Gold Price

The outlook for gold in 2013 is quite positive with Morgan Stanleyrecently stating it is bullish on the gold price despite recent selling pressure, forecasting an average price per ounce of $1,773 for the year. They have made this forecast on the basis of a slower-than-expected U.S. economic recovery, a nominal interest rate environment and quantitative easing three will continue to support the price. European Bank BNP Paribas, like Morgan Stanley cut its initial forecast, but it still remains higher than theirs, with a forecast price of $1,790 per ounce. Meanwhile, Citigroup has taken a more bearish outlook cutting their forecast price for 2013 to $1,675 per ounce and for 2014 to $1,653. Citigroup was bearish on the belief that investors appear to be losing faith in the bull story for gold and this along with falling jewelry demand and reduced private sector demand will curb any growth in the price.

All of these prices are still higher than the price at the time of writing of $1,608 per ounce and also higher than Gran Colombia's average nine month price per ounce for 2012 of $1,647. It is clear that the ongoing economic uncertainty, market volatility and central bank buying along with season buying for jewelry and investment will continue to underpin the price. At any of the forecast prices, Gran Colombia continues to remain profitable and should see an increase in profitability because the company's costs are falling gradually.

Exploration and Mine Development Remain Key to the Company's Growth

An important part of the company's operations are its ongoing exploration operations and the development of existing assets including its existing operational mines. As the chart below illustrates, the company has significant upside with only four of the 27 known structures at its Segovia operation having been modeled.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

This indicates significant further potential for the company to make further gold discoveries at this location adding to its already significant inferred reserves of 1.1 million ounces. This also underscores the need for the company to continue securing funding for that development work to continue across its Segovia holdings, which are illustrated in the chart below.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

The company also during the third quarter 2012 closed a $100 million, senior secured 10% gold-linked notes financing to fund its planned expansion of the Segovia Operations, which bodes well for the continued development of producing mines and unmapped reserves.

This strong exploration upside is also emphasized by the companies Marmato operations, which as the chart below illustrates has seen a new deep mineralization zone discovered boosting reserves by 46%.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

This has seen this deposit now expected to contain a total of 14.4 million ounces, broken down across inferred, indicated and measured, illustrated by the chart below, which also highlights the new deep mineralization zone that has a potential for up to 300 million tonnes of potential ore.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

This operation is also currently producing 22,000 ounce of gold and 35,000 ounces of silver annually and as the company continues to explore and develop the location, this production should increase.

Valuing Gran Colombia

In the past, Gran Colombia has developed a reputation for over-promising but under delivering through failing to efficiently execute its exploration and mine development strategies. This has had a significant impact on investor sentiment, seeing the company's share price plunge by around 90% from an all-time high of $2.34 reach on 29 November 2010, to now be trading at around 23 cents.

The reasons for this negative sentiment can be seen when we evaluate the company's risk metrics and compare that to other peers operating in South America. As the chart below illustrates, Gran Colombia is quite a risky investment with a debt-to-EBITDA ratio of almost 5, indicating that there is a high default risk associated with the company and this is further under-scored by the company's current ratio of less than one.

But on a positive note, Gran Colombia does have a low level of leverage and this indicates that the majority of this risk relates to its low operating cash flow, which should improve with growing production, falling costs and a rising gold price.

When reviewing Gran Colombia's valuation metrics, it does appear to be quite expensive even at its current price with a market cap and an enterprise value per ounce of $976 and $1,938 respectively. But its EV-to-EBITDA ratio does indicate that it is cheap, particularly in comparison to its peers such as New Gold and Buenaventura as the table below shows.

As Gran Colombia continues it development and exploration plans, I would expect to see its proven and probable reserves, which should see its market cap and enterprise value per ounce fall. But I doubt that the company will ever be able to compete with many of the medium-to-large peers operating in South America, such as Barrick, New Gold or Buenaventura, on the basis of this valuation.

But regardless of this, there were a number of positive developments through 2012 that bode well for the company to improve its execution and deliver improved value for shareholders. This includes securing $100 million in funding for its mine development and exploration activities, doubling the capacity of its Segovia processing plant to 1,000 tonnes per day and bringing the Marmato operation closer to production. Accordingly, I believe that the company is unfairly valued by the market at this time and this becomes clear when the company's net-asset-value (NYSE:NAV) is considered.

To determine Gran Colombia's indicative fair value, I have applied a net-asset-valuation methodology in concert with a range of assumptions to predict the value of the company's future cash flow from these assets at today's value. I have done this by determining the present value of Gran Colombia's post-tax and royalty cash flows from its gold assets and then divided this by the number of common shares outstanding. As part of this valuation, I have used the following assumptions:

  • I have discounted all future cash flows by 10% to determine their present value.
  • I have factored in an additional 6% risk premium into the discount calculation to represent the risk inherent from operating in Colombia, thus totaling all future cash flows by a total of 16% to derive their present value.
  • I have discounted the value of all cash flows from Gran Colombia's measured and indicated reserves by 60%, to represent the likely portion of those reserves that will become available to the company.
  • I have discounted the company's inferred reserves by 80% to represent the likely portion of those reserves that will go on to generate revenue.
  • I have used Morgan Stanley's 2013 forecast gold price of $1,773 to calculate the value of those reserves.
  • I have conducted the valuation over a ten-year period with no residual value to represent the finite life of Gran Colombia's gold reserves.
  • I have calculated the present value of debt and asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the period of the valuation factoring in the likelihood that these will continue to grow in value as the company expands.
  • I have not factored in any increase in reserves from exploration operations and future discoveries because of the uncertainty that surrounds gold exploration.

After applying all of these assumptions and factoring in the positive and negative growth catalysts discussed earlier, I have determined that Gran Colombia has an indicative fair-value per share of around 50 cents as illustrated by the chart below.

With Gran Colombia trading at around 22 cents at the time of writing this represents potential upside of almost 128% for investors, making Gran Colombia an attractive investment opportunity. But when the additional risks associated with the company are considered in conjunction with its high cash cost per ounce produced and low proven and probable reserves, it becomes clear why investor sentiment has turned against Gran Colombia despite being undervalued.

Bottom Line

It is clear that on a pure net-asset-value basis, Gran Colombia is significantly undervalued by the market and there is considerable potential upside available to investors. But there are clear reasons why the company has fallen into disfavor with investors, including its poor operating cash flow, high production cost per ounce, poor margins and low proven and probable reserves. These factors along with the risks inherent with investing in any micro-cap stock make Gran Colombia in my view, nothing more than a speculative play on the company's future ability to convert its measured, indicated and inferred reserves into production. Therefore, until the company is able to demonstrate a solid production history, reduce production costs and improve margins, it is purely a speculative play for the high-risk investor.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.