Beta and Price to NAV

So I woke up this morning thinking about gold producer price to NAV5% discounts/premiums. I’ve struggled to understand the intuition behind being priced at a premium to NAV5% as this implies that the appropriate discount rate for the stream of cash flows is less than 5%. How can this be given that gold mining is inherently risky. Arguably more so than the typical business in the S&P 500.

Well there are a couple of explanations for this pricing behavior:

  • Analyst NAV assessments underestimate the future stream of cash flows
    • This is possible but I doubt this is the answer as any future resource conversion is going to occur so far in to the future that it would be discounted to oblivion
  • Analysts use a flat price deck when creating the NAV forecasts
    • You could make the case that a nominal price deck should be used but this change would be offset by the use of a nominal discount rate; probably not the answer.
  • NAV5% is not the correct discount rate to be used for specific gold producers.
    • I think this is the underlying logic driving the price to NAV logic.

In the gold space, small companies typically trade at a discount to their NAV. Generally, discount to NAV is negatively correlated with size; smaller company, larger discount. The intuition behind this equilibrium makes sense as larger companies are more diversified (operationally and jurisdictionally). Senior producers generally trade at a premium to NAV and streaming companies trade at an even higher premium.

Being priced at a premium is a challenging concept to understand. At the extreme, this can imply that the purchase of the security will provide cash flows that are less than the purchase price. This is very similar to negative interest rates. Unlike negative interest rates, however, the pricing of these securities is not manipulated by quantitative easing and central banks. The “rational” investor is doing the pricing.

So how can a discount rate of zero (or negative) be justified. The capital asset pricing model states that the equity risk premium is the risk free rate + beta * equity risk premium. The current T-bill rate is around 1% so this implies that the beta of these investments must be zero or slightly negative. This train of thought led me to start looking into beta and the correlation of gold to the broader economy.

So what is beta? I like to think of it as a leverage factor for stock returns. A beta of 1.25 means that the stock will move 125% of the move of the general market. Beta can also be thought of as “risk” factor. A high beta implies high risk -higher volatility- and investors will require a higher rate of return for an investment in the security.

If we look at the beta of monthly returns from 1973 to the end of 2018 we see that gold has exhibited a negative beta with respect to the S&P500. Conversely, copper, oil, and silver have positive betas. These relationships make sense as these other commodities are more related to economic growth and, in turn, the S&P500.

The beta values are misleading as they understate gold’s performance relative the S&P500 during times of instability.

Because, as you’ll see in this chart, gold generally hovers around a beta of zero during periods of relative calm and spikes in other occasions (2008).

This chart that gold acts as insurance during calamity, increasing in value by more than the S&P falls.

Is Grade King? Post 2

This post is a continuation of yesterday’s dive into the relationship between company-wide grade and cash flow from operations. Spoiler alert, there was no relationship. This fact isn’t surprising given the multitude of other factors that impact a company’s cash flow from operations.

I decided to get a little more granular and look at this relationship on an asset basis.

The chart shows that increased production correlates with lower AISC, an expected result given economies of scale. Large scale project require large capex and, as such, require low operating costs to provide attractive rates of return. This makes sense. 

If we compare AISC for open pit operations vs. processed grades we see the trend that we were looking for! Increased grades results in lower AISC. Finally.

Similarly with UG operations, higher grade and lower opex.

Hope you find this interesting.  

Is Grade King?

The purpose of this analysis is to answer the question: “Is Grade King?”

I’ve heard this line often and am interested in correlating mined grade to cash flow from operations to see if there is any relationship.

I’ll start with a broad assessment, ignoring the obvious impact of mine type (UG/OP).

The chart shows a couple of interesting points. Pretium and Kirkland Lake are really in a league of their own in terms of reserve grade for producers with >200K oz per annum of production.

The chart isn’t that useful with these higher reserve grade operators. Let’s take them out.

The chart, with a 5 g/t cap looks as follows:

Moreover, unfortunately, there really isn’t any relationship between reserve grade and CFO/oz (darn). This isn’t that surprising as reserve grades aren’t mined grades and there are countless other factors that impact the profitability of an operation. I was hoping that grade would be king-enough to prove some relationship.

This investigation will require further analysis. While we’re at it. Let’s look at 2018 production.

The chart shows that, as expected, more gold production = more CFO. It’s interesting to note which operators fall above or below the trend line. Kirkland Lake, Newcrest, and Sibanye stand out as a strong performers while Anglo Gold Ashanti is a laggard.

The last chart we’ll look at is a comparison between 2018 CFO per oz produced vs. current enterprise value per ounce. Now we wouldn’t expect CFO to directly translate to enterprise value but I think that this chart is interesting because it provides commentary regarding how much reserve value is going to be captured by the company (or at least the market’s perception of it). The shading of the dots reflects the comparison between these two metrics.

The variation in this metric is very impressive. Take New Gold for example, in 2018 the CFO per oz was close $550 while the company’s enterprise value per reserve ounce is only $100/oz. As mentioned, there are innumerable other items to consider (asset quality, assets not in production, CFI, capital structure).

Not really sure how to conclude this. Relating grade to cash flow is going to be tricky.

Reserve and Resource Additions in 2018

Most of the miners have released 2018 production results and reserve and resource updates. I thought it would be interesting to see which properties added or lost the most ounces during the year.

Out the list there are a couple development projects that saw some serious jumps:

  • Cerro Blanco
  • Cote
  • Kharmagtai
  • Transvaal
  • Misisi
  • Camino Rojo
  • Block 14
  • Curraghinalt
  • Rackla
  • Windfall
  • Eskay Creek
  • Valentine Lake

Would be interesting to look at the corresponding jump in share price of the single asset owners.

Franco Nevada Continued

Mining is risky. With a commodity output, they operate in an environment of perfect competition. It’s capital intensive and they don’t need to contend with depreciation alone, there’s also depletion. Pit walls can fall, people can get injured, and governments can penalize mines at will (nationalization, permitting, fines).

In a previous post I looked at Franco Nevada’s negative retained earnings and meager returns on capital invested. Given historic performance I thought it would be interesting to look at implied returns from prospective investments and the sensitivity of project failure.

Let’s say that Franco invests $250M in eight projects and the expected post-tax return is 4%. Well, what needs to go wrong to obliterate the return of the portfolio.

Well, this would do it:

  • 1 project fails immediately
  • 1 project fails at year eight
  • 1 project fails at year ten
  • 1 project ends two years early

What are the odds that this could happen? That’s an interesting question. It’s certainly higher than 5%. I imagine 50% is closer to reality. There’s also the impacts with grade issues and ramp up.

Capital Allocation and Franco Nevada

What is the purpose of a corporation? Let’s not get into the stakeholder vs. shareholder debate. At the core, a corporation’s goal is to increase its shareholder’s wealth. Otherwise, why start the corporation? I’d only start a company if I believed this investment would yield more value (return) than a risk free asset. I’d want to be compensated for this risk as well, hopefully earning a materially higher return than a riskless asset.

A corporation’s purpose, while simple, is easily convoluted by countless factors. The owners of the corporation may not understand it in themselves. I’m not Stanley Druckenmiller but I’m no finance/business slouch either. After a couple thousand hours of studying/working in finance, I can honestly say that I’m only starting to build a picture of what I consider to be a “good” business. Why is this the case?

There’s so much noise. A company’s price and fundamentals are so detached. Who am I to say that a company with zero earnings is a bad company? The FANGs, they don’t earn much and yet they are the best performing stocks in the past decade. The fact that growth stocks don’t trade on fundamentals makes it easier for non-growth stocks to trade on the same basis. The market doesn’t hold them to account, don’t they see the difference?

I think Warren Buffet has it right. The Berkshire Hathaway owner’s manual states that their goal “is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.” This makes sense. If I’ve got a dollar, I want to invest it in the area that’s going to give me the most dollars in return. Berkshire defines intrinsic value as the present value of future cash flows. They trade money. Trade 1 dollar for 1.08 dollars. Makes sense.

A $100 million investment with a $100 million NPV is subjecting your hard earned dollars to zero return. Now that doesn’t make sense. Who would do that?

Well, as far as I can tell Franco Nevada does this, and a whole-heck of the mining industry.

Why do I say this? Well let’s take a look at the financial statements for FNV for year end 2017.

Ok, so I’m a shareholder. How much money have I pumped into this company?

Wow! 6.5 Billion in total, the value has steadily marched higher over the past decade. Must be some good returns to justify this. Well, FNV has generated $836M in net income of the past ten years. That’s a pretty measly 1.88% on the contributed capital. Hmmmm.


But, but, they pay a dividend!

Yeah, they do. But it’s more than their net income.

So what does this really mean. Well FNV is paying out more than their making. Is this good business? Let’s keep issuing capital, take on some debt, and pay some dividends. More people see the dividend track record and subscribe. That’s an interesting cycle… sounds familiar. What’s the name for that?

Well, if you were a shareholder between 2007 and 2016 it hasn’t been good business. Earnings haven’t increased and the return on your equity has been pretty lousy.

But who cares! The stock price is going up.

And a big reason for that is steeper valuations from a PE perspective (note the chart above takes out PE ratios over 100). In an environment where your competition is miners with a destructive track record for capital allocation, you’re the best looking girl at the bar.

Now I’m not saying that the people that run FNV are bad miners. They just aren’t deploying capital in a fashion that produces high returns. But this begs the question, why are new players (triple flag, orion, osisko, sandstorm) entering the business? With competition, prospective returns surely aren’t going to go higher. The narrow margin of error may get pushed lower.

There’s also the question about why people own these stocks. I mean, it’s precious metals exposure and it’s certainly outperforming Barrick but common. Return on equity less than a LT treasuries. These are not risk free assets.

So what is going on with Solgold?

Yesterday Newcrest announced that they were increasing their stake in Solgold (owner of Cascabel property in Ecuador (85%)). This will take Newcrest’s ownership of Solgold to 15.33%. Newcrest had previously purchaed shares of Solgold in 2016 and 2017. What makes this interesting is that BHP has also shown interest in the property, purchased 100,000 shares in October. Newcrest will not be the larget shareholder in the company, followed by DGR global (11.24%) and BHP (11.18%). 

So what is going on here? Well SolGold has an enterprise value of US$810M so this company is not cheap. Cascabel must be one hot ticket. Yup sure is...

Resource update in November showed 10,900,000 tonnes of copper and 23.2M oz of gold. Wow. Amazing. The resource contains 2.95B tonnes at 0.52% Cu.  Perhaps even more interesting, there’s a high-grade core of 420M tonnes at 1.47%Cu; almsot $100/tonne rock at $3/lb Cu. 

The November 2018 investor presentation highlights the fact that modern exploration activities have allowed the for the discovery of the property. Drill results contain some of the best porphyry copper gold intervals ever recorded. For example. Hole 12, 1560m at .59% Cu and 0.54 g/t. 

The image above (from November 2018 investor presentation) shows the gargantuan extent of the deposit. Based on the geochem data it looks like there are a bunch more targets as well. 

Given Newcrest’s experience with block caving, it’s not surprising how interested they are with the property. Look at the benchmarking!

Solgold also owns multiple subsidiaries with a 3,200 km2 land package.

Well. Solgold is pretty amazing. That’s what’s going on with Solgold.

Mining In Armenia

What is the state of mining in Armenia? How should foreign investors view this country? I’ll spend some time reviewing some recent developments in the country and formulate a view.

Politics:

  • Gained independence in 1991
  • Had been governed by Serzh Sargsyan since 2007 as part of the right-wing republican party
  • Serzh Sargsyan was reelected for a fourth term in April 2018, peaceful protests started which were concerned about what was starting to look like an indefinite rule
  • Serzh steps down and the leader of the Civil Contract Party is elected (Nikol Pashinyan)

It would be impossible to look at Armenia without investigating the state of affairs with Lydian. Lydian received approval to build the project (Amulsar) in 2014 but construction has been impacted by local protests. 

In August, Armenia’s inspectorate for Natural Protecion and Mineral Resources suggested that the environmental assessment be re-evaluated. 

The inspectorate stated that new ecological factors should be considered for the property. Specifically, there are new sightings of red plants and animal species. 

But get this, so the head (Artur Grigoryan) of the Environmental and Mining Inspection agency directs Lydian to refrain from any mining activities until the ministry can conclude if these new “red plants” are actually at the site. So Grigoryan sends in his team. The team concludes that these new organisms cannot live at this site and are not there. Lydian appeals the original directive, but the appeal is heard by Grigoryan. Obviously, he rejects the appeal which is predicated on information from his own ministry. So now Lydian has challenged Grigoryan’s position through an administrative court. The court has accepted the appeal which suspends Grigoryan’s edict. Great! It doesn’t matter though because the place is still blockaded.  

It’s pretty amazing that a country with 16.8% unemployment is challenging industry and preventing the creation of hundreds of jobs. 

Seems to me that Armenia is not a jurisdiction you want to be developing a project in. 

The McNulty Curve

In general, mining companies have a poor track record of delivering projects on time or on budget. Today, for the first time, I heard about the McNulty Curve; a graph which predicts the level of pain that companies will endure when ramping up a project.

Some previous studies on project cost overruns highlighted a few key reasons for process plant failure (defined as major cost over-run or inability to achieve design capacity):

  1. insufficient effort was devoted to understanding process chemistry
  2. insufficient continuous pilot-scale testing was conducted
  3. the plant lacked parallel process streams and/or in-line spare equipment units
  4. the design incorporated sequential unit operations that either were first-of-a-kind or the largest ever built or both

Terry McNulty advanced this concept and derived ramp up curves for various types of processes. He defined the types as follows:

  1. Series 1
    1. The owners relied on mature technology.
    2. Standard types of equipment were selected.
    3. Thorough pilot-scale testing was done on potentially risky unit operations.
  2. Series 2 
    1. If the technology was licensed, the project was one of the first licensees.
    2. Some equipment was a prototype in size or application.
    3. Pilot-scale testing was incomplete or was conducted on non-representative samples.
    4. Process conditions were unusually severe or corrosive.
    5. Non-innovative parts of the flowsheet received inadequate attention
  3. Series 3
    1. There was very limited pilot-scale testing and important steps were ignored.
    2. Feed characteristics such as mineralogy were poorly understood.
    3. During process development, product quality received little attention.
    4. There were serious design flaws.
    5. Engineering, design, and construction were on a “fast track” with inadequate planning to offset added risk.
  4. Series 4
    1. If continuous tests were run, they were only to make the product.
    2. Equipment was downsized or design criteria were compromised to reduce cost overruns.
    3. The flowsheet was unusually complex with prototype equipment in two or more unit operations.
    4. Process chemistry was poorly understood. 

McNulty highlights a few other factors that were correlated with project over runs, some of which are particularly relevant for the mining industry.

  1. Corporate management had a promotional or overly aggressive attitude.
  2. The owners had very little day-to-day engineering input.
  3. Driving forces underlying the project were ill-conceived.
  4. The ore receiving and preparation areas received little attention.
  5. Translation of the testwork to design criteria was flawed.

Sources: Most of this information was from a paper called Minimization of Delays in Plant Startups. It can be found here: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.126.1359&rep=rep1&type=pdf#page=119

Asymmetric Returns For This Gold Developer; Not For The Faint of Heart

Positive asymmetric returns are those with limited downside and much higher upside. This article looks at the prospects for a gold developer whose share price has been battered. Orca Gold is developing the Block 14 gold property located in Sudan. Their share price is down 40% YTD even after significantly advancing their flagship property.

In early November, Orca released the details of an updated feasibility study which describes an open pit operation producing 167K oz per annum. Reserves contain 80 million tonnes grading 1.11 g/t Au for 2.85M ounces. The property is expected to produce gold at an all-in sustaining cost of $789/oz. The after-tax NPV of the project is estimated to total $403M; at a 5% discount rate.

If you look at the chart below you will notice that the share price did not budge after the release of the study (early November) and the stock continued its downward march. So what’s the deal? The enterprise value of Orca is $37M and their 70% stake in Block 14 is worth US$282M. They are trading at 13% of the NPV5% of the property. This is a massive discount. The implied discount rate of the property is approaching 50%. So, the market is pricing in a serious chance that this asset does not make it to production.

This is interesting. The discount rate assumed for this property is egregiously high. Maybe the worst is already priced into the stock price?

So why is the market pricing in such a steep discount? Well, Sudan -the location of their asset- is still designated by the United States as a State Sponsor of Terrorism. In 2017 the U.S removed some of the economic sanctions for the country but it is unclear if financial institutions could lend money to Orca to fund the project (the government has a carried interest in the property). I think that as long as Sudan is on this list, Orca’s share price will suffer.

This is where it gets interesting. Sudan is progressing talks with the US to be removed from the terrorism sponsor list1 (which would remove the associated sanctions). If this were to occur, it’s reasonable to assume that Orca would be re-rated to a much higher level.

The project is probably still riskier than the typical gold mine. It’s located in the desert, away from infrastructure, needs a well field, and Sudan does not have an established mining workforce.

That being said, and as shown in the chart below, Orca is amongst the most discounted juniors out there with a near-term development project. This investment is not for the faint of heart. If talks with Sudan do not progress than the share price could easily continue to suffer. A successful resolution, however, could result in 1X share price appreciation. This is asymmetry.

1: https://www.channelnewsasia.com/news/world/sudan-and-us-to-hold-further-talks-on-removing-khartoum-from-terrorism-sponsor-list-10909098