Oceanagold: Don’t Confuse the Headline with Cash flow

Over the last few weeks I have bought back a reasonably sized position of OceanaGold. This after having been out of the stock since the day of their Q2 update. When the Q2 update came out I took one look at the cash cost number ($900+) and one look at the production number (60,000 oz) and figured it was best to run to the sidelines and wait for the inevitable shakedown to pass.

That turned out to be a good decision.

When I read bad news, I have found it is usually better to sell first than it is to wait for the reaction to play out.  It is better to “panic”.   Why you would buy and hold a stock that you know is sure to go down, even if it is only in the short run?  In OceanaGold’s case, it was clear that at $2.70 or even $2.50, the share price was too high given the severity of the quarter.  The stock had traded to $2.20 only weeks before news of the quarter came out.  Certainly one could expect it to trade to at least $2.20 once such news was public.

And it did. The stocks traded all the way down to $1.80 in fact. I was glad that I had “panicked” on the morning of the press release and gotten out at $2.58.

But one has to be careful not to confuse the reaction with the facts. The initial market reaction can be based on the inefficiencies of investors/speculators who do not read past the headline, do not know what they own, or are selling on technicals. The trick, I think, is to understand enough to both know how bad the bad news will be taken, as well as how bad the news actually is.

In OceanaGold’s case, the perception was clearly going to be a short term drag on the stock. The headline numbers were awful and that is what is most important to most investors. Equally important though, was the knowledge that the details of the quarter were not quite as disasterous as they appeared at a glance.

The majority of the miss from the quarter can be attributed to three reasons. First, the New Zealand dollar appreciated far further than I think anyone has expected. Second, the mine plan is causing the company to expense more costs. Third, they lost some of their underground workforce.

There is, of course, nothing OceanaGold can do about the New Zealand dollar.

However the latter two problems are worth expanding on.

The issue with mining costs took place at Macraes open pit. The problem, as the company explained it, had to do with a change to the mine plan and the effect it had on the accounting treatment of strip mining. When the company is pre-stripping a new orezone, the company can capitalize that strip. It will show up some time later as depreciation on the balance sheet. However once the company reaches a new orezone, all strip needs to be expensed as it is incurred.

What happened in the second quarter is that there was far less pre-strip incurred then has been the case in previous quarters. And so most of the costs of mining were expensed directly on the income statement as opposed to having some of those costs expensed.

More specifically, the original mine plan had the Company mining an area (stage 4) of the open pit that, after drilling, was determined to be uneconomic.   Some of the mining fleet was supposed to be utilized prestripping stage 4 but because the area was determined uneconomic the fleet was used instead for waste mining of stage 5.  Because the ore from stage 5 is already accessible, this waste mining could not be capitalized and had to be expensed.

As an aside, it’s interesting to note here how this scenario demonstrates how cash costs are not really cash costs. Cash costs are actually the expensed portion of costs for that particular period. Depending on the accounting treatment, a company could spend much more cash in a quarter than what gets attributed to cash costs.

In the case of OceanaGold, the best way to see this effect is to look at the total cash outflow that OceanaGold has been spending on producing its mines over the past few years. This cash outflow includes both expensed production costs (the costs on the income statement) and capitalized production costs (the pre-stripping that only shows up on the cashflow statement). This is shown in the chart below.  Now unfortunately you can’t just look at Macraes alone.  The cashflow statement gives the combined capitalized costs of all operations.  But still, you get the basic idea of how costs were higher in Q2, but not as much higher as the cash costs would suggest.

The key point to be made by the graph is that while cash costs per ounce increased a whopping 25% quarter over quarter, total mining costs, as shown in the graph, increased 6%.

To get an idea of just how much money was deferred in the second quarter, when compared to previous quarters, the following chart plots total capitalized production costs on a quarterly basis. You can see how relatively little was capitalized in the recent quarter.

So really, from a cost of mining perspective, OceanaGold did not have nearly as bad of a quarter as the headline appears.  Make no mistake, it also wasn’t a great quarter, but it wasn’t nearly as bad as the headline.

At Reefton, management said the problems are entirely attributable to workforce turnover. They had a bunch of their miners quit, and the new miners weren’t as efficient. So they had to mill low grade stockpiles. You can see the low grade milling in Q2 versus previous quarters below.

What is somewhat puzzling about the reason given is that when you looking at the mining output at Reefton over the last few quarters, it really doesn’t suggest that severe of a deficiency in ore.  And from the figure above, mined grade for the quarter was actually quite a bit higher than milled grade (~1.8 g/t versus ~1.4 g/t).

I’m not really sure what to make of this.  Either A. they’re lying about what the problems are, or B. the problems were more temporary than the company is letting on and recovered even during the quarter (they said Reefton wouldn’t fully recover until Q4)

I think the more likely explanation is  that they are quietly hedging their future expectations.

Management also said they are bringing on-line the smaller Souvenir deposit at Reefton. This is somewhat interesting. Souvenir is a fairly narrow, almost vertical vein that hosts about 10,000 oz of reserves and another 30,000 oz of resource. The grade is somewhere between 3g/t and 4g/t; based on drill results it is probably closer to 4g/t but because there is sparse drilling at Souvenir the auditors decided to err cautiously.

Souvenir should help make a dent in cash costs at Reefton by bringing up the overall grade through the mill. But given the small size of the deposit, this is not really a long term solution to the labour force issues. Those need to be (and hopefully are being) addressed.

Valuation

The thing about OceanaGold is that they are just so cheap compared to their peers. Therefore, if you can’t discount the company’s value because of major operational issues (which I have tried to show is not the case) then there is just no reason for it to be trading as cheaply as it is.

BMO wrote a great report on the gold miners a week ago.  OceanaGold was included in the comparisons.  Below I have cut and paste a couple valuation metrics that BMO used in a recent report on precious metal miners. These comparisons show clearly just how undervalued OGC is relative to its peers.

The company trades on metrics that are only comparable to low caliber junior miners and larger miners with high cost operations that cannot generate cash flow. Heck, there are some miners that haven’t consistently generated cash flow that trade at a premium to OceanaGold. Its ridiculous.  OceanaGold has consistently been generating between $30M and $40M of operating cash flow.  They should be able to bring on their next project Didipio, without having to raise any money and while maintaining a decent cash balance.

As I’ve tried to point out above, while the company has had some operational issues, these are by no means debilitating. Moreover, the company has a strong growth profile, with Didipio expecting to add to gold production at low costs (because of copper by-product credits) in a little over a year. The company should, if anything, be trading as a growth story, not at the tremendous discount that it is given.

So I bought a position. We’ll see how it goes.