A Rick Rule Example: Aurizon Mines

“Top mining companies are finally generating dramatically higher profit margin. Free cash flow is now “gushing” and will double in the next year as huge capital investments by the majors pay off.

That quote comes from a recent interview with investor Rick Rule.

The observation that gold equities are undervalued has been coming from a number of fronts of late.  Donald Coxe, David Einhorn, heck even Cramer was touting gold stocks a few months ago before his favorite, Agnico Eage, ran into stability issues at Goldex and scared Cramer silly.  Rick Rule said the following recently about the attractiveness of gold equities:

“There have only been two times in the past ten years when, from our own calculations, gold and silver equities were attractively priced relative to the metal, that being 2001 and 2008.  We are back strongly in that territory.

I believe if current gold and silver prices hold up, and I believe they are actually going to increase, that we are going to see a rather dramatic jump higher in the prices of select gold and silver equities on a go-forward basis.

The point, made best by Rule but also by others, is that gold miners are finally in the business of making money, not just producing gold.  A case and point of Rule’s comments: Aurizon Mines.

Here is a company that gets no respect from the market.  The company can release an excellent quarter, as they did two weeks ago, and the market will yawn.  If the price of gold falls a few bucks on any given day, the stock will crater 3% or more.  You’d think the company was some sort of fly-by-night chop shop given the way the market treats their paper.  Yet nothing could be further from the truth.

Below is Aurizon’s free cash flow and cash on hand on a quarterly basis.  Free cash flow is cash flow from operations less capital expenditures. Keep in mind that at its current price of $5.80, Aurizon has a market capitalization of $940M and no debt.

The free cash is allowing the company to grow its cash on hand significantly every quarter.

As the above figure points out, about 20% of Aurizon’s market cap is in the form of cash on the balance sheet.  The enterprise value of the company is only $740M after subtracting this cash.  Annualizing the last four quarters, the company is trading at about 9x its free cash flow generated.  That would be using an average gold price of about $1500/oz.

If you annualize the third quarter, where the realized gold price for Aurizon was $1695/oz, the company is generating $104M in free cash a year.  This puts the companyvaluation at a little less than 7.5x free cash flow.

It is important to recognize that what I am talking about here is free cash flow.  This is different then the metric that is often touted by the mining analysts in their evaluations.  They focus on the operating cash flow, which ignores any capital expenditures a company has.  I’ve chosen to look at free cash because:

1. As I pointed out last week in my comparison between Jaguar Mining and Aurizon, companies generating similar amounts of operating cash flow can have drastically different expenditures required to maintain that level of cash flow.
2. Free cash is what ultimately goes to the bottom line and increases the cash position of the company.

If I was going to look at cash flow from operations for Aurizon, here is what I would find.  In the estimates below I have removed the exploration expense to get a true picture of cash flow from operations.  Exploration expense is a tricky beast, because a company can choose to expense or capitalize the cost, which can work to obscure comparisons.  I prefer to leave it out when talking about operating cash flow (though I left it in when we talk about free cash).

• In the last four quarters Aurizon generated $111M of operating cash flow (6.6x)
• Third quarter annualized operating cash flow was $136M (5.4x)

On either metric the equity is cheap.

So Aurizon is cheap on a basis of four quarter trailing gold prices (~$1500/oz) and certainly on the basis of current gold prices $1700/oz.  I am certain that if you did the same analysis for other gold companies you would draw similar conclusions.  Some would come out astoundingly cheap.  OceanaGold comes to mind as a gold producer priced particularly inefficiently.

The next step I want to focus on is how Aurizon looks on a NAV basis.  Cash flow is the metric to evaluate current profitability, but to fully appreciate all the assets of the company, and the productive life of those assets, you have to look beyond the current cash flow and into the expected cash generated in the future.  But I will leave that for a later post.