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Jul 27

Buying Gran Colombia Gold, A Levered, Free Cash Flow generating Gold Producer

I like the looks of gold right now. Short positions in the metal have been climbing for a number of weeks. Fred Hickey (of the High Tech Strategist) tweeted on Friday that “gold large spec future shorts at 157.4K contracts are second highest on record”. Anecdotally, the charts of many of the gold mining stocks have been depressed for some time. Often July is a seasonal turning point for the miners, as they perform well into the second half.

I took positions in Argonaut Gold and Klondex Gold a few weeks ago. Argonaut worked out, and I actually sold some of my position last week, but Klondex has not. To be honest, the more I look at both of these names, the less excited I am about them. They haven’t generated free cash in the past, so their projections about the future leave me skeptical. I have been searching for other ways to play gold (in addition to Gran Colombia I have bought Rox Gold and Americas Silver).

I found out about Gran Colombia from this tweet from Brown Marubozu. They are a tiny gold producer with two mines in Colombia. They operate the Segovia mine and the Marmato mine. They also have an exploration project called Zancudo.

The Segovia mine is by far the bigger of the two mines. It produced 126,000 ounces in 2016. Marmato produced 23,500 ounces.

Costs at Segovia are much lower than Marmato. In 2016 cash costs at Segovia were $655 per ounce while Marmato cash costs were $981 per ounce. The company doesn’t break down all-in sustaining costs (AISC) on a per mine basis but over in 2016 they had AISC of $850 per ounce

For 2017 Gran Colombia is expecting production of 150,000-160,000 ounces of gold and AISC are expected to be under $900 per ounce. The rise in costs is because of more exploration at Segovia and a higher Colombian peso. AISC of $900 per ounce and under makes them a relatively low cost producer.

Debt and Cash flow

Gran Colombia is heavily indebted compared to most gold miners. The company has $145 million of debt outstanding, denominated in US dollars. They have 20 million shares outstanding.

However, looking at nominal debt and shares outstanding is a bit misleading. The outstanding debt is comprised of 3 convertible debentures. There is a $46 million 2018 debenture, a $52.4 million 2020 debenture and a $47 million 2024 debenture. All of the debentures are convertible at $1.95 per share.

The 2018 debentures have a unique feature that I have not seen before. If the share price of Gran Colombia at the debenture maturity is less than $1.95, the company has the option to repay up to 81% of the debentures with shares at $1.95. It’s a very odd clause, and it factors into debt and outstanding share calculations. . Nevertheless it is clearly stated in note 8 from the debentures FAQ:

The 2018 debenture pays only 1% interest.

The reason that the 2018 debentures have such a strange structure is because they are the result of a restructuring of debt in early 2016. The company exchanged two sets of existing notes (called the silver and gold notes) for debentures and shares. The silver notes, which presumably were subordinate (I admit I haven’t looked into all the details of the old securities) were given poorer terms than the gold notes, including this odd repayment clause. The 2020 and 2024 debentures, which are the successors of the gold notes, are payable in cash at maturity and carry an interest rate of 6.5% and 8.5% respectively.

Assuming the conversion of 80% of the 2018 debentures into stock at $1.95 per share, the true amount of shares outstanding is 39 million, so a market capitalization of $58 million. Likewise, true debt is $108 million USD, which is still a lot of debt, but not quite as much as it appears at first glance.

How about Cash Flow

Gran Colombia has a lot of debt but they also generate a lot of cash flow. Looking at cash flow from operations before working capital changes and capital expenditures, I calculate that the company generated $17 million in free cash flow (I am calculating this before working capital changes, just to be clear) over the last four quarters. In 2017 the company has given rough guidance (slide 19 of this presentation) that “excess cash flow” will be “at least” $15 million.

I actually think that may understate free cash flow. The company includes debt repayments as part of their calculation of excess cash flow. Below is a reconciliation of excess cash flow to EBITDA for the first quarter of 2017. Note that excess cash flow is calculated after subtracting $390,000 of debt repayments. This repayment is likely to a small term loan they have with a Colombian bank that is paid down on a quarterly basis. There is $700,000 remaining on this loan that will be repaid this year. True free cash flow would be $1 million higher after accounting for this.

Guidance suggests that excess cash flow may exceed the $15 million minimum that the company has guided to. The midpoint of the company’s production guidance is 155,000 ounces for 2017. AISC is expected to be $900 per ounce. At an average price of $1,200 per ounce gold, the company generates an AISC margin of $300 per ounce, or $46.5 million. If I assume the same level of cash interest and cash taxes as 2016 I deduct another $26.5 million. This would leave $20 million of excess cash flow.

The company is likely to have a very strong second quarter. On the 12^th of July the company announced second quarter production of 46,000 ounces. This is significantly above the 39,000 ounces that they produced in the first quarter and is more than 10% higher than any quarter in 2016.

Summing it up

I find it very hard to resist a gold miner trading at less than 4x free cash flow (I’m using a market capitalization of $60 million Canadian which includes conversion of the 2018 debentures and free cash flow of $15 million USD for 2017, which I believe to be conservative). To say it is unusual to find a miner with this sort of free cash yield is an understatement. Unheard of is more like it.

Gran Colombia compares well to the peers I have looked at. Below is a table of 4 other gold stocks that I liked because I didn’t think they were exorbitantly expensive. Gran Colombia is the cheapest of the bunch.

However I know there have been issues with management. They clearly got themselves into way too much debt and had to restructure once already. The shares had to be consolidated due to the fall in the stock price. Management may be the Achilles heel of the idea. But the last few quarters they have produced solid, if not stellar results. So maybe the past is the past.

I also understand that the debt level remains quite high. It makes them a leveraged bet, no question. And that leverage can go both ways if they fail to perform. However because it is convertible debt, it can easily play into the company’s favor if the stock price moves up.

Let’s say the stock goes to $2 USD. I have a nice return from my recent buys (60%). The convertible is now in the money and is exchanged into stock at $1.95 USD. The result is dilution of 55 million shares. Total shares outstanding are 94.4 million, so the market capitalization is $190 million. Free cash flow increases by $10.5 million because cash interest goes to zero. So free cash flow is somewhere between $25 million and $30 million.

At this point, do you think a gold miner with $25 million plus in free cash flow and no debt is going to trade at a multiple of 7.6x FCF? I highly doubt that. The reality, whether you agree with it or not, is that historically gold miners trade at above market multiples. Most miners (at least those not currently at depressed levels caused by in discriminant GDXJ selling), trade at 10x operating cash flow, not free cash flow.

My point is that the share price could be its own best friend. Confidence that the company can generate the free cash needed to deleverage could quickly cause that deleveraging to occur and in turn cause a revaluation to a level consistent with other miners. I think the path is there. If the company executes, and the gold price stays at this level (or even better, moves higher), I think we will see this process occur over the next 12-18 months.

Jul 12

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Week 314: Trying to Digest the Dollar

Portfolio Performance

Top 10 Holdings

See the end of the post for my full portfolio breakdown and the last four weeks of trades

Thoughts and Review

The Canadian dollar has been a massive headwind for my portfolio over the last 2 months. I created a simple little spreadsheet to quantify just how much of a headwind it has been. Below I have recreated that spreadsheet but normalized to a starting amount of $1 million so we are looking at round numbers. Since mid-May the majority of my losses have come from the Canadian dollar.

The performance of my portfolio has been poor since mid-May. Stocking picking hasn’t been great, and I am down 3.7% over that time. This isn’t totally surprising to me. I had a big run in the months after the US election and had wondered when the inevitable pull back would occur. What I didn’t expect was that the pullback would coincide with a huge currency headwind.

The rise in the Canadian dollar has taken place as oil prices have fallen. This has made the move particularly painful. In the past I have been able to offset Canadian dollar gains by trading oil stocks that have tended to rise along with the dollar. Not so this time. Oil stocks have mostly fallen along with oil as the dollar has risen. On Friday the Canadian dollar was up almost a full percent even has oil traded down over $1/bbl.

Scott Barlow, who is a writer at the Globe and Mail, had an interesting piece on the Canadian dollar a couple of years ago. In it he pointed out that there was a strong correlation between the Canadian dollar and oil, which is not surprising, but also an even stronger correlation between the Canadian dollar and the yield spread of the US 2-year Treasury and the Canadian Government 2-year note. He presented the chart below.

While the Canadian dollar/oil relationship has went out the window over the last two months, the yield spread relationship has not. Below is a table taken from the Financial Post website that shows Canadian and US Government bond yields. I tried to find a chart to update the one above but could not. Nevertheless, looking at even just the last 4-week data in the table, its clear that Canadian yields have risen substantially while US yields have only risen modestly. The spread has risen from -0.592 to -0.236.

Comparing that to the historical spread chart from the Globe, we can see that a spread of -0.236 is pretty much in line with a Canadian dollar in the 77-78c range. In this context the move in the Canadian dollar is no surprise. The dollar is just moving along with yields.

The other factor at play right now are the short positions. I read back in May that Canadian dollar short positions were at an all-time high. It worried me, but I didn’t react to the news, incorrectly assuming that the short covering might send the dollar up a couple cents and I could handle the blow if it occurred.

The shorts have begun to unwind. Below is a chart posted by Frances Horodelski.

We aren’t quite at a level where the Canadian dollar is overbought. The net position remains short. It is still larger than it has been over the past year. But much of the froth has been worked off.

The last consideration is what the Bank of Canada is going to do. The rise in the dollar has coincided with hawkish comments from the Bank of Canada. The market is now 95% convinced there will be a rate hike this week.

So it seems like much of the coming rate hikes has been (painfully) priced in. The rise in the Canadian 2-year yield has been 43 basis points. This pretty much prices out the 50 basis points of rate cuts expected this week and in October.

I would think that for spreads to rise further there would have to be evidence that the Canadian economy is actually stronger than the US economy. While the Canadian economy is showing strength at the moment, so is the US. The jobs numbers in Canada were strong (though a lot of it was part time work) but so was the jobs number in the US. Historically, the only times that the Canadian economy has outperformed the US economy were during times of commodity price strength. This isn’t one of those times.

Meanwhile so much of the Canadian economy is being driven by housing right now. I know many will disagree with this, and I know I have been wrong about this for some time, but I still do not think this is healthy and I do not think this is going to end well. I read over the weekend that transaction costs on housing make up 2% of Canadian GDP. That seems incredible to me. It is but one example of how important housing, and buoyant housing prices, have become to the Canadian economy.

There was an interesting BNN interview last week with John Pasalis, president at Realosophy Realty. Pasalis said that over the last couple of months the “Toronto housing market turned on a dime”. June home sales were down 37% year over year and prices declined 14% from the April peak.

I am sure that the response of the housing bulls is that this is just another buying opportunity, and they will point to Vancouver, which quickly recovered from its dip last year. Maybe so. But what is going on in housing has every earmark of a bubble. When I read about the foreign ownership, about the domestic speculation, and about prices exceeding traditional metrics of income as debt piles up, it sounds so familiar to other speculative bubbles I’ve read about. I’ve read Extraordinary Popular Delusions and The Madness of Crowds multiple times, as have I read Manias, Panics and Crashes multiple times. All of the lessons I tried to learn in those book rhyme with what I read about Canadian housing.

I have no idea when Canadian housing plays out in the way I expect it to. But being short the currency of such a bubble does not make me lose sleep at night.

Could I lose more because of the Canadian dollar? Most definitely. I can see a path to 80 cents. There are more shorts that need to be unwound. If the Bank of Canada raises rates and strikes a hawkish tone this week, the market will likely push the dollar up.

But I am not going to try to trade this for a couple of cents. My belief is that the only thing that is going to move the Canadian dollar sustainably higher is higher commodity prices. If we get those, then the stocks I own should more than compensate me for any rise. Unless that happens I will take the lumps that I am getting from this move, try to focus on maximizing the performance of the stocks I own, and not focus on what the short-term movements of the dollar are doing to my portfolio.

Portfolio Changes

I’m going to be brief with my transactions this last month and a half.

Radisys has been a disaster and I have reduced my position some in my actual portfolio but I have not in the portfolio tracked here. As usual I was a bit slow to the trigger with the online portfolio and by the time I got around to it the stock had sunk to a level that I believe is too low, even given the reduced guidance and lowered debt covenants.

What led me to reduce my position were the changes to the credit agreement amendment that they filed. There was a change to EBITDA, which was consistent with the change in guidance and therefore not unexpected. But there was also a change to the expected restructuring charges in the second and third quarter. Total TTM restructuring costs are expected to be $9.5 million by the end of the third quarter. This compares to $1 million in the previous amendment. I’m a little worried what precipitated this and until the earnings call, its impossible to know. If this is restructuring of the legacy business, then no problem. If its something to do Software Systems or DCEngine, that would be bad. And until we get to earnings, we won’t know.

With that said, the credit agreement also implies decent revenue in the third or fourth quarter. Below I have recreated what their minimum EBITDA covenants, which were just amended in the new agreement and therefore presumably at levels that management is comfortable with, imply about the third and fourth quarter.

They are still predicting a revenue ramp, albeit not as significant as they had been suggesting previously.

At $2.75 the stock is kind of in no man’s land. It seems too low to me to sell (its essentially back to the level it was at before they even had Verizon as a customer). However I find it impossible to be a buyer until there is some clarity around the restructuring and what constitutes the delays.

The other portfolio change that I will mentions is that I added a few gold stocks, Klondex Mines, Argonaut Gold and US Gold (which I already wrote about here). I like how beaten up the junior miners are, and I will write something up shortly describing how changes to the GDXJ have impacted these stocks. Apart from that early in the month I sold out of a number of names which in retrospect, for the most part at least, turned out to be a mistake (GIMO, ATTU, SUPN, SIEN, BVX and OCLR) as many of these names are higher now. I would have been better off selling Radisys!

Portfolio Composition

Click here for the last four weeks of trades.

Jul 9

1 Comment

US Gold (formerly Dataram): Hopefully another Gold Standard Ventures in the Making

In my first few years of investing many of my biggest winners were gold explorers. This was before 2008 and the financial crisis. I spent a good portion of my time analyzing drill holes, reviewing land packages, and reading preliminary economic assessments and resource reports.

In 2005 and 2006 the gold explorers hit on a bull market. The stocks ran up on drill hole hits and speculative sentiment. Miranda Gold, Endeavor Silver, Atna Resources (before they had a mine), Full Metal Minerals, Mirabel Resources, and others that I can’t remember saw doubles and triples. I remember gains of 10-20% a day in some of the names. I’m pretty sure that my first ever “quick triple” was in Miranda Gold, which went from 60c to $2 in the matter of two or three months (going off the top of my head here so don’t hold me to the numbers). It was a fun time.

However junior explorers can try one’s patience. There are long periods where very little will happen and the stocks will drift lower. They are also illiquid and constantly in need of cash. But they can be extremely fun when the sector is in favor or if one hits on a big drill intercept.

I haven’t invested in the sector in a while. Gold has been lackluster and the valuation of explorers has tended to price in multi-million ounces even when the companies had little more than a package of land and an idea. But I’m warming up to the idea. I have a hunch that January 2016 was the bottom for many gold names, and that we are in the early stages (the part where no one believes it yet) of another move higher in gold. If this turns out to be right, the juniors will have their day.

My Gold Standard Memoir

One company that I did particularly well on a few years back was Gold Standard Ventures. In 2010 Gold Standard was formed to explore a package of land claims in Nevada. The claims were very close to and on trend with large existing mines owned by Barrick, Newmont and the like. Gold Standard was pursuing a large, low-grade, sediment hosted, open pit-able deposits like many of the Nevada mines host. What made the company particularly interesting to me was that its VP of Exploration was Dave Mathewson. Mathewson had been head of Exploration for Newmont Mining for a number of years and was responsible for discovering a number of the Nevada deposits that Newmont owned. He had done this before, was well known and extremely well respected, and for some reason he had decided to shack up with a tiny little exploreco to try to find the next elephant.

As it turned out I didn’t own Gold Standard Ventures for very long. The company’s flag ship project was called Railroad. Shortly after listing they began to drill out targets at Railroad, and within the first couple of rounds of drilling the company hit on a number of very exciting intercepts. Numbers like 56.4 metres grading 4.26 grams gold and 164 metres of 3.38 grams gold. This, along with the proximity to the existing monster deposits owned by Barrick and Newmont, and the pedigree of Mathewson, created a bit of a frenzy in the stock. I can’t remember exactly what I bought and sold the stock for, but I believe when I originally bought it the market capitalization was around $50 million (which was not cheap for a gold explorer with little more than a property at the time) and close to $200 million when I sold it. At $200 million I figured the stock was pricing in more than a million ounces already, and so it was best to take the money and run.

Gold Standard 2.0

Flash forward to last month and I was listening to a weekly podcast that I tune into. Its hosted by a newsletter writer who periodically invests in gold exploration stocks. He is describing a new pick that he is very excited about, a gold explorer with massive upside potential. Of course before you get the name you are going to have to subscribe.

But throughout the podcast he gives a few clues. He says he recently traveled to Nevada for an exciting new idea, and while he didn’t link that directly to the gold explorer it wasn’t difficult to deduce the two might be one in the same. He said that the explorer had a very experienced management team who had done this sort of thing before. And he said that the company was flying under the radar because they had recently took over a shell of another company, had yet to change their name, and so very few knew they existed.

It took me about 15 minutes of googling to figure out who he was talking about.

Mathewsen’s latest vehicle for discovering a large, sediment hosted, Carlin style deposit in Nevada is a company that, at the time, was called Dataram. Dataram, somewhat surprisingly, actually seems to have operated a real business pre-Mathewson. They manufacture memory modules. While they are a small company, they did have $30 million of revenue in the last twelve months.

While it seems a little odd that this memory module manufacturer would be used to host Mathewson’s new gold explorer, I don’t know if delving into the details is really relevant to the story. At the time of the reverse merger a clause was included regarding the distribution of net proceeds of the legacy memory business such that only holders of the stock prior to the acquisition date will participate in any proceeds from the sale of the memory business. So when you are buying Dataram today you are only buying the gold assets. And you aren’t actually buying Dataram any more. They changed their name to US Gold, the company they merged with, a couple of weeks ago, ticker symbol USAU.

Project #1: Keystone

US Gold has two assets. The first, what you would call the flagship asset, is called Keystone. Keystone is very similar to what Mathewson started with at Railroad. Its located in Nevada along one of the major fault trends (called the Cortez Gold trend) about 10 miles south of the Barrick Cortez Hills mine. It is in the middle of a number of elephant deposits, along a major fault and close to other faults. This map of Nevada, from the company’s presentation, shows where Keystone is in relation to other discoveries and mines.

As depicted on the areal view below, you can actually see Keystone from high above the Cortez Hills mine.

US Gold provides background in this 8-K filing. The history of the Keystone is pretty much what you would want to have in a gold exploration target. There has been “no comprehensive, modern-era, model-driven exploration has ever been conducted on the Keystone Project.” What drilling that was done occurred before other Carlin style deposits were discovered and generally targeted formations that aren’t consistent with the large, low-grade, sediment hosted deposits that characterize the elephants in the region. US Gold described it as such in a June press release:

“most of the historical drilling going back to the 1960s appear to have been largely focused on exploring for massive sulfide within skarn and hornfels adjacent to the Walti Springs pluton.

The more recent history of ownership is marred with fits and starts that prevented any serious exploration. In 2004, after the area potential of the Carlin trend was well recognized, the Keystone land package was bought by Nevada Pacific Gold. Given that this was at the height of the last gold exploration boom, one might have expected a big drill program to ensue. But fate and a takeover intervened as Nevada Pacific’s joint venture partner, Placer Dome, was bought out by Barrick. Barrick subsequently did house keeping by dropping all of Placer Dome’s exploration and joint venture projects. Eventually in 2006 the package was bought by McEwan Mining, and 35 holes were drilled before the financial crisis put another hold on exploration.

The consequence is that very little drilling has been done on the project, and what drilling has been done has mostly targeted the wrong formations. After acquiring Keystone in May of 2016, US Gold undertook a review of the historic drill holes, geology, surface geochemistry, and geophysics. In the same June press release I referred to earlier the company said:

Large target areas prospective for potential Carlin-type deposits are beginning to emerge as a result of synthesis from the historical data and the newly obtained detailed gravity survey data and geology.

They concluded that:

A thorough review of all the available data, in addition to some historical holes that included economically significant gold, strongly suggested that Keystone comprised a very large gold-bearing mineral system. US Gold Corp.’s assessment further indicated that this opportunity had potential for high-quality Carlin-type gold deposits. The rock units appeared, now confirmed, to be very much like the same package of stratigraphy and lithologic rock types as is present as host rocks in the Pipeline, Cortez Hills, Goldrush, etc., of the Cortez district within the apparently same northwest-trending Cortez-Keystone structural corridor.

Its expected that they will begin to drill Keystone early in 2018.

Project 2: Copper King

While Keystone has to be considered the focus for US Gold, the company also has a second project that is interesting. The Copper King project – located 32km west of Cheyenne Wyoming, with 5 square kilometers of land claims, is intriguing in that it has had significant drilling in the past and already boasts a measured and indicated resource estimate (from this 8-K filing).

In total there are 1.5 million gold equivalent ounces in the resource. 80% of that resource is sulphide rock, which means that it won’t be amenable to heap leaching and therefore will not be as cheap to process. One thing I have learned in my years of gold exploration speculation is that low-grade sulphide projects are not ideal. Nevertheless in 2012 a preliminary economic assessment was completed on the resource. At $1,100/oz gold and $3/lb copper the project had a net present value of $159.5 million. And it was bought by Mathewson, which counts for something.

I haven’t delved into Copper King but I can tell you already that its true economics is going to greatly depend on those details. Things like: how easily is the ore processed, how much overburden is there, is the shape of the deposit well-fitted to an open pit design, and is there a higher grade oxide zone that can boost the economics by being mined first (20% of the deposit is oxide ore) to name a few. Given Mathewson’s pedigree, I suspect that the answers to many of these questions will be favorable.

Its expected that in the coming months US Gold will review and update the PEA on Copper King, initiate the permitting strategy and further delineate the resource.

Summing it up

US Gold has 8.1 million shares outstanding, but there are also preferred shares outstanding that are convertible into another 4 million shares. At 12 million shares and a $3 stock price the company has a market capitalization of $36 million. They have $7 million in the bank.

The cash should be enough to get them started on Copper King and Keystone, but they will undoubtedly have to raise capital in the next 12 months (all gold juniors are serial capital raisers, it just comes with the territory). I’m not too worried about that though. Given the pedigree of management and the location of the Keystone project, I think they can raise cash without crashing the stock price.

Quite honestly, the $36 million market cap does not seem unreasonable to me. While it was years ago and exact details evade me, I am pretty sure that when I bought into Gold Standard it was with a $50 million market capitalization. And Gold Standard did not have a second property with an M&I resource and PEA assessment valued at more than 3x its market capitalization.

On the other hand, $36 million is not incredibly cheap in an absolute sense of what you want to pay for an early stage exploration company. I am positive you can find scores of gold juniors trading for a few million bucks. But none of those companies boasts the team or location that US Gold has and none of them are going to be able to raise capital with the ease that I am sure this team will. I am inclined to agree with my podcast host that the stock has thus far been overlooked by investors.

Nevertheless the fact is that this is a pure speculation. Keystone may not work out. The probability of failure for the initial drill program even if there is a deposit somewhere under the ground is likely greater than the probability of success. Consider that they are going to punch 20 or 30 4” holes into a 15 square mile land package. Its easy to miss.

In the face of such odds you just have to look for situations where there are as many factors in your favor as possible. US Gold has a lot going for it. It has a management team that is very familiar with the area, Mathewson has already discovered a number of deposits with the exact geology they are prospecting for here in the same area and on the same trend, and they have a land package bearing favorably geology to these other discoveries. You can’t line up your target much better than this. It still might miss, but those would just be the breaks. And if it hits, there is no question it will be a multi-bagger.