I have been investing in the stock market and one of my investment "finds" started to have a sell-off when I thought it was undervalued. I needed to be sure that I had properly assessed my stock of interest, so I started on a journey of comparing two stocks for market valuation.
The stock that interested me is Northern Orion. The stock that I decided to compare it to was Goldcorp. I chose Goldcorp because Northern Orion owns 1/8th of the Alumbrera mine and Goldcorp owns 3/8th. It seemed that they should have similar valuation based on this one interest.
What I discovered was that Northern Orion was trading for about 10c on the dollar compared to Goldcorp. I still strongly believe that Northern Orion is undervalued, I never expected to find a gold bubble in mature gold stocks, one that in my mind is as serious as the tech bubble.
Read my analysis and decide for yourself. Aside from the copper concern, the majority of these concerns apply to mature gold stocks and will make them under perform beyond anyone's expectations.
The over valuation of Goldcorp
Goldcorp is a company with 702 million shares that took over Glamis in late 2006. Currently a check on any stock website is still not showing the 280 million extra shares from that takeover and is enormously understating market cap. At a share price of about $28.50, Goldcorp has a market Cap of $20 billion.
To understand why Goldcorp is overvalued, these things need to be examined and evaluated:
- The leverage of earnings of both copper and gold.
- The price elasticity of gold bullion to gold stocks, ie, market cap.
- The increasing cost of acquisitions.
- The roll of the life of a mine - increasing rates of depletion.
- The roll of lower quality gold properties.
- The roll of depreciating mines.
- The level of reserves to market cap.
When I looked at Goldcorp, it was prior to the Glamis merger. At that time I found from reading the financials that in Q2/06 64% of earnings came from one mine for Goldcorp, the Alumbrera mine, and for the first 9 months of 2006 60% of earnings came from Alumbrera. Alumbrera is copper, not gold. I'm not entirely sure for Goldcorp, but for Northern Orion in Q2/06 they got $4.44/lb average. When 60% of earning come from one mine, where the price of the commodity is going down, that is huge in terms of loss of income for the business.
Before the merger, there were 60% of the number of shares that there are now. This means that for the year, it can be expected that about 1/3rd of earnings for the entire company will have come from copper.
If you look at the average price of $1.01 prior to the bull on copper, copper increased to roughly 440% of its previous price. I truly believe this leverage effect of earnings on Goldcorp has been grossly under appreciated in terms of how Goldcorp can never again have the stellar performance of the past.
Alumbrera has a twofold effect on earnings for Goldcorp. First, for 2005, the earnings were not subject to the 20% royalty, so earn estimates for Goldcorp for Alumbrera for 2005 based on those copper prices will be less. The upside is that 2006 only saw gross earnings without that royalty payment for Q1, so 2006 earnings are not completely plumped up by an unrealized 20% decline in copper prices due to the royalty kicking in.
The second effect is that copper prices are going down and copper LME stocks are going up. Traditionally demand for copper is lower this time of year, so even though copper stocks are going up, that may turn around this quarter, but copper stocks are increasing rapidly. The other thing about copper, every producer that can has increased their existing output as best they can. This has in the shorter term increased supply, but in the longer term shortens mine life.
I have not done the required homework, so I really don't know how much of the new production is new mines, and how much is increased output of existing mines. But, my overall sense from my reading is that producers have gone for the fastest path to increasing production, which was to eliminate inefficiencies in current operations, Alumbrera is not exception, production has been increase by 10%.
The other thing that may have happened as well is that mines have not kept up on maintenance the requires reduction in output. As copper prices decline, those scheduled maintenance needs will happen, so in some respects, In the short term there may be an unsustainable increase in production. If I'm wrong, copper prices will decline further this year and will probably settle in the $2.25 range. I do not see copper averaging at $3.40 as predicted in the BMO analyst report, but possibly in the $3 range, but the recent decline in copper price and increases in stock make that an unlikely prospect.
The effect of the decline in copper prices is enormous for Goldcorp, as such a high percentage of its earnings were from copper. With 168 million pounds of copper, every dollar decline in copper requires gold to go up $54 at current production rates just to offset it. So, from the high of $4.44 to today's low of $2.51, based on a production of 2.8 million ounces, gold has to go up $92/oz for Goldcorp's earning to remain constant. I have taken into consideration that 20% royalty in this calculation.
Major, Major, Major Concern #2 - reduced leverage of Gold.
This concern is more a concept than actual numbers, but this concept will play out in earnings. It mathematically has to. I believe that the concept of leverage of earnings is being utterly ignored in analysts and brokers alike, and not recognized in terms of its ability to never again give repeatable results regardless of what the price of gold does now.
The simplest and most dramatic way to demonstrate this concern is to do a mathematical analysis using ratios. I teach ratios to kids in grade 8.
Say you have a producer who when gold was $300/oz managed to make $10/oz profits and the earnings/share worked out to 4%. Say the share costs $1. Now say gold is $600/oz. So now profit is $310 and a simple ratio gives earnings (310/10)x4 = 124%. This kind of leverage of earnings made gold such a stellar performer up to now in the market, but mathematically, it can never be repeated. The leverage ratio here is 31, utterly enormous. Share price would then adjust, go up 31 times, to $31 and the return would again be 4%.
What has happened is share prices have adjusted to market cap and shares have gone way up, so earnings are again 4%. Market cap has also gone up 31 times. If it was 1 billion, now it is 31 billion. Keep everything else constant, costs are still $290 for the sake of this analysis of the reduced effects of leverage.
So, now say gold goes up another $300, to $900. Now profit is $610. The leverage effect is now (610/310)x4 = 7.9%. The leverage effect now is 1.97. The reduced leverage effect of increasing prices is 31/1.97 is 15.8. This is a decimal number. I also teach percents to kids in grade 8. This is a reduction of leverage of 1580%, providing costs remain constant.
Leverage of earnings early in the bull run played a dramatic effect on the increase in earnings on gold shares from increases in gold prices in a way that I believe is *unrecognized and unrepeatable*.
This incredible leverage of earning early in the bull run, in my assessment, is probably responsible for erroneously justifying P/E of 25 to 50 are acceptable for gold stocks because profit grow rapidly with increasing gold prices. The stellar leverage is a one time only deal. It declines further with every dollar increase in the price of gold.
Major Concern - Price Elasticity of Bullion versus Market Cap Concern
This is a simple mathematical analysis that I've talked about with high school students in the classroom in terms of what I see happening with gold stocks in general.
Take gold at say a price of $625/oz. Say you buy an ounce and the gold price goes up to $725, or by $100. Your investment has increased by 16% and you own the gold bullion.
For simplicity, say the market cap of Goldcorp is $20 billion (it was very close to that). Their production forecast is 2.8 million ounces of gold, which at @ a $100 increase in the price of gold would bring in an additional $280 million. So, the absolute value of how much earnings could go up relative to market cap is 280/20000*100% = 1.4%. So, if earnings were 4% they could go up to 5.4% if gold went up $100, but taxes also have to be paid.
The price elasticity of the raw numbers of what you actually have is the bullion is 11 time better to own right now than the gold stock, if you believe that gold is going to go up in value.
What is really remarkable here, is that not only is the level of earnings pathetic with the stock in comparison to bullion, you not longer own the gold, or essentially you have a very negative return. The gold has been sold.
Major concern - Increasing cost of Acquisitions
The cost of replacement properties has increased dramatically. I've pasted a recent report at the end. At the beginning of the bull run reserves cost about $33 oz. The Glamis take-over cost $175/oz. This is around $140/oz increase in acquisition costs.
The exact numbers don't matter, for simplicity, there is about $140/oz increase in gold replacement costs. Previous analysis was just looking at all things constant. All things aren't constant, and in fact work against profitability. Costs are increasing. Gold needs to go up to about $750/oz just to maintain earnings in terms of what those replacement cost are.
For Goldcorp, $140/oz in increased costs translated to 2% less to earnings per share.
Major concern - The life of a mine - increasing rates of depletion
Some of the spins I've read on the life of mine gives that a short mine life is a good thing because mines stop producing and it gives constant demand.
My spin on it is very different.
Red deer, a Goldcorp's second largest contibutor to earnings, has a mine life left of 12 years. Alumbrera has a mine life left of 10 years. Prior to the merger, those two mines were making 80% of Goldcorp's earnings. There are 23 properties listed. It means that one, and sometimes two mines need to be built every year just to keep up, never mind growth. Replacement is enormous...
In the shorter term for Goldcorp you see production going from 2.8 million ounces to 3.5 million ounces. From that point on you see a rapid decline in output due to the end of the life of the mines, with 60% of the 3.5 million ounces in mines that come to the end of their life within 12 years.
The rate of depletion of Goldcorp gold reserves without replacement looks something like this:
2005 - 40.5 million ounces
2006 - 38.5 million ounces, 2 million mined, depletion, 5%
2007 - 35.7 million ounces, 2.8 million mined, depletion, 7.3%
2008 - 32.6 million ounces, 3.1 million mined, depletion 8.6%
2009 - 29.3 million ounces, 3.3 million mined, depletion 10.1%
2010 - 25.9 million ounces, 3.4 million mined, depletion 11.6%
2011 - 22.4 million ounces, 3.5 million mined, depletion 13.5%
2012 - 18.9 million ounces, 3.5 million mined, depletion 15.6%
This means that Goldcorp is in a squeeze position of having to constantly be acquiring new properties to keep this monster machine going. It puts Goldcorp at major risk for increasing costs, and indeed, the costs never stop because of the constant need for recapitalization.
Major concern - depreciating mines
Mines are depreciating assets. The average life of a gold mine is 14 years.
To my way of thinking in terms of valuation, that means that earnings need to be 7% to make up for the average depletion rate plus inflation plus whatever it is you expect for the risk you take. Strictly my opinion here, but without strong other mathematical reasons and evaluation, a P/E of 10 is the minimum as to where you start, and then make adjustments up or down based on the fundamentals of the gold stocks. How much is being added to reserves and how much is being mined. If new reserves are being added at the same rate as the depletion, a P/E of 12-15 may be justified.
Another way of looking at it for Goldcorp based on the 41 million ounces of reserves and 3.5 million ounces of production fore casted in the future, well, that means that in 41/3.5 = 12, so in 12 years all you own is empty holes, with the gold all mined and sold.
12 years of earnings at 3%, if Goldcorp can even manage that, gives earning returned over the life its reserves that is only 36% of market cap. With a P/E of 12 you'd get 100% of market cap returned, with no time cost of the investment. With an estimate of 2006 earnings at $1.03, a P/E of 12 would give a share price of $12.38.
Goldcorp has a higher rate of depletion than average, so imho, even a P/E of 8 for it is generous.
Major concern - Lower quality properties available for replacement.
Again, from the source below, there has been a drastic reduction in property finds with more than 2.5 million ounces. With production rates fore casted to be going up to 3.5 million ounces, there needs to be 1-2 of these properties per year found and purchased just as a replacement activity. The low supply should further increase costs of acquiring these properties.
Lower quality properties generally means higher mining costs.
Major concern - value of reserves to market cap
Goldcorp's web site reports for 2005 the following reserves:
40.5 million oz gold @$425 = $17 billion
687 million oz silver @$10 = $6.9 billion
1.5 billion lb copper @$1.35 = $2 billion
3.7 billion lb lead @$0.50 = $1.9 billion
8 billion lb zinc @$1.25 = $10 billion
Total: $38 billion
It isn't corrected for the 2 million ounces of gold production for 2006, but that can slide...
And there are properties that haven't been properly assessed. There may be 10 million ounces in those properties, or there may be 100 million ounces. The properties have not be assessed.
However, what they can show gives a mere 2.2 times the market cap (using $17 billion market cap).
It seems prudent that market cap to what they can show at bearish prices should be at least 5 times the known reserves. This valuation alone puts Goldcorp's share price at $10.80.
Summary of concerns about Goldcorp
- Negative leverage of copper - gold must go up $90 to cover.
- Declining leverage of gold - leveraged increases in earning can never match early performance -- it is mathematically impossible.
- Price elasticity of the bullion is 11x that of the stock.
- Increasing cost of acquisitions means that gold must go up $140 just to cover.
- Depreciation of mines is higher in the gold industry than any other mining industry.
- Quality of replacement properties is declining, meaning costs will increase.
- Availability of replacement properties is declining meaning acquisition costs can further be expected to increase.
- The ratio of reserves to market cap for Goldcorp is disgraceful.
At the end of my analysis of Goldcorp I was truly horrified that anyone would be recommending this stock. Certainly if any of my analysis has merit, many reputations will be seriously hurt. But personally, I wouldn't buy Goldcorp at $10. I simply don't see growth potential at that price.
- Gold prices must increase $230/oz to maintain earnings for Goldcorp.
- Assets are depleting at a much higher rate than earnings.
- Goldcorp is trading at about 3 times its value.
- All Gold companies are facing increasing costs, reduced leverage, and greater difficulty for finding replacement properties.
The Under Valuation of Northern Orion
I stated that I saw Northern Orion has being grossly undervalue. All of its earning come from copper, so it too should expect much lower earning from its existing operations. My interest in Northern Orion came not from it current earnings, but it massive reserves and massive growth prospects, comparable to the potential of Goldcorp 6-7 years ago. Northern Orion has massive increase in earning opportunity even in a declining-copper price market.
Points that favor Northern Orion
- Market cap to reserves is enormous.
- Strong cash position.
- Expected cash from warrants can provide some capital costs.
- Good cash flow from Alumbrera.
- Aqua Rica property is well studied and Northern Orion has applied for building permits.
- Production increase is forecast to increase by 660% when the new mine starts.
- Low cost producer because of net credits of gold and molybdenum.
- Lower depletion rates.
Northern Orion has two properties, its 1/8th interest in the Alumbrera mine and Agua Rica.
The Alumbrera mine has 10 years of life left, Northern Orion's share is 50 million pounds per year of copper and 75,000 ounces of gold, exactly 1/3 of what Goldcorp gets from this mine.
Simple extrapolation, total reserve of this property is 1/2 billion pounds of copper and 750,000 ounces of gold, which at $1.35 for copper and $400 for gold is $0.675 billion for copper and $0.300 billion for gold, or about $1 billion.
The Agua Rica property is Northern Orion's hidden gem.
The feasibility study gives this total as to what can be mined over a 23 year period. This is more conservative than just looking at the reserve because recovery rates are taken into account. There are 6 million ounces of gold in the reserve, but only 3 million ounces are considered recoverable as about 50% of the reserve is not recoverable in the mining process. There are 13 million ounces in the resource. There are 21.4 billion pounds in the resource for copper and 1.7 billion pounds for molybdenum.
The recoverable metal estimates for Agua are
7.6 billion pounds of copper @1.35 = $10.3 billion
3 million ounces of gold @400 = $1.2 billion
360 million pounds of molybdenum. @12 = $4.3 billion
The two properties combine give $17 billion at $1.35 for copper, $12 for molybdenum and $400 for gold.
Diluted, Northern Orion has 221.5 million shares. At $3.70/share that gives a diluted market cap of $820 million ($560 million undiluted).
So, at bearish prices reserves to market is 21 times. A valuation of 1/10th production forecasts at bearish prices gives a valuation of $7.40.
Strong Cash Position and Warrants
Northern Orion has $180 million in cash in the bank. Should the fully diluted market cap be realized, it will have an extra $160 million from warrants. That's $340 million dollars, leaving only $400 million of market cap for valuation of the rest of the assets.
If you take the bearish value of what's in the ground, $17 billion and compare it to the rest of the market cap, well, that's 42 times the market cap less cash position.
Strong cash flow from Alumbrera
For 2005, with average copper prices at $2.37 equity earning were $46,755,000, and cash flow was $75,500,000. Earning per share at this price was $0.31. This is in the "ball park" of where copper prices can be expected and cash flow for the size of the company is strong.
Over the three years to bring the new mine to production, it is reasonable to expect another $150 million to retained earnings which can be used towards the construction costs of the new mine. Quarter 2/06 had cash flow of around $56 million alone. This drastically reduced estimate takes into account strong declines in copper prices, but is still strong cash flow.
Aqua Rica is ready for building.
The Aqua Rica property has an strong investment in drilling and feasibility studies and is at the point that permits have been applied for to build the new mine. The down side is that it is expected to take 8-10 months to get the permits approved.
Production growth is enormous compared to current operations.
The new production is expected to be:
- 368 million pounds of copper
- 120,000 oz gold
- 15.4 million pounds of molybdenum.
At a price of $2.37 for copper Alumbrera earned $0.31/share. A simple ratio extrapolation for a $2 price with a 660% increase in production gives (2/2.37) x (7.70) x 0.31 = 6.5 x 0.31 = $2/share earnings. This doesn't take into account there would also be molybdenum, which is like a bonus production. 185/221.5 = $0.84, so earnings should go to somewhere between $2-3/share.
The cash flow situation is that Northern Orion will have in the range of a half billion to pay for the new mine and will need to finance $1.5 billion. Their assets and cash flow are strong enough to do this without further dilution.
The new mine production is going to generate a cash flow in the range of what Alumbrera generates, only this will be 100% Northern Orion owned. To put this into perspective, Northern Orion's cash flow can be expected to be in the range of 40-50% of Goldcorp's 2007 cash flow, yet it has a market valuation 1/20th of that of Goldcorp. ($820m vs $17 billion) Further, the difference in the mine life (23 years) and availability of replacement reserves means that Northern Orion would not be subjected to they same types of increasing costs.
Low cost producer due to gold and molybdenum cash credits, lower depletion rates
Aqua Rica's cash costs for production would make it one of the lowest cost producers. This is the type of circumstance that led to the stellar growth and returns for Goldcorp, with a difference, depletion rates are lower. After the new mine is built, the shorter term, depletion rates are very high and cash flow is higher. Total production for 2012-2016 for copper would be 418 million pounds. It declines to 368 million pounds in 2017 when Alumbrera has come to the end of its life, and in 2022 the highest streams of copper are expected to be mined and production further declines to 300 million pounds for another 13 years.
The rate of depletion of Northern Orion's copper reserves looks something like this:
2006 - 8.1 billion pounds
2007 - 8.05 billion pounds, 50 million mined, depletion, 0.6%
2008 - 8 billion pounds, 50 million mined, depletion 0.6%
2009 - 7.95 billion pounds, 50 million mined, depletion 0.6%
2010 - 7.7 billion pounds, 250 million mined, depletion 3.1%
2011 - 7.28 billion pounds, 420 million mined, depletion 5.5%
2012 - 6.86 billion pounds, 420 million mined, depletion 5.8%
The cash flow is such that capital cost can be paid back while there is the higher production from the new mine as well as the continued cash flow from Alumbrera.
With longer mine life, Northern Orion is never in the type of squeeze position that mature gold stocks are in. Over the long term, they are not subjected to the same squeeze to keep production going to ensure maintenance of earnings, never mind to increase them.
Summary of under valuation of Northern Orion
- The value of what's expected to be sold at half of today's market prices is $17 billion, 22 times the diluted market cap, and using a value of market cap being 10 times bearish price estimates give a today value for Northern Orion of $7.40.
- Earnings per share can be expected to increase to about $2/share even if copper is $2/lb. With a target P/E of 10, once production is in full swing, target price can be $20/share. With a target P/E of 8, target price can be $16.00.
- Northern Orion has a strong cash position, 35% of it undiluted market cap in cash, and 46% of its diluted market cap taking into account the cash from warrants.
My Conclusion: Northern Orion is grossly undervalued. It is a strong buy to $7 based of property holdings alone.
Everywhere I look, I think I've been conservative towards Northern Orion, and actually generous towards Goldcorp. For example, I've stated 10 times bearish prices for Northern Orion, using bearish prices, whereas for for Goldcorp I've suggested it should have 5 times the reserves at bearish prices relative to market cap. The estimate for Northern Orion puts copper at $1.35, highly, highly bearish. The estimate for Goldcorp uses reserve, for Northern Orion the estimate is corrected for the non-recoverable percentage in the mining process.
Copper prices have declined faster than expected, but there is a new mine entry barrier price. Northern Orion's entry price is much lower than average due to low production costs, and the enormous reserve was acquired at very low costs.
The recent Phelps Dodge merger puts an in the ground valuation for copper at $0.70. Their average production costs are $0.50/pound. With Northern's Orion's net of metal credits production costs at -$0.02, it is simply far more competitive. Another tiny cap stock, Equinox, shows production costs of $0.70/lb.
Starting at a copper price of about $2.25 high cost producers start to have problems raising capital costs, and it increase from there. The sell off of Northern Orion indicates how true that is in terms of being able to attract capital for investment as copper prices decline. Copper was able to stay at around $1/lb for so long because land and capital costs had long been paid for, and the long life of mines enabled them to simply continue as ongoing concerns, without capital for replacement or new investment. And, at those prices, mines were going bankrupt.