Description

Alamos Gold (AGI) offers investors: (1) a rising gold production outlook (+67% by 2027), (2) a declining cost profile (-34% AISC by 2025), (3) a management team that has been together for 18 years, has a history of enviable capital allocation, and has outperformed the gold price and its peers, and (4) the potential for a buyout by a senior producer; after 3 recent deals involving Canadian gold miners, AGI’s mines are now the most attractive independent assets of size in Canada, a low-risk jurisdiction sought after by global producers with exposure to high-risk jurisdiction.   

Since gold miners offer leverage (both ways) to the gold price, I’ll first answer the question “Why gold, why now?” and then answer “Why Alamos?”

Why gold, why now?

Since October 2021, when Google searches for the word “stagflation” broke out to a new recent high, the price of crude oil is up 47% while gold is up 4%. Directionally, this is as it should be as crude historically has delivered the best average real return during stagflationary periods. However, gold - the second best performer - has historically generated 39% of crude’s average return, and since October it has delivered just 9% of crude’s return. Gold may be due for a catch up.       

Source: In Gold We Trust

Another reason to consider gold is due to where we are in the commodities to equities cycle.

Source: Crescat Capital

There’s also the matter of the Fourth Turning that we’re in, which runs through about 2030. The authors of the 1997 book have already been proven right on a couple of predictions: a financial crisis followed by a period of calm and then a resuming of the unraveling through events such as “the spread of a new communicable disease” and a war. A half-fulfilled prediction of their was “Gold and oil prices soar.” We’ve seen the latter, but the former has been more muted. The last Fourth Turning occurred during the 1930s.

The following chart shows the performance of the DJIA (red line), Barron’s Gold Mining Index or BGMI (blue line) and Currency in Circulation or CinC data (green line) – all indexed to 1 in January 1920. In the 1930s, the BGMI consisted of just Homestake Mining and Alaska Juneau Gold, although the index has since expanded. Note that the BGMI preserved capital during the crash of 1929 and subsequent stock market decline – and, starting in 1932, it went on to deliver strong absolute returns.   

Source: Barron’s & Goeff

Investment demand for gold could increase as we progress further into the turmoil of the Fourth Turning. On the supply side, the gold story is similar to the oil story: underinvestment in capex. The gold mining industry was plagued by terrible capital allocation during the peak of the last gold bull market (2011-2012), when companies paid significant premiums for acquisitions and went ahead with projects assuming perpetually high gold prices. This led to large write-downs in subsequent years.

Source: Crescat Capital

Most of the management teams at the worst offenders were replaced. Over the past few years, gold miners have shied away from capex, and have focused on FCF generation and returning capital to shareholders. There is a general reluctance to pay significant premiums for acquisitions and project IRRs are calculated using conservative  $1,200-1,500/oz gold price assumptions (spot price: $1,825). As the following chart shows, capex is down substantially from the peak.

Source: Crescat Capital

Due to this underinvestment, there have been no new major gold discoveries during the last 4 years. At the 20 largest gold producers, production from proven and probable reserves is projected to remain flat out to 2025, and then go into long-term decline, getting cut in half by 2033.  

Gold bugs often try to predict the catalysts that will spark a rise in the price of gold. I can’t remember any of them getting it right. If a catalyst can be identified, it’s probably late to buy gold, as financial markets are anticipatory. For example, gold started sniffing something in late 2018 and went on an 18-month run with no visible catalyst. Then Covid hit and by the time the Fed’s massive money printing program was unleashed, the smart money was selling to the dumb money piling in near the top, creating the mid-2020 peak. Another peak occurred earlier this year catalyzed by the outbreak of war in Ukraine.

However, the temperature of the gold market turned cold rather quickly as Fed rate hikes are seen as negative for gold, and the USD has been quite strong. The Gold Miners Bullish Percent Index ($BPGDM) has fallen to 20 - readings below 30 are considered oversold - and managed money net long gold futures contracts have plunged to their lowest level this year. Since gold is an insurance policy, you want to buy insurance when it's cheap.  

The chart below is a 15-year composite showing gold’s seasonality. We’re now near the June seasonal low and over the short-term are set up for a run that, based on history, should last through Feb ‘23.

From a longer-term technical perspective, gold is showing a potentially very strong set up. The double top in mid-2020 and early-2022 potentially formed a cup. The weakness we’re experiencing now may be forming a handle. If this is a cup-and-handle formation, a very strong move higher could follow.  

Why Alamos? – Part I

The quick answer is, Alamos is the gold miner that I believe has the greatest odds of being acquired next. With everyone’s attention on crypto, SPACs NFTs and cash burning SaaS companies that are supposedly eating the world (most of which are likely this cycle’s dot coms), Canadian gold mining assets have been quietly getting acquired by senior producers looking to replace their depleting reserves and increase their exposure to Canada, one of the best mining jurisdictions, in order to diversify away from high-risk jurisdictions.

The Canadian consolidation wave started with the MoE between Agnico Eagle and Kirkland Lake (KL) announced in Dec 2021, creating the largest Canadian producer by far. Then Australia-based Newcrest (with exposure to Papau New Guinea) acquired Canada’s Pretium Resources, followed Kinross Gold (with exposure to Chile, Mauritania and Ghana) buying Great Bear Resources (a Canadian exploration company), and South Africa-based Gold Fields (with exposure to Ghana, Peru and Chile) acquiring Canada’s Yamana Gold.

As the following chart shows, with Newmont being the world’s largest producer, Alamos is now the largest and highest quality remaining intermediate producer in Canada that could be acquired. The next largest – New Gold – is of far lower quality and has struggled to meet expectations for years. Alamos is (1) large enough to move the needle for a senior miner, and (2) it has a rising production outlook with 465,000 oz of production this year growing to >700,000 oz by 2027 if AGI remains independent, whereas a buyer with a larger balance sheet could accelerate new mine development and get AGI to >700,000 oz by 2025. Newmont produces just over 6 mn oz of gold annually, and #4 AngloGold Ashanti produces 2.7mn oz. The type of production growth AGI could generate as part of a senior producer would move the needle on the flat production outlook of any senior. 

Source: AEM presentation

Most of the senior miners large enough to acquire Alamos are shown on the following chart from the AEM-KL merger presentation. The x-axis shows the NAV-weighted exposure to North America, Australia and Northern Europe (i.e., low risk jurisdictions).

Newmont, which is in the S&P 500 and based in Colorado, has solid exposure to the U.S. and Canada, but risker exposure to Suriname, Dominican Republic, Ghana, Peru and Argentina. Newmont was rumored to have been interested in Kirkland Lake.

Australia-based Newcrest’s position on the chart is pre-Pretium, which lowered its jurisdictional risk profile. Excluded from the chart is AngloGold Ashanti which would land at the 20% mark on the x-axis. It has the worst footprint of any global producer with 57% of its production in Africa (DRC, Ghana, Tanzania and Guinea), and its Americas exposure is in Argentina and Brazil.

Agnico Eagle’s highly respected management created an enviable footprint via the KL merger which should protect shareholders if and when jurisdictional risk becomes a reality. Since the KL merger was all stock, AEM does have the balance sheet to acquire AGI if it wanted to further dominate Canadian gold production, although IMO AGI should insist on AEM shares in such a deal.

Source: AEM presentation

The worst case outcome of jurisdictional risk was experienced by Alamos itself. It had mining assets in Turkey, which the government essentially expropriated by not granting a routine renewal of its mining licenses and forestry permit, well into the construction of the mine, despite Alamos having met all of the legal and regulatory requirements for renewal. AGI wrote off all of its assets in Turkey and has filed a $1.2 billion investment treaty claim against the Republic of Turkey. AGI’s CEO stated the following in a press release on 4/20/21:

“Alamos began investing in Turkey in 2010, warmly welcomed by the Turkish government through its foreign investment office. After 10 years of effort and over $250 million invested by the Company we have been shut down for over 18 months in a manner without precedent in Turkey, despite having received all the permits required to build and operate a mine. The Company has worked in Turkey to the highest standard of conduct with respect to social and environmental best practices. Despite this effort, the Turkish government has given us no indication that relief is in sight, nor will they engage with us in an effort to renew the outstanding licenses.” – John McCluskey.

No mining CEO wants to issue such a press release. But if you own mines in high risk jurisdictions, all you can do is dilute down your exposure through acquisitions in low risk jurisdictions. AGI’s impairment charge amounted to a not-great-but-not-terrible 9% of its market cap. Today, 70% of its production is in Canada, and 30% is in Mexico. Once the Lynn Lake mine in Canada starts producing (discussed later), Mexico will fall to 17%. And the Mexican operation has the shorted mine life of any of AGI’s assets, at 6 years. While AGI has a good track record of extending projected mine lives, Mexico will be the first of its operations to shut down, leaving AGI as a 100% Canadian producer.    

Why Alamos? – Part II

You’ve already read about AGI’s only blemish: Turkey. The rest of the AGI story can be summarized in two words: high quality. Unlike other miners which had their management teams replaced for poor capital allocation, AGI’s management has been together for 18 years and has produced a very good capital allocation track record. They’ve made acquisitions when gold prices were depressed and substantially increased the value of those assets.

Source: Alamos presentation

Importantly, this value creation has occurred on a per share basis.

Source: Alamos presentation

AGI maintains a conservative balance sheet, with a modest net cash position (2% of the market cap). Its Steady Eddy approach has delivered what shareholders want in owning a gold miner: leverage to the gold price; whereas the poor capital allocation of much of the rest of the industry has resulted in shareholders underperforming gold prices. While Warren Buffett would never own gold, let alone a gold miner, if he ever changed his mind, AGI would be his type of company.

Source: Alamos presentation

AGI has 3 operating mines: Young-Davidson (Canada), Island Gold (Canada), and Mulatos (Mexico), with a new mine in Canada to be developed over the medium-term: Lynn Lake.

Island Gold

Island Gold is one of the best assets in Canada that is not held by a senior producer. Its gold grade has increased over time to 10.1 grams/tonne (global average: 1.18), and is the 3^rd highest in Canada, and 6^th highest globally. The mine has a projected 14 year life (above average in this industry). Macassa, the #1 Canadian mine in terms of gold grade, was owned by KL, and is now part of AEM. #2 Eagle River is owned by Wesdome, another interesting Canadian intermediate, but far smaller than AGI, with about 1/3^rd of AGI’s current production. #4 Brucejack was owned by Pretium, which was acquired by Newcrest.

Source: Alamos presentation

AGI is currently investing growth capex to expand capacity at Island Gold (“Phase III expansion”). The average mine site All-In Sustaining Costs (AISC) of this project is a very low $514 per oz (global average is $1,100). AGI projects that the expansion will yield an after-tax IRR of 22% at $1,750 gold. The Phase III expansion will take Island Gold from 130,000 oz of production this year to an annual average of 236,000 oz for a decade starting in 2025 (+80% increase). AGI projects that Island Gold will throw off $210mn in average annual FCF at $1,750 gold, or $0.53 per share, for a decade starting in 2025.

As a prior chart showed, Island Gold was acquired for $624mn in 2017 and its consensus NAV estimate is $1,434mn. AGI continues to invest in exploration, and its CEO believes this mine’s NAV could reach $2B. AGI’s EV is $2.7B.   

Young-Davidson

This mine is one of Canada’s largest underground mines, and another marquee asset. Its gold grade of 2.4 g/t is double the global average. Projected mine life is 15 years, and production is expected to remain flat at 195,000 oz per year. Mine-site AISC is $1,150, near the industry average. This mine generated negligible FCF through 2020, but FCF jumped to $100mn in 2021 ($0.25 per share) as costs declined and gold prices were attractive. FCF should sustain near this level as capex will decline further. Young-Davidson should be a cash cow for AGI, obviously with leverage to the gold price.     

Mulatos

At Mulatos, production is shifting from an average-cost region to a low-cost region, resulting in mine-site AISC falling to $578 per oz from $1,085 while production remains flat. Mulatos is projected to have 6 years of remaining life, and that’s how I’ve modeled it, but AGI’s management is conservative and has a track record of extending mine lives beyond initial projections. For example, Mulatos started producing in 2005 with a 7 year projected mine life; 17 years it’s still going and has another projected 6 years to go. AGI will spend an additional $50mn in growth capex over ‘23/’24 to develop a new region of the Mulatos mine (“Puerto Del Aire”, or “PDA development”), which will generate 45,000 oz per year for 10 years, starting in 2025.

Lynn Lake

Lynn Lake is a Canadian development project that is poised to begin production in a few years and add 190,000 oz of annual production over a projected 13 year mine life. AGI completed a feasibility study in 2017 and expects its environmental impact study (EIS) to be approved later this year, at which point AGI will issue an update feasibility study and make an official construction decision. The 2017 study projected a 21% IRR at $1,500 gold, and an attractive  mine-site AISC of $745. But since 2017, inflation has increased, but reserves have increased by 27% (mine life was projected at 10.4 years in 2017, now 13 years) and gold prices are higher. In order to move forward, AGI needs to see a +15% IRR at $1,500 gold, which appears probable. Gold grade is an above average 1.89 g/t. Lynn Lake will require roughly $450mn in growth capital to develop.

Adding everything up, AGI has one of the most attractive profiles of any gold miner: a growing production outlook and a declining AISC, falling to $800 by 2025.

Source: Alamos presentation

There is a “but”, though, and management delivered the news on its 1Q22 earnings call.

Since AGI is currently investing growth capex into the Island Gold Phase III expansion and will spend another $50mn over ‘23/’24 for the Mulatos PDA development, its FCF will be depressed through 2024. If it started the Lynn Lake project next year, I estimate it would be FCF break-even from ’22 to ’24 at $1,900 gold, but would burn $200mn at $1,700 gold, and would burn almost $500mn at $1,500 gold.

AGI management is conservative and doesn’t want to be forced to take on debt if gold prices fall. It reported that it will postpone Lynn Lake development spend until after the current projects are completed, meaning that spending for Lynn lake will take place in ’25 and ’26, and production will begin in ’27. This makes the top box the preceding chart showing the added production of Lynn Lake in 2025E a hypothetical scenario.

However, this postponement news is a 2-sided coin. A senior producer with a larger balance sheet could acquire AGI and start Lynn Lake development next year, making the preceding chart a reality. The acquiring CEO would certainly look good in the eyes of shareholders as he would not only accelerate production growth versus what AGI would do independently, but also wound gain an AISC profile that declines by 34% from ’23 to ’25. In addition, the preceding chart excludes the 45,000 additional oz/year from the Mulatos PDA development, so the 2025E production number a buyer could generate is actually 795,000 oz, up 74% from 2021.

All this, and the buyer increases its exposure to low-risk Canada by picking up the largest remaining independent asset in the country. The only way a senior miner CEO would not look like a rock star announcing this deal would be by massively overpaying for AGI.     

Given all this, one would think AGI trades at a premium. Not in the neglected gold mining space (refer back to the second chart: Commodities to Equity Ratio chart). In recent years, “investors” have been enthralled by supposed “digital gold” and other concoctions of human nonsense that ought to make it into an updated chapter of Extraordinary Popular Delusions and the Madness of Crowds. As a result, AGI trades at a large discount to NAV; roughly 71% of the average sell-side NAV estimate of $10.10.  

Source: Alamos presentation, May 2022

I’ve modeled AGI’s expected production, AISC and growth capital spent out to 2037E, on a stand-alone basis and under a buyout scenario. As mentioned earlier, I assumed the current Mulatos operation ends in 6 years, despite management’s track record of extending mine life, and included the Mulatos PDA development as a separate line item.

Within 2026E after-tax FCF, I’ve included a $250mn payment from Turkey, compensating AGI for the investment it made in the country. I’m comfortable with this for a couple of reasons. Bilateral investment treaties are agreements between countries to assist in the protection of investments, and judgement will be rendered by 3 independent arbitrators. The process takes 5 years, and we are 1 year into it. Moreover, Turkey wants to join the EU and, IMO, it cannot go rogue in a situation like this. I wrote earlier that the investment in Turkey is the only blemish on AGI, but I believe this management was smart about how it went into a higher-risk jurisdiction. AGI believes it has a strong case. They’ve sued for $1.2 billion, but will clearly settle for less. I believe $250mn is a conservative estimate of a settlement, reflecting no interest accrued onto AGI’s investment.

https://www.globenewswire.com/en/news-release/2021/04/20/2213076/0/en/Alamos-Gold-Announces-US-1-Billion-Investment-Treaty-Claim-Against-the-Republic-of-Turkey.html

I used a 6% discount rate reflecting a blend of 5% for existing mines and 7-8% for development projects in low-risk jurisdiction, in line with industry standards. I arrive at an NAV of $9.93 at a $1,900 gold price (just under the $10.10 sell-side average). The $250mn settlement with Turkey accounts for $0.50 of the NAV, or 5%.    

IMO, $1,900 gold over the next 15 years is extremely conservative. At the bottom of the following table, you can see the leverage to the gold price. At $2,300 gold, which could still prove conservative over a 15 year period, but a number I’m more comfortable with, AGI’s stand-alone NAV is $14.53, more than double the current share price. These numbers give no credit for future exploration success and mine life extension, areas where AGI management has proven adept.  

In the following table, I looked at what a buyer could do with AGI’s assets by pulling forward Lynn Lake’s development by 2 years such that production starts in 2025 vs. 2027, and by eliminating  $25mn in corporate expenses. Compared to the stand-alone case, NAV increases by 7% to $10.65 at $1,900 gold and to $15.47 at $2,300 gold.  

One final interesting item to note, but not one to put much weight in, is that AGI was blacked out from buying back stock in 1Q22 due to “full year results.” I’ve never heard a company give this excuse and to my knowledge (and a large public company confirmed this) the only reasons why a company would be precluded from buying back their stock are (1) they are in talks to be acquired, or (2) they are in talks to make a substantial acquisition (with “substantial” being defined by its legal team, and typically 10+% of the market cap qualifies). Given AGI’s depressed share price, they don’t have a currency to pursue a stock deal, and given their conservative stance toward debt, they don’t even have the balance sheet to pursue their own internal development projects in a timely manner.

The background to the AEM/KL merger revealed that the companies were in talks for 2 years before the deal was announced. During the due diligence period, which got prolonged due to Covid, both CEOs visited every one of the other company’s mines personally. Take this with a large grain of salt as there is a high probability that I’m reading into nothing here, but I wouldn’t be surprised if we later learn that a buyer was doing diligence on AGI during 1Q22 - and may have submitted an offer, which was rejected as too low by the board, given that AGI is back in the market buying back shares. 

Last and definitely least, since AGI's recent peak near $11 in mid-2020, the shares have found strong support in the high-$6s (below 70 cents on the dollar vs. the consensus $10.10 NAV), and that proved to be the case once again yesterday and this morning. The company buys back shares opportunistically, and they likely step in down there as well.     

Catalyst

-       A green light and attractive IRR communicated by management in 2H22 regarding the Lynn Lake development project

-       An annual decline in AISC to $800 by 2025

-       An increase in production beginning in 2025 from the Island Gold Phase III expansion

-       An increase in production beginning in 2025 from the Mulatos PDA development

-       An increase in production beginning in 2027 from the startup of Lynn Lake

-       Continued exploration success and reserve life extension

-       Potential buyout by a senior producer