Description

Can I interest you in an investment in a terrible sector that has historically destroyed value by using debt to fund projects that are constantly over budget, in order to dig up a supposedly valuable shiny metal while experiencing some of the most volatile stock prices in the world?  If so, read on!

Investment Thesis

Alamos Gold (AGI) is a mid-sized gold miner with operating mines in high-quality jurisdictions including Canada and Mexico.  The firm also has very attractive development projects in Turkey and Canada. Alamos reported earnings recently that sent the stock down 10%, but the shares were already down over 50% from the 2016 peak seen after gold prices recovered.

Alamos shares have performed significantly worse than peers as gold prices have sagged over the last two years.  Since the July 2015 merger between Alamos and AuRico Gold, AGI shares are down 40% while GDXJ is up 17%. Gold prices are marginally higher and are up significantly from the bottom in late 2015.  While AGI shares trade about 40% higher than the 2016 low, the median gain in the top 15 companies in GDX (excluding streamers) is 110%. The difference is even starker when looking at the junior miners.  The top 18 holdings in GDXJ have produced a median gain of 155% since the bottom. Alamos is one of the worst performers in this group. The median price to book of both large and small miners in the sample set is 1.6x compared to less than 0.5x for Alamos.  

Alamos is headquartered in Canada but has U.S. listed shares.  At USD 3.6 per share, the stock is only about $1 above the 2015/2016 nadir despite higher gold prices, significant depreciation in the Canadian Dollar where most of its costs are denominated, a large acquisition completed with high priced shares last year, and a debt-free balance sheet that is unique in this industry.  Based only on proved and probable reserves (2P), I believe the shares are significantly undervalued and should trade close to USD 5.15 per share (+42%) in a $1,200 gold price environment.

Company Description

Alamos Gold merged with AuRico Gold in 2015 in a transaction that complimented each business.  AuRico brought operating mines to the table with a mediocre balance sheet, and Alamos brought one operating solid mine, a slew of development projects, and a pristine balance sheet.  Alamos and AuRico shareholders each ended up with 50% of the shares. Technically AuRico acquired Alamos, but the Alamos name was kept, and its CEO was put in the top spot of the combined entity.

Early last year the company raised $250 million in equity at $8 per share and used the proceeds to take out the 7.75% 2nd lien bonds.  Later in 2017, the firm acquired Richmont Mines in an all-stock deal for $683 million net of cash.  Alamos gave Richmont holders 1.385 Alamos shares per Richmont share. AGI shares traded from ~$8.4 to almost $7 on the day of the announcement.  Gold prices came off about $100/oz before the deal was done as well, and the final price was $550 million. The acquisition added a third strong operating mine named Island Gold that management claimed to have relatively cheap expansion potential.  While gold prices were $50-$100 higher than they are currently, the deal significantly overvalued the Island Gold mine compared to my estimate, although the higher priced equity used offsets some of the value loss. Alamos’s portfolio is shown in the slide below, with operating mines on the left and development projects on the right.

At the end of 2017, Alamos had proved and probable gold reserves of nearly 10 million ounces.  Resources that could potentially be converted to reserves are also significant at 7.5 million ounces measured and indicated, and 5 million ounces inferred.

Young Davidson

Young-Davidson is an underground mine located in Ontario that accounts for a large portion of Alamos’s book value and about 35% of my valuation.  The mine was previously owned by AuRico and has been undergoing transition from open pit to underground for the last several years. Open pit mining concluded in 2014, but there is still plenty of low grade stockpile to supplement underground production while the ramp up continues.  The mine achieved positive free cash flow two years ago and is now self-financing.

Proved and probable gold reserves totaled 3.4 million ounces at the end of 2017, and reserve replacement has been solid.  Based on these reserves, the mine life is 13 years from the end of 2018, assuming 90% recoveries and 220,000 ounces of annual production when fully ramped.  Management expects the actual mine life to exceed 20 years based on exploration potential. To achieve 220k ounces, underground production will need to expand to 8,000 tonnes per day in order to fill the mill to capacity.  The company was consistently hitting its productivity targets over the last few years and was up to 6.6k tpd last year. However, mining rates have disappointed in 2018 as the lower mine expansion has continued. Management recently reduced production guidance for 2018 from 200-210k ounces to 180-190k ounces.  Management claims some abnormal events (ex. forest fires) hindered production, and 8k tpd is still an achievable goal once the lower mine buildout is complete. Nevertheless, the ramp up has been slower than anticipated and has likely frustrated investors.

An updated technical report was released in 2017 that details the mine’s annual operating assumptions.  At 220k ounces, total cash costs (95% of which are in Canadian Dollars) are expected to be CAD 708/oz, or $540 per ounce at the current FX rate.  This compares to $660/oz in 2017 and low $800s so far this year, but 2018 full year guidance is $675/ounce. Grades have been modestly lower than life of mine recently, which pressures cash costs per ounce, but I don’t expect this to be permanent.  Including sustaining capex, all-in sustaining costs (AISC) is expected to be $850/oz in 2018. Once full ramped, AISC should be solid at less than $750/oz.   

Capex has been somewhat of an issue, as it has steadily risen over the years and is expected to be higher than budgeted in the 2016/17 technical report.  I think management is tired of under-budgeting and is now being very conservative about guidance. The company will spend about $150 million over the next two years to complete the lower half of the mine, which will be funded by mine cash flows, then sustain the operation at $40-$50 million annually.  Management believes this sustaining level is very conservative and expects it to fall off considerably several years before the end of the mine’s life. At $1,250/oz, management is forecasting the mine will deliver $80-$100 million in free cash flow for 18 years. This seems optimistic but is supported by the technical report.  If achieved, it will result in significant upside to my valuation. At $1,200 gold, current FX rates and a 6% real discount rate, I am valuing the mine at $715 million using only 13 years of 2P reserves.  In my model, the mine hits management’s targeted FCF range in only seven of the next thirteen years and excludes five or more potential cash flow generating years.  The present value of five additional operating years producing $67 million in free cash flow annually is $135 million.

Mulatos

Mulatos is an open-pit mine with both heap leaching and high-grade ore that is located near the Alamos’s El Chanate mine in Sonora, Mexico.  Mulatos is the company’s second largest producer with 170-180k ounces anticipated this year.  Cash costs are expected to be $800/oz this year, and AISC is not significantly higher at $900/oz.  Royal Gold has a 5% net smelter royalty in the project, where it receives a payment for 5% of total gold sales when gold is priced above $400/ounce.  The agreement has added about $60/ounce to cash costs. The NSR will cease when cumulative mine production reaches two million ounces, which should be early next year.  Combined with a new power grid, management expects cash costs to come down by $100/oz.

Alamos had successfully replaced reserves and lengthened the mine’s life over the last three years.  At the time of the merger with AuRico, the mine’s remaining life was expected to be seven years, but management touted many expansion opportunities.  It has delivered on these opportunities. Two areas called La Yaqui and Cerro Pelon have grown P&P reserves from 220k ounces in 2014 to 880k ounces in 2017.  After three years of ownership, the mine life is now eight years. At the end of 2017, proved and probable reserves of 1.9 million ounces were 10% higher than they were at the time of the merger.  Using a 75% recovery implies 1.4 million ounces to be recovered. Management expects the production rate to drop to historical levels of 150-160k ounces for the remainder of the mine’s life. An active exploration program continues in the area, which management believes will allow the mine to run well past 10 years.

I am modeling seven years of life from the beginning of 2019 with cash costs and AISC of $700 and $780/oz, respectively.  I include an additional $25 million in spending in 2019 for expansion of La Yaqui and Cerro Pelon. Sustaining capex is expected to be between $8 and $10 million per year.  I’m also including $3.4 million annually for decommissioning and regular exploration. Using a gold price of $1,225 per ounce, a 30% tax rate applied to EBIT, and discounting the cash flows at a 5% real rate, results in a mine value of $242 million.  If Mulatos’s life we extended an additional three additional years for $25 million in incremental capex, as suggested by management might be possible, the mine value grows to $315 million.  I am assigning no value to this possibility.

Island Gold

Island Gold is a high-grade underground mine located in Ontario.  It is the primary operating asset acquired in the Richmont deal and has been operating since 2007.  The mine held 959k ounces of 2P reserves at the end of 2017, and, of course, management believes there is significant exploration potential.  It has committed $18 million for exploration this year, up from an initial estimate of $15 million after successful drilling results were announced in May and again earlier this month.  Since 2014, the mine’s reserves have grown by 300%.

The mine is expected to produce 100-110k ounces this year.  It is relatively low cost, with expected 2018 cash costs of $575/oz and AISC of $825/oz.  The company provides a simplified life of mine plan in its presentations that anticipates production growth over the next few years due to mill expansion, with depletion of the current 2P reserves in 2024.  Average production over the period is expected to be 125k ounces per year with average cash costs of $479 per ounce at a 1.35:1 FX rate. The mine is already generating free cash flow, which is expected to grow materially with the mill expansion.  The mine has significant NOLs it can utilize. Cash taxes are unlikely to be paid for several years.  Using a 6% real discount rate, I am valuing the 2P reserves at $462 million at $1,200 gold.

El Chanate

A smaller open pit operation, El Chanate is near the end of its life.  Mining is likely to cease next year. However, heap leaching will continue for up to three years after mining is completed, which will be done at much lower costs and drive free cash flow.  Still, the mine is small and is not meaningful to the valuation. At $1,200 gold, I’m putting the NPV5 at $20 million.

Development and Exploration Projects

Alamos has three development projects located in Turkey.  They are all open pit, low cash cost, low capex mines with short lives.  Two of them, Kirazli and Agi Dagi (pronounced ah dah), had feasibility studies completed last year and the environmental impact assessments have been approved.  Both have significant proved and probable reserves.  Kirazli will commence first.  The project has been permitted.  Site work is under way and initial production is expected to be in the second half of 2020.  The mine is expected to produce 104k ounces of gold on average for five years at a low cash cost of $339/oz.  AISC is also very low at $373/oz. Initial capex is relatively low at $152 million (which will be funded from cash) according to the feasibility study, but the Lira has moved significantly from the 2.9 FX rate assumed in the study to almost 5.4.  About two-thirds of costs (Q217 conference call) and 60% of capital costs are denominated in Lira (Q218 conference call). However, management does not expect to save much on construction because the labor inflation has been meaningful. Management confirmed the $152 million capital cost estimate on the most recent call, so I’m going to stick to the assumptions in the feasibility study.   

A detailed life of mine schedule in included in the feasibility study.  The report puts Kirazli’s NPV8 at $187 million based on $1,250 gold, $16 silver, and TRY 2.9.  The after-tax IRR is 44%. Silver has declined to $14.5, but only makes up about 15% of reserves and is accounted for as a byproduct.  I reduced the gold price input to $1,200 per ounce and added a 15% tax rate to the cash flows as the study does not account for repatriation taxes.  The adjusted NPV8 is $144 million not including any benefit from depreciation in the Lira. Explicitly accounting for depreciation could add $20 million if not offset by labor inflation.

Agi Dagi is a larger project that will be funded by cash flows from Kirazli.  Production could begin in 2022 and will continue for six years with average gold production of 178k ounces per year.  Cash costs are a bit higher than Kirazli, at $375/oz and AISC of $411/oz with silver as a byproduct. The initial investment is also larger at $250 million, but the estimated after tax IRR is still very high at 39%.  I applied the same assumptions to my life of mine model including the 15% tax. My NPV8 is $158 million. Despite having roughly double the reserves of Kirazli, the mine valuation is lower due to higher cast costs, higher initial capex, and time value of money.

Camyurt is the final project in Turkey.  The project is located near Agi Dagi and has very favorable economics with initial capex of just $10 million and after-tax IRR of 253% at $1,250 gold.  However, the project is much smaller with just a four year mine life at average annual production of 93k ounces. Further, the project is still in the preliminary phase and therefore has no booked 2P reserves.  The expected NPV8 is $86 million, which is calculated with a 2% tax rate. While it is likely the resources will be converted into reserves just as Kirazli and Agi Dagi, I’m placing a higher discount on the mine and valuing it at $50 million.

The Esperanza project is in Mexico but is located far south of El Chanate and Mulatos.  The proposed mine is a low-grade heap leach operation with 1.08 million ounces of measured and indicated resources (using $1,400 gold and $22 silver).  Management expects production to be about 100k ounces annually with a low AISC at around $750/oz. Alamos completed a study of the mineral resources in early 2014, but an economic assessment hasn’t been done since 2011.  The 2011 assessment found the NPV of the project to be $122 million using a 5% discount rate, including $114 million in initial capex.

The Mexican government denied the initial permitting requests for Esperanza submitted by the previous owner, Esperanza Resources.  Alamos bought Esperanza in 2013 when its stock declined from $1.35 to $0.50 in just a few months after it was announced that the permit would not be granted.  One month after the buyout offer was made, the State of Morelos (where the project is located) passed a new law restricting the use of cyanide in the state. The buyout was still completed.  Management was confident the project would be permitted, but it was opposed by the governor, Graco Ramirez. Ramirez was succeeded in October by Cuauhtémoc Blanco, a former professional soccer player some consider to be Mexico’s greatest player of all time.  While I have not found details of Blanco’s views on the mining industry, he is a member of president-elect Andreas Manuel Lopez Obrador’s political group called Juntos Haremos Historia. Obrador is a leftist that has derided foreign investment in Mexico’s oil industry.  I do not have high hopes that the cyanide ban in Morelos will be overturned.  I am assigning no value to the project, but it certainly has significant optionality.

Lynn Lake is the last meaningful development project, and the market probably isn’t giving the company any credit for this potentially high-value mine.  The project is located in Manitoba, with the rare combination of being open pit with high grades. The 2017 feasibility study places average production at 143k ounces for 10 years. Total 2P gold reserves are 1.6 million ounces.  With $750 AISC, $1,250 gold, and $16 silver, the after tax NPV5 is $123 million for a 13% IRR. The IRR seems low, but there are an additional 500k ounces M&I and 1.6 million inferred resources waiting in the wings. I am not valuing any of the resources, but I’m giving it less of a haircut due to the jurisdiction and potential resource conversion.

Valuation

Alamos is debt free and has $230 million in cash and investments.  Growth projects at the operating mines are self-funded. There is plenty of liquidity to fund development projects with cash and the undrawn $400 million revolver.  I believe the stock is one of the most attractive of the peer group. Alamos’s intrinsic value is conservatively $5.15 per share. This equates to $191 per 2P reserve.  The current EV/2P reserves ratio is $119/oz.

Risks

-Cost overruns

-Lower metal prices

-Political turmoil in Turkey

-New populist administration in Mexico negatively impacts mining industry

Catalyst

-Higher metal prices

-Successful ramp-up of Young Davidson mine

-Resource conversion