Description

Summary

Brio Gold is an undervalued spin-off whose shares should be worth at the very least 50% more than today’s price (~C$2.40 per share for a ~US$220mn market cap) at today’s gold price around US$1,200 / oz and Brazilian reais exchange rate of 3.25, with some potential to become a multi-bagger if gold prices rise due to its comparatively high cost position (~$1,000 /oz AISC). Brio’s intrinsic value has been obscured by (i) relentless selling pressure by its parent Yamana since the spin-off, (ii) a number of one-off impairments and separation costs related to the spin-off, and (iii) scant research coverage. Over the next 2-3 years, Brio will get to reap the rewards from its current capex program which will see its gold production double from its current level of 200k oz and triple EBITDA to ~US$180mn as it optimizes production and brings back online the Santa Luz mine, so it’s hard to see Brio’s shares languishing at current levels for too long.

In addition to being fundamentally undervalued, Brio’s shares also represent an embedded call option on gold prices. Due to its relatively high cost position (6/7th decile on an AISC basis), Brio shares are disproportionately geared towards increases in gold prices. However, unlike most junior gold plays that have a lot of potential future growth, Brio already is producing a steady stream of cash flows from its existing mine base so will not need capital injections in the foreseeable future because it has virtually no debt other than what they are taking on to develop Santa Luz.

Situation Background

The history of Brio and its separation from parent Yamana (“AUY”) is a textbook exercise of how to destroy value and alienate shareholders despite having high quality assets with low operating costs and long mine lives.

AUY is a medium sized gold miner, which has assembled a portfolio of good quality gold mines over the years, including the four mines in Brazil that constitute Brio’s portfolio today. AUY’s management team is made up of savvy geologists but not so savvy financial engineers, who undertook a debt-fueled acquisition binge that saw them swooping up low-cost mines with significant potential to (i) expand mine life and (ii) increase production. Inevitably, AUY’s acquisition spree ended with a hangover as gold prices fell, which has already resulted in the 2015 capital increase and an incessant drive to reduce debt levels ever since.

AUY has been looking for a buyer of the Brio assets since 2015, but unrealistic valuation expectations of US$400-500mn (and that’s before they acquired RDM for Brio for US$51mn in 2016) drove them to pursue the IPO option for the four Brio mines. Before we go into the financial details, I want to stress how poorly entire divestiture process was executed, which contributed to the terrible technical overhang that is contributing to the poor trading of Brio’s shares today.

First, AUY engaged in an overly complicated quasi spin-off where YAU shareholders that resulted in very poor take-up by shareholders, little cash proceeds raised and limited free float in Brio shares. In November 2016, AUY shareholders received 1 subscription right for 16 AUY shares, which they could exercise to acquire Brio shares at C$3.25 from AUY, which is roughly 50% of all Brio shares if fully exercised. Per se, the implied valuation of US$290mn was on the reasonably cheap side, but given AUY was really just doing a covert capital increase, this really is just a left-pocket / right-pocket exercise for AUY shareholders. However, take-up was very poor which resulted in ~15% free float and AUY still holding ~80% of the Brio shares after the rights offering (NB: 5% went to Brio management in the form of RSUs). 80% shares held by a shareholder that is desperate to raise cash, you can see why no one (well, hardly anyone) will be keen to jump on this.

With that significant overhang from AUY, Brio shares were never going to trade very well in the short term despite the significant discount to intrinsic value, but AUY management decided to make things worse by launching a fully underwritten secondary offering of 26.7mn shares (~25% of total) Brio shares at C$3.00 in May 2017. Kudos to management for convincing investment banks these days to take down 25% of your subsidiary at a ~5% discount to prevailing trading prices, but overall, this is not a great way to maximize cash proceeds for AUY shareholders from Brio. Also, note that some fund had approached AUY to buy 5% of Brio shares at C$3.35 just in March 2017.

Pro forma for the aforementioned transactions, AUY now holds 50% of Brio with 25% gone to not very happy underwriters and 5% more in the hands of some unhappy fund manager.

Description of the Mines

Brio consists of 3 producing mines, Pilar, Fazenda, and RDM, as well as Santa Luz that is scheduled to restart operations in 2018. I think the mines are of decent quality, all in the 6-7th quartile in terms of AISC, solid mine life of 7+ years mostly, plus a lot of potential to convert additional resources into reserves. Fazenda and Pilar are underground mines, although the Três Buracos deposit near the existing Pilar mine has potential for another open pit mine, with RDM and Santa Luz being open-pit mines. A few years ago, AUY’s management complained that Brio constituted <10% of overall production yet devising a new mine plan to Santa Cruz back online took almost 25% of management’s overall attention, so they decided that they want to leave the pleasure to someone else. Frankly, I do have to say that Brio’s mines are worse than the remainder of AUY’s portfolio, which tend to be solid 2nd or even 1st quartile on an AISC basis and have 10 years+ of resource life, but regardless, I think Brio offers good value now.

Pilar is the best mine in Brio’s portfolio with a nine year mine life that can be extended using its plentiful resource base. Its AISC are on the higher end at $951 / oz in 2016 because of a number of optimization measures undertaken and management guided AISC to drop a touch below $900 / oz by 2019.

Fazenda has been the cash cow in Brio’s portfolio with relatively lower AISC but it’s nearing the end of its mine life as an open pit mine after more than 30 years of production. Fazenda production moving underground will put a floor on management’s ability to lower AISC here going forward.

RDM was added to Brio’s portfolio in 2015 when AUY acquired the mine from Macquarie for ~US$51mn. Management intends to significantly increase production to 100k oz, which will keep AISC relatively high above US$900 / oz for the foreseeable future because Brio will need to build infrastructure, e.g. water storage facilities and powerlines, in order to optimize production Brio management bought RDM from bankruptcy as the previous owner didn’t have the financial wherewithal to complete necessary works to bring production to 100k oz.

Santa Luz has been in care and maintenance since 2013, when the gold price drop drew AUY management’s attention towards addressing its debt woes and optimizing production at its larger producing mines. Brio intends to spend US$84mn in capex to bring online more than 100k oz of production at an attractive AISC around US$ 950 / oz.

Valuation

I’ve valued Brio using a DCF based on technical reports prepared by RPA and transactions based on analysis from the BAML analysts, which point towards upside in the range of 50-100%+, even if you do not believe in management’s forecasts for lower AISCs below $900 / oz and assumed that AISCs stayed at 2016 levels.

DCF

I’ve reconstructed forecasts from the technical reports to flex gold prices as well as BRL, and based on a 10% discount rate, based on spot gold prices of US$1,200 / oz and a BRL exchange rate of 3.25, Brio should be worth ~US$340mn, which is ~50% higher than today’s market capitalization.

Transaction Comps

BAML analysts have dissected M&A transactions to find that over the past 7 years, gold company transactions have generally valued reserves between US$1,000-1,200/oz, with 2016 company transactions being at US1,337/oz excluding the Kirkland Lake / Newmarket merger that had an all-in cost of US$4,874/oz. 2016 was the first time in a while that acquirers have been willing to pay up as companies look to expand their resource base again after several years of disposals and deleveraging. Given Brio’s somewhat higher cost position, this valuation exercise becomes highly sensitive to your gold price and AISC assumptions, where I’m trying to err on the more conservative side, but even with an AISC of $1,000 / oz and current spot gold prices, shares should almost double from here.

Key Risks

Key risks revolve around the feasibility of management to meet their production volume and cost targets whilst staying within budgeted capex amounts, as well as a general capital allocation question.

Whilst the production volume target of 377-397k oz for 2019 does look ambitious, it’s not an outlandish goal given they have managed to increase Brio’s production from 124k oz per annum in 2014 to 190k oz in 2016 (158k oz on a comparable basis if you included only Pilar and Fazenda). Once the water storage facility and the transmission lines in place, ramping up production at RDM shouldn’t be too difficult, although the bigger question here, and even more so at Santa Luz, is whether they will blow through their capex budgets, which is admittedly hard to underwrite. The fact that both RDM and Santa Luz are open-pit mines with vanilla mining plans should provide some comfort but this is a risk that’s hard to mitigate in these situations with aggressive upfront capex plans.

Last but not least is the question around capital allocation as gold miners in particular are notoriously good at digging for more gold but notoriously bad for rewarding shareholders. Brio does plan to increase its reserve base as there are several underexplored deposits, but I think there is a good chance that the CEO Gil Clausen will ultimately pursue a sale as he did at Augusta Resource Corp that he sold to HudBay pre-production. Similarly to the capex risk, the capital allocation question is a bit harder to underwrite, but once the company generates $100mn+ in levered free cash flow, I’m sure that at current valuations, one may find a friendly or not so friendly acquirer for these mines.

Catalyst

Conclusion of share sales by AUY, gradual implementation of management's overall production and drilling plan, ultimately a take-over by a major gold company.

Key risks beyond inherent macro risks of gold prices FX are (i) operational issues preventing full production ramp up, (ii) higher than expected capex to bring online Santa Cruz, and last but not least (iii) significant overestimation of gold reserves.