I want to introduce you to Dragon Mining (DRA), a mispriced, producing, cash flow positive, gold miner with an outstanding upside/downside return profile and short and medium term catalysts to drive a share price re-rating.  I also want to flag Eurogold (EUG), which owns 19.99% of DRA and trades at a 40% discount to its MTM NAV (NAV consists of shares in listed companies and cash).

SUMMARY

• Increasing production from existing producing assets: >50% production increase from 2011 to 2013
• Expansion projects, each of which are extensions/expansions of current producing assets, buttress production growth
• One project is already complete (currently ramping up) and the remaining one is scheduled for completion in Q1/Q2 2012
• Both projects have short paybacks (<2 years) & very robust IRRs (>100% on my modelling)
• Exploration Project in North Finland (“Kuusamo”): potentially company transforming project.  The Kuusamo Resource could be larger than all of DRA’s other projects combined and have more attractive economics.  To give you some idea of the potential of this project drill intercepts have included: 57.30m @ 62.56 g/t gold, 3.70m @ 426.98 g/t gold, 21.30m @ 58.79 g/t gold, 5.30m @ 206.85 g/t gold, 31.9m @ 45.67 g/t gold; and 23.5m @ 13.25 g/t

In summary, you have a very positively skewed payoff profile from this investment with a series of catalysts over the next 12-24 months.  DRA trades cheap to the value of its current producing assets assuming none of the upside materializes (i.e. ~3x LTM Operating Cash Flow) and you get the upside thrown in “for free”.  The production growth is “real” (i.e. capital has been spent and operations are currently ramping up) and is a high return deployment of capital.  Additionally, Kuusamo is potentially company transforming given its probable size versus DRA’s current resource base and its economics (grades in the drill results to date have been very high and the Resource can likely be mined as an open pit). 

Why does this opportunity exist?  Firstly, DRA is small and under the radar for most investors.  Secondly, DRA has no real sell side research coverage and, up until very recently, management has not promoted the Company.  In short, very few sophisticated investors have done work on the company. 

One final point to note at the outset is that I assume a $1,700/oz gold price in this analysis (current spot gold prices are ~$1,725/oz).  My assumption is based on the fact that the metal price/exposure can be hedged as there is a liquid market that trades in spot and forward gold (I would suggest considering a gold hedge to de-risk this investment as the investment is not a play on metal prices but rather an idiosyncratic opportunity with a number of catalysts).  I understand you may prefer to make a different assumption about the gold price, so I have tried to provide as much information as I can about sensitivities to movements in the gold price. 

DRAGON MINING

Overview

I categorize DRA’s assets into four groups:

1. Sweden (producing): Svartliden
2. Southern Finland (producing): vamalla (Orivesi, Jokisivu)
3. Northern Finland (advanced exploration): Kuusamo
4. Other: Weld Range Metals: 40% o/ship (private); Chalice Gold Mines: ~1% o/ship (ASX: CHN); other early stage exploration assets; hedge book

I will provide more detail on each of these below. 

One important point to mention at the outset is that in addition to being safe geopolitical jurisdictions both Sweden and Finland have a long history of mining and tax regimes that are mining friendly.  Specifically, no mining royalties are payable and the corporate tax rate is 26% in Finland and 26.3% in Sweden.

1. Sweden

DRA’s Svartliden mine has delivered 35,000-50,000 oz of gold production per annum since being commissioned in 2005.  The open pit reserve will be mined through to mid-2012 at which point underground mining will commence (there will be a transition through 2012 where mining from both the open pit and underground will occur).  The current resource supports a 5 year mine life (note however that further successful drilling has taken place since the cut-off for the most recent resource update – March 2011 – and as such further extension of the current resource is likely).   The Svartliden mine is expected to produce ~30,000-35,000oz of gold per annum at cash costs of $750-$850/oz.  

There are three things I want to highlight about this mine:

1. Cash Costs: There are two anomalies with 2011 cash costs which are important to understand as they have impacted reported cash costs.  Both relate to waste removal (“pre-stripping”) for the open pit. 

• Pre-stripping costs are being expensed as incurred rather than capitalized and depreciated.  Because the remaining life of the open pit mine is short DRA is expensing all waste removal expenditure as it is incurred.  Typically these costs would be capitalized and depreciated over the life of the mine (this is standard practice in the industry). The impact of this is that reported cash costs (on a $/oz basis) will be front end weighted, when the waste removed relative to the ore mined was highest.  You can see this in the table below.   Going forward waste-to-ore is expected to normalize.

* The volume of waste mined (removed) relative to the volume of ore mined

• While the pre-stripping was being completed limited ore could be mined from the pit.  As such, the balance of the ore milled came from low grade stockpiles.  This had the impact of reducing overall milled grades and consequently increasing cash costs.  You can see this in the table below.  Significant pre-stripping has now been completed and DRA has access the large parts of the open pit mine.  The amount of low grade stockpile ore to be processed in Q4 is expected to slightly higher than Q3 (but much lower than Q2).  From Q1’12 2012 onward no stockpile ore is expected to be milled.  This will have a positive impact on grades.

Using 32,500oz of gold production per annum and $850/oz cash costs produces approximately $20m p.a. post-tax (but pre-exploration) at a $1,700/oz gold price.  A $100/oz change in the gold price will impact annual post-tax cash flow by approximately $2.5m.  Ongoing capex should be minimal but there will be some ongoing development required for the underground operation.  In aggregate this will probably be in the order of $3-5m p.a.  So, over a 4-5yr mine life the Swedish operations should generate approximately $60-$80m of FCF.   There could be upside to the mine life from the resource update incorporating the 2011 drilling but this is not included in the above.

2. Southern Finland (Producing)

DRA has one production centre (Vammala) in south Finland that is serviced by two operating mines, Orivesi and Jokisivu.  The Vammala production centre has produced approximately 30,000oz of gold p.a. since commencing operations in 2007.  The current Resource supports a ~6-7 year mine life (Measured and Indicated Resource only).  Production from Vammala is expected to be 28,000oz in 2011 increasing to 40,000oz in 2012 as two mine expansion projects ramp-up.  

More information about the two mine expansion projects: 

1. Jokisivu – Kujankallio: the open-pit mine at Kujankallio was exhausted in Q3’10.  Development of the underground mine at this property commenced in Sep’10.  Development ore from the underground was milled in Q3’11 and mined ore is to be milled in Q4’11.   The economics of the underground development are: (i) approximately US$12m capex (note: approximately $10m had already been spent at 30-Sep-11); (ii) approximately 15,000oz p.a. of production; and (iii) ~$750-850/oz life of mine cash costs.  Assuming $1,700/oz gold and modelling only existing reserves I calculate a project payback in year 2, an overall post tax project IRR of over 100% and >3x overall cash-on-cash return vs. capex invested.  The cash-on-cash return doubles if I model Measured & Indicated Resources rather than Reserves only.  The breakeven gold price is approximately $1,025/oz (modelling reserves only). 
2. Orivesi – Kutema: Underground development commenced in Q4’10.  Development ore is expected to be available for milling from Q1’12 and mined ore is expected to be available for milling from Q2’12.  The economics of the underground development are: (i) US$14m capex, including $3m for new equipment (note: approximately $3m had already been spent at 30-Sep-11); (ii) approximately 15,000oz p.a. of production; and (iii) ~$750-850/oz life of mine cash costs.  Assuming $1,700/oz gold and modelling only existing reserves I calculate a project payback in year 2, an overall post tax project IRR of >100% and >3x overall cash-on-cash return vs. capex invested.  The breakeven gold price for this project is approximately $1,000/oz (modelling reserves only).

Assuming 40,000oz of gold production per annum @ $850/oz cash costs produces approximately $25m p.a. post-tax (but pre-exploration) at a $1,700/oz gold price.  A $100/oz change in the gold price will impact annual post-tax cash flow by approximately $3m.  Ongoing capex, including underground mine development should be approximately $5-7m p.a.   Over a 6 year mine life this equates to approximately $110-$120m of FCF.   

3. Northern Finland (Advanced Exploration)

The Kuusamo project in North Finland is DRA’s advanced stage exploration project, which could become DRA’s third production centre.  The Resource has the potential to be well over 1 million ounces and could double DRA’s existing Resource base.  Importantly, gold grades achieved through historical and current drilling as well as the nature of the ore body (which make an open pit mine likely) make the potential economics of this project very favourable.   Historical drill results included the following intercepts (which are some of the highest grades I have seen from drill results from a gold miner, certainly in a safe geopolitical jurisdiction):

• 57.30m @ 62.56 g/t gold
• 3.70m @ 426.98 g/t gold
• 21.30m @ 58.79 g/t gold
• 5.30m @ 206.85 g/t gold
• 8.00m @ 48.85 g/t gold
• 23.50m @ 13.25 g/t gold
• 13.00m @ 20.41 g/t gold
• 21.05m @ 13.70 g/t gold

The current Measured & Indicated Resource is 786Kt @ 7 g/t (for 177koz of gold) and the Inferred Resource is 1.4Mt @ 4.6 g/t (for 206.5kpz of gold). 

Over the past year DRA has completed a 20km drilling campaign (98 holes) at Kuusamo North.   To date, results have been received from only 55 of the 98 holes. None of the results of this drilling are included in the current Resource (i.e. all of this drilling has taken place after the most recent Resource was completed).  The drilling campaign included: (i) 61 holes (15km) at the Juomasuo deposit; (ii) 30 holes (4km) at the Hangaslampi deposit; (iii) 7 holes (1km) at the Pohjasvaara deposit. 

Results from this drilling campaign have included the following selection of significant intercepts:

1.  Juomasuo

• 14.55m @ 4.81 g/t gold
• 11.85m @ 5.30 g/t gold
• 5.30m @ 12.97 g/t gold
• 7 30m @ 8 18 g/t gold
• 34.90m @ 9.30 g/t gold
• 25.60m @ 9.66 g/t gold
• 31.90m @ 45.67 g/t gold

 2. Hangaslampi

• 9.00m @ 30.17 g/t gold
• 12.45m @ 7.15 g/t gold
• 6.00m @ 7.51 g/t gold

To date none of the drill results for the Pohjasvaara deposit have been released.   

Before the end of October 2011, DRA is expecting to release a resource update for the Juomasuo deposit only.  The updated resource will include the results of only 10km of the 20km of drilling that has been completed (this is all that was available when the resource update commenced).   A further resource update, which will include the remaining 10km of drilling is expected to be released in Q1’12. 

DRA is planning 100km of drilling over the next 18 months.  DRA currently has three drill rigs operating at Kuusamo and is looking to increase this over the coming months. 

DRA has commenced an environmental impact assessment, metallurgy and flow sheet development and has a target to bring Kuusamo into production by 2014.  Depending on results from the drilling program the project could move to pre-feasibility stage as early as 2012.

4. Other Assets

DRA has a number of other assets. 

• Hedge Book: In order to provide protection against an adverse movement in gold prices during 2011 & 2012 DRA has hedged approximately 40% of production for 2011 and 2012.  Specifically:
  • Sweden: 8,750oz sold forward from Oct’11 to Mar’12 at a weighted average price of SEK8,890/oz (approximately $1,345/oz at current SEKUSD FX rates).  See p.18 of Q3’11 Report for a detailed breakdown of price & oz per month)
  • Finland: 26,500oz sold forward for Sep’11 to Dec’12 at a weighted average price of EUR1,056/oz (approximately $1,470/oz at current EURUSD FX rates).  See p.18 of Q3’11 Report for a detailed breakdown of price & oz per month)
  • At 30-Sep-11, the mark to market value of the hedge book was negative A$9m. 
• Chalice Gold Mines (ASX: CHN): DRA owns 2.3m shares in CHN which it received as partial consideration for the sale of an asset it Eritrea to CHN.  Additionally, DRA is entitled to a payment of $4m from CHN in the event a 1Moz reserve is delineated on that asset (current reserve is 760koz).  CHN is currently undertaking a 10,000m near mine drilling program (see here: http://asx.com.au/asxpdf/20110609/pdf/41z439v49024cd.pdf).   The CHN shares are non-core to DRA and will likely be sold at some point
• Weld Range Metals (DRA: 40%): privately held company with chromium, iron and nickel holdings in Western Australia.   The company is seeking funding to complete a definitive feasibility study.  DRA will not provide funding to this project.  This asset is non-core and DRA will likely divest it as some point
• Other exploration assets: DRA also has a number of early stage development projects including: Harpsund (Sweden, adjacent to its existing mine); Hanhima (North Finland); Ritakallio (South Finland near the Vammala production centre).  While these projects may look promising, they are all very early stage and require further exploration work.  More information is available here: http://www.dragon-mining.com.au/-Overview,27-.html

Valuation

My DCF valuation for the producing assets only (assuming a $1,700/oz gold price) less the (negative) impact of the hedge book is $135-155m.  This represents ~3x 2012E EBIT and 5.5x LTM Operating Cash Flow.  Net cash at 30-Sep-11 was approximately 23m.  The aggregate of the producing asset valuation and net cash equals $158-178m (~$2.10-$2.40/share or +60-80% vs. the current price).   The sensitivity is approximately $0.25/share for a $100/oz  change in the gold price. 

Importantly, this valuation ascribes zero value to:

(i) Kuusamo.  Pre-production junior miners typically trade for $25-75/oz Resources.  The top end of that range will typically be achieved by companies with (i) large potential resources, (ii) which are high grade; and (iii) are in geopolitically safe jurisdictions.  Using Kuusamo’s current Resources and the mid-point of the range implies a value of ~$20m.  This is likely a conservative estimate of value in light of the success to date of the current drilling campaign (i.e. the defined resource is likely to grow in the very short term).  My industry checks suggest a transaction value of greater than $50m could be achieved if Kuusamo was put up for sale today

(ii) The $4m payment DRA is due if Chalice increases its reserve to 1 million ounces (+32% versus current);

(iii) DRA’s other exploration projects (including Weld Range).  These are early stage projects so value is difficult to determine with any precision however there is very likely value in these assets and buyers for them if they were to be sold

Conservatively, I think there is at least $25m ($0.33/share) in (i)-(iii) above, but very likely much more.   However, the Kuusamo project is potentially game changing for DRA and could be worth several multiples of DRA’s current market value on its own. 

As I said at the outset, I am thinking of this as a situation where downside is limited as the value of the producing assets (which are solidly cash flow positive) plus cash on hand should limit downside losses (even assuming lower gold prices than current spot).  As I suggested above spot gold can be shorted to mitigate the metal price risk (and effectively lock in cash margin).   The upside is essentially a call option on the value of Kuusamo, which could be a very significant.  I believe the upside vs. downside (especially in light of the known drill results for Kuusamo) is very favourable.

EUROGOLD

EUG is Australian listed company with a market capitalization of approximately A$19m.  EUG’s current Mark-To-Market Tangible NAV is approximately A$31m.  EUG’s assets are comprised predominantly of investments other listed companies and cash. EUG’s two largest investments, which in aggregate represent greater than 90% of total assets, are:

1. 19.99% shareholding in Dragon Mining: current market value A$20m
2. 3.6% shareholding in Tanami Gold (ASX: TAM): current value A$9m

EUG’s other portfolio holdings are immaterial relative to the two holdings above and in aggregate are worth approximately A$1m.  For those interested, additional information on EUG’s other holdings is available here: http://asx.com.au/asxpdf/20100909/pdf/31sdwxll6hf43p.pdf.  I understand the composition of the portfolio has not changed materially from the time this document was published (although please note EUG completed the takeover of Brinkley mining, so that shareholding should be ignored.  Brinkley’s main asset was a shareholding in DRA which is included in the shareholding shown above). 

In addition to its share portfolio EUG had approximately A$0.7m of cash on hand at 30 September 2011. 

In addition to tangible assets EUG has a contingent receivable of US$3m which becomes payable to EUG in the event a regulatory milestone is achieved in relation to a Ukrainian asset it sold in 2007.  While there is a possibility this could crystallize to be conservative I have assumed this has zero value. 

EUG has <$1m of total liabilities. 

Other relevant information:

1. EUG has been increasing its stake in DRA:

• In January 2011 EUG announced it had increased its shareholding in DRA from 17.34% of total shares outstanding to 18.84% of total shares outstanding. See here for more detail: http://asx.com.au/asxpdf/20110127/pdf/41wdm17gbygcpt.pdf
• In August 2011 EUG announced it had increased its shareholding in DRA to 19.99%.  Please note that (subjected to certain limited exceptions) 19.99% is the maximum shareholding allowable in Australia before the shareholder is required to make a takeover.  See here for details of EUG’s substantial shareholder notice: http://asx.com.au/asxpdf/20110815/pdf/420dgjws4h81bk.pdf

It is noteworthy that EUG’s Executive Chairman (who is a 5% shareholder of EUG) is also a Board member of DRA.  He has been on the DRA Board since February 2010 and so has detailed knowledge of DRA, its assets and future growth plans. 

• 1st Resource update expected to be released in late Oct’11
• 2nd Resource Update expected to be released Q1’12