Description

Durban Roodeport Deep (DROOY) is a South Africa based gold mining company. I recommend this company because it is undervalued in comparison to other gold mining companies, and has huge upside if the price of gold increases.

Because gold investing has a certain amount of opprobrium associated with it, a little background information is called for. Holding the physical commodity itself has never been a very good long term “investment”. In the book Contrarian Investment Strategies, the author David Dremen presents long run evidence which shows that gold has a real (inflation adjusted) return of approximately 0%. Since gold reached a peak of $800/oz in the early 1980s, gold has steadily declined, and today sells for between $270/oz and $280/oz. (The closing spot price on Friday, August 25th was $273.50.).

But I am not recommending that you hold gold. I am recommending that you hold shares in a company that takes the gold out of the ground and sells it. This can be a profitable business. For example, Anglogold Limited (AU), the world’s largest gold producer, has earnings per share of $1.86 and pays dividends of $1.40, but trades at only 19 7/16 as of the time of this writing, giving it a conservative PE ratio of 10.45 and a dividend yield of 7.20%. It’s a pretty attractively priced investment. (AU is probably the most attractively priced gold mining company. I’m not trying to trick anyone by choosing one of the less attractively priced companies as a comparison.)

My stock pick, however, is DROOY and not AU. I recommend DROOY because its stock is undervalued compared to all other gold mining companies. DROOY’s key measure of undervaluation is the price/ounces of gold mined ratio. DROOY, with 66.7 million shares outstanding, mines 1.2 million ounces of gold per year. That’s 1.80 ounces per 100 shares. At the current share price of 1 1/16, that comes out to a price/ounce of gold ratio of $59.

Our comparison company, AU, mines 7 million ounces of gold per year and has 213.2 million shares outstanding, That’s 3.28 ounces per 100 shares. At the current price of 19 7/16, that comes out to a price/ounce of gold ratio of $593

Now compare $59 to $593. Wow! On the basis of price/gold mined, DROOY sure is undervalued. Every dollar invested in DROOY controls ten times as much gold production as the same dollar invested in AU.

With every dollar of your investment controlling so many ounces of gold, a small increase in the price of gold means a much large increase in the value of DROOY. If the price of gold were to increase to $400/oz, then it’s easy to see that (assuming a 30% tax rate and a starting price of gold at $280/oz) that DROOY would have profits of $84 million a year, or $1.25/share. If investors then gave DROOY a PE ratio of 10, each share of stock would trade for $12.50. This is more than a 1200% increase over the current price! This is huge. Shares of DROOY are like an option on the price of gold that never expires.

So why does DROOY trade for so little? Mostly because DROOY has not had profits during the last few years. The good news, however, is that DROOY has been close to breaking even. This is good news because you don’t want to invest in a company that loses lots of money; eventually it would go bankrupt.

The even better news is that DROOY is turning things around. Assuming that gold doesn’t sink below its current price, DROOY will have cash operating profits on a going forward basis. DROOY has recently closed down mines that were not profitable because they were producing gold for more than what the gold was sold for. (The mines may be closed, but DROOY still owns them, and if the price of gold goes up, DROOY can reactivate the mines.)

DROOY will be completing the Blyvoor 2000 project during the next year. DROOY is digging a new tunnel at its Blyvoor mine to allow more direct access to the ore bodies. The new tunnel will allow extraction of twice as much gold, and the operating costs will decrease by $50/oz. This will bring DROOY’s overall operating costs down from $240/oz during the last quarter to $230/oz. With 1.2 million ounces of gold mined per year, this will increase cash flow by $12 million per year (not accounting for taxes).

During the most recent quarter, DROOY had a loss of $2.3 million on continuing operations. So with the additional profits from the completion of the Blyvoor 2000 project, DROOY could be showing some profits.

There are also some other positive developments that will improve the stock price. DROOY is reducing the amount of hedging it is doing. Gold investors hate hedges because it limits the upside if the price of gold increases. Only 20% of DROOY’s gold production for the next four years is hedged.

Also DROOY is now taking a more active role in getting the word out to investors. DROOY has a new website at www.durbans.com, DROOY is now releasing its quarterly earning statements on U.S. newswires, and the conference call is available on the internet. 55% of DROOY is owned by United States investors.

Catalyst

(1) DROOY’s stock price is not currently reflecting its new lower operating costs. The financial results for the next year will look a lot better than the previous year. When investors see the results the stock price will go up. DROOY’s management has even mentioned the possibility of paying dividends once they increase their cash operating profits. (South African tax law encourages dividends, unlike U.S. tax law.) And don’t forget that investors will give DROOY a higher value than it might merit merely on its PE ratio, because they know that the value of DROOY will increase explosively if the price of gold increases.

(2) If the price of gold goes up, DROOY will skyrocket, regardless of its operating costs. And with the price of oil going higher, I am hoping that gold will soon follow. The oil price shocks of the early 1970s led to inflation and soaring gold prices. It seems that almost all investors have forgotten that. With DROOY being so sensitive to the price of gold, even a small increase to the $300 level will cause DROOY to double in price. (Earlier this year gold went to $310/oz, but unfortunately for DROOY investors it didn’t stay there very long.) And if the glorious event happens and gold goes to $600/oz, you will be able to retire on just your DROOY investment. DROOY would probably increase to FIFTY times its current value if the price of gold was to increase that much.