Description

Given the recent drop in gold prices, I believe now is a good opportunity for a speculative investment in Klondex, a low cost gold miner with significant exploration upside.

Investment highlights:

• High grade, low-cost producer: The Company’s flagship property, Fire Creek, has some of the highest head grade ore in North America, meaning it will be a low cost producer (Fire Creek Q2 14 production cash cost was CA$568/oz). The property has an estimated M&I resource grade of 41.5 g/t (1.21 opt).

• Properties are under-explored: 93% of the flagship Fire Creek Property remains unexplored. Midas property received little exploration spending in recent years under Newmont’s ownership.

• Upcoming updated resource updates may serve as a short-term catalyst: The Company expects to release its updated Fire Creek Resource estimate by the end of 2014, which will include drill results from three newly discovered vein systems (that were not included in the prior estimate).

• Exploration/development should be self-financed: Bulk sampling program in FY 14/FY 15 should finance further exploration and development.

• Midas mine acquisition synergies: The Midas acquisition allows sharing of common equipment and cost leveraging. Midas’s toll mill reduces reliance on third parties. Over half of the core management team previously worked together at Midas.

• CEO’s interests are aligned with shareholders: CEO Paul Huet owns ~0.4% of the Company, which represents 80% of his net wealth (he has a wife and five kids).

Company description: Klondex is a junior gold miner with properties in northern Nevada. Its flagship property, Fire Creek, is situated along the Northern Nevada Rift in North Central Nevada and strategically located in the Crescent Valley area of the Battle Mountain gold belt. The property contains 286,000 oz of measured and indicated (M&I) gold at 41.8 g/t (1.22 opt) grade and 428,000 oz of inferred gold at 23.4 g/t (0.68 opt). Klondex Mines trades as KDX in Canada and KLNDF in the US.

Brief company history: Historically, the Fire Creek Property was mismanaged for years by its former management team. In June of 2011, one of the Company’s largest shareholders, K2, initiated a proxy fight with the former management team. The parties settled a few weeks later with a 7 person board consisting of three former management members, three K2 nominees, and an independent director. Over the course of the next year, K2 used its influence to slowly replace the management team and at the 2012 Annual General Meeting of shareholders, a large portion of the board was reorganized. Since replacing the former management team and the board, K2 has amassed a strong team with significant operating experience in the Nevada gold mining industry.

Midas background: On 12/04/13, the Company announced it would acquire the Midas mine and the related toll milling facility from Newmont. The aggregate purchase price was CA$71.4 million, which was financed through a combination of debt and equity (mgmt and long-time large shareholders participated in the financing). The Midas property consists of a high grade underground mine and ore mill complex in north central Nevada, ~112 miles North of Fire Creek. The Midas mine has a long history of high-grade gold production dating back to 1998 with significant infrastructure already in place. Currently, the Midas mine is estimated to have a gold equivalent M&I resource of 526,000 oz at 16.2 g/t (0.471 opt) and an inferred resource of 287,000 at 11.5 g/t (0.334 opt).

Midas acquisition is expected to provide synergies: The Company expects the acquisition to result in cost savings in SG&A, HR, payroll, geology, engineering, surveying, mine rescue, processing, and transportation costs. The acquisition also allows for the shared use of equipment between the two properties. The acquisition of Midas also included ~CA$30M in mobile equipment. The Company anticipates sharing the equipment between both properties. Another important aspect of the acquisition is the strategically placed ore milling facility. The facility is capable of processing 1,200 tpd and the Company. The acquisition of the Midas mill is strategic because it reduces reliance on third parties. The Company estimates it would take 5 years and $100.0M to fully permit and build a mill of similar caliber to the Midas mill in Nevada.

Midas acquisition will leverage core management team: Four out of seven members of the core operational management team have previously worked at the Midas property. Most importantly, CEO Paul Huet previously spent seven years of his career at Midas (from 2000 – 2007) working his way up to Mine Superintendent and Mine Manager. Given that a significant portion of the core management team previously worked at Midas, the current exploration and development activities should be streamlined given their familiarity with the property.

Significant exploration potential at the Midas property: The Company expects to spend the next two years exploring the Midas property to extend its life. Since several key management members previously worked at Midas, they already know the best exploration targets. Less than three weeks after acquiring the property, the Company began drilling and blasting underground. The initial blast rounds exposed high-grade gold and silver veins along an existing vein. After the second blast round, the vein widened and the grade increased.

On 09/30/14, the Company announced a new resource estimate for Midas less than eight months after they acquired the property. Overall, the resource was expanded pretty significantly; the Company increased the M&I resource estimate by 37.0% to 526,000 oz, while the inferred resource was increased by 282.7% to 287,000 oz. I believe the updated estimate underscores what management has been talking about in the past—that Midas was significantly under-invested under its prior ownership by Newmont. With the recent CA$16.1 million of financing that was completed on 07/30/14, the Company is going to accelerate its exploration spend on Midas (in addition to Fire Creek). I expect the additional capital to continue to increase the resource estimate in the future.

Strong year-to-date operating performance: After years of exploration at Fire Creek, the Company finally began production in FY 14 under a bulk sampling program. In Q2 14 the Company generated CA$36.4M of revenue from the sale of 25,725 gold equivalent ounces. The total cash cost of production was CA$730/oz. At Fire Creek, the Company produced 12,700 oz of gold at a cash cost of CA$568/oz (one of the lowest cost operations in the world). At Midas, the Company produced 9,473 oz of gold at a cash cost of CA$1,091/oz.

The Company recently announced its preliminary Q3 14 operational results late last month. Based on the selected financial data presented, results were strong. Gold recoveries increased 73.4% quarter-over-quarter to 38,552 gold equivalent ounces. The significant jump in gold recoveries was due to the processing of multiple zones of very high grade ore at the Company’s flagship Fire Creek property. Due to the strong Q3 14 operational results, the Company increased its FY 14 recovered ounces guidance from 75,000 – 85,000 ounces to 95,000 ounces, or an 18.8% increase at midpoint.

Fire Creek drill results likely indicative of significant resource estimate increase: On 10/08/14, the Company announced results for its recent drill program at Fire Creek. A total of 124 infill and exploration core holes have been drilled since 02/01/14 for a total of 12,490 meters, including several high grade intercepts. The updated resource estimate for Fire Creek is expected to be out before the end of the year. I am bullish on the results of that announcement since the Company has made three significant (in my view) new discoveries since the last Fire Creek resource estimate.

Since the last resource estimate, the Company has discovered three additional veins: (1) the Karen vein, (2) the Hui Wu vein, and (3) the Honeyrunner vein. The Company intercepted some high grade samples in all of these new areas and I expect that they should add handsomely to the new resource estimate.

Valuation: To value the Company, I utilized an EV/EBITA approach given that my belief that it would be difficult to value the Company relative to peers on under an EV/oz or DCF analysis, given the exploration potential at the Fire Creek and Midas properties and the fact that I don’t have a good handle of the new Fire Creek resource estimate the Company should report in the coming months.

Based on a wide sample of large and mid-sized peers, I estimate a forward peer EV/EBITDA multiple of 5.6x. In Q2 14, the Company generated EBITDA of ~CA$15.6M or ~CA$62.5 million on an annualized basis, which equates to an EV/EBITDA multiple of 4.5x, or a 24.0% discount relative to peers.

Conclusion: Overall, I believe Klondex is an interesting speculative gold play given the decline in the precious metal. I believe both properties are under-explored and could result in significant resource estimate increases in the next few years. Further, I believe the Company’s low-cost operations should downside risk to gold price declines relative to peers.

Catalysts:

Fire Creek updated resource estimate should be released by the end of 2014

Ongoing exploration at new Fire Creek and Midas discover new mineral veins

Risks:

Project and/or permitting delays

Significant decline in gold prices

Dilution risk

Midas acquisition debt causes cash flow and liquidity problems

Veins may be too narrow to economically extract

Note: given that gold has been extremely volatile in recent months and there could be further downside to the spot price, it may be prudent to hedge against the precious metal by shorting some of the Company’s high cost/high levered peers as a pair trade.

Catalyst

Catalysts:

Fire Creek updated resource estimate should be released by the end of 2014

Ongoing exploration at new Fire Creek and Midas discover new mineral veins