This is an equity investment in a gold company with assets in Mexico. I believe Gold is a legitimate financial asset and that the metal is in a multi year secular uptrend based on my chartist friends.  The fundamental appeal of gold is based on the expected deterioration of the US$ due to the twin deficits, a more competitive Asia, geopolitical issues etc.  We are not gold bulls per se but do think gold companies can be analyzed just as producers of other goods and services.  The optionality inherent in the metal allows for significant  upside (and downside) if the call is right.  There is an active futures market which shows the price rising from a current spot of $620 to almost $800 in June 2011.

 

There are certain bedrock investment principles to be followed as in other equities.  There should be growth, assets should be in a secure part of the world and should generate good free cash.  This eliminates companies such as Newmont and Barrick both of which have had difficulty achieving any growth and trade at high 18-20 cash flow multiples.  Historically, investors have not paid much attention to assets in the ground while a mine is under construction.  However, the company gets quickly revalued once it looks like production is going to commence and when it does actually commence.  Examples of companies in Mexico which have recently been revalued  include Alamos Gold (AGIGF) and Gammon Lake (GRS) which brought their mines into production in mid 2006 and October 2006 respectively.

 

Minefinders is a junior gold and silver company which should benefit from the above and is actively constructing its first mine, Dolores, in Mexico.  Construction is on schedule to commence production in Aug 2007 with full production in 2008.  In addition, there will continue to be an active exploration effort around Dolores and at other properties just south of the US border.

 

In 2008, Minefinders is expected to produce about 200,000 Ounces of gold and 3.2 million ounces of silver or about 250k oz of gold equivalent.  Cash cost should be about $240 /oz.  This implies pre-tax operating cash flow of US$ 90 million or $1.50/share based on a fully diluted 60 mm shares outstanding ( the 2008 futures strip is at $673 but I am conservatively assuming $600 to account for a 3% royalty and any possible cost escalations) .  The company at end 2007 should have cash of about $60 mm - $40 mm from funds remaining after construction and $20 from exercise of options – or $1/share. At a current price of $8 (or $7 after the cash), the company is trading at less than 5 times 2008 free cash flow.  Due to tax pools, the company will pay no tax through 2009 (tax rate will be 29% in 2010 onwards) and maintenance capex is only $3 mm/year. Comparable companies in Mexico which have recently started production such as Alamos Gold or Gammon Lake trade at much higher multiples – Alamos at 13 times and Gammon at 10 times 2008 cash flow, all based on $600 gold. 

 

Minefinders is selling at a discount due to several reasons:  1. Management is poorly regarded (with some justification).  2. After telling the street that they would raise project debt, they suddenly announced a convert deal in October with JP Morgan and 3. Companies with mines under construction always get discounted.  The poor reputation of the management is what is providing the current opportunity – there have been some recent hires including Brent McFarlane, the country manager who managed construction of Gammon Lake’s Ocampo project which was successfully completed in October and is now in production.  There were also some legitimate reasons for choosing convert over debt financing – the convert required no hedging, is unsecured, is at 4.5%against project debt at LIBOR + 2%,  is redeemable and is payable in cash at the Companies option.  Based on recent discussions with the company and analyst site visits, I do believe that the company has included some slack (time and cost ) in their project schedule  and that the production targets will be met.

 

I have not mentioned the potential exploration upside from 3 additional properties in Mexico on which the company will spend $5 mm in 2007.  In addition, they are starting a feasibility study on a mill ($30-50 mm) which will come on line in 2010 and could significantly increase recoveries by as much as 20-25%.  In the first stage, Dolores will use a heap-leach method which enables them to get to production more rapidly.  There are also plans to go underground at Dolores and to actively explore North and South of the current pit.