Description

Investment case summary

Torex is a Canadian-based resource company engaged in the exploration, development and operation of gold properties in Mexico. It is currently producing from one mine complex on the property (which is 75% unexplored), will release an updated assessment report on the second later this year (potential to double NAV), and will release crucial updates on its new mining technology that can change the entire industry by the end of the year. Based on the current share price, the company trades at >20% FCF yield with several significant valuable options.

Business and assets

Torex is a Canadian-based resource company engaged in the exploration, development and operation of gold properties in Mexico. The company currently operates its 100% owned Morelos gold property located in the Guerro Gold Belt in southern Mexico. The property consists of 7 mineral concessions (all granted for 50 years) covering a total area of 29,000 ha. in a very attractive mining region, judged based on the nearby resources. The company is currently producing from the ELG Complex and has released a preliminary economic assessment report for a second asset Media Luna, but the property remains 75% unexplored. In 2014-2017 the company conducted several regional explorations that indicated several other targets on the property that are highly prospective (Victoria, Tecate and ML-05 in particular).

ELG Complex

The company has been producing gold from the ELG Complex since December 2015 (commercial since April 2016) and it is the only asset that is currently being mined. The ELG Complex consist of three open pit mines (El Limon, Guajes, and El Limon Sur) and the Sub-sill section of the El Limon underground mine (ELG UG). The complex is expected to produce 2.7m oz of gold over the life of the mine (LOM) at an average all in sustaining cost (AISC) of USD 734 per ounce. Average annual production is expected to be 430k Au oz from 2019-2023, and 240k in 2024. The open pits are amongst the largest and lowest cost gold mines in the world, with a reserve grade of 2.7 g/t.

Initially the asset only consisted of the three open pit mines, but discovery and development of the ELG UG mine to exploit the Sub-Sill mineral reserve added 180k oz AU to proven and probable reserves at a reserve grade of 10.8 g/t (!). The Sub-Sill section was first identified in Q4 2015 and already reached first ore in 2017, which demonstrates that resources at this complex can be increased. The company is currently working on upgrading another identified resource in the ELG UG, El Limon Deep, which has 182k oz inferred with recent drilling results showing grades between 9 g/t and 25 g/t. There is reason to believe that as the company continues its ELD and Sub-Sill infill drilling program the reserves of the ELG Complex will be upgraded.

Media Luna

The Media Luna deposit is another resource on the Morelos property that has the potential to more than double Torex’s current reserves. Based on the resource estimate from June 2015, the deposit contains 7.4m oz gold equivalent (2g/t Au Eq. cut-off grade @ a gold price of USD 1,470) but this resource is inferred, and the company is working on upgrading its classification. The company released a preliminary economic assessment report (PEA) in September 2018 based on inferred mineral resource estimates and a conceptual mine planning. This PEA outlined a total production of 3.9m oz of Au Eq. with an AISC at $619 per oz with commercial production from 2023 to 2033. The deposit is located 7km south of the ELG Complex and can therefore use the existing processing plant installed at ELG, reducing capex.

The PEA was prepared based on a gold price of USD 1,200 and it is therefore reasonable to expect that the economically viable resources are higher at the current gold price.

Muckahi Mining System

The company is working on developing a proprietary mining technology that will completely change the design, development and operations of underground mines. Mining consist of steps that either transform rock, transport rock, or store rock. The goal when designing the system was to reduce underground mine build capex, mine build schedule, and mine opex by 30% each.

The conventional method for underground mining is based on transporting the ore to the surface using massive mining trucks (think a 50 ton CAT off-road truck). These diesel-powered trucks are massive and therefore require tunnel openings to be 30m2 for a single lane road, which can have a maximum angle of 10-degrees due to tire-spin. The key idea behind the Muckahi is that by investing in accurate drilling and placement of explosives, one can control the size of the rock (blast fragmentation) and as a result reduce the required tunnel size. Instead of a single lane wide road for massive trucks, the Muckahi is based on a dual-lane conveyor belt that is suspended from the ceiling of the tunnel. It is believed that the cross-section of the tunnel can be 16m2, significantly reducing the amount of waste material that has to be transported to the surface. In addition, as the Muckahi is a cog-driven electric system it can operate at a 30-degree gradient, which is 4x steeper than the conventional method. A ramp that is 4x steeper only requires ¼ the length to achieve the same elevation change. Further, as the Muckahi equipment is fully electric, it eliminates the ventilation costs associated with conventional diesel-powered equipment. These improvements is expected to reduce capex and mine build schedule.

In a traditional mine, the blasted rock from the face is first moved to a cut-out 10-150m away from the face for then to be re-handled to be brought to the surface. With the Muckahi system the rock is dropped straight on the ramp conveyor, eliminating the need for rock storage and all associated capex and rehandling opex. The rock does not touch the ground from when it is picked up at the face until it reaches the surface.   

The company has successfully proven that the dual mono-lane system works and that it can advance at a 30 degree down ramp. By the end of 2019, the company expects to have tested all 4 key milestones.

The company is currently considering developing the Media Luna based on the Muckahi system. Based on the PEA, the Muckahi system can reduce the development capex by 30%, opex by 20% and the time to commercial production by one year. This would increase the after-tax IRR of the mine to 46% (based on $1,200 Au price) vs 27% with a conventional mining system.

Further, the system also opens licensing opportunities to nearly extinct mines as the reduced mining cost makes certain resources economical to mine.

Valuation comments

Gold companies are typically valued on a P/NAV multiple where the NAV includes the most recent estimate of proven and probable reserves from the company based on the gold price at the time of the report. This fails to take into account possible resources that can be upgraded to reserves as the company continues in-fill drilling, economic studies, and other explorations. It is also very important to understand that reserves are based on ore above a certain cut-off grade based on the gold price at the time of the resource statement. What is economical to mine, and therefore included in reserves, changes with fluctuations in gold price.

As an example, the reserve statement for El Limon Guajes open pit from Decembre 2018 is based on a cut-off grade that is considered appropriate for metal prices of USD 1,200 for gold and USD 17 for silver. The Media Luna is still an inferred resource that has not been included in reserves yet, but that is only because it has not completed the full economic study yet, not that it is proven uneconomical to develop. As the company continues its in-fill program, the certainty of the resource will increase and the resources that are economical to mine will be added to reserves.

The picture below illustrates the difference between resources and reserves:

Source: Crirsco

Looking back at the boom and bust history of this industry (especially 2012), and terrible capital allocation, one can understand why the market does not give companies credit for potentially positive NPV projects. However, certain operators are better capital allocators than others, and some resources have a higher probability of becoming reserves than others. It is quite strange how the market assigns 100% probability to Life of Mine plans that are disclosed by the company, but give 0 credit to resources that can become reserves in the future.

Instead of thinking about gold businesses as static businesses with a finite life (when the current reserves run out), certain reserve companies (such as Torex) are on-going businesses that will continue to develop new reserves and therefore continue to produce cash flows beyond the lifetime of the current mines. However, given that most investors look at P/NAV, the biggest driver of share price performance will be upgrades to NAVs driven by upgrades in reserves.

Torex valuation

Torex is currently producing gold from its ELG Complex and is expected to only generate cash flow from this mine until 2022-2023 when the Media Luna will be brought online (excluding potential revenues from Muckahi).

During the last twelve months, the ELG Complex generated $180m FCF before expansion capex from a total production of 426k oz of gold (in line with its annual guidance going forward). This cash flow was based on an average realized gold price of $1,340 vs the current gold price of $1,490. At the current gold price, the company would have generated $250m FCF on an EV of $1,220m (FCF yield of 20% !!). There is further upside to this annual cash flow as the cost per ounce during the past twelve months were higher than what management expects going forward.

This cash flow is expected to last for another 5 years based on the current reserves, with options for upgrades. Media Luna will be commercialized by the time the ELG Complex reaches its EOL, producing a higher FCF per year than the ELG Complex.

We simply choose to look at it as a 20% FCF yielding business, soon to be net cash, that has several opportunities to increase its valuation through in-fill programs, reserve upgrades, and launch of a block-buster drilling technology.

Case for owning gold

Boom and bust: impacting reserve life, grade, and discovery costs

The gold industry peaked in 2012 after having been in an up cycle since the early 2000s. Gold mining is a very pro-cyclical industry. In 2012, when gold prices were above $1,800, anyone with a mining plan that could dig a hole got funded, then prices went to $1,100 and the industry got in trouble and it has had a negative reputation among equity investors ever since. As a result, capital has dried up and miners have not been spending money on exploring new assets. This has led to a drop in the reserve life (reserves/production) from 23 years in 2012 to 15 years in 2017.  At the same time, the reserve grade has dropped, meaning the current reserves of the major gold producers have worse economics. Further, discovery costs for new major discoveries have increased significantly in the last 10 years.

All these factors point to that majors might be looking to acquire assets in order to continue their current production. With the increased discovery cost, their willingness to pay for high quality reserves should be high.

Price of gold companies relative to gold and stock market

The HUI index is a NYSE index of companies involved in major gold mining. Relative to gold, the index is only at 25th percentile of its 20-year history, indicating that gold companies are currently very cheap compared to gold.

At the same time, the HUI index / SP 500 is almost at its all-time low, showing how out of favor this sector is. The index relative to SP 500 has not been this low since 2000, from when it went on to go up more than 10x.

Recent setbacks for Torex

Strike

In late 2017 - early 2018, Torex’s workforce went on strike due to some disputes about union representation. Although it is unclear what exactly happened, it was a terrible time for the company as several of its workers were killed and production was stopped for a long time. This is all settled now with no interference of production since Q1 2018.

The strike happened just as it was ramping the production from the ELG Complex. The company had spent a lot of capital on bringing the mine to production and was therefore quite leveraged, and at the same time EBITDA got severely impacted by the blockade. As a result, the banks demanded the company to do an equity raise, which was taken quite badly by the market at the time and it has taken time for management to regain confidence among investors.

Reserve update on April 2nd

The company released a technical reserve update which reduced its reserves within current operations by 6%. This adjustment was made based on higher costs and cut-off grade. Importantly, the update was related to reserves the company is currently producing from, meaning it is only a technical adjustment that will have no impact on the actual operations of the mine. We have later learned that it was a newly employed “qualified person” that did an academic assessment of the reserves that led to the update. Again, no impact on business and cash flows.

TMAC and Chairman

On October 7th, Marlin Sams Fund (which owns 4.1% of Torex) sent a letter to the Board of Torex outlining its concern that Torex might make a bid for TMAC Resources (a struggling gold miner). The main point of concern was related to the independence of the Chairman, Mr. MacGibbon, as he is also the Chairman of TMAC. Two other directors of Torex also serves on the board of TMAC.  

Torex released an answer to this letter 2 days later, clearly stating that it is not in dialogue, or considering a transaction, with any resource company, specifically naming TMAC.

Risks / bear case

• Single asset Mexico: The biggest risk with this company is that it is producing from a single asset in Mexcio. The Mexico discount will probably not go away, but the single asset risk should disappear as the company produce from Media Luna and start generating cash flows from Muckahi.
• Muchahi failure: The technology could fail and cause a negative sentiment around the stock. Although it is important to note that sellside does not attribute any value to Muckahi and we don’t believe the current stock price does either.
• Media Luna: Not a proven reserve yet. If this resource cannot be developed, the company does not have any cash flows beyond 2024.
• Chairman: Related to the independence of the Chairman and potential conflicts mentioned above.

Catalyst

• Another record-breaking quarter: Torex gold recently released a notice of its Q3 ’19 financial and operational results showing that it generated a stunning $95m in FCF. It was a record-breaking quarter with sales of 132,500 oz taking away all doubts that the company will not reach its 430,000 target for the year (there were several negative reports post Q1 stating that the company would never reach its target).
  
  We expect Q4 to be another strong quarter, with high production, low cost, and high gold price. This should give investors even more confidence in the management and its targets.
• Update on Media Luna or other reserve upgrades: Torex has completed in-fill drilling of 25% of the Media Luna resource now and is only awaiting final assays. A positive announcement from this drilling coupled with the feasibility study that is scheduled to begin early 2020 is expected to be a positive catalyst for upgrades of reserves.
• Muckahi: Two out of four critical milestones have been achieved to date with the final 2 expected to be completed by the end of the year. Any positive announcement on the Muckahi will be a catalyst for the stock.
• Quarters with strong cash flows: We find it hard to believe that the company will continue to trade at the current cash flow yield for a long time, and therefore expect the stock to move up as the company continues to deliver strong cash flows.