Being a value growth investor, I’d recommend a stock that has a strong margin of safety—thus little chance of permanent capital loss—while also having huge upside coming from market recognized or unrecognized catalysts.
There are some investments out there where the potential loss is total while the potential upside is extremely high. I wouldn’t call these investments, and only would recommend one as it’s more like a bet.
To keep things interesting, today I want to share with you such a bet by discussing a non-linear stock with out of the box thinking management, McEwen Mining (NYSE: MUX). MUX will give you a clue as to how I research potential investments and analyze their risk reward ratios.
MUX is a producing, developing, and exploring gold/coper miner. Currently, it produces only gold, so the market puts it into the gold miners basket. Nevertheless, it has 3 producing mines in Ontario, Mexico, and Argentina, two gold mines in development, and various exploration targets.
In order to figure out what MUX’s potential and value is, the best thing to do is to look at each of its assets and estimate a fair and potential value.
Producing Assets: San Jose Mine, Argentina – El Gallo Mine, Mexico – Black Fox Mine, Ontario
MUX owns 49% of the San Jose mine which has only a 5-year mine life remaining. The yearly production is around 100,000 gold ounces and 6.7 million silver ounces. The gold equivalent all-in sustaining cash cost is $954 per ounce which makes it profitable but subject to the extreme influence of gold prices.
The El Gallo mine has an even shorter life mine at only 2.5 years, but it produces gold at an all-in sustaining cost of $610 per gold equivalent ounce, which is good. Estimated production for 2017 is 47,000 gold equivalent ounces.
The third producing asset is the Black Fox mine in Timmins, Ontario, which was just acquired by MUX for $35 million. The mine is producing 50,000 gold ounces per year, but the costs are pretty high and on average, above $1,000 per ounce. Such a high cost makes it clear why MUX could buy the asset for only $35 million despite Primero Mining paying more than $300 million for it and investing $120 million in exploration.
To sum it all up, MUX should produce around 180,000 gold equivalent ounces in 2018 at all sustaining cash costs of around $1,000 per ounce in the best case scenario. Thus, MUX’s operating profits should be around $37 million, or around $0.11 per share given that there are 347 million fully diluted shares outstanding.
At current gold prices, we really can’t attach any value to mines with such a short life time. If gold prices decline just slightly, MUX’s operating profits would soon turn into losses.
Let’s see if there is some value in new development projects.
Gold Bar is in Nevada and located 25 miles from Barrick’s (NYSE: ABX) largest gold mine.
Key estimates include initial capital of $60 million, an after-tax internal rate of return of 20% at $1,150 per gold ounce and of 36% at $1,300, an average annual production of 65,000 ounces, and an estimated cash cost of $728 per ounce. This should give MUX some cash flows from 2019 onward when the mine will be in production. However, $32 million in cash flows isn’t all that much when you consider the cost is $60 million and the NPV of the project is just $30 million.
El Gallo Silver
El Gallo Silver is expected to be in production in 2019 with a mine life of 6.5 years, and is expected to produce almost 100,000 gold equivalent ounces.
The 2012 pre-feasibility study indicated a $118 million net present value with silver at $25 per ounce and gold at $1,400 per ounce. Given the current low silver and gold prices, El Gallo Silver is another practically worthless asset. Estimated initial capital expenditures of $178 million is something MUX doesn’t have, so it’ll be interesting to see how MUX will achieve production in 2019.
So there isn’t much value in current or projected production at current metal prices. Let’s see about exploration.
At El Gallo in Mexico, MUX hopes to find similar deposits to the ones it’s already mining and the ones it is about to mine.
Every miner hopes to find additional deposits close to an operating mine, but from how I see it, the value of that potential is zero until it’s actually confirmed.
MUX is exploring 496,000 acres around San Jose. The Black Fox mine also offers a lot of potential because it’s close to many historical and current mines.
On the left side of the above image, the two blue arrows identify another of MUX’s exploration projects, Lexam, where there is an 800,000 gold once resource but given that it’s at a depth of 4,000 feet, the mining profitability and costs should be high at current gold prices. Additionally, a preliminary economic assessment has been made around the old open pit mines at Timmins owned by MUX, but the net present values are really low at current gold prices.
The final and perhaps the most interesting project MUX owns is the Los Azules project in Argentina which has almost 20 billion pounds of copper, 135 million ounces of silver, and 3.8 million ounces of gold as inferred resources.
Now, a net present value of $2.2 billion is extremely high, but we have to consider that MUX doesn’t have the money to even start developing it because is needs $2.3 billion in initial costs, it needs Argentina and Chile to make a deal that allows copper concentrate exports through a Chilean port, and then, all should also go as planned.
However, developing a mine at high altitudes in Argentina in the middle of nowhere and with no money isn’t really a walk in the park.
Conclusion & Investment Proposition
MUX’s market capitalization at the moment is around $676 million. Given that the gold mines might get to $100 million if sold now, we can assume that the current value of the Los Azules project is about $500 million. Given the NPV of the complete project is $2.2 billion and the fact that MUX would need to find a partner to develop the mine and also solve all the administrative and logistical issues to mine in the middle of nowhere in Argentina, I don’t find the current value there to be even close to 10% of the NPV. Thus, from a current value perspective, MUX would be a sell. However…
I have to ask, where does the value the market obviously sees in MUX come from? Well, it comes from the potential if we see much higher future metal prices, and from its charismatic CEO, Rob McEwen.
Let’s look at the resources, which are mining deposits that are potentially valuable and for which there are reasonable prospects for being mined.
MUX owns 10.8 million ounces of gold, 221 million ounces of silver, and 20 billion pounds of copper.
The problem is that at current prices, these resources aren’t really attractive to mine, which is why MUX managed to buy the Black Fox complex for just $35 million.
But, what if gold prices double in the future? All those resources that have limited economic value now, suddenly become hugely valuable. For example, let’s imagine that MUX manages to produce 300,000 ounces of gold in 2020 at a cost of $1,200 per ounce and gold prices are at $2,500. Take off some taxes, and royalties, and we can imagine a profit margin of $1,000 per ounce, thus MUX’s profit would be around $300 million. Attach a 12.5 valuation to that and you get a stock price of $10.8 which is a fivefold potential increase. Add the potential from the huge resources, and you are quickly at a stock price way above $20, $30, or even $50.
This is hard to believe, just look at the same strategy applied to Goldcorp in the 2000s, of which Rob McEwen was then CEO, as he is now of MUX.
So that’s the upside. Let’s take a look at the downside.
What you can expect from MUX is to be highly leveraged to gold prices. Given the tight margins, it’s one of the most leveraged gold plays I know of and is therefore incredibly volatile.
However, MUX has something that is very important and rare among miners. It doesn’t have any kind of long term debt and its CEO owns 24% of the company, so his interests are very much aligned to those of his shareholders.
The lack of debt limits the possibility that MUX could go bankrupt, but the relatively high mining costs and high development and exploration costs surely don’t create downside protection for the stock price.
MUX is a real extremistan investment, the potential is huge but the downside is also large and there isn’t any guarantee of stability, cash flows, future success, or anything else except a volatile stock price.
While the potential is enticing, ask yourself, is this stock for you?