Mining Investor Guide: The Alamos-AuRico Merger, Part 2

Keeping a finger on the industry pulse, looking for growth opportunities, Cipher Research applies its GEONOMICS analyses on the potential merger between Alamos Gold Inc. and AuRico Gold Inc. announced on April 13. The two Canadian mid-sized gold companies will be merging in a $1.5-billion (U.S.) friendly deal. Shareholders of Alamos Gold Inc. and AuRico Gold Inc. would each own half of the new company.

The following is a brief overview of Cipher’s analysis in a three part series.

• Part 1: Alamos Gold Company Analysis
• Part 2: AuRico Gold Company Analysis
• Part 3: Merged Entity Analysis

PART 2: AURICO GOLD COMPANY ANALYSIS

AuRico Gold Overview

• Project
  • Quality of Operations – VERY LOW
    • Operations have been poor for the last 3 years but with OPEX and IMP accounting for well over 100% of Revenues.  Expectations are for production to increase and for IMP to drop but without a much higher gold price these operations will not provide positive Adjusted Free Cash Flows.
    • Quality of Reserves – VERY LOW
  • Quality of Resources – LOW
    • The company has total R&R of over 18.5 million oz Au-equiv but other than the 1.2 million oz resource at Lynn Lake, and the fact that 6.4 million oz R&R are producing the remaining 11 million oz have little or no value at current gold prices
• Capital
  • Quality of Financials – VERY LOW
    • The company has $100 million in cash and $650 million in total debts and has average -5% annual ROI over the last 2 years and has lost money in each of the last 3 years
  • Quality of Structure – LOW
    • The Company has total share capital of $2.03 billion issued through conventional equity offerings, exercise of stock options and for acquisitions.  Investors have provided a large amount of capital and as yet have not seen any positive return on it
  • Quality of Liquidity & Valuation – LOW
    • The liquidity ranks very high with an annual 1.0 turnover ratio
    • The Market Cap and EV have been high relative to the quality of the assets throughout the company’s history
• People
  • Quality of Management – MODERATE
    • Well qualified management team committed to a sound growth strategy of merger and acquisitions

In our opinion both companies are pursuing a sound growth strategy however Alamos Gold seems to be selling itself short with the proposed 50%-50% structure. Unless there is more to the story, we do not consider the companies to be equals.

AuRico Gold Detailed Analysis

In our opinion AuRico Gold has several challenges to overcome before it will become a quality mining company and at present may not be the ideal option for Alamos Gold.

Following a brief company introduction our analysis is divided as follows, applying a 5-point grading scale:

• Project
  • Quality of Operations
  • Quality of Reserves
  • Quality of Resources
• Capital
  • Quality of Financials
  • Quality of Structure
  • Quality of Liquidity & Valuation
• People
  • Quality of Management

AuRico Gold is an intermediate gold mining and exploration company that, until August 2011 operated only in Mexico.   It reached intermediate gold producer status in August 2011 when it acquired Northgate Minerals, then owner of the Young-Davidson mine and the Kemess project in a take-over valued at C$1.46 billion.

AuRico now operates the Young-Davidson mine in Ontario, Canada and the El Chanate mine in Sonora, Mexico.

In addition AuRico has several development stage projects: Kemess Copper Gold Project, British Columbia, Canada and the Lynn Lake gold projects, Manitoba, Canada.

PROJECT

Quality of Operations

Cipher’s unique analysis of key operating parameters over the last three years is summarized in the following table:

Production Levels and Revenues

Of some concern are the declining production levels, which is mostly attributable to the decrease in average grade.  Management reports that production is expected to reach 300,000 ounces in 2017; however costs will also expected to rise as the company move to only underground mining. On the positive side the Investment in Mining Properties will decrease by as much as $50 million in 2015 but will likely only be a temporary reprieve as the underground operations will require significant investment over the years to maintain production levels.

Average Grade and Operating Costs

Rising Operating Costs as underground production ramps up is to be expected; however at the current gold price these costs represent 65% of revenues for each of the last 2 years which is not sustainable over the long term.   The high percentage of operating costs to revenues is not going to change as it is also a function of the relatively low grade of the underground mine.   In addition as the Young-Davidson mine matures, operating costs will rise even further as the mine gets deeper and further away from the shafts.  The only way this scenario changes is if gold price rises considerably

Investments in Mining Properties

IMP has shown a steady decrease over the last 3 years as the Young-Davidson mine gets closer to full-scale production and development works start to slow.  According to management’s projections this number should fall significantly in 2015 but at the current level of 65% of revenues this mine will struggle to generate actual positive cash flow.

Adjusted Free Cash Flow (AFCF)

AFCF is cash flows from operations (CFO) adjusted for changes in non-cash working capital less Investment in Mining Property (IMP).  Cipher uses this number as its measure of the real profitability of the operations.  As shown this number has fallen from -340 million in 2012 to -140 million in 2014 but there is a long way to go before it will be positive.

Total Operating Costs and Break Even Price of Gold

Total Operating Cost is calculated as Revenues less Adjusted Free Cash Flow (AFCF) and represents the total costs incurred running the mining operations.  Calculated this way we are sure to capture all of the costs associated with the operations.  When divided by the total ounces produced we derive the break-even price. This is the price of gold, which would sustain operations but not allow for growth or other return on investment.  As shown, the Total Operating Costs in 2014 were $415 million resulting in a Break Even price of gold of $1854/oz at which there is still no cash left for growth or other return on investment.

Adequacy Ratios

Cipher calculates 2 Adequacy Ratios, the first one Cash Adequacy Ratio (CAR) is based on actual inflows and outflows for the company and is calculated as Revenues/Total Operating Costs + Dividends paid + Debt Repayments.  The CAR for AuRico is very poor at 0.42 for 2014.

The second is Cipher’s Cash Adequacy Ratio (CCAR) where we measure the ability of the company to offer reasonable returns on investment.  In this measure we use total debt plus share capital as the measure of the company’s total investment.  We deem 10% on debt and 5% on equity as reasonable returns for those investments and use them in the denominator in place of actual dividends and debt repayments.  This is our most comprehensive measure of corporate health.  As we see the CCAR has been increasing since 2012 but in 2014 it was still only 0.50.

Since it is has been below 1.0 for 3 consecutive years, we must analyze further to see if the company is at risk.

Based on current production levels, we determine the company requires an average gold price of $2597/oz in order for the CCAR to reach healthy levels of greater than 1.0. Conversely, based on current gold prices and operating costs the company would need to produce 485,000 ounces per year in order for the CCAR to return to greater than 1.0.

The company does report that it expected its IMP to decrease by $50 million in 2015, if this is to occur, the company would require an average gold price of $1797/oz in order for the CCAR to reach healthy levels of greater than 1.0.  Conversely, based on current gold prices and the new operating costs the company would need to produce 305,000 ounces per year in order for the CCAR to return to greater than 1.0.

It is important to note that the company also expects production to rise to over 300,000 oz per year by 2016 as the underground mine starts to produce all of the mill feed.  While this is possible it should be noted that the increased production will bring increased costs of production which will more than offset the savings anticipated in lower IMP, meaning that the company will struggle to break even below $1600/oz and will need $1800/oz in order to provide adequate ROI.

Based on the most recent years of operations we rate the Quality of Operations as VERY LOW (1.5).   Production levels will need to rise considerably with minimal cost increases or the gold price will need to rise considerably before this rating will change.

Quality of Reserves and Mineable Resource

Young-Davidson Mine (In Production)

The updated Reserve Report on the Young-Davidson mine in Canada shows:

The mine is in production but the quality of operations is low

• Gold price assumed is $1250/oz is reasonable
• Cut-off grade of 0.5 g/t for open pit is reasonable, 1.9 g/t for underground is rather low
• Average grade of 2.63 g/t for predominately underground mine will make profitability very dependent on gold price and operating costs.

Based on the quality of operations we give the Reserves a grading of VERY LOW (1.0)

EL Chanate, Mexico (In Production)

The updated Reserve Report on the El Chanate mine in Mexico shows:

The mine is in production but the quality of operations is low

• Gold price assumed is $1250/oz is reasonable
• Cut-off grade of 0.15 g/t is low; but given the consistent operations it is acceptable
• Average grade of 0.74 g/t is low and at current gold prices it will be challenging to continue to make this project profitable

Based on the quality of operations we give the Reserves a grading of LOW (2.0)

Kemess Project, Canada (past producer)

The Reserve Report on the Kemess project in Canada shows:

This project was a past producer but:

• Price assumptions for gold and copper of $1300/oz and $3.00/lb are reasonable, Silver is insignificant since it only amounts to 3% of the total resource
• Cut-off grade of $15/t or 0.35 g/t is far too low for an underground mine in British Columbia
• With an average grade of 1.04 g/t Au equiv this project will never be a profitable mine at or near todays commodity prices

Based on the quality of reserves we give these Reserves a grading of VERY LOW (0.5) 

Quality of Resources

Overall

• Gold price assumptions are all too high and reducing them will negatively impact the resources

Young-Davidson

• Cut-off grade of 0.5 g/t for open pit is reasonable but 1.9 g/t for underground is low
• Average grade of 2.96 g/t is very low for the majority underground mine and it will be challenging to make this project profitable at current metal prices

El Chanate

• Cut-off grade of 0.15 g/t is low; but the mine is already producing so this is acceptable
• Average grade of 0.75 g/t is low and it will be challenging to continue to make this project profitable at current gold prices

Kemess

• Cut-off grade of $15/t or 0.35 g/t is too low for a majority underground mine especially since it is gold and copper; raising the cut-off grade will reduce the overall resource size
• Average grade of 0.96 g/t is a red flag for a majority underground operation and it will be very challenging to make this project profitable even at much high prices

Lynn Lake

• Cut-off grade of 0.40 g/t is reasonable for an open pit mine
• Average grade of 1.61 g/t is good and should make this project profitable at current gold prices

Overall the Resources would be graded as LOW (1.4), with the Producing Canadian Resources VERY LOW (1.0), the Producing Mexican Resources LOW–MODERATE (2.0), the Kemess Resources grading VERY LOW (0.5), the Lynn Lake Resources grading MODERATE-HIGH (4.0)

CAPITAL

Quality of Financials

Cipher’s unique analysis of key financial information over the last three years is summarized in the following table:

The Company has $100 in cash and $75 million in inventory but had negative adjusted free cash flow of $125 million last year alone.  The operations are not enough to cover its costs and this company will continue to struggle unless the gold price rises to well over $1800 per ounce.  The company has over $300 million in debt obligations and in 2013 it used $300 million of its cash to buy back shares from the market at over $8.00 per share.  In 2014 it borrowed $309 million and repaid over $250 million in debt that was due.

The Company has invested of $2.5 billion to date acquiring and developing its assets and has yet to provide any return on that investment and doesn’t appear it will unless gold rises considerably.

The Quality of Financials is POOR and gets a grade of 1.0.

Quality of Structure

The company has share capital totaling $2.030 billion and 253 million shares issued.  Since 2002 it has issued 235 million shares at an average price of $8.60 per share; the highest equity offering was 10 million shares done in 2007 at a price of approximately $18.00 per share.  In August 2011 it issued nearly 107 million shares (38% of Aurico) to Northgate shareholders as part of its acquisition of Northgate.

Management has exercised stock options each year since 2006 at least and as a result has been well compensated with increases in share price.  In 2007 alone nearly 5.3 million options were exercised at an average of $6.33, with an average share price of $12.00 and a high of over $17.50, management and others would have profited at least $30 million and possible over $60 million this year alone.

The company’s practice of granting stock options to directors management and other key persons has helped ensure that management has incentive to perform well and have that reflected in share price.

In general the public has been asked to finance this company at levels above what would have been deemed fair value by Cipher but it was able to as a result of the market exuberance.

The Quality of Structure is LOW and grades 2.0

Quality of Liquidity & Valuation

Since acquiring Northgate in 2011 the company has maintained reasonable liquidity; since May 2011 it has averaged $1.4 billion per year with levels reaching $2.5 billion in 2011.  In the most recent 12 months the company has traded approximately $750 million.  This represents an average annual share turnover of approximately 1.4 and a recent turnover of 0.75.

The annual average market capitalization for the company peaked in 2011 at over $3.3 billion and averaged nearly $1.5 billion from 2006 – 2012.  Since 2012 the average annual market capitalization has averaged closer to $1 billion.  The average Adjusted Free Cash Flow (AFCF) for these years was ($200) million, which may imply the company is still trading too high.

The Quality of Liquidity is HIGH and grades 4.0, and Quality of Valuation is LOW and grades 1.5

PEOPLE

Quality of Management

Directors, Officers and Management all have good credentials, have executed built a company with 2 producing mines and a significant Reserve and Resource Base (18.5 million ounce Au equivalent).   The quality of the operation and resources is not very good but management maybe felt that gold prices would continue to maintain the $1800 level reached in 2011.

Since 2006 stock options have been exercised at prices well below the average trading price giving management the opportunity to profit significantly from the increase in share prices along with shareholders.

Based on insiders report on Sedi, management owns a very low percentage of equity, which could indicate misalignment with shareholders interest.

Salaries and benefits to related parties totaled $5.4 and $6.0 million in cash and over $4.5 in share based compensations for annual totals of $11.5 and $10.5 million. The overall administrative costs totaled between $26-28 million/yr or 10% of revenues over the last 2 years and are on the high side of acceptable.  Management uses stock options to ensure key people can be rewarded with rising share prices and has done this very well in the past.

Management appears intent on building a larger mining company, which will be in the best interest of all investors provided it can improve the efficiency of current operations.

The Quality of Management is MODERATE and grades 2.0

CIPHER VALUE

The market value of a mining company roughly follows the market value of its reserves and resources which based on Cipher’s research is currently ranging between $150-$ 350 per oz of gold in the ground.  The value of an exploration and development company with a non-producing reserve or resource has been examined by Cipher as well and the results show that 80% are worth $90/oz or less.  Companies with quality operations (particularly with long history of it) are valued higher on the range; if the quality of operations is not as good the company is discounted accordingly.

In the case of AuRico, due to the low quality of production from 2012 through 2014, we value the producing reserves and resource (6.4 Mi oz) on the lower end of the range – at $150 with extreme caution.  We will adjust that value as the production levels are shown to grow to the 170,000 oz per year level.

At $150/oz for the producing reserves and resources of 6.4 we derive a cautious Value of $960 million.  Our valuation would be adjusted down unless we see a significant improvement in operations. Cipher will monitor the company closely.

The Lynn Lake Resources (1.1 million ounces) rank high and are valued at $90/oz or $100 million.

The remaining 11.0 million ounces in reserves and resources attributable to Kemess were rated very low and Cipher assigns no value to them.

We currently value Aurico as follows:

• $960 million Value of producing reserves and resource, plus
• $100 million paid for the Lynn Lake resource, plus
• -$200 million (cash – debt)

Resulting in total Value of $860 million or $3.40 per share.

With a current market capitalization of  $960 million ($3.78 per share), Cipher considers Aurico a sell.

Note: Since this report the share price has risen from $3.78 on the day of the announced merger to $4.31 as of the close on 28 Apr 2015.

Columnist Rod Husband is a partner at Cipher Research. Cipher Research is an independent research and analysis company that covers the mining and metals sector of the commodity markets. For more information on this topic or on Cipher Research please visit:  https://www.cipherresearch.com or contact info@cipherresearch.com.