Seeking Alpha: Widening discount to fair value

Medusa Mining's Higher Production Guidance Further Widens The Discount Its Shares Are Trading To Fair Value

Jun. 22, 2015 10:02 AM ET |
Disclosure: I am/we are long MDSMF.
Summary

• Medusa Mining surprised many last week with the release of significantly higher production guidance for 2016 and even higher for 2017.
• Since September last year, Medusa's management team has not put a foot wrong in repositioning the company and pushing to regain investor confidence.
• The higher than expected production guidance for next year and the year after significantly lifts the company's expected cash flow yield to one of the highest in the industry.
• I believe the next upside surprise over the coming months will be significant progress in reducing costs.
• I still find it unbelievable that the company continues to trade at the discount to its peers that it does given the improvements management has made and continues to make.

Background and Recap

Medusa Mining (OTCPK:MDSMF) (MML) is an ASX listed junior gold miner with mining operations based on the Philippine island of Mindanao. It has one currently producing mine (Co-O) and several development prospects nearby (Bananghilig and Guinhalinan being the most prospective with Bananghilig classified as a pre development project and Guinhalinan a high quality exploration target).

Last fiscal year (to 30 June 2014) it produced 60 koz of gold at an average C1 cost of US$418/oz and head grade of 4.76 g/t. In the half year to 31 December 2015, it produced 47.9 koz at an average C1 cost of US$381/oz and head grade 5.31 g/t.
For the year to 30 June 2015, management has forecast production of 95 - 100 koz at an average C1 cash cost of US$400 - US$450/oz and All In Sustaining Cost (AISC) of $900 - $1,000/oz and with grades over 5%. Given the strong performance in the first half year and the robust third quarter result (23.9 koz at US$391/oz for the third quarter) the full year 2015 guidance (year to June) looks in the bag on the production front, especially since the final quarter to June should be significantly higher than the previous ones on account of the upgraded L8 hitting its target in March.
Last January, I published an article on Medusa following its December half year results; commenting that management had delivered on one of its most fundamental pledges following its installation 5 months earlier - i.e., returning the company to positive cash flow generation. You can find it here.
Since then, Medusa has declined marginally by around 3%. The junior gold miner ETF (Vectors Junior Gold Miners) listed on ARCA however has fallen 11% in that time. Also, back then, gold was trading at about US$100/oz more than today, at US$1,275/oz.
(click to enlarge)
Source : Googlefinance
Value destruction last year ...

Medusa has had a checkered history. Before the new management team was put in place, the company had a poor history of meeting guidance and each earnings report highlighted a new failing. By August last year, investors had had enough and the stock tumbled; making it the worst performing gold stock in losing 70% of its value in the space of 3.5 months following its June 2014 results release - underperforming the junior index by a landslide.
However, for the value investor this is a the ideal scenario - a stock that has fallen so out of favor that investors blindly run for the door without standing back and looking at the bigger picture. Nothing much had changed in terms of the quality of the assets but sentiment had shifted. In fact, irrational sentiment appears to be on hand again as I write this. Just yesterday the stock was down 6% at one stage whilst the rest of the industry was rallying on higher gold prices.
(click to enlarge)
Source : Googlefinance
I first noticed the stock in October, just after the new management team had been announced and put in place. I was impressed with the manner in which they set about managing expectations and committing themselves to actually delivering on guidance and investor expectations. They committed themselves to reversing the slide in cash flow and undertaking a thorough review of the operations and a series of steps to improve the assets.
... has given way to a new approach to regaining investor confidence

With the appointment of the new team, I suggested in an article on Medusa that the recent history of disappointing performance and missed management forecasts was coming to an end with the return of the company's founder (Geoff Davis) to the CEO position - drawing a line under the previous management of the company. You can find the article here. Back then the share price was A49c/share. Today it's A85c.
One of the things I particularly liked about the new management team and approach was its commitment to meeting its stated guidance and forecasts. It rightly saw this as fundamental in rebuilding confidence with the investment community which had too often been let down by the previous team. Since taking over last year, the new CEO has delivered on a number of fronts:

• Kicked off a comprehensive review of the company's operations in order to optimize the Co-O mine's long-term mine planning. This culminated in the company releasing 2015 production guidance of 95 - 100koz, which was greater than many expected at the time
• Completed the restatement of the company's reserves to the latest JORC standard - delivering a better result than many expected (or rather a less worse result)
• Completed the L8 shaft upgrade on time (increasing hoisting capacity from 45kt to 60kt/month), which is key to the company's efforts to lift monthly mine production and bringing it closer to the mill's capacity
• Made a commitment to complete a new service shaft next to the newly completed L8 shaft (cost $10m over 17 months) which will further lift mine hoisting capacity from 60kt to 68kt/month
• Restored the company to positive cash flow generation in each of the quarters since the new team was installed (September, December and March)

A substantial upgrade to forecast production now official

Last week, however, management signed up to another pleasing commitment; providing production and cost guidance for 2016 and production guidance for 2017. You can find the announcement here.
On the production side, it is expecting 120 - 130 koz for next year and 135 - 145 koz the year after (i.e. year to June 2017). Two things give me a strong sense that Medusa will meet this new guidance. First, management has been very careful these last 8 months to promise only what it can deliver, as I mentioned above. So far it has delivered on each of the commitments it has set it self. I've no reason to believe this will be any different.
Second, the uplift in production seems realistic. The mining capacity of Co-O has now increased from 45 - 60 kt/month off the back of the L8 shaft upgrade. That's a 33% increase and corresponds to the production increase from this year (guidance for this year to June is 95 - 100 koz). Further, the increase slated for the following year to June 2017 also seems realistic. Having undertaken to complete the L8 service shaft earlier this year, which will take 17 months, mining capacity will be lifted from 60 kt/month now up to 68 kt/month, a lift of 13%. Thus an increase from 2016 guidance of 125 koz up to 140 koz for 2017 - 13% - seems possible.
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Source : Author
When I looked for market reaction to the guidance the thing that struck me most was how many people regarded this as a surprise. Given the recently completed L8 shaft upgrade and the resulting increase in mine capacity, it should not really have come as much of a surprise. The second thing that surprised me was the lack of any real move in stock price. The increase in production has the potential to drive significant cash generation over the next year but once more it seems the market either doesn't get it or doesn't believe it.
Costs - The next dragon to slay?

Whilst progress is being made on the production side, with the L8 shaft upgrade enabling a near doubling of capacity over the next 18 months, the next area of focus needs to be cost reduction. Management recognizes this I think and it features heavily as the core focus in the most recent investor presentation
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Source : Medusa Mining
My sense is that there is some scope to pare costs back. AISC up over US$1,000/oz certainly isn't 'low cost miner' territory. Where I think there is source for encouragement though is the C1 cash costs which the company is guiding towards US$400 - US$450/oz. If you look though at the last 3 quarters, MML has averaged US$384/oz (despite a prolonged period of production disruption due to the L8 upgrade) so it's likely the company will better its cash cost guidance significantly for this year to June 2015.
More vexing though is the company's performance on the AISC line which remains stubbornly around US$1,000/oz notwithstanding the strong performance on at the C1 cash cost line. The average over the first 9 months so far was US$1,100/oz, although that was heavily skewed by the September 2014 quarter at US$1,238/oz which was around when the new team was installed.
Below I have included information from an Oceanagold presentation from September 2014. It shows the industry AISC and MML's 2015 guidance. It shows that, at US$900 - US$1,000/oz, MML's AISC is not earth shattering and really just positions the company towards the back end of the second quartile. Further, as this was complied last year, and with the increase in the USD over the last 9 months, its highly likely that many gold producer currencies have fallen relative to USD which would act to reduce this curve; making US$900 - US$1,000/oz seem relatively higher. This is a long way of saying that I think that MML could well surprise many over the coming year with lower costs than their current guidance for next year.
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Source : Oceanagold, Medusa Mining
The major items of difference between AISC and cash costs are exploration, sustaining capex and corporate/G&A costs. MML has been spending around US$3m per quarter on discretionary exploration or about US$12m a year. For a company making revenue of US$84m that is impressive. It also represents quite a cost - about US$125/oz based on current 2015 expected production.
That said, the exploration program is also is proving quite successful. Last quarter MML announced some very encouraging drill results for Co-O; 7.95m @6.36g/t, [email protected]/t and even an intersection of [email protected]/t. All this augurs well for a future for Co-O well beyond the 450koz of reserves. As it stands, the mineralisation remains open to the east.
On the sustaining capital side, MML has spent quite a lot recently on the L8 shaft as mentioned. Some $10m was spent in the December quarter and another $10m will be spent over the period to June 2016 in completing the L8 service shaft - required to deliver the production increases in 2016 and 2017 just released. As a guide here, total capital expenditure for MML (excluding exploration expense) was US$32m for the half year to December 2014, compared to depreciation of US$15m. To me this suggests the company's AISC is abnormally high relative to its long run sustaining level.
To be fair here, the team is already achieving progress on costs. When they arrived back in September, corporate costs were averaging about $2.8m/quarter. Now they are around $1.7m.
Management provided a clear cost target during the November AGM

The forecast production guidance released last week also included guidance on AISC and cash costs. On the cash cost side, management has set a target of US$380 - US$430/oz whilst for AISC it is guiding towards US$960 - US$1,060/oz. Importantly here though is the inclusion of the US$10m capex associated with the service shaft, which adds some US$80/oz to the AISC for 2016.

Source : Medusa Mining
My view here is that I believe costs will come in significantly below the 2016 guidance range. I also believe management perhaps thinks that too but for now perhaps wishes to remain conservative. In fact, during the November AGM, the CEO said as much when he forecast that after 6 months or so from the L8 shaft upgrade (completed in January), AISC should fall to around US$800 - US$900/oz off the back of higher production, better grades (he actually said he expected grades of around 6-7g/t "over the next 6 months or so") and higher mill recoveries and further efficiencies. You can listen to the presentation here.
(click to enlarge)
Source : Author
So what's the impact on cash flow of the new guidance ... ?

Cash is king when it comes to evaluating any investment so naturally the first thing I did when the new guidance came out was to determine the cash flow impact. Here, I looked at 2 material changes to the current 2015 performance. The first was the impact of additional production in 2016. The second was the impact of what I expect to be a beat in management's AISC guidance for the year to June 2016, i.e. US$960/oz - US$1,060/oz. In this instance I assumed that MML's AISC for the year to June 2016 falls to US$800 - US$900/oz, as mentioned by the CEO during the November AGM.
My analysis below assumes the gold price averages US$1,300/oz over the year to June 2016, which is in line with many broker forecasts. I have assumed 2016 production for MML is 125 koz - the mid point of management's latest guidance. I have also assumed the mid point of guidance for 2016 AISC - US$1,010/oz. Further, I have used UBS data in preparing the table of comparable company yields, also based on US$1,300/oz gold. From the below, even based on the what I believe to be conservative AISC guidance, MML's cash flow yield is above all its peers at 26%. If I repeat my analysis at the current the current spot price of US$1,200/oz, MML's cash flow yield falls to 18% - still well over its peer group.
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Source : Author, UBS
If we assume that the CEO's comments on AISC during the November AGM come to pass, and it averages US$800 - US$900/oz, the cash flow yield is significantly higher again - at 41%. This represents a free cash flow margin rising from US$290/oz under management's official 2016 AISC guidance up to US$450/oz if AISC falls to where the CEO said he believed it would during the AGM. For me, this suggests substantial upside to current returns implied in the share price and much higher than anything else in the gold space.
(click to enlarge)
Source : Author, UBS
... and what's the valuation impact?

With free cash flow yield so high, you would expect MML to trade at a material discount to its peer group. And you would be right. Below I have again pulled MML's comparable company EV/EBITDA multiples for 2016. As you can see from the below, MML still trades at a huge discount to the peer group, notwithstanding the continued de-risking of the company that has occurred over the last 9 months with the initiatives and measures the new management team has been making. Given this, its pretty easy to foresee a material shift upwards in MML's share price over the coming year.
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Source : Author, UBS
So what gives?

So why is the cash flow yield and the valuation discount to its peers so high for MML? If I had to suggest a reason it might be perhaps because of the perceived short reserve life the MML has; frequently cited by some investors as a key concern. Technically MML has only 450koz of reserves booked which is enough for about 4 years production at the current rate. But what investors need to focus on here is the reserve replacement record. Each year, as you can see below MML as actually increased its reserves as further drilling has enabled it to recognize more gold reserves than it removed through production. The only exception was last year, when the company moved to the most recent JORC code which resulted in 150koz of reserves being inadmissible as reserves. Importantly though these reserves are still there, its just that for the purposes of the JORC code they cannot be included in the new code's stricter definition of reserves.
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Source : Medusa Mining
Thus, I would suggest, the low reserves are really a non issue and I think investors that punish the company for them arguably don't fully understand. Further, as I mentioned above, since the new management team stepped in, they have funneling even more resources and cash into exploration and re-interpreting previous geological data. As a result there is every reason to be confident that new reserves will be recognised in the near future.
Given the ore body remains open in all directions right now, there is no reason to believe that MML will continue well beyond the current reserve life of 4-5 years.
Conclusion

Readers of my articles will note that I have been a believer in MML's story since the new management team and CEO took the helm last September. I have been impressed with the measured way they have taken a step back and addressed one by one the issues that dogged the company over the years to their appointment and lead to a 70% loss of value over the space of 3.5 months.
Last week, the results of their overhaul of the company showed through with the substantial increase in 2016 and 2017 production guidance over what is expected this year.
Notwithstanding this and the number of earlier positives the management team have made in de-risking the business these last 9 months, the stock continues to trade at a very material discount to its peers and what I would argue is fair value; actually falling on the day following the announced new production guidance, despite gold rallying over 1% on that day.
I believe last week's decline in the share price represents a great opportunity for investors to build a position in MML ahead of the rest of the market finally waking up to what is, in my opinion, one of the best value stocks in the gold space.

http://seekingalpha.com/article/327...discount-its-shares-are-trading-to-fair-value