This website presents my analysis of macro economics trends and individual companies.

Friday, January 23, 2015

The Consequences of QE

There is a good article by Mervyn King, then Deputy Governor and subsequently Governor of the Bank of England, published in 2001 that is very pertinent to today's quantitative easing (QE) program and its consequences in time. Specifically, in Chart 1 he shows rather convincingly that expansions in the money supply, with an appropriate lag, will lead to an proportionate increase in consumer price inflation with a 99% correlation. With today's QE program, we already see 1-to-1 correlation between increases in the monetary base and assets prices, particularly stock prices as seen in Chart 2 where the ratio of the S&P500 index / US monetary base has flat-lined since 2009. In other words, the strong growth we have seen as of late in the US stock market is being equally offset by the growth in the monetary base. This increase in the S&P500 index can be dubbed in general, asset inflation, and financial assets such as stocks tend to be among the first things 'bid-up' in price due to an expansion in the money supply. And as clear as day turns to night, with an appropriate lag, eventually that asset price inflation will spread into consumer prices and formally enter the 'inflation' metrics as commonly computed; the CPI.

 Chart 1 : Money growth shows a 99% correlation to consumer inflation with an appropriate time lag.

The stated objective by central banks for engaging in these QE money expansion programs is to stimulate the economy. However, again thanks to Mervyn King, Chart 3 in his paper blows a hole in this stated objective. As can be seen below, there is no correlation (-0.09) between money growth and real GDP output growth. In other words, the historical data refutes the idea that money expansion will stimulate the economy in real terms. So behind the talk, what is the real reason why QE is being used so aggressively? It seems to be for the purpose of creating asset price inflation in order to avoid governments, banks, and central banks fear of asset price deflation. In hard core asset price deflation, particularly for assets that are collateralized and debt financed, they could end up on the banks balance sheet and their deflating value could lead to individual and system-wide bank failures. For government, their inflation tax does not work during deflation. For example, if nominal asset prices increase 100% after 5yrs, that gain can be taxed even though say in real terms (inflation adjusted) the price is still the same. In a deflationary world, if asset prices fall 50% in nominal terms, the holder of that asset can get a tax benefit by taking a tax loss even if in real terms the price had not changed. Without inflation, a large portion of a government's effective tax revenue would go into reverse. The last reason for QE has to do with decreasing the relative value of the 'unit of account', i.e. the US dollar. By doing so the effective level of debt can be decrease without formally defaulting on it. In the common vernacular, this has been called inflating ones debt away.
Chart 2 : Ratio of the S&P500 / US monetary base

Chart 3: Money growth shows no correlation with real output growth.

Sunday, January 4, 2015

35 Year Stock Market Cycle : Implications For 2017 - 2020 and Gold

We are all familiar with the exponential rise in the stock market over the past 100 years. However, less commonly known is that within that rise has been a rather predictable cycle of 35year with distinct peaks and troughs.
Figure 1: The 35 year stock market cycle with a sine-wave to help guide the eye.  This S&P500 / US GDP ratio can be considered to be akin to a macro version of the price / sales ratio for the US economy.

By normalizing the S&P 500 index to the US GDP, the 35 year cycle becomes plainly obvious as shown in the above figure.  When the ratio is rising into the peaks, the stock market in general outperforms the US economy and when it descends into the troughs, it underperforms.  Or considering it from another perspective, the ratio is akin to a macro version of the price/sales ratio for the US stock market.  Either way one looks at it, the best buying opportunity is when the cycle is low.  Others, including Warren Buffett in a Fortune article in 1999, have noted this peculiar cyclical feature of the stock market when talking about the two 17 year periods of outperformance and underperformance.

Since the market peak in 2000, we have remained in the underperformance portion of the cycle which does not reach its cycle bottom until mid-2017. Despite the QE fueled counter-cycle run-up in stocks that we have seen as of late, one should heed caution as this cycle chart suggest that the period of underperformance is not over with. Considering that the GDP tends to be the slower moving of the two, one can assume that it is the value of the S&P500 that will be the dominant influence in pushing the ratio down. Incidentally, Charles Nenner, a cycle expert, is also predicting a major stock market crash around a similar time frame, 2018 - 2020.

One can analyze the implication of this cycle low further by considering a log plot of the S&P500 index and its residual (i.e. the difference between the actual S&P500 value and its trendline expressed in % terms). Within the residual, we also can make out the 35 year cycle as well as identify that during the previous two cycle lows, (mid-1940s) and (late-1970's to early-1980s), the S&P500 was down 50% from its trendline. (Please see the arrows pointing to this on the residual line.) If history were to repeat again the chart would suggest the S&P500 bottoming out between 1000 - 1200 on the monthly chart during the upcoming cycle low. On this point, Charles Nenner is suggesting a low for the DOW of 5000 during the 2020 low which would imply an S&P500 of around 600 or down 75% from the trendline; an outcome that would be without precedent based on this chart. Another thing to note from here is the "bubble" prices in the S&P500, both in 1929 and 2000, become clearly evident as the index deviates over 100% above the trendline.

Figure 2 : S&P500 and its trendline.
One possible flaw with this S&P500 price-target analysis is it implicitly assumes a linear projection into the future which could be thrown off due to the radical monetary policy currently underway with quantitative easing (QE).  Granted, that linear projection has held for the past 87 year (from 1928 - 2015) despite the ups and downs of both the monetary base and the S&P500, however, if one looks at the S&P500 to US monetary base ratio, Figure 3, it suggests two things: (a) the ratio is already at or close to a cyclical low and (b) since the ratio has flat-lined since 2009, the stock market is tracking 1:1 with increases in the monetary base. One possible interpretation of this is the stock market will be range-bound, within the confines of this ratio, for the balance of the decade.  However, if this turns out to be the case it would also have to imply that the nominal GDP in the US will increase substantially, 20% annually, to get the stock market cycle ratio, from Figure 1, down to its cycle low.  Most of this nominal GDP increase would likely have to be derived from the inflation component as real GDP growth of this magnitude would be practically impossible.  However, even nominal growth at that level seems highly unlikely.

Regardless of the interpretation though, the implication remains the same that the S&P500 index's upside will likely be limited.

Figure 3: The ratio of the S&P500 to the US monetary base indicates we are already at a cycle low and it has essentially flat-lined since 2009.

If one is of the opinion that the S&P500 will play out as suggested by the 35 year stock market cycle, then what would be one's best course of action as no easy mechanism exists to go long US GDP and short the US stock market. Incidentally, this 35 year cycle period also manifests itself in the stock market to gold price ratio as seen in the figure below. Not only that, but it is more leveraged to the cycle than the stock to GDP ratio by a factor of 8x.
Figure 4: Gold to S&P500 cycle

By starting with the adage, 'gold is money', one can attempt to extract future price targets for gold from a monetary point of view. Assuming that the 'model' price of gold proportionately tracks changes in the US monetary base starting in 1934 when gold was officially revalued to $35/oz and further discounting that 'model' price by 1.5% annually to account for added gold supply from mining production then the implied 'model' price today would be $5,500/oz. Turning ones attention to the residual (i.e. the difference between the 'model' price and the actual price of gold) one can see the bubble prices clearly standing out as it did in 1980 when the actual price exceeded the 'model' price by 140%. In comparison, in 2011 when the gold price touched $1,923 to form a local maxima, it was still at a discount to the model price and thus not indicative of a bubble. If we were to get similar bubble again in gold price today, i.e. greater than 100% above the model price, then it would suggest gold trading at greater than $10,000 per oz. 

Figure 5: Gold model-price based on a proportionate increase with the US monetary base compared to the actual price of gold.

Lastly, further insights can be gained by looking at the monetary base itself. From 1919 - 2008, the US monetary base increased at an annualized rate of 6.9% which is roughly equivalent to that of the S&P500 rate of 6.7% (as seen the prior chart). This suggests that on average, the capital gains realized on long-term investments in the broader stock market match precisely the amount of money-inflation that has occurred over that period of time. In other words, backing out money-inflation, in real terms one is only getting the roughly 2% return from dividends.
Figure 6: US monetary base and its residual.

The analysis above makes the case that the broader markets, represented by the S&P500 Index, has limited upside or the potential to be significantly lower in the 2017-2020 time frame. In contrast, gold and other precious metal investments in general are likely to be significantly higher. After the 2017 - 2020 low is reached, going long stocks would be appropriate as the next upswing in the 35 year cycle begins and would last until the next cycle peak is reached in the year 2035.

Sunday, February 12, 2012

ADF Group (TSX: DRX)

ADF Group (TSX: DRX) is a small Canadian company that designs, fabricates, and installs complex steel superstructures and other metals works to clients in North America.  It is a family run business with three members of the Paschini family being executives of the company as well as collectively having 44% ownership of the shares outstanding and voting control via the dual share-structure.

Obviously their industry is highly cyclical but ADF Group's shares price has fallen much further than fundamentals would suggest.  Consequently, the company fits the mark as a deep-value opportunity.  Below I will highlight some of my reasons for thinking so.
Trades Well Below Book Value

Net Current Asset = Current Assets - Total Liabilities

Strong Balance Sheet

With the strong and growing net-cash position they are well positioned to weather any rough-times ADF may encounter in the coming years.  Thus, the dilution risk is low.  Currently it has a net-cash position of C$0.55 per share on a shares price of C$1.30.

Still Operating Profitably & History of Good ROA

 The company is still operating profitably with much of its revenue from 2011 originating from the World Trade Center : Freedom Tower in New York.  However, due to the cyclical nature of its business one could expect the ROA possibly go zero or negative as the business cycle lulls. 

Large Insider-Ownership

The Paschini family executives who own 44% of ADF Group's economic interest are well incentivised to continue acting prudently and seeing to it that shareholder value is not destroyed.  Currently there is a normal course issue bid (i.e. corporate share buyback program) in place to repurchase ~5% of shares outstanding.  Although financially this will not be a problem to realize considering their strong cash position but due to the low liquidity of their shares, it will probably be difficult to fill that entire order over the course of 2012.

Thus far I do not own any shares of ADF Group but as my current holdings reach full value I look forward to eventually rotating some of the proceeds into DRX.

Tuesday, November 8, 2011

Minera Andes : 49% San Jose mine ABOVE AVERAGE in Profit Margin & ROA

In the previous post I presented the case that the market is significantly undervaluing Minera Andes' primary asset, 49% of the San Jose mine.  Turning now to some fundamental metrics of the San Jose mine namely its profit margin and ROA (return-on-assets) we can see that it is above-average in its peer-group.

Within its peer-group, the San Jose mine is performing above average in both metrics Profit Margin (EBITDA / Revenue) and Return-on-Assets (EBITDA / Non-Current-Assets).  NOTE: I am using two times the revenue and EBITDA numbers from 1H2011.  Non-current assets were used instead of total-assets because 1) to exclude the large cash-balances that are above and beyond what is needed for maintenance working capital levels and 2) Hochschild Mining does not disclose the cash level of the San Jose mine subsidiary so removing all current assets was the next alternative.  NOTE on Silvercorp: Since the development-stage projects, GC & Silvertip, are not in production, I have removed their assigned assets from those listed in the table above.  Also, Silvercorp reports its revenue net of a 17% VAT tax while Minera Santa Cruz SA (San Jose) reports its export duty tax as an operating expense.  To compensate for this I have increased Silvercorp's revenue by 17%.  Lastly, revenue and EBITDA for Silvercorp were taken as 4/3 of the previous 3 qrts (Jun11-Sep10) due to the cyclically low period in Jan.

Sunday, November 6, 2011

Valuation Multiples of Minera Andes Clearly Show Undervaluation

Using market prices as of November 4, 2011, Minera Andes (MNEAF) is clearly undervalued relative to its peers even in today's depressed price environment.
Valuation multiples of Minera Andes and its peer group.  In Minera Andes** I backout the Los Azules valuation from the enterprise value (EV), using a conservative value for Los Azules (LA) of $130m, so the multiples reflect 49% San Jose only.  Revenue and EBITDA were taken as two times the 1H2011 numbers.  The EBITDA for Minera Andes was taken as two times, 49% of 1H2011 operating income plus depreciation, i.e. (2 x 0.49 x ($79.6m + $17.3m)) of San Jose mine which can be found from Hochschild Mining and I have subtracted off a further $7m ($3.5m x 2) for Minera Andes' G&A expense.

To get Minera Andes valuation up to the average multiple of its comps would require a share price of $3.80 to $5.20 when you adjust for Los Azules.  In nearly any other industry, an earnings multiple would be among the more important valuation metrics.  Yet Raymond James never used any such metric in its valuation analysis.

Enterprise Value (EV) = Market Cap + Debt - Cash
EBITDA = Operating Income + Depreciation/depletion Non-cash Expense

Saturday, October 15, 2011

Long Term View of S&P / TSX Gold Stock Index

Taking a long-term view of various asset-class levels from 1928-2011 one can see that the S&P / TSX Gold Index has yet to revert to the S&P 500 / 10yr T-Bond Total Return trend line.  As for gold, it is just now arriving at the trend line meaning that it is far from a "bubble-state".

A comparison chart of gold price and the US money supply metric, Money-Zero-Maturity (MZM).  Again the gold price is far from being in a "bubble-state".   If the gold price were to reach the same heights as in Jan-1980 relative to MZM, in today's dollars gold would need to be $8,500/oz.  This number should be considered a point-of-reference rather than a prediction for future prices.

There is a good paper by then Deputy Governor, Bank of England, Mervyn King, on the relationship between money supply and inflation called: "No money, no inflation—the role of money in the economy"

Monday, September 12, 2011

Minera Andes (MNEAF) merger with US Gold (UXG)

A large, long-term holding of mine, Minera Andes (MNEAF), is currently involved in a pending merger agreement with another Mr. McEwen company, US Gold (UXG).  Since the original announcement, many Minera Andes shareholders have expressed concerns regarding the inequitableness of the terms which have recently seen a modest increase from 0.40 to 0.45 UXG shares per MNEAF share.  In an effort to ascertain what a fair merger exchange ratio should be I have used the  method of valuation-by-comparables to arrived at a fair ratio of 0.62 to 0.81.   The range comes about due to the assumptions one makes regarding the lack of control discount (LOC) one applies to Minera Andes 49% interest San Jose mine; a 30% LOC discount gives 0.62 and 0% LOC discount gives 0.81.


Valuation of US GOLD (UXG)

  1. Valuation of El Gallo Deposit
    • Comparable Company : Tahoe Resources (TSX: THO)
      • CEO : Kevin McArthur is former CEO of Goldcorp & Glamis
      • High-grade (600 g/t), development-stage silver deposit in Guatemala with 400m oz of Ag in M&I + Inf.
      • Current Market Cap is $2,500m.
      • THO Trades at $6.25 per oz of Ag resource ($2500m / 400m oz)
      • NPV 5% discount = $2,783m, IRR=70%, Payback = 1.1yrs assuming price of Ag = $25, Au = $1,300, Pb = $1.00, Zn = $1.00
      • THO Trades at 90% of NPV 5% discount
    • US Gold's El Gallo
      •  High-Low grade (77 g/t Ag), development stage silver deposit in Mexico with 60m oz of Ag in M&I + Inf.
      •  NPV 5% discount = $521m, IRR = 65%,  assuming a price of Ag = $28.50, Au = $1,350
      •  NPV 5% discount = $155m, IRR = 27%,  assuming a price of Ag = $18, Au = $1,000
      • Using linear interpolation we get:
        • NPV 5% discount = $400m, assuming a price of Ag=$25
    • VALUATION OF EL GALLO (1) = (60m oz Ag resource) * ($6.25 / oz Ag resource) = $375m
    •  VALUATION OF EL GALLO (2) = ($400m NPV5%) * (90% of NPV 5%) = $360m
  2.  Valuation of Nevada Properties
    • Comparable-Company : Atna Resources (TSX: ATN)
      • ATN is bringing back multiple, older gold mines in the Nevada area.
      • Currently ATN has 3.2m oz of Au M&I + Inf with a grade of 0.8 g/t
      • Current Market Cap is $82m
      • ATN trades at $26 per oz of Au resource ( $82m / 3.2m)
    • US Gold's Nevada Properties
      • Currently has 3.2m oz of Au in M&I + Inf with a grade of 1.0 g/t
    • ---VALUATION OF NEVADA PROPERTY'S RESOURCES = $85m  :  (3.2m oz Au resource) * ($26 / oz Au resource)


$593m = $368m + $85m + $40m + $100m (Cash)

Per share basis = $4.23

Valuation of Minera Andes (MNEAF)

  1. Valuation of 49% of San Jose Mine
    • Comparable-Company : Great Panther Silver (TSX:GPR)
      • High-grade (450 g/t), producing silver-lead-zinc mine in Mexico
      • Current Market Cap is $470m.
      • Expected Production for 2011 is 2.6m oz of Ag-eq:
      • Trades at $180 per oz of Ag-eq production ($470m / 2.6m oz Ag-eq)
    • Minera Andes's 49% of San Jose
      •  High-grade grade (450 g/t Ag, 6.33 g/t Au), producing silver-gold mine in Argentina
      •  4.35m oz Ag-eq production (on 49% base)
    •  VALUATION OF 49% SAN JOSE  = $783m  : (4.35m oz Ag-eq production) * ($180 / oz Ag-eq production)
  2.  Valuation of Los Azules Copper Deposit
    • Comparable-Company : Candente Copper (TSX: DNT)
      • Large undeveloped Copper deposit in Peru
      • Currently has a 9,000m lbs of Cu with a grade of 0.45%
      • Current Market Cap is $140m
      • Trades at 0.015 per lbs of Cu ( $140m / 9,000m lbs Cu)
    • Minera Andes' Los Azules Copper Deposit
      • Large undeveloped Copper deposit in Argentina
      •  Due to litigation over ownership, we can roughly say MNEAF owns 87% of it.
      • Contains 12,000m lbs of Cu at a grade of 0.55%.
    • ---VALUATION OF LOS AZULES = $155m  :  (12,000m lbs Cu resource) * (0.87) * (0.015 / lbs Cu resource) = $155m


$978m = $783m + $155m + $40m

 Per-share basis = $3.43

Based on this analysis, the implied exchange ratio ought to be between 0.81 UXG shares for each MNEAF share (assuming 0% LOC discount for San Jose) and 0.62 (assuming 30% LOC discount).  Thus, I will be voting NO on the current merger until the terms are improved.

US Gold Trades at Speculative Premium

The speculative premium US Gold trades at is not all that out of the ordinary for junior resource mining companies.  As many know and as posted on Minera Andes website, these companies have a tendency to reach their first price zenith just prior to going into the mine building phase.  The reason for this is during the discovery phase the market enthusiastically prices in increase in the mineral resource and feeds off this consistent news flow.  However, once mine building phase starts, this resource building news-flow drops off and is replaced by news of dilutive cash-raises to finance the mine construction, growing-pains, and start-up issues which all weigh on the share price during this period, in general. Once production is smoothly underway, the share price performance picks up again

Minera Andes is just beginning to exit it price trough as production is now smoothly underway and cash flow is coming in.  So again, from a mine-cycle point of view, this chart would substantiate that US Gold is overvalued and Minera Andes is undervalued reinforcing what fundamental analysis would suggest.
Source: Minera Andes website

For US Gold, their flagship El Gallo project will be releasing it feasibility study in Dec 2011 and mine construction is set to commence in 2012.  As pointed out on the above chart with the red ovals, now is not the best time to be buying UXG stock.  However, by the terms of the merger that is essentially what is being asked of Minera Andes shareholders.  The current merger terms are financially equivalent to Minera Andes shareholders selling 52% of their undervalued MNEAF shares and using the proceeds to buy overvalued UXG shares.  That does not sound like a good deal.

Furthermore, it is ridiculous that US Gold shareholder will be the owners of 52% of the combined company, McEwen Mining, and Minera Andes shareholder will be the minority participant with only 48%.  A simple look at the assets of each company will suggests that something is not right there.  

Overview of Minera Andes Assets

 49% of San Jose Mine
The San Jose mine is a high-grade epithermal Au-Ag system that currently produces 5.8m oz of Ag and 80k oz of Au per year.  At current metals prices the mine is producing an operating income of roughly $80m/yr on a 49% basis.

Estimate of 2011 year results

-- Silver Financials (per oz) ----
   $34 : Revenue
  ($14) : Production Expense
+($3) : Argentina Tax on Sales*
= $17 : Operating Income per Ag oz inclusive of non-cash depreciation expense

-- Gold Financials (per oz) ----
   $1600 : Revenue
  ($600) : Production Expense
+($170) : Argentina Tax on Sales*
= $830 : Operating Income per Au oz inclusive of non-cash depreciation expense

     *10% tax on concentrate & 5% tax on dore; being conservative, I am using the higher end of that range

On a 100% basis, San Jose will produce 5.8 m oz of Ag and 80 k oz of Au.

TOTAL OPERATING INCOME = $165m : ($830*0.08m + $17*5.8m)


----- San Jose Cash Flow (100% basis) -----
   $165m : Total Operating Income
   $35m : Non-cash depreciation Expense
+($50m) : Capital expenditure
= $150m : pre-tax Cash Flow

Minera Andes gets 49% or $74m in pre-tax cash flow

Using a conservative 7x pre-tax CF multiple, that would value 49% SJ at $520m

100% Owned Exploration Properties Adjacent to San Jose & Cerro Negro
Major land positions within the San Jose / Cerro Negro area.  Hochschild Mining (HOC), Minera Andes (MAI), Coeur d'Alene (CDE), and Goldcorp's land positions are noted.  Google Earth

To say this area has rich real estate is an understatement.  Not only is it adjacent to the rich San Jose mine with its dense high-grade epithermal vein network but to the south is the Cerro Negro property that Goldcorp purchased from Andean Resources for $3,600m in the fall of 2010.  Goldcorp's comments at that time were
Andean’s principal asset is the 100%-owned Cerro Negro gold project, an advanced-stage, high-grade vein system located in the Santa Cruz province of Argentina.  Comprising 215 square kilometers, Cerro Negro currently has reported indicated resources of 2.54 million ounces of gold and 23.56 million ounces of silver.  Inferred resources total 523,000 ounces of gold and 3.12 million ounces of silver1.  Cerro Negro also contains several other vein structures, including the Mariana Central zone, where numerous recent drill intercepts have demonstrated high-grade gold and silver over significant widths.
“This transaction adds another key asset to Goldcorp’s peer-leading growth profile and low-cost gold production pipeline,” said Chuck Jeannes, Goldcorp President and Chief Executive Officer. “Cerro Negro is a high-grade, near-surface system that is expected to generate significant gold production at low cash operating costs following a relatively short construction period.  A very exciting feature of the project is the opportunity for significant continued growth of gold resources through expansion of the existing deposits and the discovery of additional zones along the strike of the veins. As well, the potential exists for discoveries of new veins within this large, prospective land position. 
Now, a year later, the high-grade gold is 4.24m oz Proven & probable at a grade of 10g/t.   In fact, Goldcorp is so excited for the Cerro Negro deposit that they have created a video promoting its richness and continued growth potential.  

Satellite Map of Goldcorp's Cerro Negro land position.  Major vein systems are noted as well.

Nearly surrounding the Cerro Negro property is Minera Andes 100% owned exploration claims which are just now beginning to be explored.  For the past few years cash at Minera Andes has been very tight so much of the exploration work was put on hold.  But now, with San Jose up-and-running and cash-flow coming in, the second-act for Minera Andes on an exploration front is yet to come.  (Its first act was the discovery of the San Jose deposit)  Needless to say, both San Jose property and Minera's adjoining Cerro Negro adjacent properties have a great chance of making further exploration discoveries in this target rich real estate.

Los Azules Copper Project

Wide satellite image with an approximate outline of the entire Los Azules land position.

Land concessions in the Los Azules property. Escorpio IV, the property claim in dispute with TNR Gold, is in the blank space to the left of Escorpio II.  Source: Los Azules Technical Report 2010.

Close-up satellite image of the Los Azules copper deposit. Google Earth
Los Azules is a large copper project at the Preliminary Economic Assessment (PEA) level with a mineral resource of 12b lbs of Cu at a grade of 0.5% - 0.7%.   In the above analysis, I valued Los Azules at $0.015 per lbs of Cu which is inline with similar large copper projects.  However, as the deposit becomes more mature and reaches the full feasibility stage, that valuation has the potential to increase dramatically.  For a hint on possible upside valuation one can consider recent M&A activity of large copper deposits.  The chart below from a Candente Copper slide shows that the average valuation increases to about $0.07 per lbs of Cu for such deposits.  A recent data point not included below is the purchase of Peregrine Metals' 12b lbs Cu, 0.42% grade Altar deposit, for an implied price of $0.03-$0.04 per lbs Cu.   

*Sept 27, 2011- Percent of NPV= Acquisition Price / Net Present Value of the Project 's most advanced stage engineering study at $2.50 Copper (blue) and $2.25 copper (red) fixed; all using 8% discount rate and approx. equal Au Ag Mo price assumptions.

Assuming at buyout-price of 54% of NPV, as based on recent M&A activity (see above slide), than Los Azules could have a potential value around $790m.

One factor weighing on the Los Azules valuation is the pending litigation with TRN Gold regarding a couple claims.  1) The original claim regards their back-in right for 25% of the 50% Xtrata had of the project (thus 12.5%). 2) In their latest hail-marry claim, TNR contend that "Xstrata and Minera Andes did not complete the required exploration expenditure required for Xstrata's exercise option on April 23, 2007 to Properties" as per their May 16, 2011 press release.  However, TNR can claim anything they want but proving it in court will be another thing. I would contend the chance of them being successful in their new claim is low considering the facts.  On Sept. 6 2007 press release titled "Xstrata PLC Vests its interest in the Los Azules Property, Argentina" within which it states:
"To earn the 100% option, Xstrata agreed to cash payments totaling US$560,000 and incur exploration expenditures totaling US$1,000,000 by May 15, 2008. ... All cash payments due by May 15, 2008 have been received. All exploration expenditures have been incurred."
So basically they are contradicting themselves between then and now. Thus, it will be tough for them to make much of a case in court of why they took the money and said the obligations were fulfilled yet 4yrs later they comeback when things are not going their way and claim the obligations were not fulfilled. This is a TNR pressure bluff in my opinion.

Even TNR Gold shareholders are not convinced. Their shares trade at C$0.07 or a market-cap of C$10m. In fact, since the updated claim was presented their share price has been cut in half. It does not look like TNR Gold shareholders give them a high probability of winning either. The best case for TNR is they get some sort of compromise out of Minera Andes; but unfortunately for them that is not how Mr. McEwen seems to roll. 

As it regards the merger with US Gold, one can write down the Los Azules asset by 50% and still not get a share exchange ratio of 0.45 UXG shares per MNEAF share.

Other 100% Minera Andes Exploration Properties in Santa Cruz, Argentina

Satellite Map of Other 100% owned properties of Minera Andes within Santa Cruz.

 Martes Property:

Satellite Map with an approximate outline of Minera Andes' Martes Property.  Noted are the visible outcroppings.  Google Earth
Satellite Map showing Minera Andes' Martes Property relative to Argentex Mining's Pinguino property.  Noted are the visible outcroppings

Per Minera Andes website:
Martes - Located northwest of the Cerro Vanguardia mine and adjacent to Argentex Mining’s Pingüino property on the “Tranquillo Trend” that extends northwest from Cerro Vanguardia. Numerous outcrops of quartz veins with anomalous gold values at surface are present at Martes, and several geophysical anomalies have been identified indicating the possible presence of epithermal gold/silver veins typical of the region.

Celestina Property

Satellite Map with an approximate outline of Minera Andes' Celestina Property.  Noted are the visible outcroppings.  Google Earth

Per Minera Andes website:
Celestina - Located 40 kilometres southwest of AngloGold Ashanti's producing Cerro Vanguardia mine. Several northwest and northeast trending quartz veins have been identified at Celestina. Drilling in 2009 indicated the presence of a low-sulfidation epithermal mineralized system. Additional drilling is planned during the second half of 2011.

UPDATE : October 12, 2011 

Raymond James Hatchet-Job on Minera Andes Valuation

In delivering its positive fairness-opinion to the board of US Gold, Raymond James provides valuation analysis of both Minera Andes and US Gold.  Multiple valuation approaches were employed, as contained in the Preliminary Prospectus, and here I highlight my notes on three of those approaches: 1) Net-Asset-Value Approach, 2) Comparable Trading Approach, & 3) Comparable Transaction Approach, as they pertain to the valuation of Minera Andes.  All of them contained either blatant errors or questionable assumption in their valuation analysis.

Net Asset Value Approach: (mid case)
$408m : San Jose
$110m : Los Azules
$15m : Exploration properties
$21m : Corp. Adjustment
$554m or $1.94 per share

The first problem in the above is their NAV on Los Azules.  They perform a sensitivity analysis on LA's value with respect to Cu price and discount rate and they go on to say that they use 8% discount (which is the industry standard as seen in LA technical report and comparable company NAV valuations; see LA discussion above) and $2.45-$2.55 long-term copper price.  Looking at the table they provide, this would give a value for LA of $249m to $380m.  Yet in their NAV summary they put LA at $110m!  Where did that come from?  This is perhaps the most obvious error because they give the correct answer right there in the table so no further due diligence is required.  However, this is only the first of many errors that I have found.

UPDATE: If this single error is corrected and $314m is used as the value of Los Azules (as the RJ table suggests), the implied merger exchange ratio in the NAV Approach becomes 0.57.

Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source

Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source


My Question to US Gold:  In the NAV approach on Los Azules, using the assumptions that Raymond James stated, why is it that their sensitivity table says that LA is valued between $248.6m and $379.5m yet in the NAV summary, Raymond James has LA valued at between $87.0m and $132.8m?

ANSWER FROM US GOLD:  The sensitivity table refers to the NPV of the Los Azules Project – based on 100% ownership and unadjusted for trading value. The NPV is then adjusted according to what is stated in the Formal Valuation “Raymond James applied a risk adjusted developer multiple to Los Azules, in line with industry comparables, to reflect the current stage of development of the project, and also made additional adjustments to reflect the risks associated with the current litigation.”

    As a result, we adjusted the NPV by a multiple of 0.35x and the range becomes US$87-US$132.8M from US$248-US$375. There are essentially no copper development stage companies that trade at 1.0x NPV, and given the political, technical and litigation risk associated with this project the 0.35x multiple was merited.

My Follow up Question to US Gold:
In the Los Azules Technical Report page 144, assuming $2.50 copper prices and 8% discount, the NPV on the Los Azules project is stated to be $1,462m.  I understand that the project will not trade at 1.0 NPV or $1,462m but Raymond James has already included a risk adjusted developer multiple of 0.21x to get from $1,462m to $314m?  Why would they apply a further risk adjusted developer multiple of 0.35x to go from ~$314m to ~$110m?  The cumulative risk adjusted developers multiple applied to Los Azules comes to 0.075x of NPV yet the comparable transaction M&A has puts the cumulative risk adjusted developers multiple around 0.54x at time of M&A. Even in Raymond James comparable transactions approach they are valuing Los Azules at $375m or 0.256x of $1,426m.   Why was their no discount added to this number, $375m, which corresponds to 1.19x NAV (midcase) as stated in Raymond James sensitivity table?

If I assume the Los Azules project does not start for another 10yrs, we can discount the NPV(t=10) =$1460m backwards at 8% for 10yrs and get an PV(t=0)=$675m.  Then subtract out $20m per year in development costs for each intervening year and we get PV(development cost: t=0) = ($125m).  This brings the NPV(t=0) = $550.  Take a 45% discount to this number and we are in the ballpark of Raymond James' "NAV" numbers from their sensitivity table.  From their RJ adds even more discounts which go undocumented.  I do not know what assumptions RJ made but this is my process of thinking through possible scenarios.
Comparable Trading Approach (mid case)
$291m : San Jose
$176m : Los Azules (Valued at $0.017 / lbs Cu on 10.56b lbs Cu)
$15m : Exploration properties
$21m : Corp. Adjustment
$503m or $1.77 per share

The main problem here is the resource number they used for comparable companies of San Jose are largely incorrect.   For example, consider the comp, Endeavour Silver, and its stated resource of 167m oz Ag-eq and Market-Cap / Resource = $5.90/oz Ag-eq.  I was looking at the presentation slides of Golden Minerals and saw they were quoting Endeavour Silver as having a Market-Cap / Resource = $12.25 / oz Ag-eq (as seen in the figure below).  What is causing the 2x difference in MC / resource metric?  The data would suggest the problem lies in the denominator, i.e. Raymond James resource measure.

Going to Endeavour Silver's website and retrieving their resource (PP+MI+I) one would get 81m oz of Silver, 19m oz Ag-eq in GOLD (assuming 50 Ag/Au ratio), and 15m oz in Ag-eq in ZINC & LEAD (assuming 30lbs of Zn or Pb equals 1 oz Ag).  This gives a total of 115m oz in Ag-eq under the stated assumptions.  Also, it should be noted, of the 115m oz stated above, 15m oz Ag-eq are associated with two development stage projects, which truthfully should not be mixed with the resource that is in production.

So the question is how is it that Raymond James says there are 167m oz Ag-eq and I am only getting 100-115m oz Ag-eq and Golden Minerals is getting even less?

UPDATE: I have found yet another example substantiating that there is in fact a large discrepancy between the Raymond James resource numbers and those presented this time by Scorpio Mining (see figure below).  In fact, their numbers backup my resource calculation and further refute those presented by Raymond James.

There is a similar problem with the comp, Alexco Resources, and its stated Ag-eq resource.  Raymond James would like us to believe that it is 71m oz Ag-eq.  However, if you take Alexco's resource numbers net-of Silver Wheaton's 25% streaming interest you get 25m oz Ag-eq of SILVER (net of SLW off-take) and 19m oz Ag-eq of ZINC & LEAD (assuming 30lbs of Zn or Pb equals 1 oz Ag), for a TOTAL RESOURCE of 44m oz Ag-eq.

So yet again, Raymond James would like us to believe that Alexco has 71m oz Ag-eq yet they actually only have 44m oz Ag-eq.  And for argument sake, even if you were to take Alexco's GROSS-RESOURCE (i.e. inclusive of SLW's 25% silver-streaming interest), it would only be 52m oz Ag-eq; thus still far short of the 71m oz Ag-eq that Raymond James suggests.  UPDATE: The data presented in a Scorpio Mining slide, see figure below, further substantiates my resources number calculation for Alexco (inclusive of SLW off-take) and refutes that of Raymond James.

These inflated resource numbers are biasing the valuation on San Jose down by over 40%. In other words, if the real numbers had been used the valuation of San Jose would have been around $500m and NOT $291m like Raymond James would like us to believe.

Another thing, Alexco has 43% of its "silver-equivalent" as BASE METALS. It seems to me there should be a valuation premium for those mines (e.g. San Jose) where 100% of their production is PRECIOUS METALS. However, Raymond James has San Jose at a valuation discount to Alexco.

I have yet to look at the remaining five comps to see if similar discrepancies exist but either way, Raymond James has a lot of explaining to do.  UPDATE: Data presented in the Scorpio Mining slide below calls into question the resource numbers that Raymond James used for Majestic Silver.

UPDATE:  If the correct resources numbers had been used, the implied merger exchange ratio from the comparable trading approach would be in the range 0.62 - 0.66.

Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source
An example showing the large discrepancy between Raymond James' market cap / resource numbers and those presented by Golden Minerals in their slide presentation.

UPDATE: Here is another example further substantiating that there is a large discrepancy between Raymond James resource numbers and those presented by Scorpio Mining in their slide presentation.  As you can see, Scorpio Mining arrived at nearly the same resources numbers as myself for Endeavour Silver and Alexco Resources (inclusive of SLW off-take).  First Majestic numbers are also off.

Question to US GOLD:   In the Net Trading Approach for El Gallo, Raymond James uses Minco Silver as one of its comps and lists its resource as 174.7m oz Ag-eq. Working backwards to the stated amount of Silver, Gold, Lead, Zinc that Minco Silver has as resource we know that Raymond James was using the equivalency assumptions within 2% of the following: 1 oz Au = 50 oz Ag-eq, 30 lbs of Zn or Pb = 1 oz Ag-eq.

If you apply the same assumptions to the resource of Endeavour Silver, and Alexco (both comps used to value San Jose) one would get 115m oz Ag-eq (Endeavour Silver) and for Alexco, 52m oz Ag-eq (inclusive of SLW offtake) and 44m oz Ag-eq(exclusive of SLW offtake).

Yet, Raymond James states that Endeavour silver has 167.1m oz Ag-eq and Alexco has a resource 70.9m oz Ag-eq.
ANSWER FROM US GOLD: Endeavour Silver (and many of the other comparables) have several deposits from which the total resource was calculated, and within those deposits there are several commodities. We used the Raymond James LT commodity price assumptions for the purposes of calculating equivalency. It is possible that this person is using a different commodity price deck than we are and applying it across all of the comparables which result in differing values. Additionally, they may not be using all of the deposits or the same cut-off grade as we are. Lastly, we also value attributable ounces – applying the ownership of those resources over the resource estimate

    Sources for our work for the companies in question are:
    Minco: 2010 Annual Information Form - Resource Estimate Summary at a 40 g/t Silver Cutoff
    Endeavour: Endeavour Press Release March 8, 2011
    Alexco: Alexco Press Release July 27 2011.

So I redid my calculations using the sources provided by US Gold and arrived at essentially the same numbers as before which I have provided in the tables below.  Also, I had a long talk with Perry, Ian, and Simon. Basically management of US Gold will not comment specifically about the discrepancy between the Raymond James numbers and those that I have provided. All they can and are willing to do is pass the information along to the special committee. But the special committee is essentially a black hole in terms of reciprocating the communications. However, it seems Raymond James is sticking with their work and so is the special committee.

As far as I am concerned, Raymond James juiced the numbers on Alexco and Endeavour Silver above and beyond what the two companies themselves even proclaim to have under their own assumptions. If there truly was a legitimate reason for juicing the numbers as RJ did, they should tell the secret to Alexco and Endeavour Silver as it would significantly increase their valuations.

UPDATE: Upon communicating with US Gold, I was told to use the above sourced press-release from Endeavour Silver in my resource calculation. Yet the result still REFUTES Raymond James resource number.  Only if one uses a long-term price of $3.00 for Pb & Zn does the numbers make sense.  But such a price is unrealistic so it still does NOT MAKE SENSE.

UPDATE: Upon communicating with US Gold, I recalculated the Alexco resource.  Yet the result still REFUTES Raymond James resource number. Only if one uses a long-term price of $1.35 for Pb & Zn does the number match that of RJ.  But such a price is much higher than other comps use and well above the long-term moving avg.  Recently, Alexco had a long-term price of $0.85 which I have used here.


Another potential problem is their valuation of San Jose is based solely on EV/resource ratio which is an appropriate metric for open-pit mines where the resource is heavily drilled off but that is NOT the case for narrow-vein mining.(see below for details)  It seems to me a better suited metric for narrow vein mining is EV / Production which would produce a valuation ratio of the following:
  • Endeavour Silver : EV / Prod = $157 / oz Ag-eq :  ($706m / 4.5m oz Ag-eq)
  • Great Panther : EV / Prod = $124 / oz Ag-eq :  ($323m / 2.6m oz Ag-eq)
  • Hecla Mining : EV / Prod = $113 / oz Ag-eq : ($1250m / 11m oz Ag-eq)
  • Alexco : EV / Prod = $153 / oz Ag-eq : ($382m / 2.5m oz Ag-eq)
  • Excellon : EV / Prod = $79 / oz Ag-eq : ($138m / 1.75m oz Ag-eq)
Average : $125 / oz Ag-eq

      Note: Here the EV are based on share-prices as of Oct. 12, 2011 which are lower than those used by Raymond James due to the recent sharp decrease in all their share prices.  Yet, even with this downward bias, the valuation implied from my avg. EV / Prod. is still higher than that arrived at by Raymond James method of EV / resource.

 This implies a valuation for SJ of $544m : ($125/oz Ag-eq * 4.35m oz Ag-eq)

UPDATE: If this valuation were used for San Jose, $544m, and all other valuations from the comparable trading approach remained the same, the implied merger exchange ratio from this approach would increase to ~0.70.

Here is an article from Medusa Mining explaining the nature of narrow vein mining and why basing the valuation on reserves & resources may NOT be the most appropriate.

Explanation of the nature of Narrow Vein Mining
by Medusa Mining

 "As a generalization, many narrow vein mines do not have long life reserves, but in general have significant resource bases. This applies not only to narrow vein gold mines, but also to silver and tin narrow vein mines, diamond fissure mines, base metal narrow vein mines, and others.

Narrow veins are challenging to evaluate because of their geologically variable nature. They are generally less than 3 metres wide, discordant, of variable dip (<30 to 90º) and display complex structure and paragenesis (the sequence of formation). A high degree of grade and geometrical discontinuity is generally observed which makes it difficult to assess their shape and reserves from drill data alone. There is thus a need for expensive underground development and in-fill drilling typically on 25 metre centres or less.

Hence many operators of narrow vein mines use drilling to initially locate the veins and to estimate Inferred Resources, but use underground development along the veins to raise the category of the resource to Indicated (and maybe Measured) as the level of confidence in the resource interpretations increases.

There is a limit to the amount of development that can be done in a period (drilling and blasting advance is limited each time the process is repeated), and to the cost effectiveness of doing this work beyond the amount required to maintain planned production levels, i.e., to use massive development programmes just to define large resources which will not be mined for many years.

A well known Australian example of long lived narrow vein gold mine is the Norseman Mine in Western Australia which has been in almost continuous operation for some 70 years but is understood to have rarely had more than 2 years reserve life. A well known United Kingdom example is the South Crofty Tin Mine in Cornwall."
As we can see here, the real operating life of a epithermal-low-sulphidation vein system, like that of San Jose mine, typically greatly exceeds the reported life of mine (LOM) based on measured reserves & resources.  Source: Hochschild Presentation Oct. 2010

Comparable Transactions Approach (mid case)
$158m : San Jose  (What!!!)
$375m : Los Azules (valued 10.6b lbs-Cu at $0.036 / lbs-Cu )
$15m : Exploration Properties
$21m : Corp. Adjustment
$569m or $2.00 per share

Seriously!  The comparable transaction (i.e. previous buyouts of comparable companies) values SJ at $158m!  If one believes this, based on the estimated $74m (see above content in thread) of 2011 pre-tax CF from 49% San Jose, then the Raymond James valuation would imply a pre-tax CF multiple of 2x.  That is ridiculous!  So where did they go wrong?  The answer can be found in the comparable transactions they used.  According to the report, "The transactions considered by Raymond James in determining a value for San Jose were the same as those reviewed for El Gallo."  And "the transactions considered by Raymond James for determining a value for El Gallo were as follows:"

    1) Hecla Mining - Greens Creek (2008)
    2) Bear Creek Mining - Corani (2008)
    3) Aurcana - Shafter (2008)
    4) Silvercorp - Gaocheng (2008)
    5) Polymetals MNPO - Goltsovoye (2008)
    6) Excellon Resources - Miguel Auza (2009)
    7) First Majestic Silver - Real de Catorce (2009)
    8) Pan American Silver - Navidad (2009)
    9) Silvercorp Metals - Silvertip (2010)
    10) Tahoe Resources - Escobal (2010)

There are a number of obvious problems with this.
  1. Nearly all of these comps are for development stage projects and NOT for producing mines like San Jose.  So in the truest sense, they are not even good comps.
  2. The comps presented represent old, dated transactions with about half from 2008 (back when Silver's 52wk moving avg. price was $15/oz compared to $35/oz now) which would tend to undervalue both El Gallo and San Jose since the same comps are used for both.
  3. Absolutely the most surprising aspect is which comp Raymond James did not include when valuing SJ.  The most appropriate and important comp, the $3,600m buyout of Andean Resources by Goldcorp in 2010, a property with its major vein system less than 15mi from the San Jose mine, was NOT EVEN INCLUDED!  Not only should it be included but it should have received amongst the highest weighting considering how comparable it is.

And again in this case they are using EV / Resources as their only metric which I guess is all they can use since nearly all these comps are non-producing.  Basically, bad comps leads to bad valuation method, which means bad data in, bad data out.  Using these comps and value method are fine for El Gallo, Gold Bar, Limo, which are all non-producing, open-pit deposit, but NOT for SJ as I outline above.  To show further how ridiculous Raymond James valuation analysis is, they are using $3,600m buy out of Andean Resources (a high grade underground gold silver deposit) as a comp for Gold Bar & Limo (which are low-grade, open-pit deposits).  And using these wacky comps they figure that Gold Bar & Limo are collectively valued at $265m ($205 per oz Au) while the flag-ship El Gallo project only gets a value of $131m.  For El Gallo, it is the dated transactions that skew the results low.

Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source

UPDATE: Valuation Summary of US Gold (Oct. 22, 2011)
Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source

The blue dots plot the four valuation approaches used by Raymond James and the blue-line is the average of those blue dots.  The red- and green-lines are the high & low of the valuation range RJ assigns as the "fair market value" of US Gold.  Clearly, RJ biased this range towards the higher end of its valuation approaches.

UPDATE: Valuation Summary of Minera Andes (Oct. 22, 2011)

Raymond James valuation analysis from the US Gold Preliminary Prospectus. Source
The blue dots plot the four valuation approaches used by Raymond James and the blue-line is the average of those blue dots.  The red- and green-lines are the high & low of the valuation range RJ assigns as the "fair market value" of Minera Andes.  Clearly, RJ biased this range towards the lower end of its valuation approaches.

As you can see in the table and figures above , Raymond James puts a negative bias to the "fair market-value" range it assigns to Minera Andes.  This amounts to NEGATIVE 5% valuation bias for Minera Andes which is the percent difference between the high-low midpoint valuation ($2.00) and the average of the four valuation approaches ($2.11).  Also you can notice that the LOW end of the valuation range, $1.75, is even lower than any of the four valuation-approaches would suggest.

On the other hand, Raymond James puts a positive bias to the "fair market-value" range it assigns to US Gold.  This amounts to POSITIVE 4% valuation bias for US Gold which is the percent difference between the high-low midpoint valuation ($4.75) and the average of the four valuation methods ($4.55).

Although subtler and perhaps less significant, this is yet another example of Raymond James biasing the valuation of US Gold higher while doing the exact opposite for Minera Andes.

UPDATE: Raymond James Gold Bar Valuation Overvalues Project by 340% (Nov. 29, 2011)
Net Asset Value sensitivity table as computed by Raymond James for US Gold's Gold Bar project.  They figure that NPV 8% discount is $160.2m at $1200 gold. Source
The pre-feasibility study on Gold Bar was released on Nov. 28, 2011 and indicates an NPV 8% discount of $36.4m at $1200 gold. Source


Based on all the above blatant errors, questionable assumptions, and in general, negatively biasing the valuation of Minera Andes, it would seem Raymond James was more interested in delivering a valuation analysis in the ballpark of 0.45, (i.e. a low buyout premium), than doing an honest valuation of Minera Andes. If the blatant errors are corrected the implied exchange ratio will increase.


The reasons I think why Mr. McEwen is pushing for these low-ball terms are as follows:

1)  Simply he thinks he can.  He is probably thinking if the markets does not want to recognize the intrinsic value for Minera why should he pay up for it.

2) Financially, Mr. McEwen will not be harmed much by a low exchange ratio because of his US Gold holdings buffer much of his loss on the Minera side. For example, Mr. McEwen owns 86m shares of MNEAF and 29m shares of UXG which under the present terms, 0.45 exchange ratio, would mean he will own 25.3% of the merged company, McEwen Mining. If more favorable terms were presented, such as a 0.8 exchange ratio (as I have considered), Mr. McEwen would own 26.6% of the merged company. Thus, it is plain to see why McEwen will be indifferent to whether the exchange ratio is 0.45 or 0.8 because it changes his ownership by only 5.1% (= 0.266/0.253 - 1).  

However, if Mr. McEwen were to only own MNEAF shares the difference between a 0.45 and 0.8 exchange ratio would be 28% increase in his ownership in McEwen Mining. (A nearly 6x relative difference) 

3)  Since US Gold will be the surviving company, I can see him wanting to give it the maximum benefit. Mr. McEwen wants to create another Goldcorp, particularly in its younger days when it grew at a 30%+ rate of return annually. One way to help deliver on that is to buy assets well below intrinsic value which is exactly what he is doing with Minera Andes. That is great for US Gold shareholders but bad for us if we let it happen.

Disclaimer:  All efforts were made by myself to present accurate data and facts but like anyone, I can make mistakes.  If you find any factual error, please let me know and I will make the necessary corrections. As for my opinions, well, they are just one person's opinion so take them as that.

    About Me

    Los Angeles, California, United States
    Chris Rutherglen is a scientist and engineer by profession and pursues financial & investment analysis on the side. In 2011, he completed lever 3 of the CFA program.