Junior-Gold Confidence Crisis

Gold’s miserable 2013 has been devastating for gold stocks.  This sector, arguably the best performing over the 2000s, has quickly become the pariah of the markets.  And no group of gold stocks has seen more carnage than the junior explorers.

Descriptive of their name, junior gold explorers are small mining companies that explore for gold.  And within this sub-sector is a wide spectrum of exploration stages, from early-stage to advanced-stage.

Early-stagers are either in the process of looking for a gold deposit, or are in the beginning stages of delineating one.  In some cases they’ve moved to resource definition, but any inventory estimates are still rough due to their deposits not yet seeing enough drill holes.  Resources would be categorized as “in-house” or “inferred” (as measured by NI 43-101 standards), and they’re nowhere near reliable enough to build an operating and/or economic model.

Advanced-stage junior gold explorers already have gold deposits.  And these deposits have seen enough drill holes to give a greater confidence in their depth/breadth and resource estimates.  In this stage resources are categorized as measured and/or indicated, and in some cases proven and/or probable reserves.

Advanced-stagers on the far end of the spectrum are in the process of or have completed various stages of feasibility studies.  And the most advanced are ones that have completed positive preliminary economic assessments and prefeasibility studies to feed a final definitive feasibility study.

DFSs definitively outline the economic reserves contained within a deposit.  And the operator has performed enough design/engineering work to map out such features as process flow, development costs, timelines, and even the NPV, IRR, and capex payback period of a vertically-integrated mining operation.

Common to all junior gold explorers though, regardless of their stage, is that they don’t generate any revenue.  They may be indispensable in the gold ecosystem, but since they don’t spin out cash these hyper-risky companies are typically the first that investors will abandon when things turn sour in the gold market.

I recently took a look at how the juniors have fared amidst gold’s bloodbath via the popular GDXJ Junior Gold Miners ETF.  And there’s no sugarcoating it, it’s been ugly.  GDXJ was down 68% from its September 2012 high to its June 2013 low, and a staggering 81% from its 2011 all-time high.

GDXJ is a great proxy for the junior-gold sector as a whole.  But since it includes producers (two-thirds of GDXJ’s components are junior-level producers), it doesn’t necessarily offer the essence of the more speculative explorer-only class.  With that in mind I decided to drill down another level to look at a vehicle specifically designed to encapsulate this class, the GLDX Gold Explorers ETF.

With only about $38m in assets, GLDX certainly hasn’t gained the popularity that fund manager Global X had envisioned.  And this is largely attributable to the timing of its inception in November 2010.

Unfortunately it was around that time that gold stocks started disconnecting from gold, really missing the major upleg that lifted the metal to its August 2011 all-time high.  Global X had no way of predicting this disconnect and the subsequent multi-year carnage that would stifle gold stocks, and sadly it’s watched its ETF trend down ever since inception.  And speaking of trending down, its performance is nearly identical to GDXJ’s (down 69% from September 2012 to its June low, and 84% from its 2010 apex).

Even though it’s hard to get much worse than the colossal 80%+ haircuts that both of these ETFs experienced, this performance parallel was actually quite surprising to me.  I figured they’d be close considering investors’ across-the-board selling of the entire junior sector.  But I would have expected GDXJ’s producer-heavy portfolio to hold up a little better than GLDX’s higher-risk exploration-only portfolio.

This anomaly prompted me to take a closer look at GLDX’s makeup.  And I didn’t need to go any farther than the description of its mirrored index (Solactive Global Gold Explorers Index) to get a reasonable explanation.  It is designed to track the performance of the largest and most-liquid listed companies active in the exploration for gold.

Of all the junior gold exploration stocks, the ones that will get sold off least aggressively ought to be those with the biggest and most advanced projects.  These companies have assets with value, and they also tend to have the sturdiest balance sheets in their sector.  So as indicated by the recent lockstep performances of these two ETFs, GLDX’s explorers can indeed hold a candle to GDXJ’s producer/explorer mix.

As for GLDX’s components (20 stocks, 19 of which trade in the US and Canada) some are a surprise, but many are ones I would have expected.  Most own advanced-stage projects with significant resources and positive feasibility studies.  And most have strong balance sheets relative to their junior-explorer peers.

In looking at this component list knowing how sharply these stocks have sold off, I couldn’t help but wonder what kind of value investors place in these companies today.  With sentiment so bad across the entire gold complex, are the markets even taking seriously the next-generation gold mines that these juniors are pushing towards development?

Value is of course a whole different ballgame for junior gold explorers.  Since they don’t generate revenue, and thus have no earnings and pay no dividends, they are certainly not value stocks per se.  So we need to view different angles to gauge their value.

A junior gold explorer’s primary asset is the gold mineralization contained in the bowels of a piece of land it controls.  And this mineralization is measured in ounces of resources.  So the first thing I wanted to look at as a possible measure of value was GLDX’s resource base.

Each of the 20 companies that comprise GLDX holds resources, some obviously more than others.  And they collectively add up to a whopping 342m ounces in all categories.  If I go by simple average, this works out to around 17m ounces of resources per company.

By definition a mineral resource is “a concentration or occurrence of material of intrinsic economic interest in or on the earth’s crust in such form, quality, and quantity that there are reasonable prospects for eventual economic extraction”.  Regardless of the confidence of these resources (inferred, M&I, reserves), the miners believe they have some chance of getting mined.

Using $1200 gold, the average GLDX company holds an inventory worth $20.4b at face value!  In-ground resources at face value is of course an unrealistic way to measure these companies’ worths.  Not only will a portion of this gold end up proving uneconomic (due to such factors as price, grade, and ore complexity), we must take into account the fact that it actually costs money to get it from rock to ingot.

So let’s be conservative and say that only one-quarter of these resources (4.25m ounces) will ever be economically feasible to mine at $1200 gold.  Let’s also say that all-in costs to mine these ounces comes to $1000, which would leave $200 of margin for the miners.  $200 on 4.25m ounces would translate to profit potential of $850m.

I realize this is a crude measure, but GLDX’s component stocks do in fact have the resource strength to back this up.  Well over a quarter of its collective resource base has been proven up to economic reserves.  And more drilling in the lower-category resources has led and will lead to more upgrades.

This proving up is a product of feasibility work.  And as it turns out 16 of GLDX’s 20 components have completed some form of feasibility study on their flagship project.  In order to wrap my mind around the scope of operations that this group offers to the markets, I catalogued these studies’ key data.  And interestingly the average Net Present Value (at a 5% discount rate) of these future mines is an impressive $1.3b.

Critical to NPV is of course the base case gold prices that were used to run the studies.  While $1.3b absolute is impressive, it wouldn’t look so good if I told you it was the product of studies that used $1800 gold.  Thankfully the average base case of these 16 studies was just $1334.  There’s definitely value in the mines these juniors are interested in building!

So with robust in-ground resources and positive project NPVs, on balance these junior explorers should still hold significant value even if gold was to stay where it is today.  And with higher gold prices, which I believe is inevitable, the NPVs would obviously scale much higher.

Unfortunately GLDX’s performance alone leads one to believe these stocks are radically undervalued.  Those of us who’ve owned junior explorers snort the stench of this rotten undervalued state every time we log in to our trading accounts.  But I had no idea how bad it really was until I took a closer look at the sector elites portrayed by GLDX.

Amazingly as of this week (which mind you is on the heels of a healthy 25% rally off GLDX’s June low) the average market capitalization of these stocks was a pitiful $289m.  In aggregate this values GLDX’s resources at $17/ounce.  If only one-tenth the resources were truly mineable, they’d still only be valued at $169/ounce.

To make matters worse, these resources value even lower when you extract these companies’ cash positions.  You wouldn’t think this would be a material factor, but with these stocks selling off so hard their cash as a proportion of market cap is enormous.

As of their Q1 filings, GLDX’s components carry an average of $83m in cash on their balance sheets, which represents a whopping 29% of their value.  This places the fundamental, or intrinsic, value of multi-million-ounce billion-dollar-plus-NPV projects at a paltry $206m.

The markets are affixing so little value to these resources and their mining prospectivity it’s pitiful.  Investors are literally banking on the notion that there is little to no chance of these deposits ever being developed into a mining operation.  At present time there’s a huge crisis of confidence in junior gold explorers.

Interestingly one thing that really scares off investors is the pre-production capex required to build some of these mines.  And this is particularly applicable to many of the big juniors that comprise GLDX.

Given an average capex of $1.8b, there are some big mines being proposed among the GLDX 20.  And none are bigger than four topside outliers that have capexes that exceed $4b.  Unfortunately given today’s challenging financing environment investors have a valid concern in being scared of these mega mines, especially if the company trying to raise the funds has a sub-$1b market cap.  Dazzling economics doesn’t always equate to a blank check.

Mega mine or not, junior-explorer valuations are at epic extreme lows.  Now if gold’s bull is in fact over, then these low valuations would be justified since most of these resources would never see the light of day.  But if gold’s bull is not over, which is what I believe the case to be, then value must find its way back into these projects once gold regains its legs.

Battle-hardened contrarians who can overcome this sector’s confidence crisis have the opportunity to make legendary gains by buying into these undervalued projects.  And I’m of the firm belief that investors are best off skillfully hand-picking high-potential juniors.  Indeed several of GLDX’s components are ones I would pick.  But there are many others outside this ETF that are well-positioned to survive the storm and thrive once conditions improve.

At Zeal we specialize in researching junior explorers, finding those nuggets that fall outside the realm of a conditions-based index.  This research involves exhaustive studies of the universe of gold and silver stocks trading in the US in Canada.  And it culminates in the identification of high-potential companies that we fundamentally profile in our popular reports.

Interestingly two-thirds of the juniors that comprise GLDX are former Zeal favorites that we’ve profiled in past reports, some well before they achieved mega status.  If you’re interested in finding out about our latest batch of favorites, buy our newest report today!

At Zeal we’ve been aggressively recommending gold stocks, including juniors, in our acclaimed weekly and monthly newsletters.  In them we explain why we’re due for what should be one of the biggest gold rallies ever seen.  And this will lead to a crazy-sharp reversion to the mean for the hated gold stocks.  For expert contrarian analysis and stock recommendations, get your subscription today!

The bottom line is non-producing junior explorers tend to be on the bottom of the gold-stock totem pole.  These hyper-risky stocks are essential in the gold ecosystem and can be very profitable for investors.  But when gold turns decisively to the downside, they are first in line to take a beating.

And boy have the junior explorers taken it on the chin.  Even the advanced-stage GLDX component stocks have been decimated.  This carnage has ultimately spawned a huge crisis of confidence in the explorer class.  And this is readily apparent by the absurdly-low values the markets are giving these stocks.  Contrarians who are betting that value will return ought to be rewarded greatly.

Scott Wright

August 2, 2013

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