Medusa Mining - A golden opportunity?

Friday, 8th June 2012 10:20 - by David Harbage

Following on from our review of Commodities... ...as a potential asset class for long term savings on 29 May, and the stock exchange listed Mining sector on 1 June, we wish to highlight a particular company to illustrate the investment opportunity and associated risks. Historically, driven by its beauty and scarcity, gold has always appealed to consumers, while representing a source of value to traders and investors. Although a gold standard that dictated monetary worth, via a link between coins and currency in circulation, effectively broke down in the western world in 1914 (as governments sought to fund WW1), gold retains its ancient appeal as an international source of value. Increasing the supply of paper and coins in issue must logically devalue the purchasing power and worth of such monetary currency, as and when inflation inevitably catches up and impacts. Since November 2008, US and European central banks initiated successive bouts of quantitative easing - essentially increasing money supply - as a means of stimulating economic activity, and countering the threat of recession. The price of gold (and silver too, for that matter) has more than doubled since QE began, as global investors increasingly adopted the limited supply precious metal as an alternative currency. Allied to divergent underlying economic performance - sluggish developed, versus robust emerging nations - the prospect of wealth and financial power moving from the western world to the eastern hemisphere increases. And, as intimated in our earlier blog on commodities, it is countries like India, amongst others in Asia, who represent the biggest consumers of gold. The demand for gold also rose - as central banks became net purchasers in 2010, after two decades of being net sellers, increasing again last year - and exceeds mined supply by a factor of almost two. If investors subscribe to the view that current economic conditions, and a polarised pace of geographic growth in favour of Asia, is likely to continue in the foreseeable future, then precious minerals - and gold in particular - are likely to retain their appeal. One can invest in gold or silver, to capture any further appreciation in the metals' worth, or seek an alternative by owning the producing mines. The former can be accomplished by acquiring coins, bullion or stock exchange traded funds; the latter can also be achieved via ETFs (such as the i share which follows the S&P Commodity Producers Gold index), or by considering individual gold mines such as the FTSE100 index constituent Randgold Resources. However, having made the case for gold, over the remainder of this article we wish to introduce you to a medium sized gold miner: Medusa Mining (MML). Based in Australia, but since 2006 solely focused on mining in the Philippines (a relatively low risk location from a political and business perspective), MML is a constituent of the MSCI Australia 200 index as well as having a secondary full listing on the London stock exchange. The company, which has grown rapidly over the past five years, has ambitious plans to expand gold production from 101,474 ounces in the year to 30 June 2011 to 400,000 by 2016, on a self-funded basis. The writer calculates the latter by reference to a US$71m cash balance as at 31 March 2012 (no debt), and a conservative estimate of US$100m per annum net profit generation. One of the lowest cost producers in the world (US$189 per oz last year), MML is profitable (US$105.6m in year to 30 June 2011, equating to $0.587 cents earnings per share, and a trailing Price Earnings ratio of 10x current 360p share price), has no immediate tax liabilities, pays a dividend (A$0.10 cents) and possesses a market capitalisation of £700m. The prospect of taking a stake in an apparently successful owner of a producing gold mine, and the developer of another potentially rich resource, has appeal beyond the gold price. In particular it extends to an expectation that the pace of profit growth - and, in due course, dividends - will exceed that of the gold price, as operational efficiencies apply (unit costs fall and profit margins rise). However seemingly benign the outlook (for the price of gold), investors must never become complacent to risks of various sorts, known and unanticipated, operational or otherwise. While MML management have a conceptual exploration target of between 3 and 7 million ozs of gold for its core Co-O mine, and for production of its second mine Bananghilig to catch up (via 200,000 ozs production) with Co-O in 2016, the nature of the industry features natural difficulty in assessing reserves (from inferred to indicated to proven) and is for budgeted costs to escalate. In the case of risks to MML, the past six months has witnessed two particular natural events: a typhoon in December closed the road between the Co-O mine and mill, and an earthquake in February caused four leach tanks (in the process of being replaced) to tilt. The exceptional rain, described locally as a �once in a lifetime� event, did not affect the mine, but had an adverse impact on production in 2012 as a consequence. This shortfall was in addition to a planned and well-flagged reduction emanating from a focus on developing new veins within the Co-O mine. The market now expects MML�s current year (to 30 June 2012) production to fall to 65,000 ozs, costs to rise to US$250 per ounce, and resultant profits to be in the region of US$60m. The extensive drilling at Co-O should ease by the end of 2012 and production ramp up, to meet medium term milestones � of 120,000ozs, at a cost of US$210 per oz, in the year to June 2013 and 200,000ozs, at US$200, in the year to June 2014 � before Bananghilig comes on stream. This operation is likely to incur start-up costs of circa US$200m and to extract 200,000ozs of gold, albeit at a higher cost of US$550, in the year to June 2016 (and for the following five years, at the least, it is hoped). MML�s development is also subject to gaining the necessary government licence (which may be slowed as the authorities assess new applications, as well as address illegal miners who have little regard for the environment). In particular, permits are required for Bananghilig and for the expansion of Co-O. By the end of 2013 the company should have these approvals, along with greater visibility on the fiscal outlook - which may feature higher royalty payments (an increase from 3% to 5% would add US$50 per ounce to costs), eased by a new four year tax holiday. Subject to the above mentioned significant unknowns, MML appears set to produce profits of US$140m & US$190m - based on a gold price of US$1,630 per ounce - equating to earnings per share of US$0.75cents & US$1 in the years to 30 June 2013 & 2014. This puts MML stock on a forward looking PE multiple of 8x for June 2013, and 5.7x prospective earnings in the year to June 2014. This is a significant discount to larger peers: for example, lower yielding, owner of several gold mines in Africa, Randgold Resources is currently valued on forward looking PE multiples of 16.2x & 13.4x for calendar years 2012 & 2013 respectively. MML is also developing seven copper resources and, post an extensive drilling programme over the next year, plan to release this value via a trade sale (there are a number of cash-rich high profile miners operating in the Philippines). After trading above US$1,800 per ounce in November last year, the price of gold has eased back in 2012. In similar vein, but exaggerated in magnitude, the price of listed gold mining companies fell sharply - partly in response to company specific bad news, but also to an appreciation that they are equity investments which necessarily carry market risk. At the same time, the well-publicised travails of the Euro currency has prompted some restoration in the perceived worth of the US dollar as a safe haven. As ever, investors should carry out their own analysis of individual companies - many of whom feature high levels of risk-reward - and will no doubt bring their own intuition and perception to the global macro events that will influence the worth of precious metals. The writer concludes by declaring his own concerns about stagnant developed economies - such as the UK, Europe or the US - and considers that an element of diversification, into less economically sensitive types of investment, have appeal including businesses like MML which own scarce assets such as gold or silver.