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$TPRFD - $GCM.TO - Gran Colombia's Recent Sell Down Creates A Speculative Buy With Significant Upside

http://seekingalpha.com/article/1519972-gran-colombia-s-recent-sell-down-creates-a-speculative-buy-with-significant-upside?source=email_investing_ideas&ifp=0

I last wrote on Canadian domiciled gold miner Gran Colombia (TPRFD.PK) in February of this year and concluded that while the company was under-valued by 56% it constituted a high risk speculative investment. Since that time the value of gold has fallen precipitously to be down by 19% to be $1,283.95 per ounce at the time of writing. This significant drop in the gold price is contrary to the bullish forecasts of many analysts and has had a significant impact on the profitability of micro and small-cap gold miners. The reason for this significant impact is the high operating and production costs of smaller gold miners such as Gran Colombia.

Investment case summary

Since that article Gran Colombia has seen its share price plunge by 63% to new lows, which on a pre-consolidation basis give it a new 52-week low of only $0.07, or $1.81 post-consolidation. I believe that this sell down has created a deep value investment opportunity for the risk-tolerant speculative long-term investor. This opportunity exists because market sentiment has turned against high cost small-cap gold producers operating in what are perceived to be high risk economic and political environments such as Colombia.

Furthermore, I believe that while it still represents a speculative play with its profitability significantly exposed to the volatile gold price, investors have failed to take into account the company's strengths. These include growing production and falling costs on the back of aggressive mine development and cost cutting plans and an exploration program that is set to build the company's reserves.

All of these factors along with Gran Colombia's already substantial measured and indicated reserves of 12 million ounces of gold, make it an attractive deep value investment proposition with the potential to double in value over the short to medium term. In this article I will examine each of these factors in depth and explain why this opportunity exists.

Key recent events

Gran Colombia still remains the largest gold miner in Colombia with its key mining and exploration operations located at Segovia and Marmato in the departments of Antioquia and Caldas respectively, as illustrated by the map below.

Source: Gran Colombia Gold Corporate Presentation - January 2013.

On June 14, 2013 the company consolidated its common shares outstanding on a one-for-twenty-five basis, reducing the number of common shares outstanding to 15,279,936 from 381,984,916 on a pre-consolidation basis. However, despite this consolidation Gran Colombia's share price has continued to fall to be down by 78% for the year-to-date to be trading at around $2.13 on a post-consolidation basis, or $0.09 on a pre-consolidation basis.

Costs continue to fall

During the first quarter 2013 the company commenced a comprehensive review to identify the areas where it could implement $12 million in costs savings in order to reduce both its operating and production costs. This resulted in $850,000 per month of savings which commenced in February of this year, with almost 82% of those cost savings directly relating to operating costs at its flagship Segovia Operations. The remainder of those cost savings were made in the area of general and administrative spending.

As a result for the first quarter 2013 the company's average total cash cost per ounce fell by almost 7% QoQ to $1,281 per ounce of gold as the chart below illustrates.

(click to enlarge)

Source data: Gran Colombia Financial Filings 1Q12 to 1Q13.

This is a significant reduction and goes some way to mitigating one of the key risks identified in my last article. Furthermore, as at the end of March 2013 the average total cash cost per ounce at Gran Colombia's Segovia operations had fallen to $1,164 per ounce, which is a further 11% reduction in comparison to the average for the first quarter 2013. I would also expect to see this average cash cost per ounce being maintained throughout the remainder of 2013 if the company is able to avoid any further unforeseen events that impact production.

Despite this reduction in average cash cost per ounce Gran Colombia still has a particularly high cost of goods sold (COGS) to revenue ratio, which as the chart below illustrates is one of the highest among its peers at 89%.

(click to enlarge)

Source data: Gran Colombia Financial Filings 1Q12 to 1Q13.

However, I am expecting this ratio to improve as the company boosts revenue through increased production while reducing the overall costs associated with its operations and in particular its Segovia operations. A significant driver that will reduce Gran Colombia's COGS will be the completion of the Pampa Verde project in Segovia, discussed in the section on exploration and development, which is scheduled for completion in the latter half of 2014. A key aspect of this project is to establish sufficient infrastructure for Gran Colombia to be able to reduce its average total cash costs per ounce to around $800 to $900.

Accordingly, I am expecting Gran Colombia's total cash costs per ounce to continue to fall, with the company having already embarked on another cost reduction program in May 2013 aimed at further reducing the operating costs at its Segovia operations by $500,000. This decrease in costs along with those expected during the second quarter 2013 bodes well for increased profitability especially in an environment where the gold price is declining.

However, at this time with the outlook for the price of gold being volatile and uncertain, the company needs to reduce costs further if it is to remain profitable. The high cost of production, combined with this uncertain outlook for the price of gold I believe has been one of the key drivers of the recent sell-down of Gran Colombia's stock.

Production continues to grow

Another pleasing aspect of Gran Colombia's first quarter results is that total gold production continued to grow up by 10% QoQ to 23,450 ounces for that period as the chart below illustrates.

(click to enlarge)

Source data: Gran Colombia Financial Filings 1Q12 to 1Q13.

This increase in production was primarily driven by a 13% increase in production at the company's Segovia operations with milling output at the Dama Maria plant at Segovia stabilizing. As a result the company is on track to meet its 2013 production target of 110,000 ounces of gold, which is 9% higher than its total gold production for 2012 of 100,895 ounces. But investors should note that while production has continued to grow, it has fallen by 7% YoY, primarily due to the ongoing decline in ore grades at the company's flagship Segovia operations.

In a recent press release Gran Colombia stated that production at Segovia in April and May increased by 11% in comparison to the first quarter 2013 to a record high of 235 ounces per day. This indicates that the mine development program is already paying dividends for the company and bodes well for further increased production, which will offset the fall in the gold price.

Ore grades remain in decline

A key concern for investors is that Gran Colombia's ore grades have continued to decline at its flagship Segovia operations, which is responsible for 78% of the company's production. The head grade of the gold ore extracted has continued to fall, with the head grade down by 11 grams per ton in the first quarter, but the recovery rate has increased by almost 7% QoQ to be 83%, although this is still 13% lower YoY, as the chart below illustrates.

(click to enlarge)

Source data: Gran Colombia Financial Filings 1Q12 to 1Q13.

This issue is currently being dealt with by way of a mine development program at Segovia and it is expected that head grades will start to improve by the end of the second quarter 2013. But despite this program, there is no guarantee that head grades will increase significantly once the program is complete. This in itself does not bode well for any substantial increase in head grades and indicates that grades in the future may continue to fall as the operation moves closer to depletion point.

The outlook for the price of gold is volatile potentially making high cost producers unprofitable

At the time of writing gold is trading at $1,350 per ounce which is almost 25% below its 52-week high of $1,792 reached in December 2012. Furthermore, the outlook for gold remains relatively pessimistic with it expected to have an average price per ounce during 2013 of $1,400, which will fall to $1,300 in 2014. This significant fall in the price of gold will impact the profitability of gold miners and in particular those high costs operators such as Gran Colombia.

But investors should be aware that as the chart below illustrates Gran Colombia is a particularly high cost operator in comparison to its peers, with an average total cash cost per ounce of $1,281 in the first quarter 2013. This is more than 39% higher than Barrick Gold (ABX) and more than double Buenaventura (BVN) and New Gold (NGD).

(click to enlarge)

Source data: Gran Colombia, Barrick Gold, Buenaventura and New Gold Financial Filings 1Q13.

Furthermore, with the gold price continuing to fall and the outlook less than optimistic I do not believe that Gran Colombia's current production is sustainable on total cash cost basis unless there is a significant reduction in the average cash cost per ounce to under $1,000.

Financial performance is improving

Gran Colombia's financial performance for some time now has been in decline with the company having reported a net loss for the three quarters prior to the first quarter 2013. These losses have been predominantly driven by issues relating to costs, exploration and development expenses and fair value adjustments. For the first quarter 2013 despite revenue remaining flat QoQ and falling by 12% YoY, the company saw its net income increase significantly both in comparison to the previous quarter and the equivalent period in the previous year to $10 million, as the financial snapshot below illustrates.

Source data: Gran Colombia Financial Filings 1Q12 to 1Q13.

However, disappointingly this significant jump in net income was not driven by sales growth or reduced costs but by mark-to-market (MTM) gains of $15.5 million on the value of financial instruments held by the company. This includes a MTM gain of $13.5 million on the Silver Notes and a $2.4 million gain on the Gold Notes held by Gran Colombia. While any income is desirable for investors, I would like to see Gran Colombia grow consistently both its revenue and net income as a means of demonstrating to investors that its core gold mining operations are sustainable and profitable.

Exploration and mine development outlook is positive

As I indicated in my last review of Gran Colombia, exploration and mine development are key to the company's growth, particularly with regard to increasing proven and probable reserves, production and ore quality. This includes the company needing to continue developing both its Segovia and Marmato operations as well as continuing its exploration projects to build its reserves.

Marmato upgrade

During 2013 the company has scheduled a range of improvements to its Marmato mining operations including the upgrading of the crusher being scheduled for the second quarter 2013 and the modernization and expansion of that location's underground operation there commencing in the third quarter 2013. This upgrade includes an assessment of the Marmato operations resources in order to develop further growth strategies.

Segovia upgrade

The company continues to press on with developing its Segovia operations in order to boost production and head grades, which should be completed by the end of second quarter 2013. It is also focused on bringing on line the Pampa Verde operation which includes:

Providing mechanized mining access to the Providencia, Silencio and Sandra K mines.

Developing and mining new vein systems.

Installing new plant and tailing facilities (which have been approved).

These are expected to boost Segovia's production to 2,000 ounces of gold annually and reduce the average total cash cost per ounce to around $900. First production from the project is expected in the third quarter 2014 and to date it is under budget with a current estimated total cost of $84 million, which is $6 million less than the original estimated cost.

(click to enlarge)

Source: Gran Colombia Gold Q1 2013 Results.

The completion of this project bodes well for Gran Colombia to be able to boost production and reduce the total cash cost per ounce reduced to a sustainable and profitable level.

The company has also continued with its exploration program at Segovia, which is focused on upgrading 200,000 ounces of gold from inferred to indicated. This project consists of the drilling of 82 holes and 2,000 meters and at the end of the first quarter 2013 was 88% complete, with an official valuation to take place in July 2013 to confirm the outcome of the upgrade. The results of the upgrade on a mine by mine basis at the end of the first quarter 2013 are set out in the chart below.

(click to enlarge)

Source: Gran Colombia Gold Q1 2013 Results.

It is clear the Gran Colombia is committed to further developing its flagship Segovia operations, which will not only see a reduction in production costs but the growth of the company's reserves particularly proven along with measured and indicated. When this development is concluded it should add considerable value to Gran Colombia's operations and hopefully see the company finally deliver value to shareholders as previously promised.

Mazamorras exploration property

Gran Colombia is currently continuing with its formal process to sell 100% of its interest in the Mazamorras exploration property, with several parties currently interested in acquiring the property. The Mazamorras acquisition was not a successful venture for Gran Colombia and saw a $3.4 million impairment charge made against it in the second quarter of 2012. The sale of this property will be a positive outcome for investors because it will remove what is increasingly looking like a liability on the company's books and free up cash for further investment in the Segovia and Marmato improvements.

Gran Colombia has promising development and exploration operations, which with their focus on the company's existing operations in Segovia and Marmato bodes well for their success. The completion of these projects should allow Gran Colombia to improve both its profitability and reserves along with unlocking value for shareholders. But any failure by Gran Colombia to successfully completed these operations as planned will generate further concern in the market with the company having a long history of over-promising and under-delivering.

Valuing Gran Colombia

In order to determine the indicative fair value for Gran Colombia I have used the same net asset valuation methodology that I used in my last article on Gran Colombia in order to determine its indicative fair value per share. However, I have adjusted by assumptions to take into account the positive and negative catalysts identified in this article in conjunction with the revised outlook for the gold price. The key assumptions that I have used in this valuation are set out below:

I have discounted all future cash flows by 10% to determine their present value.

I have factored in an additional 6% risk premium into the discount calculation to represent the risk inherent from operating in Colombia, thus totaling all future cash flows by a total of 16% to derive their present value.

I have discounted the value of all cash flows from Gran Colombia's measured and indicated reserves by 50%, to represent the likely portion of those reserves that will become available to the company.

I have discounted the company's inferred reserves by 75% to represent the likely portion of those reserves that will go on to generate revenue.

I have used an average gold price of $1,429 per ounce representing the average of the first quarter 2013 realized price of $1,639 per ounce combined with the outlook for 2013 of an average price of $1,400 per ounce and $1,300 for 2014.

I have used a recovery rate of 86% representing the average recovery rate for Gran Colombia over the last five quarters.

I have used an average cash cost per ounce of $1,167 representing the average cash cost per ounce produced as at the end of March 2013.

I have conducted the valuation over a ten-year period with no residual value to represent the finite life of Gran Colombia's current gold reserves.

I have calculated the present value of debt and asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the period of the valuation factoring in the likelihood that these will continue to grow in value as the company expands.

I have not factored in any increase in reserves from exploration operations and future discoveries because of the uncertainty that surrounds gold exploration.

After taking these assumptions into account and using the NAV methodology I have determined an indicative fair value per share for Gran Colombia of $4.61 as the chart below illustrates.

With Gran Colombia at the time of writing trading at $2.29 per share this represents potential upside of just over 100% for investors. However, the key drivers of this valuation are the gold price, ore grades and recovery rates and the total average cash cost per ounce. Accordingly, it should be noted that any significant change in these will affect the company's indicative valuation.

To give an indication of how these can affect Gran Colombia's valuation in my last article I determined a pre-consolidation indicative price per share of $0.57, which on a post-consolidation basis is an indicative fair value per share of $14.25. This earlier indicative fair value per share is 68% higher than the current fair value per share and this is because when it was calculated I assumed an average price of gold of $1,773 per ounce, a recovery rate of 91% and an average total cash cost per ounce of $1,261. As the difference in the current valuation and earlier valuation illustrates, should any of those key assumptions change then the indicative fair value of Gran Colombia will change significantly.

Opportunities for investors

Already after announcing record production at its Segovia operations Gran Colombia's share price spiked by just over 9% on the 24th June 2013 and I would expect to see Gran Colombia's share price continuing to rise on the back of the mine development operations at Segovia reaching completion in mid 2014. This will boost production and reduce costs, in particular the average cash cost per ounce to under $1,000, boosting Gran Colombia's profitability. Furthermore, the release of official reserve assessments later in 2013 should also boost the company's share price as its measured and indicated reserves will increase as a result of the exploration and mine development work at both Segovia and Marmato.

Bottom line

As this article illustrates, Gran Colombia continues to remain significantly under-valued by the market, offering investors potential upside of just over 100%. A key driver of Gran Colombia's sell-down has been the increasing antipathy of investors towards small-cap gold miners operating in what are perceived to be high risk geo-political and economic environments such as Colombia. This has seen many investors move to reduce their exposure to economic and political risk in their portfolios.

In addition, while Gran Colombia remains significantly undervalued by the market, it is still a speculative high risk play for investors. This is because of the company's volatile cost and production history, combined with the risks that a high average cash cost per ounce producer presents in a macro-environment where the outlook for gold remains volatile and uncertain. All of which, has worked to push down Gran Colombia's share price to compelling levels, creating a speculative deep value investment opportunity for patient risk tolerant investors.

But this is reliant on the company being able to maintain its average total cash cost per ounce at under $1,170, along with Gran Colombia receiving an average price per ounce of $1,429. Should any of those change, then this indicative valuation will change markedly. But at this time with Gran Colombia trading at a price that gives investors potential upside of just over 100% there is a significant margin of error. This despite the speculative nature of the company's operations at this time, makes Gran Colombia's current trading price a compelling entry point for speculative risk tolerant investors.

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