World Of Wallstreet: Valuing Open Pit Gold Miners: Capital Gold (CGC.TO)

This post continues the series on Open Pit Gold miners begun here and now starts the consideration of open pit gold miners that I consider undervalued and hold as a significant part of my portfolio.

Capital Gold (CGC.TO) is a straight ahead, still ramping up Mexican heap-leach, one-mine gold miner. It is a pure play with almost no byproducts. Unlike many miners, Capital Gold has a track record of meeting guidance. It opened its mine, El Chanate, on-time and on-budget. It produced 40K oz in its recently completed first year of operation. It produced more than 5K oz in Dec 2008 (60K oz annualized) and is providing guidance of 70K for 2009.

The next major stock price catalyst for the company is the release of an NI43-101 report with increased mineral resources. Management expects that this expanded resource will allow production to grow to 100K oz / year in 2010. At 100K oz / year, the company becomes large enough to move out of the "too small to ever be a takeover candidate" and, in my opinion, become a potential takeover target for a mid-sized gold producer. Having been around the block more than once, I try to stay away from mining stocks when they don't have a plan that allows them to grow big enough to be a takeover target.

The valuation in the table below is based the current proven and probable reserves and my guesstimate of 2 million oz for the measured and indicated to be announced in February. This guesstimate is backed by the fact that, as part of its joint-venture exploration effort with Anglo-Gold Ashanti, Capital Gold reported that its El Chanate project had achieved 2 million "drill indicated oz" in January 2008. This was a contractural milestone which forced Anglo Ashanti to either provide Capital Gold with a large amount of cash to gain a controlling interest in the mine or lose all interest in the mine. This decision came due last summer near the worst point in the credit crisis which allowed Capital Gold to regain complete ownership of the mine. This, in my view, is the only case I know of where something nice for a Jr gold miner has come out of the credit crisis.

The operating cash flow estimates are based on $432/ oz which comes from my totaling all non-expansion related expenses from the most recent quarter and dividing by the number of oz. This is thus based not my taking management's own cash cost estimate (with perhaps lots of loopholes) but on the actual costs of production.

As you can see from the table below, Capital Gold is significantly undervalued relative to our two reference miners (Alamos Gold and Western Goldfields), particularly in the price to annual oz and price to operating cash flow ratios. It is also undervalued relative to Minefinders, especially if you include the much higher startup risk that Minefinders has.

Prior to its recent 50% stock price pop (which I luckily benefited from having gotten in around $C.40/share), Capital Gold was even more undervalued.

Here's the factors that I think primarily account for Capital Gold's relative undervaluation:

The company has been starting up and Mexican Heap-Leach peers have had significant startup problems (which Capital Gold avoided).
The company has a large number of shares outstanding leaving it in the penny-stock category. The company has plans in place to address this by doing a reverse stock split and then getting an AMEX listing. These plans have been on hold, up until recently, as without the recent 50% stock price pop the stock after the reverse split would still not have been high enough to allow an AMEX listing. I consider a dual-list (AMEX and TSX) to be a very positive thing and one of the things that has benefitted Minefinders. I expect this reverse split will soon be back on the table and take place.
The company has been busy executing its strategy and has not done a great job promoting itself. For example, the web site has no easy way of getting the key facts about the company necessary to produce the inputs to the table below. Other companies have presentations and/or webcasts that present the company in the best possible light while providing easy access to key facts such as recent production and production guidances, reserves and resources and the number of fully diluted shares.

None of these factors are significant for the long-term and I expect that Capital Gold will continue its recent price appreciation either via the open market or by being the target of a takeover.

Before moving on, its worth highlighting Capital Gold's estimated price to operating cash/flow ratio of 2.6 to 1. What other kind of company do you know that is poised to make that kind of money? This is the kind of ratio we were seeing with the base metal miners before they had their big run in late 2006 and early 2007. Gold miners are typically valued at a price to operating cash flow ratio of 10. Overall, I'd say capital gold has another 50% price rise to go to achieve a valuation that brings it close to our reference gold miners and could easily be a multibagger (e.g. say a four-bagger) should either the price of gold rise or the gold mining industry return to its historical valuations.

This forecast, like all others in this series, is based on a reasonably conservative gold price of $800. It seems pretty unlikely that Capital Gold is "going to zero" even in the face of a severe gold price drop. Even at $600 gold, my spreadsheet estimates a quite respectable price to operating cash-flow ratio of 5.8 to 1. Of course, gold stocks may get hammered beyond what makes fundamental sense in a gold price decline as they did last summer and its certainly possible that gold could decline below $600 (look at what happened to nickel, zinc, lead, copper, oil and natural gas), but fundamentally I'm reasonably satisfied with Capital Gold's safety as an investment for the next few months.

The chart below gives my technical assessment of Capital Gold's stock price action:

The chart looks pretty bullish short term as its clearly broken its "commodity-crash" downtrend line, crossed back over the 50 day and 200 day moving averages and has crossed the third fibonacci. Capital Gold is thus targeting a retest of last summer's high of $C.72.

It took me a full week to edge into this stock without moving the stock price. Its pretty illiquid.

I like Capital Gold alot and hold as much as I can stand given its limited liquidity.

Of course, everyone should do their own due-diligence and make their own investment decisions. All of the above material comes from my own amateurish reading of the company website and related financial documents. As you know, I am a software engineer, not a financial advisor.

Finally, as an individual investor in illiquid stocks you cannot expect me to announce when my sentiment changes about a stock or announce when I am entering or leaving a stock. There's only room for one at a time to enter and leave these stocks.

Best wishes to you.

MontyHigh, www.worldofwallstreet.us