Buy Goldcorp, target 44.40

Posted by Iyad Atuan at 03:53 PM on May 31, 2009

delete edit comments (0)

Current price (May 29): $39.73

Target 12-month price: $44.40

For downloadable vrsion click here.

Summary

GG is a rapidly growing senior mining company. Having the lowest cash cost of $305/oz among its main competitors, GG has more profitable ventures providing more free cash flow to invest in new promising projects such as Penasquito and Pueblo Viejo. Additionally, GG is quickly reacting to the current economic times. As one of its main measures, it has very minimal debt making its balance sheet one of the strongest in the industry. Also, GG has decided to consolidate geographically in order to minimize its country-related risk. Currently, Alumbrera is the only mine outside of NAFTA region. By developing new mines, GG is expecting to increase its gold production by 50% in the next five years making it one of the most aggressive large-cap gold companies.

Industry attractiveness

Current appreciation of gold price makes it attractive to new junior companies to enter the market. However, there are several barriers such as lack of economies of scale, high capital intensity, difficulty of finding new untapped reserves. Even if reserves are found, those are in remote locations that are not close to an electric grid. The threat of substitutes depends on the market segmentation. While the threat of substitute in the jewellery market can be considered high, this threat is considered very low in other industries such as in the computer hardware production.

Why is GG a good investment?

Aggressive growth strategy: GG is planning to increase production by 50% in the following 5years. This growth will be driven by Penasquito and Pueblo Viejo.Penasquito is one of the largest new mines in the world. It is 100% owned by GG. The mine consists of two open pits that are expected to produce 500,00 oz annually for the life of the mine. Pueblo Viejo is 40% owned by GG and 60% owned by Barrick. GG?s gold production is expected to be 400,000 oz for the first five years. Currently, drilling is being performed in Eleonore to define and understand its deposits. Definition drilling is scheduled for 2009 at Cerro Blanco ? another promising project.

Lowest total cash cost among senior gold companies: One of the biggest drives of GG?s success is its low cash cost compared to other competitors. GG?s total cash cost was $353/oz for 09Q1 compared to $379/oz, $404/oz, $419/oz and $435/oz for AUY, ABX, KCG and NEM respectively.

Geographical consolidation: While GG is consolidating its mines to lower-risk NAFTA regions, none of the major competitors are following the same strategy. Barrick Gold (ABX) is still highly dependable on gold production in higher-risk locations. Currently more than 50% of ABX?s gold production and 65% of its gold reserves are located outside of North America. Furthermore, ABX?s development of the Pascua-Lama mine implies that ABX has no intention of geographical consolidation. Kinross Gold (KCG) and Newmont Mining (NEM) depend on a considerable portion of its gold production in higher-risk regions but Yamana Gold (AUY) has all its operations the Americas.

Low financial risk: In the current economic times, cash flow volatility increases. GG has responded to this situation by deleveraging substantially increasing its safety cushion. The other three major competitors have kept their leverage unchanged as shown below.

Risks faced by GG

Gold price fluctuation: The main risk is fluctuation in the price of gold. However, this risk is not specific to GG as none of the senior gold companies hedges its gold production. The table below demonstrates the sensitivity of the NAV-derived price to gold price fluctuations.

Unexpected project expenses: One of GG?s main advantages is its low cash cost. Therefore, unexpected project expenditure especially regarding Eleonore and Cerro Blanco will increase the average total cash cost.

Failure to find new gold reserves: With the recent increase in the gold price, more junior gold companies and new entrants have an incentive to explore for new reserves. However, this risk is somehow limited since most of the remaining gold reserves are in remote locations that require large capital investments.

Fuel cost and fluctuation in exchange rates: Since energy is the main input and the gold business is truly global, the cost of fuel and exchange rates have a significant impact on the profitability of GG. GG hedges most of its exposure to fluctuations in fuel cost and exchange rates through several derivative instruments dampening this risk substantially.

As more of these risks occur, the NAV multiple will decrease to industry average or even lower. The above table illustrates the effects of fluctuations in the gold price and in the P/NAV utilized on the NAV derived stock price.

Valuation

GG was valued using a NAV approach and comp analysis. The final target price is the weighted average of the two prices (75% NAV and 25% comps).

For the NAV approach, earnings from each mine were forecasted for the lifetime of the mine, then discounted at a discount rate that reflects the risks incurred due to geographical location, currency and success probability of the project. Then, several items were added to the Value of Operational Assets to reflect items that are not accounted for such as reclamation costs, long-term debt and working capital.

Using Tier I gold suppliers as the universe, the average NAV was calculated to be 1.65x. Three premiums were added to reflect the advantage GG has over its competitors due to having the lowest cash cost, lowest debt ratio and lowest risk due to geographical consolidation in NAFTA region. Using this P/NAV multiple of 2.40x, the target price is $48.90.

The weighted average of three comps was utilized. Those comps were EV/ 2009 production estimate, EV/reserves (P&P) and EV/ forecasted 2009 EBITDA. The universe used was only Tier I gold companies while premiums were added for GG?s low financial risk, aggressive growth approach and low geographical risk. The comps fair price was calculated as $31.10 leading to a 75%NAV-25%comps target value of $44.40.

The risk related to the comps approach is embedded in the fact that comp averages where obtained using market information for competitors. Therefore, if the whole sector is being undervalued or overvalued, the price attained could be misleading.