Gold and Silver miners (Jr and Exploration)

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Kirkland Lake Gold: Upside To Sustain On Robust Production And Cash Flows

Must Read|Aug. 16, 2017 12:22 PM ET|7 comments| About: Kirkland Lake Gold Ltd. (KL)
Street Smart Investor

Summary

Kirkland Lake Gold is undervalued even after strong upside in YTD17.

High impact investment for 2H17 can potentially deliver positive surprises from resources growth perspective.

Attractive AISC and continued improvement in cost likely to translate into expanding EBITDA margin.

Update Coverage

Author Note: All figures in USD unless otherwise stated

I initiated coverage on Kirkland Lake Gold (NYSE:KL) on April 18, 2017 when the stock was trading at C$10.37. In the next four months, the stock has trended higher by 30% and currently trades at C$13.38. Further, Kirkland Lake Gold has surged by 90% for YTD17.

There are several reasons for writing update coverage four months down the line and they are as follows –

My upside target was 30% to 50% when I initiated coverage and the stock is higher by 30%. This update coverage will discuss the potential for more upside.
Kirkland Lake Gold trades OTC where liquidity is not robust. However, the stock will be listing on the New York Stock Exchange from August 16, 2017. This update coverage therefore is an opportunity to highlight the stock that will trade with ample liquidity in the US exchange.
There are several fundamental factors that have supported upside for Kirkland Lake Gold and these factors need further discussion based on the company’s 2Q17 results, which was released on August 2, 2017. This coverage will discuss the key stock upside triggering factors from the results.
My conclusion is that even after the big upside in YTD17, Kirkland Lake Gold remains a “Strong Buy” and fresh exposure can be considered on NYSE listing.

Valuations First

For a stock that has surged by 90% in YTD17, a potential concern is overvaluation and therefore the intention is to discuss the valuation and valuation gap at the onset.

The table below provides the EV/EBITDA for Kirkland Lake Gold for 2017. My estimate of EV/EBITDA valuation is 5.5 as compared to EV/EBITDA estimate of 5.8 when I initiated coverage.

EV EBITDA Valuation Kirkland Lake Gold

The following are the considerations for calculating EV/EBITDA –

The cash position of $267 million as of 2Q17 has been considered and I have reduced the convertible debenture payment of $46 million that is due in December 2017.
For 2H17, I have considered the operating cash flow at the same levels as 1H17 ($140 million) and these are conservative estimates as gold price is likely to be higher and the company’s production is also on an upward trajectory. The capital expenditure is in-line with the company’s guidance.
For 2Q17, Kirkland Lake Gold reported EBITDA of $91.3 million as compared to 1Q17 EBITDA of $63.7 million and 2Q16 EBITDA of $31.5 million. While EBITDA has been surging, I have considered EBITDA estimate of $100 million for 3Q17 and another $100 million for 4Q17. This is likely to serve as a good base case scenario for valuation.
With these estimates, the company’s EV/EBITDA valuation comes to 5.5 and peer valuation will provide further insights on any potential valuation gap.

The table below provides 2017 EV/EBITDA valuation for Kirkland Lake Gold and Canadian peers (peer data source www.4-traders.com).

Peer Valuation Kirkland Lake Gold

From the data it’s clear that even after the big upside in 2017; Kirkland Lake Gold still remains undervalued as compared to peers. I expect this valuation gap to close in the next 6-12 months.

I expected Kirkland Lake Gold to move higher by 30% to 50% when I initiated coverage on the stock and on update coverage, I expect another 30% to 50% upside for this company registering stellar growth.

There will be questions on why the valuation gap still exists as compared to peers and my explanation is as follows –

Kirkland Lake Gold announced business combination with Newmarket Gold on September 29, 2016 with an objective of creating a new mid-tier gold company. Kirkland Lake Gold investors finally approved the takeover on November 26, 2016. As this business combination closed, the focus shifted on valuations and the stock has been on an uptrend since the beginning of 2017.

Kirkland Lake Gold has already been surging for the last 7-8 months and the valuation gap based on prior EBITDA estimates has been closed. However, Kirkland Lake Gold has reported record EBITDA numbers that is higher by 43% as compared to 1Q17 and has almost tripled as compared to 2Q16. This revises the EBITDA and valuation benchmark significantly and the stock is surging to close valuation gap based on latest numbers. It is worth noting that on a day (August 15, 2017) when gold is lower by nearly $12 an ounce, Kirkland Lake Gold is trading in green. The reason is attractive valuations coupled with the fact that the stock will now be listed on NYSE.

The stock listing factor is another reason why the valuation gap exists. In the past two quarters, the company’s stellar performance has helped the stock gain visibility that will be completed with NYSE listing. I believe that NYSE listing will help close the valuation gap with increased liquidity and market participation. It is also important to note that for a relatively small company, investor confidence builds gradually and Kirkland Lake Gold has done enough to build investor confidence through quality results, cost control and exceeding guidance. I will discuss these factors later in the coverage.

Average gold price is likely to be higher for 2H17 as compared to 1H17 and this is another reason why the stock has been trending higher. I have assumed an EBITDA of $100 million for 3Q17 as compared to an EBITDA of $91 million for 2Q17. However, these are conservative estimated based on the company’s growth trajectory and gold prices. In other words, the EV/EBITDA estimate is conservative and gold price remaining firm implies higher EBITDA and cash flow in the coming quarters. This will translate into meaningful stock upside. I believe that gold will remain firm and well above $1,250 an ounce because global geo-political tensions are at elevated levels and that’s supportive for precious metals.

Other Stock Upside Triggering Factors

Valuations justify sustained upside for Kirkland Lake Gold and I want to focus on other fundamental factors that will ensure that positive momentum sustains for the stock in the next 6-12 months.

For 2Q17, Kirkland Lake Gold reported cash & equivalents of $267 million and even after deducting the convertible debentures payment due for December 2017, the company’s cash position is likely to be $220 million. This is with an assumption that operating cash flow in 2H17 cover for the capital expenditure. The estimate is conservative as I expect free cash flows to sustain. However, Kirkland Lake Gold will enter FY18 with cash buffer of at least $200 million and this potentially implies that the company is fully financed for the next 12-24 months.

For 1H17, Kirkland Lake Gold reported capital expenditure of $61.7 million. The company has guided (2Q17 presentation) for annual capital expenditure of $180 to $200 million. Considering the mid-range of the guidance, $130 million capital expenditure is likely in 2H17 and this high impact investment program is likely to translate into production and cash flow upside in 2H17 and well into FY18. Strong quarterly numbers will ensure that the stock momentum remains positive.

On March 29, 2017, Kirkland Lake Gold announced quarterly dividend of C$0.01 per share. For 1H17, the company’s operating cash flow was $140 million with free cash flow of $82 million. As strong growth sustains and with robust cash buffer, I expect increase in dividends in the coming quarters and that will result in stock re-rating and further upside.

I talked about high impact exploration from the perspective of increase in production and cash flows. It is also worth noting that in the recent past, Kirkland has reported a flurry of news related to increase in resources/high-grade resources. On August 11, 2017, Kirkland Lake Gold reported new high grade intersections East of Taylor mine. On August 8, 2017, the company reported positive high grade drill results at Fosterville asset. On July 27, 2017, the company reported that underground ounces more than doubled at Fosterville with underground mineral grade increasing 83% to 17.9g/t Au. The key point I am making here is that as high impact investment continues in 2H17 and potentially in FY18, Kirkland Lake Gold will continue to report positive news on increase in reserves/increase in reserves grade. This is likely to keep the stock momentum positive. Another point worth noting is that the exploration results do indicate the richness of assets and Kirkland Lake Gold is likely to deliver sustained production and cash flow upside even on a long-term horizon (3-5 years).

Fosterville Asset Value Creation

I briefly touched on the company’s Fosterville asset above related to the news on increase in resources. Few upside triggers related to the asset need further elaboration.

The company’s Fosterville asset reported an AISC of $741 an ounce for 2Q16 and the AISC has reduced significantly to $388 an ounce in 2Q17. There have been few other positive developments related to the asset when the company reported 2Q17 –

Gold grade in the asset for 1Q16 was 7.3g/t Au (33,100 ounces production). This has increased to 17.2g/t Au as of 2Q17 (77,069 ounces production).
For FY17, the company’s production guidance for the asset was 200,000 to 225,000 ounces. This has been revised to 250,000 to 260,000 an ounce. As production increases from Fosterville asset, the low AISC will imply increase in EBITDA margin and cash flows.
On July 27, 2017, Kirkland Lake Gold reported that the company’s underground mineral reserves at Fosterville increased by 110% to 1,030,000 ounces. With increase in reserves and reserves grade, the asset is likely to deliver long-term value.
Risk Factors

Financial Risk “Low” – I consider the company’s financial risk as low with the company having a clean balance sheet and high cash buffer. The company is fully funded for FY18 and potentially for FY19 if internal cash flows are considered. The company’s convertible debenture maturing in December 2017 will be repaid through internal cash buffer.

Operational Risk “Low” – The Company’s assets are in zones that have low geo-political tensions and Kirkland Lake Gold has proved good execution capabilities in the last few quarters. The stock has moved higher accordingly and is likely to see sustained positive action.

Commodity Price Risk “Medium” – As geo-political tensions remain elevated globally, I believe that gold will remain firm and even if gold trades in the range of $1,250 to $1,300 an ounce, Kirkland Lake Gold is positioned to deliver strong EBITDA and cash flows (on the back of attractive AISC).

Overall, I don’t see any major risk factor playing out in the next 6-12 months (initial investment horizon).

Conclusion To Thesis

Considering all the factors discussed, Kirkland Lake Gold is worth considering even after the big rally in YTD17. The stock has surged from depressed valuations and as quarterly results continue to deliver positive surprises, the upside momentum is likely to sustain.

Further, a high impact investment program for 2H17 and possibly for FY18 will ensure that production growth and cash flow growth remains robust. In addition, the company’s exploration program has delivered excellent results in terms of resources growth and improvement in mineral grade.

All these points combine to make Kirkland Lake Gold interesting for fresh exposure as the stock lists on the New York Stock Exchange on August 16, 2017.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

https://seekingalpha.com/article/4099433-kirkland-lake-gold-upside-sustain-robust-production-cash-flows