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Caledonia Mining: A Growing Gold Miner Currently At

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NYBob Member Level  Thursday, 10/31/19 12:20:46 AM
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Caledonia Mining: A Growing Gold Miner Currently At A 3-4X PE
Oct. 30, 2019 12:00 PM ET|5 comments |
About: Caledonia Mining Corporation Plc (CMCL)


With technical signals on gold prices looking strong again, it may be one of the last moments where investors can invest at historically low prices.

Small miner stocks offer significantly higher potential rewards to diligent investors.

A very small company, Caledonia Mining, is perhaps the most profitable and least expense gold mining stock in the business with 50% margins at a "P/E" of 3-4X.

The company also has low debt, positive working capital, and is growing output at a rate much faster than the market expects.

My discounted earnings analysis suggests that the fair value of the company without an increase in gold prices is at least $15.

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(Source - Pexels)

The primary focus on my research and writing over the past week has been precious metals. I was lucky enough to take profits on most of my precious metal's portfolio in late August and have been waiting for short-term technical signals to look green again.

Following the recent 7% pullback in the price of gold and 10% on silver, now looks like a great time to get back in. While technical signals are highly fallible, they do suggest another 20%+ move in gold and even more in silver. As you can see below, silver (SLV) is just starting to break higher in a "bull flag" type pattern:

ChartData by YCharts
A few days ago in "SILJ: Precious Metals Correction Looks Over, Time To Make A Leveraged Play" I explain why junior precious metal miners are probably the best (and riskier) way to take advantage of the trend. In the article, I also explain my $1850/oz price target for gold and $40 target for silver based on the trends/my expectations regarding real interest rates. Of course, many gold investors including myself are expecting the metal to rise to $5000/oz or more, but I'll stay on the safe side.

Caledonia Mining Corporation (CMCL) is a great company to take advantage of this. It is an extremely small gold miner in Africa that has huge margins, high growth, a good management team, and comes at a "P/E" of 3-4X. After looking through over one hundred mining companies, Caledonia is the best one I found.

Caledonia Mining Corporation
There is a lot to like about Caledonia. Chiefly, the company has flown under the radar of investors despite very high profitability and in spite of low gold prices. It is a "nano-cap" stock with a market cap of only $82M, so it is less liquid and more volatile than many of its peers. That said because many institutions can't consider a company that small and that lacks analyst coverage, huge mispricings often occur.

Such is true with Caledonia who has not been covered by SA in over three years. So much has changed for the company over that period. Of its U.S ADR's, only 1.5% are owned by institutions.

Most of Caledonia's revenue comes from a mine they control in Zimbabwe called the "Blanket Mine". They bought the mine in 2006 and have steadily increased output since, despite political and economic unrest in Zimbabwe. This mine is also one of the world's most profitable with an all-in-sustaining-cost at $800/oz. This is far lower than the $1100-$1400 industry average and has enabled the company to recently operate at a 50%+ net margin. Considering many miners barely breakeven today, that is an incredibly high figure.

The management team also looks solid. They have managed to increase recovery rates from 85% to 94% and continue to search for ways to increase output while keeping costs low. Importantly, I did not find any typical red-flags regarding overpaid management in their financial reports. Mining companies often enrich management before shareholders; Caledonia appears to have great shareholder orientation.

As another example, take a look at how their mine's indicated contained ounces have grown in recent years:

(Caledonia Q2 2019 Report)

Of course, the most important metric is proven holdings, but it is likely that they hold around 800K contained oz worth of gold after removing the speculative "inferred" amount but including indicated amounts. Since I generally trust their reported expectations, I will use 800K as my base case but offer alternative valuations using their lower and higher estimates.

Discounted Cash Flow Analysis
Luckily, the operations of such a company are relatively straightforward and make for an easy DCF analysis. They also have low debt and a lot of cash on hand, so they will likely have very little need to dilute shareholders.

The company currently produces 50K ounces of gold per year and has infrastructural projects in place to grow that figure to 80K by 2022. As noted in the linked presentation, they aim to grow that figure to 100K by 2023 and eventually 250K. Because 250K would require over 800K in gold, I will not include that target in my base-case. I will also assume that gold and production costs per oz grow at 3% per year. Of course, I expect much more for gold, but this will be my base case analysis.

Using my base estimate of 800K in mineable gold, this should keep them operating the current mine until 2027. (I'll also give a DCF using other estimates).

(Self Sourced, production targets sourced from Sept. CMCL presentation)

The company has historically brought home 60% of its EBITDA to its bottom line so I'll keep it simple and assume earnings will be 60% of EBITDA. This gives me the following income projection:

Importantly, I'm not going to take depreciation out of my analysis since depreciation is a real cost for mining companies.

With 10.7M in shares outstanding, this implies a $2 EPS this year that expands to just over $5 by 2027. Using a 10% cost of the capital discount rate (typical in mining), this implies a share price of $22.80. Even without a change to the gold price, this implies a 2X return on the stock. Of course, the fact that they're focusing on one mine in Zimbabwe makes it a bit riskier, but even at an extremely high cost of capital of 20%, a $16.29 share price is implied (120% return).

From here on out I'll use both the normal 10% figure and 20%. 20% may be more accurate due to the nature of the company's geography. Labor problems could certainly occur as they have in the past in Zimbabwe and put a pause on operations. Even more, the country has a record of violating property rights. I personally believe the worst is behind Zimbabwe but will use a 20% discount rate to account for these risks.

A Note On How I'm Calculating This
If you're curious how I'm making these calculations, what I'm doing is translating gold prices to probable revenue and then taking out production and overhead costs to get net income. From there, I divide by shares outstanding to get an EPS forecast.

I could then sum up all the future EPS's to get total expected returns, but I want today's fair price, so I discount those cash flows by 10-20% per year and add them up. Because Zimbabwe is a riskier place of business, a higher discount rate is appropriate.

To illustrate, take a look at this chart:

(Self Sourced)

Date EPS Forecast 10% Cost of Equity Discounting 20% Cost of Equity Discounting
2019 $ 2.02 $ 2.02 $ 2.02
2020 $ 2.50 $ 2.27 $ 2.08
2021 $ 3.00 $ 2.48 $ 2.09
2022 $ 3.53 $ 2.66 $ 2.05
2023 $ 4.10 $ 2.80 $ 1.98
2024 $ 4.69 $ 2.91 $ 1.88
2025 $ 4.83 $ 2.73 $ 1.62
2026 $ 4.97 $ 2.55 $ 1.39
2027 $ 5.12 $ 2.39 $ 1.19
Sum $ 34.76 $ 22.80 $ 16.29
A Note on Currency Exposure
In case you are wondering why my $2 EPS estimate is much lower than the company's reported $3.5 TTM EPS, it is because I am assuming no exchange rate impacts. The company made a staggering $25M (roughly half of its total earnings) on U.S-Zimbabwean Dollar hedges due to the recent devaluation which temporarily boosted EPS over the past twelve months.

More gains like this are likely since the currency has continued to fall since their last report. To explain, the company said:

If the Zimbabwe currency remains at the current level against the US Dollar, Caledonia shareholders will eventually benefit from the devaluation, but only when the underlying liability falls due for settlement

Now, this can mean substantial profits for Caledonia, but if inflation gets out of control as it did in the late 2000s, it will harm the company's growth. The mine was temporarily shut down from 2008 to 2009 due to hyperinflation, so the ongoing devaluation does pose a material risk and is partly why I am using a 20% discount rate.

Best Case Scenario Valuations
My expected scenario implies high returns, but DCF valuations have very high exposure to underlying assumptions. Often, those assumptions miss the reality, even if they are in-line with management's guidance.

Personally, I believe that gold is headed back to $1800 over the next year and possibly as high as $2600 by 2025. If we assume that gold rises to $1800 by 2020 and continues all the way to $2600 by 2025 while AISC (cost per oz) maintains a 3% growth rate, we get to roughly $9 EPS by 2027. Using a 10% discount rate we come to a valuation of $37.5 and $26 using a 20% discount rate. Personally, this is the scenario that I expect the most and implies a return of 2.5X-4X.

Of course, if we make the likely assumption that they eventually find more gold, the story is even better. The company believes they potentially are able to pull 1800K ounces out of the ground. If that is true and we assume AISC grows at 3% with gold after 2025 and 60% of EBITDA goes to profits, we get a valuation of $38-$68 using a 10%-20% cost of equity or a 4X-8X price return.

Worst Case Scenario
I think the upside is pretty clear on Caledonia. It depends a lot on assumptions, but I think it is fair to say that the stock is very undervalued.

That said, Caledonia is a riskier mining company and if my assumptions prove to be false, the stock could certainly fall from here. They only currently have 130K in proven gold. It is almost certain that they have more, but I'll use that figure as an absolute 'worst-case scenario' valuation.

Even then, the worst-case-scenario downside looks to be limited. If we assume that gold stays at a 3% growth rate with AISC and that they only can mine 130K more in gold we get an EPS of $2 this year, $2.50 in 2020, and $1.29 in 2021 when proven gold runs out. This gives us a per-share valuation of $5.00-$5.36 depending on a 10%-20% discount rate. Thus, we arrive at a worst-case loss of 20%-30% which, to me, is certainly worth the risk.

Now, if gold prices fall back to 2019 lows then it could be more ugly. That said, the company has such a low cost of production that gold would essentially need to fall by 40% from here for the company to be in trouble.

In the absolute worst-case scenario where the company has both no non-proven gold and gold falls back to $1200 per oz, we estimate a share price minimum of $2.8-$3.0. Of course, nobody wants a 50% loss, but the odds of this event are extremely low. In my opinion, the probability of the absolute best-case scenario is higher than this scenario.

The Bottom Line
It is worth noting that the company is also currently trading 30% below book value and $15M in positive working capital ($8 in million cash and the rest in inventory). Per-share, this working capital implies another $1.4 in value that I have left off of my previous valuations.

In summary, the true fundamental value of Caledonia is likely at least $15 so long as their indicated, probable, and proven contained ounce expectations are accurate. If their indicated level turns out to be non-existent, the company is likely around its fair value. Of course, if their "inferred" level pans out, then the stock is worth around $35.

The company checks all the boxes and has great cash flows. I will stick with my base case valuation which puts the company at a fair value of $18, even without a significant increase in gold prices. That said, if gold prices continue higher then I'll happily hold until the company is overvalued.

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Disclosure: I am/we are long CMCL. 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.

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Comments 5 • Sort by

Value On The Street
Comments1907 | + Follow
Did you account for the fact that shareholders only own 49% of the mine? It doesn't appear that you did.
30 Oct 2019, 01:13 PMReply2Like

Le Sugre
Comments27 | + Follow
I was about to comment exactly the same ....
30 Oct 2019, 06:24 PMReply0Like
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