Rio Alto Washes Out; Now A Compelling Bargain At 6 Rio Alto (RIOM) shares capsized, recently plunging 26% in less than a week, drowned by a deluge of unrelenting selling. Given the carnage across the precious metal space, at first glance, Rio's dive isn't surprising. But when compared to its sector - junior gold miners (GDXJ) - Rio's drop seems vastly overdone. Rio actually crashed even faster than the juniors as a whole, despite Rio's status as one of the highest-quality operations within the index. The gold mining sector is full of unprofitable, heavily levered and high cash cost mining operations that are now, in a $1400/oz gold price world, likely cash flow negative and may end up on the brink of insolvency.
Rio Alto, by contrast, has no debt, a wildly profitable mine, and competent management. It trades at a trailing 6 P/E, and forward earnings - even despite falling gold prices - are expected to rise. In an investing era marked by stretched valuations and low yields, opportunities to invest in debt-free businesses sporting 17% earnings yields, such as Rio Alto, are vanishingly rare.
Though Rio's profit margin has fallen due to the decline in gold prices, it is still earning hundreds of dollars per ounce in net profit on the 200,000 ounces of gold per year it mines, even selling at these lower gold prices. It has no debtholders to worry about, and no reason to need to raise cash and dilute shareholders at these lower valuations, as so many other junior mining firms are being forced to do.
In short, Rio's business is only minimally affected by the drop in gold prices, while many of its competitors across the sector are seeing their very lives flash before their eyes. Given this disparity, it is stunning to see Rio's shares falling just as quickly as the junior mining sector as a whole, and buyers with the stomach to enter now while everyone else is dumping indiscriminately may well be rewarded with large gains as the market digests the new gold environment; one where strong balance sheets and low cash cost operations will be rewarded while indebted high cash cost operations will continue to be shunned and shuttered.
Rio Alto operates the La Arena mine in northwestern Peru. The mine sits in the La Libertad district of Peru, an area renowned for its prolific gold deposits. Other big gold projects including Newmont's (NEM) 2 million ounce per year Yanacocha mine and Barrick's (ABX) 750,000 ounce per year Lagunas Norte mine lie within 60 miles of Rio's La Arena mine.
La Arena is a young mine, with first production occurring in May 2011, and it has a long mine life ahead of it. La Arena has two components, the first is the oxide portion of the project, which contains 1.6 million ounces of measured and indicated gold based on a newly released resource estimate. Given Rio's current 200,000/oz per year production rate, this implies that the oxide portion of the mine has a roughly eight year mine life ahead of it.
La Arena also has a sulphide resource body which it has not yet begun to exploit. This part of the resource sees its economics heavily tilted toward copper, as the body contains 3.7 billion pounds of copper. In addition to that prodigious sum, the sulphide resource also comes with an impressive 3.8 million ounce gold kicker. Add it up, and for its $600 million price tag, Rio Alto's investors are buying up 5.4 million ounces of gold and 3.7 billion pounds of copper at an extremely attractive price.
But with the mining market in tatters and fear at unprecedented levels, I understand that many mining companies offer investors the promise of huge ore bodies selling at seemingly attractive prices. There are four things that set Rio apart from other players in the junior mining sector. These include location, (lack of) leverage, low production cost, and prudent management.
Location
Gold miners, as an industry, have been terrible allocators of capital throughout the past decade. Though their failings have been many, the industry's most profound weakness has been in risk management. Companies continue to invest in risky geographies and acquire mining prospects in dicey political localities. Pascua Lama has been grabbing headlines recently, as Barrick's $8.5 billion project in Chile/Argentina has ground to a halt under profound political pressure. Goldcorp (GG) and Barrick have seen the Dominican Republic flatly reject their mining contract for building a $4 billion mine there. And Turquoise Hill (TRQ) has seen its shares collapse in the wake of the Mongolian government's meddling with Turquoise's gargantuan Oyu Tolgoi copper/gold project.
Other companies have erred on the geography side of risk management. NovaGold (NG) is perhaps the most obvious example, with its tracts of metals-rich moose pasture in the far wastelands of northern Canada and western Alaska containing geologically promising bodies of gold and copper but decidedly less promising economics, leading to the shelving of the massive Galore Creek project in British Columbia and increasing questions about the viability of its other asset, Donlin Creek. Shares have imploded, diving 80% since I named it the precious metals sector's most overvalued stock two years ago.
By contrast, Rio Alto ticks off all the right boxes when it comes to location. Its mine is located at a good address geologically, surrounded by massive gold mines run by majors such as Newmont and Barrick. The infrastructure and mining culture in this section of Peru is quite developed, allowing low cost mining and reasonable Capex budgets. And unlike many sections of Latin America, Peru is a generally favorable political district for mining firms, even the allegedly left-wing Humala presidency has been favorably disposed to mining companies' interests to the chagrin of his own political supporters.
While there are some localized regions of Peru with strong local opposition to mining such as that which has derailed Bear Creek's (BCEKF.PK) Santa Ana mine and Newmont's Conga mine, in general, Peru is quite hospitable to mining, particularly in cases, such as Rio Alto's, where management takes an active role in community development and outreach, rather than merely paying lip service to the locals. On the whole, Peru is much closer to a Mexico or Chile than an Argentina or Bolivia in terms of geopolitical risk. Long story short, Rio Alto has great rocks at a great address.
Balance Sheet
Mining, by its very nature, is an extremely capital-intensive business. With gold and silver prices surging over the past few years, many companies have bet the farm and aggressively indebted themselves in the rush to build out massive new mines and seize the opportunity presented by higher prices. Alas, as metal prices have fallen, the debtloads have remained, leaving companies like Barrick in a world of hurt. Barrick now faces a $14 billion debtload against a mere $18 billion market cap. Can anyone say dividend cut? On the smaller end of the scale, junior miners are being forced to shut down altogether as their mines, particularly at lower gold prices, simply aren't generating enough cash to service the debt loads.
Against that backdrop, it is reassuring to invest in a company such as Rio Alto that already has an up-and-running profitable mine and no debt against it. And going forward, Rio will be developing the sulphide project with free cash flow thrown off from the existing mining operation rather than having to rely on the debt or equity markets for capital infusions. In a time when many mining companies overplayed their hands and spent aggressively on marginal projects, Rio Alto's management remained focused on consistent affordable growth while maintaining the pristine balance sheet. And now, as the sector faces hard times, Rio will carry on quite alright, while the aggressive miners, now crippled from their boom years' overeager budgets, fall by the wayside.
Cost Of Production
Even for miners that managed to avoid the leverage trap during the boom years, many still face another existential problem. Simply, these companies' mines are no longer profitable. Given the massive run-up in mining costs in recent years coupled with the sinking price of gold and silver, many mines that generated acceptable profit margins in peak years are now operating at a loss. According to a recent Bloomberg article, 30 to 40 percent of gold production is not profitable at $1300/oz gold.
If the price of gold does not rebound sharply in coming months, expect a massive wave of contraction across the industry as companies rush to shutter money-losing mines. For short periods, some companies are able to avoid cash flow problems by selectively mining higher grade ore bodies, generating enough cash to keep operations running for a couple of quarters while waiting for metal pricing to improve. These short-term strategies worked in the 2008 metals rout, as prices rebounded quickly, but it is a dangerous path to head down. For companies with gold production costs over about $1,200/oz, the economic value of these mining properties may rapidly approach zero, and investors trying to bottom-fish in these damaged companies may end up with large losses.
But Rio Alto, as a true low-cost producer (as opposed to the 'we have low cash costs and yet we keep losing money, isn't that funny spin' many junior mining companies use) has no need to fear falling gold prices. The numbers tell a simple story, in 2012, Rio Alto generated $317 million of revenue and $153 million of operating income, leading to $100 million of after-tax profit. That's a nearly 50% profit margin pre-tax. A fall in gold from $1600/oz to $1400/oz certainly dings Rio's profitability a bit, but the vast majority of that income is still going to be there. Certainly by whacking down Rio's share price from 6 to 3.50 since last fall, the market has already more than compensated for the small decline in the company's earnings power.
Putting It All Together: At Least 35% Upside Ahead
Despite the gold market's short-term gyrations, Rio's 200,000 ounces of gold production at a cost of $750/oz will continue to be a tremendous profit generator in coming years. Certainly, as an investor, I'd prefer a higher gold price, but it is not essential to my thesis. Unlike many struggling mining companies, who will literally go out of business if gold doesn't rebound, Rio is still likely to put up at least 50 cents of EPS this year, and earnings will from then on increase as production rises and, later down the line, the copper project comes on line.
As recently as three weeks ago, CIBC had an $8 price target (figures in Canadian $s) on Rio Alto, and its model assumed earnings would rise slightly in 2013, and then nearly triple in 2014 to $1.49 a share on the back on lower production costs and an increase in gold production to 230,000 ounces. Now CIBC has cut its price target to $7, but the compelling math still holds. For a stock trading at $3.50, earning 50 cents EPS this year, the result is that it trades at 7x 2013 earnings, and then earnings substantially rise in 2014. Even supposing gold trades down to say, $1300/oz and stays there, dropping earnings to roughly 40 cents, Rio still would be trading at a single-digit P/E. Being conservative and lopping down CIBC's 2014 EPS estimate from $1.49 down to a buck, you're still at crazy cheap territory for a stock priced at $3.50.
With the mine having a long mine life, and the promise of the huge copper project which is slated to come online in 2016 being yet another catalyst for rising earnings, it is hard to believe Rio Alto is trading at 6x trailing earnings and less than that based on 2014 earnings. All this for a company with a flawless balance sheet.
In a market that has made bargain hunting difficult in recent quarters, Rio Alto offers the sort of fire sale that doesn't come often. With any sort of upswing in gold, Rio Alto can easily trade back to $5 a share in a matter of weeks, still well off its 52-week high but a cool 35% higher than the current price. In 2014, with earnings potentially topping a buck, it is easy to imagine even at, say, a modest 7 P/E, a share price up toward $8.
On the downside, while anything is possible in the short run, it is hard to see Rio staying lower than here for long; companies earning 50 cents EPS with rising earnings typically don't stay priced in the low 3s. Fortunes are made in market crashes, as entire asset classes are expunged from investors' portfolios. Many of the junior mining companies' stocks are heading to zero and deserve the selling pressure they've received. But for the quality mining assets with strong balance sheets and low cost operations, the time to buy is here. There's a very real chance of investors realizing a 35% upside over the next quarter or two, and getting a double on their money over the next 18 months in Rio Alto.