Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
This article is about Rio Alto Mining (RIOM), which is mining and further developing its La Arena property in Peru. The company currently has a market capitalization of $396 million, or $420 million fully diluted.
La Arena has two primary areas: the gold oxide area and the gold/copper sulfide area. The gold oxide area is far smaller than the gold/copper sulfide area. Currently the company is mining the gold oxide area and developing the gold/copper sulfide area, using the profits from the former to fund the latter. By 2016 the company should only be mining the gold/copper sulfide area, which is much larger than the gold oxide area.
Given the mineral characteristics of these two areas, the company is currently a gold miner that will become predominantly a copper miner by 2016. Once the company becomes a copper miner it will remain as such for decades (the life of the gold/copper sulfide area is expected to exceed 20 years).
A major appeal of such a timeline is the fact that a smaller mine is being used to fund the development of a larger mine. If such a strategy works successfully then investors can forego the painful process of share dilution or debt issuance that often comes with developing a major mine.
Unfortunately there are several problems with Rio Alto Mining as an investment. First, the property is located in Peru, which is a high-risk jurisdiction for mining.
Second, the company can barely sustain positive cash flow at the current gold price. Since it only operates its gold oxide region for three more years before it switching to the gold/copper sulfide region, even running the former mine cash-flow negative for a short period of time destroys the advantage presented by the aforementioned strategy.
Third, based on my rough estimates, the company will barely make any money at the current copper price of roughly $3.15 per pound, if it does at all. Even if we assume a copper price of $4/pound then the company is only making $50 million per year in 2016, which is 8 times earnings at the current price. Given that this profitability is in the future the company should trade at a lower valuation relative to any such anticipated profitability.
Ultimately the company has an interesting property and strategy, but it is overvalued, and it requires higher gold and copper prices to justify the current valuation.
1: The La Arena Property
The La Arena property is located in Peru.
(click to enlarge)
As I have indicated it is divided into two regions: the gold oxide region and the gold/copper sulfide region, or "phase 1" and "phase 2."
A: Phase 1: Gold Oxide
La Arena's gold oxide area is an open pit mine.
Key
- Blue: < 0.2 grams of gold per ton
- Green: 0.2 - 0.5 grams per ton
- Yellow 0.5 - 1 gram per ton
- Red - > 1 gram per ton
The gold oxide area has 61.5 million tons of ore with 0.5 grams of gold per ton reserves for a total of 1 million ounces of gold reserves, and 1.66 million ounces of gold resources at 0.4 grams of gold per ton.
Production at La Arena should remain steady at around 200,000 ounces of gold per year as the company develops its gold/copper sulfide ore production. Ultimately this production is transient, so rather than valuing the company based on its price relative to this cash flow, we should look at the company's ability to raise enough capital mining its gold oxide ore in order to fund its gold/copper sulfide mining.
The company estimates that it will have cash costs of roughly $675 - $725 per ounce, which, including other costs I estimate will be roughly $1,225 - $1,275 based on 2012 figures with $625 cash costs and $1,172 "all in" costs. Thus with $1,325/ounce gold the company can barely turn a profit. Assuming conservatively that the company has costs over the next three years of $1,300 per ounce and that it produces 600,000 ounces, the following table estimates the company's total cash flow, which will be used to fund phase two, at various average gold prices (prices lower than $1,300 will be omitted as the company will not get the funding it needs at these prices)
| Average gold price over the next three years |
Rio Alto Mining's Cumulative Cash Flow |
| $1,400 |
$60 million |
| $1,600 |
$180 million |
| $1,800 |
$300 million |
| $2,000 |
$420 million |
Based on these figures, the fact that the company needs $300 million in order to fund phase two, and the company's current $48 million cash position (with just $3 million in debt), it is clear that if shareholders are not to be diluted, then the gold price needs to have a significantly higher average price over the next few years than the current price of $1,325/ounce: the company probably needs something approaching $1,800/ounce. However, something slightly lower, say $1,600/ounce will mean that dilution is limited.
B: Phase 2: Copper/Gold Sulfide
The copper/gold sulfide area is also an open pit mine: the following diagram displays it with the high copper grade zones highlighted in yellow and red.
Key
- Green: 1,000 - 3,000 parts copper per million
- Yellow: 3,000 - 5,000 ppm
- Red: > 5,000 ppm
Resources
The gold/copper sulfide region has more gold than copper at the current copper and gold price points (roughly $3.15 per pound for copper and $1,325 per ounce for gold), and this is at a ratio of about 1:2. The gold/copper sulfide deposit has about 5.9 million ounces of gold (2.1 million ounces of gold reserves at around 0.24 grams per ton and 3.8 million ounces of gold at 0.21 grams per ton) and 5.6 billion pounds of copper (1.9 billion ounces of copper reserves at 0.33% copper and 3.7 billion pounds of copper at 0.3%. The following two tables outline this data.
|
Millions of Tons |
Gold (g/t) |
Total Gold |
Copper (%) |
Total Copper |
| Reserves Data |
269 |
0.24 |
2.1 million |
0.33 |
1.9 |
(click to enlarge)
Production
The company anticipates mining 18,000 tons of ore per day, or about 6.3 million tons per year assuming that it operates 360 days per year. Given that it will produce 50 million pounds of copper and 40,000 ounces of gold annually when production commences, and given the company's current cost of roughly $31 per ton of ore mined, it should have an estimated cost of $3 per pound of copper with gold offsets assuming a $1,300/ounce gold price (although this is a rough estimate). The following table estimates the company's cash flow at various copper prices with these production figures.
| Copper Price ($/lb) |
Rio Alto's Cash Flow |
| $3 |
0 |
| $3.5 |
$25 million |
| $4 |
$50 million |
| $4.5 |
$75 million |
| $5 |
$100 million |
| $6 |
$150 million |
| $8 |
$250 million |
Given that the company is currently valued at around $400 million it appears that the shares are overvalued at the current copper price. However, investors should keep in mind that the company has cash flow from its current gold operations.
2: Risks To Longs
A:The Price of Copper
Rio Alto Mining will be a copper miner in a few years, and the price of copper is more important to its share value than the price of gold. Thus investors must be concerned with the possibility of lower copper prices hurting the shares. Copper has been in a downtrend, as is evidenced below in the chart of the iPath copper ETN (JJC).
(click to enlarge)
While copper is in a very long-term uptrend alongside gold its supply and demand fundamentals are very different, primarily in that copper is very economically sensitive, so that if there is a recession the copper price might fall significantly while the gold price rises. Further, copper producers are not in danger of losing money should the copper price fall from here, as is evidenced by the strong earnings power of some major copper producers such as Freeport-McMoRan (FCX) and Southern Copper (SCCO).
B:The Price of Gold
The price of gold has fallen recently, and Rio Alto Mining's intermediate-term cash flow is highly leveraged to the price of gold. So long as the downtrend illustrated below remains intact, there is a reasonable possibility that the gold price will continue to fall in the short term.
(click to enlarge)
C: Mining In Peru
Rio Alto Mining has not had any issues mining in Peru, but other companies have (e.g. Bear Creek Mining, see my article here). While Bear Creek Mining's Santa Ana project was halted as a result of popular opposition, the fact remains that the Peruvian government acted in a way that severely destroyed shareholder value. It is possible that the Peruvian government can do this again and halt mining at La Arena. Since La Arena is Rio Alto Mining's only property such an action would destroy nearly all of the company's value.
D: Rio Alto Mining's Size
Rio Alto Mining only has one property. If anything happens so that the company cannot mine at La Arena, then it is worth the cash it has on its balance sheet, which is roughly $48 million.
3: Risks To Shorts
A: Higher Copper and Gold Prices
Just as lower copper and gold prices can hurt Rio Alto longs, higher copper and gold prices can harm the shorts.
B: A Positive Preliminary Economic Assessment
My contention that the company is overvalued rests to some extent on my assumption that the company will mine copper at roughly $3/lb. If I am wrong and the company can mine copper at a lower price then my assumption could be wrong, or at least true to a lesser extent.
C: Exploration Success
The problem with shorting a small mining company that has an exploration program is the possibility that it finds a large mine. Such a find can potentially add hundreds of millions of dollars to a company's valuation.
Conclusion
Rio Alto Mining is a high risk investment that requires higher metal prices to be successful. This risk is amplified given the location of La Arena, as Peru has proven to be a risky place to mine. Finally the shares are overvalued given current metal prices.
That being said I don't think that Rio Alto Mining is a good short candidate except for those investors who are bearish on the copper price. For one, the company has not released an economic assessment that details its cash costs. While based on my estimates the company is overvalued, if I am wrong and the company can produce more cheaply then the current valuation appears to be more reasonable. Furthermore, even if I do not like this particular gold and copper miner, I am bullish on the prices of both, especially gold (see my following article on gold). Thus I might consider purchasing put options on Rio Alto Mining in a more bullish environment for gold and copper as a hedge against other positions, but I would not short the shares outright. Finally, even if Rio Alto Mining is overvalued, I believe that the company is creating value, and I am always hesitant to short such companies.
Ultimately I think investors should simply avoid Rio Alto Mining, although copper bulls should keep an eye on it and perhaps take a position at a lower valuation or in a higher copper price environment.