RE:Alpha report stans figures big on the Centerra Joint venture
ˇCenterra Gold: Growing Country Risk Not Justified By Potential Rewards. Feb. 13, 2015 11:30 AM ET | About: Centerra Gold Inc. (CAGDF) Subscribers to SA PRO had an early look at this article. Learn more about PRO » Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...) Summary Claims by Stans Energy are blocking a proposed solution for the dispute with the Kyrgyz government. Moves by the company to geographically diversify are duly noted. Recent outperformance has reduced rewards, while risks are mounting. (Editor's Note: Investors should be mindful of the risks of transacting in securities with limited liquidity, such as CAGDF. Centerra's listing in Toronto, CG.TO, offers stronger liquidity.) Centerra Gold (OTCPK:CAGDF) will be reporting 2014 fourth quarter and year-end results on February 20; however, we dare say that this event will have little bearing on the company's share price performance. The company's predicament has been governed by its exposure to country risk, and the manifestation thereof, thanks to the location of its flagship Kumtor gold mine in the country of Kyrgyzstan. Recent news releases indicate that Centerra Gold is addressing its country risk profile aggressively by diversifying its assets geographically. The company has been developing projects in Turkey and Mongolia, and has just closed a deal to earn into an attractive gold project in Ontario, Canada. While not immediately relevant to investor perception of Centerra Gold, we believe that this diversification will have an impact on valuation multiples for the company. As illustrated by the chart below, the company's efforts have not gone un-noticed by investors and Centerra Gold has outperformed its peers over the past six months by a significant margin. In the current article we would like to pick up where we signed off with our last article on Centerra Gold and provide an update on the company's difficulties with the Kyrgyz government; take a closer look at the development pipeline as it presents itself after recent announcements; and as always, we will finish with an updated investment thesis. CG Chart CG data by YCharts Kumtor Performance Operations at the Kumtor mine have suffered in 2014. While production was in line with guidance we are expecting Centerra Gold to miss cost guidance in the upcoming earnings call, as detailed here, and we are expecting the company to report a bottom line loss. The outlook for 2015 has been given for total production of 480,000 to 535,000 ounces at AISC of $898/lb to $1,003/lb which is lower than outlined in the life-of-mine plan for the Kumtor mine. The company has had difficulties reconciling mined ore with the existing block model, which might also impact the updated reserve statement due to be released in the near future. Furthermore, a buttress constructed in response to increased movement of an adjacent glacier may also have an impact on reserves in the high-grade Kumtor SB zone. This information has been known for some time now, and should be priced in when the company presents its 2014 results. Stand-Off Continues in Kyrgyzstan The Kumtor gold mine started operation in 1997 under an agreement between the government at the time and Cameco (NYSE:CCJ). Ownership of the mine was restructured in 2004 giving newly formed spin-off Centerra Gold control of the asset, and the Kyrgyz government a 32.7% stake in the company. Since then various elections, revolutions and uprisings have taken place and the current powers have made it quite clear that they want a bigger slice of the cake than originally agreed. In 2012, the Kyrgyz Parliament issued a resolution to review Kumtor's compliance with relevant operational, environmental, health and safety and community standards and only just stopped short of voting to nationalize the Kumtor mine. Instead, a process to revise the contract with Centerra Gold was initiated, accompanied by numerous environmental and other claims against the company by Kyrgyz state agencies. Kyrgyzstan is associated with extreme country risk, and Centerra Gold is a case in point. To resolve the situation Centerra Gold has proposed an exchange of the Kyrgyz equity holding in the company for a 50% interest in a joint venture company owning the Kumtor gold mine. After months of negotiations a heads of agreement document, or HOA, to this end was passed in the Kyrgyz parliament in February 2014. However, this parliament collapsed shortly thereafter and a new government was sworn in by April - promptly passing more legislation to complicate operations at the Kumtor mine. At the same time another mining junior called Stans Energy (HREE) won an arbitration case against the Kyrgyz government with regards to the expropriation of a rare earth project. When Kyrgyzstan refused to pay the awarded penalty of $118M Stans Energy initiated procedures to seize shares in Centerra Gold owned by the country. A Canadian court order is in place that prevents the sale or exchange of these shares through the Toronto Stock Exchange until legal proceedings have played out. And unfortunately for Centerra Gold, this court order prevents the execution of the mentioned HOA. We strongly believe that the proposed HOA has the potential to defuse the stand-off between Centerra Gold and its host nation. The HOA clearly favors the Kyrgyz side, but if executed would provide certainty for investors and presumably resolve the issue of chronic market under-valuation, a win-win situation in our view. The abovementioned court order is stalling this process, and might well provoke Kyrgyzstan to look for other, potentially more radical solutions. For the time being, this story is driving our investment thesis for Centerra Gold. Recent news about progress at other projects under the company's control have provided for some optimism, however, and we will take a look at these projects in the following. Mongolian Operations Centerra Gold has been operating its second Boroo mine in Mongolia since its inception and the mine is now nearing the end of its mine life. Secondary leaching will supply about 15,000 low cost ounces this year and probably conclude gold production from known resources at this location. The news release regarding a decision by the Mongolian parliament to assign strategic importance to the nearby Gatsuurt gold project is important in this context. This decision paves the way to accelerated development of this deposit, which would come with relatively low capital investment in an initial 2.5 year phase where oxide and transitional ore from a future Gatsuurt mine could be trucked 60km to the existing processing facilities at the Boroo mine. After this initial phase the company will need to process refractory ore, and it plans to use a bacterial oxidation facility for this purpose. Amending the existing plant to introduce this process implies considerable execution risk, and we are not anticipating the market to put much value to this expansion at the current point in time. However, the company has been able to produce gold from the Boroo operation at all-in sustaining costs of around $1,000/oz and should be able to continue to do so during the initial phase of mining at Gatsuurt. In theory, these developments in Mongolia should be value accretive for Centerra Gold; however, we would argue that this country is yet another high-risk mining destination, and valuation of the Gatsuurt project should be low until profitability can be proven. Recent headlines regarding the immense difficulties in further developing Rio Tinto's (NYSE:RIO) mighty Oyu Tolgoi mine, or seemingly bizzarre court proceedings against coal miner South Gobi Resources (OTC:SGQRF) and three of its former employees are certainly designed to discourage investor interest. Exploration Centerra Gold has exploration projects at various stages in Mongolia and Turkey. Especially the Öksüt project in Turkey has the potential to become a producing mine in the future. A preliminary economic assessment, or PEA, for this project has been released but appears unconvincing with a reported IRR of only 19%. Nevertheless, Centerra Gold has decided to proceed to a full feasibility study, or FS. We expect the company to explore aggressively for additional resources in parallel to developing the FS in order to improve economics for this heap leach project. Given the prospectivity of the landholding we would not be surprised to hear promising news from this project as the year advances. The Hardrock Deal Surprising many commentators Centerra Gold and Premier Gold (OTCPK:PIRGF) announced a deal that will allow Centerra Gold to earn a 50% interest in Premier Gold's Hardrock project in Ontario. A PEA for this project has recently been released and shows robust economics as discussed in depth here. Centerra Gold has agreed to commit up to C$300M to a partnership that will jointly develop this project. Centerra Gold has a very strong balance sheet and reported cash and short-term investments of just over $400M at the end of September. The company has been expected to make an acquisition by many commentators, and it seems that it has made its choice. The price seems high at first sight, considering the early development stage and the conservative NPV (7%) of $380M computed by fellow author Investment Doctor in the linked article, but this is a quality project with much potential to grow well beyond the open pit scenario considered in the PEA. Valuation & Investment Thesis Using price/NAV multiples assigned by the market Centerra Gold is very close to the bottom of its peer group with a mere 0.50 according to TD Securities. And using cash flow multiples as a yard stick we note that the company is trading at a mere 5.6 of expected 2015 cash flows, again well below most peers. The market is clearly punishing Centerra Gold for its high country risk exposure, but we would argue that recent outperformance is due to a market perception of growing geographical diversification. We believe that the company is essentially still valued for its Kumtor mine, and the described uncertainties weigh heavily on the applied NAV multiple; but it seems that the market is increasingly prepared to relax its stance and honour the improved outlook for the Boroo/Gatsuurt operation, as well as potential upside from the FS-in-progress in Turkey, and in future also advancements with the Hardrock project. Unfortunately, we are unable to share this assumed market sentiment. We believe that Mongolia is too risky a jurisdiction to provide any improvement in the company's country risk profile, and the other mentioned projects are still too far from production and cash flow generation to provide much sway in our very own risk assessment. By the same token the future of the Kumtor mine appears more uncertain now than a year ago considering validation of our call with respect to the Stans Energy claim. We strongly believe that an investment in Centerra Gold remains a gamble on the company's ability to control country risk in Kyrgyzstan, a task that management has performed well so far, but also a task that has become harder to manage due to outside factors. Recent outperformance might continue for some time but has reduced potential rewards. On the other hand, we see growing risks stemming from the festering dispute with the Kyrgyz government -- a risk/reward balance that has reinforced our resolve to stay away from an investment in Centerra Gold. Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks. 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