Summary
- Allied Nevada Gold, currently trading at $0.97, is priced at a significant discount to its base case intrinsic value of $4.10 and upside case of $10.27.
- A strong management team operating in the world's safest premier mining jurisdiction will continue to return shareholders value through doubling and tripling production by 2018 and 2022, respectively.
- Global demand for gold and silver from sovereign and private entities continues to support the price of gold in a strong dollar environment, showing extreme resiliency.
Source: Created by Author
Allied Nevada Gold (NYSEMKT:ANV) is an attractive stock due to resilient gold and silver prices in the face of strong dollar price appreciation against a basket of currencies, exceptional management with 35+ years experience, and the upcoming expansionary mill phase that will average approximately 730,000 gold equivalent Ozs during the life of the project (2018-2029) from an approximate 250,000 gold equivalent Ozs as of 2014E, once it secures the necessary financing. More on this later.
Source: Created by Author
Source: Created by Author
Investment Summary
My time horizon for ANV is long term (i.e. 2 to 3 years), but buying now will offer investors excess alpha within 12 months of up to 410%. To reiterate, ANV has a significant opportunity to increase annual ounces of gold produced through a simple expansion of the mill in two phases, in 2018 and 2022. The value proposition is simple; secure financing and expand the mill in two phases. Phase I will take 24 months until completion once started and Phase II will take an additional 12-month construction period.
A lot of commentators and analysts are down on ANV because they believe it won't secure financing. As of the most recent 10-Q, Credit Suisse Securities and Scotia Capital are assisting ANV to help secure financing for the first phase of construction. There is a cat and mouse game currently going on between ANV's management and lead underwriters who want cost reductions in the expansion of the mill, which ANV has done with its recent announced reduction in Phase I to $768 million from $934.5 million. Furthermore, it doesn't go without notice that the largest shareholder is a tier 1 investment bank, BNY Mellon (NYSE:BK). There is no doubt in my mind that a firm willing to pony up 12.5 million shares, about 10% of float, will be willing to secure or help secure financing for a project as lucrative as doubling and tripling current production. Another major contribution to value can potentially come from the gold-to-silver ratio reverting to the mean of 55, currently at 70+. Below, I have calculated some probabilities associated with my price target of $4.10 in 12 months.
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Source: Created by Author
I found these simply through using log-normal assumptions and the LOGNORM.DIST function in Excel. I used the GARCH(1,1) annualized volatility estimate of 98.06% (explained later) as part of my assumptions for implied volatility. As can be seen, if the log-normal assumption holds, the median price realization in 12 months (i.e. a 50% probability) will be $1.57, with a greater probability of returning 100% and 200% in 12 months than falling 50% to $0.50 or less.
Valuation Summary
Source: Created by Author
DCF: Base Case (See Appendix at the end for Bull and Bear Models)
- Unlevered FCFF DCF with Bear, Base, and Bull cases.
- Dynamic WACC using a bottom-up CAPM and bottom-up Beta approach.
- Conservative and defensible assumptions using current prices of gold and silver, as well as current futures for future years in the projection period.
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Source: Created by Author
In order to arrive at my base case target price of $4.10 (an upside potential of 410%), I used a 10-year multi-stage discounted cash flow approach, utilizing FCFF. The reason I use FCFF instead of FCFE is that ANV's capital structure will change dramatically over the projection period. ANV's bull case of $10.27 is based on gold becoming $2,000 (while holding silver prices constant at $16.87) by 2024, with incrementally spaced price moves in between now and then. Below are some metrics derived from my model.
| Enterprise Value |
Implied Equity Value |
Implied 1 Year Share Price
|
Terminal Year EBITDA (2024E) |
Implied EV/EBITDA |
Average 10-year WACC during Projection |
Cumulative PV of 10-year FCFF |
PV of Terminal Value |
| $1.22B |
$561.8M |
$4.10 |
$502.7M |
11.57x |
11.36% |
$70M |
$1.15B |
The Enterprise Value of $1.22 billion was derived using Terminal Year EBITDA (2024E) of $502.7 million and multiplying it using the Exit Multiple Method of 6.7x (the average EV/EBITDA in the entire Metals and Mining space), giving a Terminal Value of $3.37 billion, and then discounting that back to a Present Value of $1.15 billion. I then added that to the cumulative PV of FCFF of $70 million to arrive at an EV of $1.22 billion.
The other components of Enterprise Value for ANV are the Market Value of Debt, which is $668 million, including PV of operating leases, purchase obligations, interest expense, and long-term notes.
Base case prices for gold and silver are current prices for futures and spot as of early February. For example, in my projection year of 2018, the Dec. 2017 Gold Futures price of $1,264 as of Feb. 6th, 2015, was used. The current gold spot rate is approximately $1,210/ounce.
Free Cash Flow to Firm Model
My base case model assumes (image below) a changing capital structure, one in which ANV starts highly levered at a market value debt-to-capital ratio of 82.94% (debt valued to market at $668 Million) and reduces debt outstanding once capex stabilizes after Phase I and Phase II of the Hycroft Mill expansion towards the industry average market value debt-to-capital ratio of 33.63% by 2024. As mentioned in the table above and as can be seen in my model below, I used a dynamic cost of capital to discount the unlevered FCFF, which changes every year. The synthetic cost of debt starts out at 11.34% (with a 9.50% implied company default spread), assuming 2.00% 10-year risk-free rate, an equity risk premium of 5.75%, estimated by Aswath Damodaran's most recent February data, and an initial levered beta of 4.84, which reduces to 1.60 by 2024. By year 10, cost of debt stabilizes at 4.54%, derived from the year 10 target capital structure mentioned before of 33.63%. WACC in 2024 is 9.2%. The lower WACC by year 10 implies a lower required rate of return and lower levered beta, as the debt ratio is reduced, further reducing the cost of equity as well, which starts off at 29.85% in 2015 and ends at 11.20% by 2024.
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Source: Created by Author
Profitability:
Expected EBITDA in 2014 is assumed to be $105.5 million. 2015E EBITDA will be slightly lower at $96.5 million and starts to rise in 2016E to $97.5 million. I specifically highlighted 2018E and 2020E above because those are the years the Hycroft Mill will expand in Phase I to 60,000 tpd and in Phase II to 120,000 tpd. This will have the effect of more than doubling ANV's current production of approximately 250k gold equivalent ounces per year to over 545k gold equivalent ounces per year until Phase II where annual production will increase to approximately 730k gold equivalent ounces. Keep in mind, this is using a recent, as of Feb. 6, 2015, gold-to-silver ratio of 73, which historically speaking is a very high ratio. The higher silver rises (the lower, the GS ratio falls), then the more gold equivalent ounces will be produced. A simple reversion towards a mean gold-to-silver ratio of 55 would change ANV's base case 12-month stock price estimate from $4.10 to an intrinsic value of $6.43 per share, as annual gold equivalent ounces in Phase I expansion would increase 12.66% to 614k from 545k, and Phase II annual gold equivalent ounces would increase 12.87% to 824k ounces from 730k. The lower gold-to-silver ratio of 55 would cause EBITDA after Phase I (2018E) completion to increase 14.66% to $263.9 million from $234.4 million. Likewise, EBITDA after Phase II (2022E) completion would therefore increase 27.25% to $548.3 million from $430.9 million. The reason ANV's price is so highly sensitive to changes in the price of silver is that it will increase its current annual production 950% from 2 million ounces to over 21 million ounces by Phase II completion of the Hycroft Mill.
This shows that there is a large potential undervaluation occurring in ANV at the moment as the gold-to-silver ratio rarely goes above 70. This in my opinion has given investors an opportunity to buy at even more discounted values as the current gold-to-silver ratio is not in a normal true range.
Profitability to a large degree will also hinge on management's ability to decrease cash costs to $575-$600 and all-in sustaining costs between $775-$800 by Phase I completion of the Hycroft. In addition, necessary financing will be critical in the success of future operations, as equity financing is not an option for the expansion phases as recent updated estimates from management show that it will cost $768 million to finance Phase I and likely $400 million to finance Phase II. I have no doubt in my mind that when the largest institutional holder is a major investment bank, BNY Mellon, that the company will find the necessary financing for both phases of the project.
Volatility (Risk)
As an investor essentially pitching a sell-side recommendation, I think it is important to speak about ANV's volatility in a few different dimensions. I won't speak in metaphors about it. ANV is one of the most volatile stocks I have seen in a while and is quite possibly the most volatile gold miner in the industry. This is mostly because of its high debt leverage, producing an extremely high levered beta of 4.84 in 2014 (ANV's unlevered Beta is 1.22, derived from the industry average unlevered Beta). ANV's recent equity placement couldn't have come at a worst time, as the high levered beta implies a 29.85% cost of equity in 2014. Essentially, management hasn't been the most fiscally prudent over the years, but is now making amends as it realizes it has reached full debt servicing capacity at current market prices for gold and silver.
Moving on, I will talk briefly about ANV's conditional exponentially weighted moving average, unconditional volatility (or the simple standard deviation, known as Constant Volatility), GARCH(1,1), and its implied annual volatility using the daily GARCH result that I have found for the estimation period as the future estimation parameter for volatility. In addition, I will also highlight the volatility of volatility, also known as kurtosis, and give a brief insight as to why I believe ANV will exhibit superior returns.
However, before I delve into the volatility measures, I want to take a look at the return distribution over the last 504 trading days or 2 years (Feb. 6, 2013, through Feb. 6, 2015) in order to get a feel for the behavior of ANV's daily returns.
Source: Created by Author
Above is the return distribution (N=504), and as expected, with daily return distributions of stocks, the tails are fat with excess kurtosis at 5.82, known as leptokurtosis. Kurtosis is simply the volatility of volatility. In other words, you want kurtosis with positive skew in a stock if you are a less risk averse investor that is able to bear the fat tail event days, but the positive skew means you will experience those large positive returns.
A more detailed view of what is happening beneath the daily returns can be seen below, where I give a drill down of the data using half standard deviation bins. The mean daily return value for the 2-year trading period was -0.454% with a simple daily standard deviation of 6.09% (a very high value even for a small cap).
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Source: Created by Author
Looking at the left most table and starting with the bin that is -3 standard deviations below the mean, we see a frequency of 5, which means there are 5 daily returns that were less than -18.74%, or approximately 1% of the total 504 trading days. The conditional formatting is meant to highlight the shape of the distribution, green meaning a high value and red a low value. If we go to the mean at 0 sigma, or -0.45%, there were 131 daily returns that were between -3.50% and -0.45%.
Under a normal relative distribution, we would only expect to observe 96.5 daily returns in this bin range, or 14.99% of the 504 trading days, as can be seen in the middle table.
The far right table gives you the visual representation of how leptokurtic ANV's returns tend to be, as the actual daily return observations for the mean of 0 sigma exceed the normal relative frequency by 34.5. This isn't exactly bad or good. It just means that on average there will be more daily returns closer to the mean than predicted under a normal distribution. However, since the distribution is leptokurtic, the tails are fat and there will be more daily observations that are greater than and less than 3 standard deviations (99.7% of all observations). As you can see, there are 6 observations that are greater than 3 standard deviations from the mean, whereas if the returns were normally distributed, we should only see 0.7 returns greater than 3 standard deviations.
As mentioned before, investors willing to bear a risky component in their portfolio should seek return distributions that are positively skewed but leptokurtic, so that you have a higher probability of experiencing more home run return days. This was the case for ANV during its 2008-2011 period when the price rose from a low of $1.88 on October 31, 2008, to a high of $43.49 on March 31, 2011, a 2,213% return, or a CAGR of 266%!
Now that we have a good idea of the return distribution, let's move into the other volatility measures of ANV. Below is the constant daily volatility (blue line) of 6.23%, using log-normal returns this time. This is the simple standard deviation of the log returns over the same sample period as before (2/6/2013-2/6/2015).
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Source: Created by Author
The red line is the volatility measure known as exponentially weighted moving average (EWMA), which peaked on December 9, 2015, after news of the equity offering at $1.00 per share sent ANV tumbling over 33% in a day from $1.39 to $0.93 a share by close of trading. This volatility measure differs in that it is a more intelligent measure of what the true volatility is like for that particular period, as it includes information from the previous trading day's variance and yesterday's EWMA, as there exists a feedback mechanism weighting more recent data more heavily. The formula used is:
Where, Sigma^2 is that particular day's EWMA, lambda is a decay factor found using Solver, where we maximize the daily Log Likelihood Function by finding the optimal lambda value. Lambda in this case was 0.958. Values closer to 1 signify a slower rate of decay or a daily EWMA estimate that changes slowly based on recent changes of ANV's daily returns. JPMorgan RiskMetrics uses a lambda of .94 for daily returns (more can be read about EWMA here).
Another word about volatility, we know that it tends to cluster and reverts back to the mean, and it tends to return to a lower value from a higher one, and vice versa. The current daily EWMA volatility measure is 8.36%.
There is another volatility measure that is a little more accurate in my opinion, and that is GARCH, which stands for Generalized Auto-Regressive Conditional Heteroskedasticity.
- Where gamma = 1 - alpha - beta.
- VL = omega/gamma
- Omega, alpha, and beta are found using Solver by maximizing the LLF function to find optimal values for each day's return.
- Omega is your mean reverting term, therefore gamma*VL = omega.
- Beta is the coefficient on yesterday's GARCH estimate.
- Alpha is the coefficient on yesterday's variance estimate, which is the log return squared during time t.
GARCH is similar to EWMA, except that it includes a mean reverting term (omega). I am using in particular a GARCH(1,1) model, which means we use the one-day previous estimates of variance and volatility to find today's estimate. The reason GARCH tends to be a little more accurate is that volatility (among other things) tends to be mean reverting. The current one-day-ahead GARCH volatility for this period is 6.18%. We can use this value and multiply it by square root of 252 in order to get an implied volatility measure, which comes out at 98.06%.
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Source: Yahoo Finance
As can be seen in the far right column of the option chain image above, my measure of implied volatility derived from the GARCH(1,1) of 98.06% is in the range of the implied volatility from options that expire about one year from now (the closest available expiry date).
Business Risk
One of the main drivers of ongoing business risk for ANV right now is the price of gold. If gold falls below $1,000 an ounce, ANV will likely cease any expansionary plans and my model for $4.10 falls apart in addition to ANV likely not being able to cover interest costs and maintain its debt covenants, and therefore, exist as a going concern. The interesting thing about this is that below $1,000 an ounce for gold would mean a massive amount of supply coming off the market as this would be well below the cost of production for the great majority of miners. According to Citi analysts, 75% of gold mining companies are unprofitable at spot prices just below $1,200 an ounce. Although gold is more driven by macroeconomic instability and probabilities, this supply/demand imbalance should help create a floor on the price of gold.
Furthermore, here is a look at the all-in sustaining costs (AISC) of gold for some primary producers.
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Source: Denver Gold Conference
Although this data is from 2013, the costs are relevantly similar. As you can see, these are some of the largest gold companies in the world. They range in market cap from $3 billion to $18 billion. This AISC is simply unsustainable at current prices and will create supply/demand imbalances if gold trends lower and realizes Goldman's 2016 forecasted price of $1,089 per ounce from its previous estimate of $1,200, citing the likely interest rate hike of the Federal Reserve. The current February and December 2016 gold futures prices are $1,212 and $1,220 an ounce, respectively.
ANV does not hedge, and is therefore greatly exposed to the price of gold to the upside and downside. One recent development that is positive concerning business risk is the price of oil. ANV has energy-intensive equipment that uses diesel fuel. ANV estimates that it will hedge only 28% of its diesel needs for 2015. The recent low in energy prices will help boost profits in the coming quarters. Management should prudently secure more diesel swaps as oil trends lower.
Along with price declines in gold and silver, the risk of further write-downs of ore on the leach pad and ANV's heavy debt burden ($668.5 million market value of total debt, including purchase and lease obligations) will greatly affect ANV's survivability. The most recent quarter saw a write-down of production inventories of $70.7 million. Write-downs are not common, but if gold and silver continue on a downward trajectory (opposite of prevailing futures prices), then we could see the compounding effects of their approximate $12 million interest expense in 2015 and write-downs severely affect their ability to secure financing for the Hycroft expansion project, currently projected to be in operation in 2018.
Macroeconomic Risks
What happens if the Fed decides to raise rates as scheduled in April? Currently, the rest of the world's central banks are devaluing, mostly reactions from the US devaluing in the first place. Although unlikely to happen this year in my opinion, let's take a look at ANV's share price if we get a 100 basis point increase in the 10-year Treasury, an integral part of the cost of capital for any firm. It is important to note, that even if the Fed raises the Funds Rate, it is unlikely that the yield curve on the long end will move much due to treasuries being a safe haven for the rest of the world at the moment. Nonetheless, a 100 basis point increase to 3% in the 10-year US Treasury would cause ANV's base case share price to decrease 8.05% to $3.77 from $4.10 and enterprise value would fall 4.10% to $1.17 billion from $1.22 billion.
What about a 400 basis point reversion to the mean of 6% on the 10-Year US Treasury?
Even with a 400 basis point move back to the long-term average, ANV's 12-month forecast would be $2.85 a share, giving investors a 185% premium to today's price of $1.
In the current environment, it is not likely that these aforementioned scenarios are probable anytime soon. The US will be perceived as a safe haven by foreign investors for years to come causing long-term rates to stay low despite any policy changes and economic woes such as a heavy debt-to-GDP burden mixed with low labor force participation rates.
Institutional Investors
As any due diligence should include, I will talk briefly about the institutional holdings behind ANV. Currently, institutions own a significant position, 51% of float, or 64 million shares. Not all the 13Fs have been filed yet, but from what we do have for the most recent quarter of 12/31/2014, there has been significant movement both in and out of ANV, as can be seen below in the table.
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Source: Whalewisdom
Van Eck's 4.8 million share selloff is likely due to some sort of covenant breach as part of the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) due to ANV's price dropping below $1 for a brief period and not because of a newfound belief in value. However, Bank of America's Wealth Management team, Columbia Wanger Asset, has come in heavy with a 3.45 million share buying spree, as has BlackRock and CalPERS, with increases of 1.032 and 2.667 million shares, respectively.
Summary
With the recent devaluations in the currency markets by Japan, Europe, Australia, and now China, it is becoming apparent that gold is an investment that is here to stay. Global gold and silver demand is showing no signs of abating with growth coming mostly from Chinese and Indian consumers. Long-term US Treasury yields don't pose any existential threat to ANV's long-term outlook as the Fed will only make incremental increases in the Funds Rate, and foreign investors will have no other place to park funds as the Treasury will still offer protection relative to other sovereign bonds. Other possible upside scenarios include a simple reversion of the gold-to-silver ratio back to a normal range which would cause the intrinsic value of ANV to skyrocket. If you remember from before, a reversion to 55 would cause ANV's base case intrinsic share price to increase to $6.43 a share and enterprise value to increase to $1.54 billion from $1.22 billion. Keep in mind, the GS ratio has been as low as 40 as recently as July 2011. The GS ratio is essentially at its upper bound as silver producers are starting to cut production due to the price being below the cost of production and are rescinding capex for exploratory projects, further reducing future supply. This will only cause the ratio to revert back to its mean sooner rather than later, giving ANV another boost in value.
The gold and silver mining companies that will return the most in the next 12-24 months are the ones that are the most hated at the moment (ANV's current short float is 26%). Buying now should secure a significant margin of safety and allow investors to realize a sizeable return on investment. This investment is not without risk. As mentioned before, the implied annualized volatility is upwards of 98%, meaning there will be days you will experience 2 and 3 sigma moves (i.e. the stock moving up a dollar or two in this current trading range) and days where you will see your position fall up to 30% in a day. With that said, the negative correlation that ANV has with the market (recent regression testing shows ANV is negatively correlated with the market) will offer your portfolio an added security addition in lowering your overall portfolio variance. It is these characteristics that make ANV a strong buy at current market prices.
Appendix:
Bull Case: Price Target = $10.27
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Source: Created by Author
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Source: Created by Author
Bear Case: Price Target = $0.90
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Source: Created by Author
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Source: Created by Author
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.