Centerra Gold: Oversold Gold Miner With Strong Balance Sheet (TSX:CG:CA)
If Covid has proven anything, it is the failure of the Keynesian approach to economic policy. Debt accumulation appears the only constant over the preceding decades, as many Western governments have steadily deteriorated their financial positions. The fundamental flaw rests largely upon the assumption that state leaders are capable, or even willing, to spending money effectively. It fails to appreciate the enormous complexity of centrally planned economies.
Governments during Covid spent more money than during any peace time preceding it, and often with the aim of urgency over outcome. This has had, and will likely continue to have, massive disruptions to markets. Regulation and stimulus can damage value-identifying mechanisms in markets and have widespread consequences, leading to labor disruptions, inflation, and abnormal leverage. These disruptions have increased the prospects that the U.S. dollar is dethroned as the global reserve currency. While it seems improbable that another currency can take its place, gold sits in a unique position to at the least play a larger role in the international monetary system. A more detailed analysis of the gold currency thesis can he found in my previous article.
A portion of one’s portfolio in gold can provide stability in purchasing power and potentially capital appreciation. Owning gold, however, can have its drawbacks. A direct investment does not pay interim returns and can come with recurring storage costs. An alternative can be investments in gold exchange-traded funds (“ETFs”) or gold mining stocks, both of which can provide regular returns while being tied to the underlying performance of gold.
The recent rise in gold prices has lifted many gold mining stocks with the potential for further gains. If gold takes a place in the international monetary order, its price could increase considerably (for a monetary valuation for gold, please see my previous article linked above). In a market of general appreciation, it can often be difficult to find stocks trading at discounts. In the case of Centerra Gold Inc. (NYSE:CGAU), recent setbacks to operations have sent the stock considerably lower than the wider gold miner’s market. However, the underlying fundamentals of the company bode well for a return to success, and with the bulk of their issues in the rearview mirror, investors could do well to consider a position in Centerra.
Centerra Gold Inc. is a Canadian gold miner based out of Toronto, Ontario. The company was founded in 2002 and currently produces three revenue streams by mining for gold, copper, and molybdenum (a mineral often used to produce stainless and structural steel). The company operates two flagship mines, the Mount Milligan mine located 155km northwest of Prince George, British Columbia, and the Öksüt mine located in the Kayseri province of southcentral Turkey. In addition, Centerra has two major development projects, the Goldfield District Project located in Esmeralda County Nevada purchased in 2022, and the Kemess Underground Project located in northcentral British Columbia, 430km northwest of Prince George. The company has total proven and probable reserves of 4,849k oz of gold and 1,366M lbs of copper. The company pays a regular dividend with a yield of 3.16% and has a market cap of approximately at $1.455 billion.
Despite a strong trend for gold miners, Centerra’s stock is down 20% year-over-year. This is due to significant operational setbacks recently faced by the company. This could potentially create an opportunity for investors to buy into an industry with strong prospects at below-market prices. The difficulties faced by the company had significant impacts to production and book value, and as is often the case with attempted value plays, must be approached with caution. In the case of Centerra, however, the worst of the problems may be behind them.
Centerra Gold Inc. appears to have managed through the difficultly and landed in a strong financial position to potentially emerge as a profitable player once the business is back to full operations. It then makes sense to first assess the historical impact of these problems and explore each issue in greater detail before assessing the company’s financial performance, valuation, and outlook, as the latter will be made clearer once these items are addressed.
Mine Seizures and Shut Downs
The first wave of difficulties began in May 2021, when the Kyrgyz Republic, a country located in Central Asia on the western border of China, filed a lawsuit against the company for violations at their Kumtor mine, alleging the company breached environmental laws by placing waste rock on glaciers. The company denied such allegations and asserted the charges were baseless. The lawsuit came after a long history of disputes between the two sides over how to share profits from the operation. Shortly prior to bringing the charges against the company, the government had passed legislation allowing the state to seize assets of companies if its activities pose a danger to the environment or human lives.
After several months of negotiations, the company settled on an agreement that would see the mine be taken over by the government, and the government would give up all its shares in Centerra, representing 26% ownership stake, valued at $777MM, which were to be cancelled. The company also paid $36MM to the government upon the condition all legal proceedings against the company would be dropped. The setback led to a decline in production for the business and subsequently a significant drop in share price, which continued well into the end of the year.
Centerra recorded significant losses from discontinued operations of $830MM during 2021 to write down the company’s book value. The loss of the mine resulted in a sharp decline in production capacity. Centerra saw its gold output drop year-over-year by 62% in 2021, down from 824k oz in 2020 to 308k oz. The sudden drop in production meant costs were now being handled by lesser output, leading to a downward trend in free cash flow. Luckily for shareholders, the business had not over levered its operations and the reduced cash flow was not detrimental to any fixed costs, debt service payments, or shareholder dividends.
Before the company could fully rebound from the Kumtor mine incident, it was hit with a subsequent shock at its second largest producing mine, the Öksüt mine in Turkey, after elevated levels of mercury were discovered at one of the mines adsorption, desorption, and recovery (“ADR”) plants. As a result, operations were halted in March 2022 and the company’s production outlook was slashed once again, this time down over 40% from 425k oz to 251k oz of gold. This second setback sent Centerra’s stock plunging lower for a max decline of 60% from peak to trough.
The company, in addition to reducing its production guidance, greatly increased its production cost estimates, as costs that were estimated based on the historical operations profile were now being handled across a lower total output. Earnings and cash flow subsequently took a hit, and the company posted a negative return for the period.
While the halting of operations leaves money on the table in missed output, the costs to rectify the issue has subsequently proven to be minimal. Management indicated in their Q3 update that it was working with Turkish officials on a two-step solution. First, the company would begin by constructing an abatement system that would alleviate the elevated levels of mercury, with a total cost of $5MM. A small sum considering the mines output capacity. Second, Turkish officials requested that the company resubmit its environmental impact assessment (“EIA”) for review, as the environmental profile for the mine had changed since the previous submission.
While approval is not guaranteed, it seems likely that it will be granted considering the officials were the ones who suggested the system be installed. It seems unlikely the government would encourage the company to incur these costs if there wasn’t a good probability that the EIA would be approved once construction was complete. Additionally, to support this assumption, in the 2022 update provided this year, management indicated that the company’s submission for a license extension to operate at the mine had been approved, that the EIA was currently under review, and construction had begun on the abatement system and was on target for the initial cost estimate.
With this recent update, it seems likely that the issue is under control with the only significant impact to the business being the lost production. And while higher incremental costs are being absorbed by the company’s sole operating mine, Mount Milligan, the Turkish operations are not entirely shut down. Mining, crushing, and stacking operations are continuing while construction takes place, with 100k recoverable oz of stored gold-in-carbon as of Sept 2022 with a recorded cost of $45MM. This should lead to a higher margins per oz once the mine is fully operational again.
Despite the significant setbacks, Centerra Gold Inc. management has fared well under pressure to resolve both issues, although not without a cost. The question then becomes, did the market overreact and discount the company’s assets below their fair value such that it makes an attractive entry point?
Strong Financial Position Despite Mine Closure
To nobody’s surprise, Centerra’s revenue and profits took a hit with the seizure of the Kumtor mine and the subsequent reduction of operations in Turkey. Profitability and free cash flow have, as a result, witnessed a steady decline through the previous 8 quarters. This has in part been a result of the businesses increase in per production costs, as its capital commitments and overhead are now paid for by a smaller total output.
The company was past known for being a low-cost producer, often with an all-in sustaining cost (“AISC”) well below its industry peers. However, as can be seen over the recent years, and particularly with the shutdown of the Turkish mine, the AISC has risen substantially. Again, this is due, at least currently, to costs associated with a larger production being spread across a smaller output.
Despite the hit to earnings and cash flow, the company’s financial position has improved over the prior four years. Management was able generate net positive cash flow and put much of the money towards improving the company’s balance sheet. While the asset size of the company was cut back, the debt load was eliminated, and the company was able to build up cash reserves of $580MM on top of a sizable credit facility of $392MM ($400MM total facility).
The company currently has a net positive cash position, a strong trend in working capital, and a large amount of credit to draw on if it were needed to do so. With the costs of construction at the Öksüt mine contained, the company should have ample reserves to handle its increased temporary cost and manage through the period of reduced output.
The company’s financial position does not leave much worry that future operations are in jeopardy due to insolvency, and at first blush would appear strong for a gold miner, which can often become over levered due to the high capex nature of the business. However, much of this stock’s potential becomes dependent upon the company’s ability to return to full output at its Turkish mine, something management expects to be unlikely during the current year. And with the stock climbing in recent months, likely driven in part by its previously announced share buyback program, leaves a question whether the current share value makes for an attractive investment given the uncertainties surrounding a return to prior levels.
Valuation and Outlook
A comps analysis shows that Centerra is certainly still trading well below other gold miners. From a return perspective, it provides a significantly more attractive valuation profile than some of its peers as well as some of the larger gold miners who pull the market. This is largely being driven by the company’s strong financial position, which drives down its enterprise value considerably due to its high cash position and low debt. Its earnings, which are only moderate compared to its market cap, are high compared to its enterprise value.
If the business could increase its profits back to normal levels for its two operating mines, it certainly makes for an attractive valuation, despites its recent climb in price. If both mines could return to historical levels, investors buying in today would pay 5x free cash flow from the company’s two operating mines. This creates an attractive valuation when one considers it excludes any of the company’s development projects, one of which, the Goldfield Project, is expected to release a technical report this year. If the introductory gold thesis proves correct and spot prices move higher, Centerra shares could provide nice returns for investors while paying out regular dividends with a 3% yield.
Centerra Gold Inc. management has indicated that there will be no immediate return to full production, while the EIA review is underway, management suggested that 2023 will likely see below maximum production and thus suppressed earnings and elevated production costs. The cash flow profile for 2023 does not paint a concerning picture as for the survival of the company, which should be able to maintain capital costs and overhead throughout the year, currently projected at $75MM. Potentially requiring it draws down cash position in a contained manner. Due to this, investors purchasing the stock now may not see strong performance for the remainder of the year, but the dividend should be comfortably covered, and thus a return on investment can be had in the interim while potential stock appreciation is delayed. If, or when, the company can return to full output, its cash flow profile would give current entry points an attractive value.
The uncertainties facing the operations, however, have not been eliminated, but the resolutions proposed are certainly promising. How much weight investors would put on future performance should be strong tied to one’s outlook for gold.
With the recent setbacks to production faced by Centerra Gold Inc., investors looking for strong immediate capital appreciation would likely be better to avoid Centerra. The company is unlikely to quickly rectify its production issues and the below average output could last late into the year. While its other flagship mine is still operating at normal levels, this output is not enough to turn a strong return at the current market cap.
Investors with a longer time horizon, and who are bullish on the prospects of gold, would do well to consider a small position in Centerra Gold Inc. as part of their portfolio, as its current value is trading well below its full output, which appears likely to resume within a 12 month period.
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