Is This A Gold Mine?

Published in Company Comment on 12 July 2012

Stephen Bland mines Avocet for value.

Avocet Mining (LSE: AVM) is a gold miner with its principal assets based in Burkina Faso, West Africa.

Here's the usual fundies that I see as particularly relevant to the initial appraisal of a value play. The company accounts in US dollars and I have converted their figures into sterling where necessary at the current rate of 1.547/£.

Share price66p
52-week high/low287/63p
Net tangibles per share 31/03/12119p
Net cash£49.7m
Underlying eps 20119.7p
Forecast eps 20128.4p
Dividend 20116.3p
Forecast dividend 20126.0p
Price-to-book (P/TB) ratio0.55
Forward price-to-earnings (P/E) ratio7.9
Forward yield9.1%
Directors own<1%
Other majors37%

Unlike some of the small-cap value shares I have reviewed recently, Avocet does not have a large spread in its price -- less than half a penny when I checked. It's not that small, either, with a market cap even at the current depressed price of well over £100m.

The key ratio here is P/TB at 0.55, which is pretty low. Additionally, it had substantial net cash of £48m, which has arisen mainly from the sale of its South East Asia assets last year.

The forward P/E at 7.9 is fairly low, but not spectacularly so, while the forecast yield is attractive at 9.1%.

Recent poor news regarding equipment availability for the second quarter has hit the price, but this may be just a temporary dip assuming it is not a longer-term problem, making the shares quite attractive.

Gold rush

However, this is gold mining we are talking about, and there are two specific types of additional risk associated with this kind of play, over and above the kind of risks that accompany all shares generally including those of a value bent.

First is the political. This depends on the region of the mining activity and in this case the company's major interest is the Inata mine in Burkina Faso. A lot of Africa is either currently or potentially unstable. This country borders Mali, which has seen a lot of trouble recently and that could spread in some way to Burkina Faso, disrupting their main operation.

The second specific risk is the gold price. Mining share prices are a geared play on their principal ore, and thus the Avocet share price is related strongly to the gold price. The reason the share price is so geared arises from the large element of operational gearing, which is an accounting term for the level of fixed costs. The higher those costs are as a proportion of the selling price, the higher the operational gearing and the narrower the gross profit margin, with the consequence that the more sensitive the profit is to a change in the selling price.

To illustrate this, imagine a product that costs 80p to produce and that sells for 100p. The gross margin is 20p, and a 1% rise or fall in the selling price means a 5% rise or fall in gross profit. This is the operational gearing.

Compare that with a product having the same selling price but which costs 60p to produce with a 40p gross margin. Here, the same 1% change in the selling price results in a 2.5% change in gross profit because the operational gearing is lower. The lower the operational gearing, the less sensitive gross profits are to a change in selling price.

Gold is expensive to produce -- it has high operational gearing. In its first-quarter report for 2012, Avocet tells us that its cost per ounce was $800-850. Clearly, then, it can be profitable only where the price is decently above that, and currently it is at about $1,565. But the difficulty for miners is that gold fluctuates constantly; unlike widgets, where the manufacturer has some control over the selling price. Miners have no control over the selling price and instead it is the gold market that fixes it.

In the short term, the gold market price is not related directly to miners' costs but to supply and demand for the metal. Mines that were unprofitable at lower gold prices can become attractive if it rises substantially. But it works both ways and the less profitable miners can easily become marginal or loss making if the price falls sufficiently. 

This is why gold miners are to a large extent a geared play on the gold price. Gold has risen in price very substantially over recent years, although over the last 12 months it rose to about $1,900 then fell back to the current level.

Note that it is not only profits that would be affected by changes in the gold price. It is the assets, too, and that is especially important for value investors relying on P/TB. This is because the mine valuations that form the leading asset here must also be based on the gold price. Clearly, whatever the quantitative estimate of the gold still left to be mined, its value at any point will fluctuate with the market price.

So an interesting but high-risk play in my opinion. You have to believe that gold has a lot further to go for Avocet to be attractive and that may be questionable after the rise of recent years. On the other hand, further financial difficulties or other major problems in the world could deliver another big upward move. If you think gold is headed down, don't touch it. And you have to be willing also to discount the political risks.

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> Stephen does not own shares in Avocet Mining

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