Stock Review: $NG- Novagold Resources maybe a Great Bet on Rising Gold Prices

by on December 19, 2012

in Mid Cap Value Stocks

However, rising gold prices are not a given and the shareholders may not necessarily benefit.

The problem in making a long term bet on a commodity price is that you can end up being totally wrong. The price of gold, like any commodity, is a result of the demand and supply of the physical material. The demand for gold has been  strong recently as investors continue to look for a hedge against the falling dollar and potential for future inflation. Is the macro-economic environment going to be as conducive to gold demand in 5 years time? It is very difficult to predict.

And then what about the supply?

When the demand is strong, supply eventually catches up. It may take some time in capital intensive industry such as mining. So the initial run-up in the prices due to demand/supply imbalance eventually subsides with the price leveling out and ultimately declining when the demand drivers go away (let’s say if in 5 years time, US finds a way of controlling its debt and inflation and the dollar is stronger and therefore the investors are less jittery and more inclined to invest in other businesses). Periods of high demand are followed by a mining gold-rush, which eventually raises the supply and eases or reverses the commodity price appreciation.

Novagold as an Option on Gold Prices

Let’s start by looking at what Novagold Resources (NG) actually is. The Vancouver, British Columbia based company explores and develops mines for gold, silver, copper, zinc and lead ores in Alaska and British Columbia. The company is in the process of transforming itself into a pure play on the 50% interest it owns in the Donlin gold mine in Alaska along with Barrick Gold. Donlin gold deposits cover an area of approximately 81,000 acres and have measured and indicated resources of 39 million ounces of gold and another 6 million ounces inferred. The current feasibility studies indicate that when production is started, the mine could yield up to 1.5 million ounces of gold/year for the first 5 years and 1.1 million ounces/year over its initial 27 year life.

The company is in the process of monetizing its other assets to redeploy capital towards Donlin. Novagold and Barrick are currently in the permitting process and it is expected that this will take at least 4 years. So any production is 4 years away by an optimistic estimation. On the positive side, since the deposits are located in Alaska,a US jurisdiction, they are considered to be one of the least risky locations for the project.

Economics of Donlin

Keep in mind that Novagold has 50% interest in this property, and therefore its revenues and expenses will be 50% of the total at Donlin.

Net Present Value of the Donlin Assets (in $millions)

  Discount Rate: 5% Undiscounted
Price of Gold: $1200/ounce 547 6,200
$1700/ounce 4,600 14,600
$2000/ounce 6,700 19,000
Capital Expenses 5,467 6,700

 

Total capital expenditures to develop the mines is estimated at $6.7 Billion, that will be spread over several years. The next 4 years are going to see only permitting expenses at the rate of $40 million per year. As a rough estimate then, and being conservative, if we assume $6.58 B in capital expenses to be taken in 2017, 4 years from now when production starts, the NPV of the capital expenses at 5% discount rate is $5.47B.

Of course, these expenditures will in reality be spread out over multiple years as the production is likely to start and then expand. In that scenario, the NPV of the capital expenses will be lower. However, another way to look at it is that inflation is likely to take a big bite out of the 5% discount rate we used so in real terms the discount rate will be quite low and therefore the NPV we have calculated is appropriate for what is a back of the envelope calculation. Between now and the production start, the 5% discount rate represents the cost of money.

Is Gold Really an Inflation Hedge?

Given that the market value for Novagold today is just $1.22 B, the numbers in the Undiscounted column look really attractive. For instance, one can argue that gold is really an inflation hedge. Since the current gold price is close to $1700, one can expect the gold prices to stay close to $1700/ounce over the period of next 27 years (the life of the mines) in real terms (in essence, the price will keep pace with inflation) and therefore in real terms the npv calculation should be done undiscounted.

First of all, the idea that gold is an inflation hedge is a myth.

But let’s continue assuming this may be true for the future.

At the current price of gold at about $1700/ounce, the NPV of the assets is at $14,600 million. From this, we will need to subtract the Capital Expenses of $6,700

Also keep in mind that the actual production cost of gold is currently running at around $1000/ounce but after running the calculations it seems that the company has already accounted for the cost of production in it NPV estimates.

This gives us the NPV of the project, assuming a $1700/ounce gold indexed to inflation = 14,600 – 6700= $7,900 million.

$7.9 B 4 years from now is worth (at 5% discount/yr) $6,435 million.

Since Novagold has only 50% claim on the project, for Novagold investors this amounts to 6435/2 = $3218 million.

What does this mean?

It means that 4 years from now, in 2017 when the production at Donlin starts, if the price of gold is still at $1700/ounce, one can reasonably expect Novagold’s market value to be at $3.2 B. If the price of gold rises, say to $2500/ounce, the market value would increase another 50%. Currently it is at $1.22 B, so the attraction for investment cannot be denied.

However, there are a variety of risks that you should keep in mind:

  1. Most of the increase in demand for gold recently has been from investors. The actual demand for use in jewelry has actually declined. At $1200/ounce price, the project has a negative return on investment and is not worth it. So a solid case that needs to be made that the price of gold will stay flat or increase
  2. 4 years is a long time to wait and it is no guarantee that capital expenses to develop the mines will not escalate in this time
  3. This is key: Novagold does not have 50% of $6.7 B or about $3B, if you net out the cash that it does have, to contribute to the capital expenditure needed to develop the mines. If the economics are still favorable in 4 years time, money will be raised and the project will go ahead. However, the capital raise may take the form of additional equity which will wipe out any gains for the existing shareholders who are buying today. An increase in market value does not always imply an increase in share price if additional equity is issued.
  4. And finally, do not buy Novagold if you are not willing to tie up your investment for atleast 4 years.

Novagold has recently raised funding by issuing equity in private placements to Paulson and Klarman’s funds and additional raises cannot be ruled out. The risk/reward ratio can work for many investors, and indeed, it is a leveraged bet on rising gold prices,  but if you do take a position, make sure it is not a large one. Ultimately it would depend on how bullish you are on gold, and personally I am not much bullish

This analysis was requested by a reader. You can request a review of a stock you are considering over here

Leave a Comment

Ivan K. January 20, 2013 at 11:47 am

Thanks a lot for your analysis. I think for many investors in this co. point 3 is the main concern or perhaps should be. As am not particularly experienced with regards to equity issuance effects (on this company/in general) I wanted to see if you could clarify this notion “An increase in market value does not always imply an increase in share price if additional equity is issued” with providing an example of how this may be the case. Better yet, my other question is simply what might happen to the share price if they issue $3B in equity in say, 2 years down the road?

Thanks in advance,
Ivan

Reply

Shailesh Kumar January 25, 2013 at 5:57 pm

Ivan,

This typically depends on the company in question and how it is being valued. If the company is undervalued relative to the assets, additional equity issue might even be slightly positive since they increase their cash position by a dollar when the market is only valuing it at 80 cents (example)

However, in most cases, new equity is issued when the stock is over valued (so the company can get more $/share) and invariably, the secondary offering is at a discount to the market price. It is a large block of shares to move and the underwriters need to be paid to take the liquidity risk. The company often talks up the prospects of the project this equity is going to fund during their dog and pony shows in the lead up to the offering and a sensible evaluation after the equity is issued may come out with a much sobering picture.

In ideal scenario, the equity is issued at the market price and since an equivalent amount of cash comes in, it should not change the stock price. That is unless the market judges the projected use of cash as suboptimal. Since for miners, capital projects are typically long term and require upfront use of cash while the returns take years to materialize, the market will judge this project as more risky compared to the existing operation (which is ongoing and known). There fore, the new equity will only find buyers at a price lower than the market price and when issued it will move the market price down.

On another level, and something that most investors often do not worry about, new equity also means that the votes that each existing shares represent is suddenly less valuable. That also has an impact on the price, although how much is anybody’s guess.

Regards,
Shailesh

Reply

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