Avocet Mining - is there a case for hidden value?

Avocet Mining is a gold mine. Or to be precise, three operating gold mines, with significant resources, and some upside exploration potential. Yet if you'd invested in it two years ago, you would have lost half your money - despite the massive appreciation of the gold price.

It doesn't seem right. Avocet has had its problems - operational issues at both its more mature mines - and it's a relatively high cost gold producer. Cash costs in the 2009 financial year were USD 551 an ounce - that's pretty high. Some of that is due to low production levels in the year, as difficulties were encountered at both Penjom and North Lanut, so that fixed costs had to be spread across fewer ounces produced; the year before, cash costs had been only USD 316/ounce [ref] 2009 Annual report, p13: http://www.avocet.co.uk/images/Reports%20&%20Presentations/AvocetAR09.pdf [/ref] . But some of it has been due to inflation in the company's input costs, and the addition of the relatively high cost Inata mine won't help matters in the short term.

Even so, the market's valuation of Avocet seems a bit churlish, so I thought it would be worth taking a look to see if there was some hidden value.

This year has seen Avocet double both its output and its resources through the April 2009 takeover of Oslo-quoted Wega, which owns 90% of the Inata gold prospect in Burkina Faso. It was an all share deal, worth £52.5m, and Avocet is now applying for a main board quote in Oslo (which, I've been informed, could mean that though Avocet is AIM listed in the UK, you'll be able to put it in an ISA).

Since Avocet's existing operations were in Malaysia and Indonesia, the acquisition has also given it exposure for the first time to West Africa, an exciting gold region with a lot of exploration going on. Inata is already producing ore, though the first gold pour isn't expected till January 2010. It is expected to have a 7 year life, which isn't long, but there is some exploration upside as drilling continues around the mine site.

The Penjom mine is Malaysia's largest gold producer, and was developed by Avocet in 1996 on a site where traditional alluvial mining had been carried out. Penjom has not been problem free recently; in particular, the grades actually produced are coming out lower than in the published resource model. It's a difficult ore body to mine - a huge diagonal thrust - and while it's generally been producing 5,000 ounces a month, it seems to be having to shift more ore to get there, giving a relatively high cash cost of USD 560/ounce.

High grade intercepts have been found which indicate further potential, so there is some possible exploration upside, and an 80,000 metre drilling programme is being carried out. So far, the mine has produced over 1m ounces, and has about as much again in resource.

The North Lanut mine in Indonesia, also developed by Avocet, was commissioned in 2004 and is  80% owned with the remainder held by an Indonesian company, PT Lebong Tandai.. It's in a highly prospective area, so it's possible further discoveries could improve the resources, though there is apparently little scope to increase output from the existing 4,000 ounces a month. It's managed to increase recoveries 25% this year, leading to a stronger performance, after improving management of both the mining and the leach pad.

The Inata mine has low grade resource at just 2g/AU per tonne. Once it gets to full production in 2011, it should contribute half the company's annual production, with cash costs of USD 500 an ounce - less if the authorities can be prevailed upon to cut the diesel price [ref] Growth Company Investor report, 11 November 2009: http://www.growthcompany.co.uk/recommendations/1091972/avocet-mining.thtml [/ref] .

As things stand, then, Avocet doesn't have very long to make its money out of these mines - its resource is finite and its assets have a limited life. However, it is continuing to drill in order to upgrade resource at its existing mines, and it also owns a number of exploration prospects.

One of these, at Bakan, Indonesia, is quite advanced, as it is now the subject of a feasibility study. It has the potential to produce 50,000 ounces a year from a 50m ounce resource. However, development still needs agreement from the provincial government, and this has been holding it up.

Doup, also in Indonesia, could be a 2m ounce resource. It's now being drilled, and has so far shown recovery rates as high as 84% in a lab test. The feasibility study is due in 2011, and management has said this could be a 100,000 ounce a year mine.

Then there's Seruyung, a heap leachable gold prospect which could be a  500,000 ounce resource or larger; and Belahouro, the licences surrounding Inata, on 1500 square km of flat terrain,. Belahouro is interesting because the deposits appear analogous to good producing areas of Western Australia [ref] AGM presentation, September 2009: http://www.avocet.co.uk/images/Reports%20&%20Presentations/Avocet%20AGM%20170909.pdf [/ref] .

At the interims, the company lost USD 4.5m. However, that figure was struck after making a charge for impairment at Penjom. Stripping-out costs at Penjom had been deferred, in expectation of higher grades, but now that it seems low grades are likely to continue, the costs have been written off. Taking out the one-off charges, the company would have made a USD 3.4m profit.

What is particularly good news after last year's production problems is that the company increased gold production by 500 ounces to 56,300 ounces in the six months. North Lanut's  June quarter was the best since 2007, with recovery up from 45% to 56% and cash cost down 15% year on year [ref] AGM presentation, September 2009: http://www.avocet.co.uk/images/Reports%20&%20Presentations/Avocet%20AGM%20170909.pdf [/ref] . What's not so good is that production will be down again this quarter, from 28,734 oz to 23,600 oz, as planned maintenance is carried out at Penjom (which shut down for a mill liner change in October) [ref] Reuters, 11 November 2009: http://www.reuters.com/article/rbssIndustryMaterialsUtilitiesNews/idUSB19681720091111?pageNumber=2&virtualBrandChannel=11617 [/ref] .

In terms of the balance sheet and resources, the company doesn't look too bad. At the interim stage it had net debt of USD 40m, with cash on the balance sheet of USD 54m, and the construction of Inata is fully funded via a Macquarie Bank project finance facility [ref] Interim statement, http://www.avocet.co.uk/images/Reports%20&%20Presentations/Pres_091111_AVM_Interims.pdf [/ref] . Both the producing mines should be cash generative, allowing the company to fund it exploration activities.

Reserves are 1.5 m ounces, and resources some 5m [ref] AGM presentation, September 2009: http://www.avocet.co.uk/images/Reports%20&%20Presentations/Avocet%20AGM%20170909.pdf [/ref] .

But this is a company which has underperformed the gold price and the gold mining index. Perhaps the future looks dire?

Apparently not. Both the 'organic'  mines are profitable and cash generative, and Inata is set to start contributing to profits next year. Besides, the company is fully exposed to the rocketing gold price - all sales last year were at spot prices [ref] 2009 Annual Report: http://www.avocet.co.uk/images/Reports%20&%20Presentations/AvocetAR09.pdf [/ref] . Only 20% (in 2010, then 40% the year after) will be hedged next year, and that's because Macquarie has demanded it as backup for the Inata financing.

This all indicates that the company should make £32.5m in 2010 [ref] Growth Company Investor, 11 November 2009: http://www.growthcompany.co.uk/recommendations/1091972/avocet-mining.thtml [/ref] The PER looks to be about 20x for next year, which is high - but this year's profits will be affected by the stripping charge and even next year's won't benefit fully from Inata. Look at 2011 forecasts on the other hand, when Inata should be up to speed, and the PER only looks about 10x. That's pretty modest.

My guess is if you think 10x is about right then you have all the upside potential in there for free - exploration, and a third pit (Effendi) being developed at North Lanut; 27 exploration licences that came with Wega; the Koulekoun project in Guinea, a potential 667,000 ounces resource; Inata satellite prospects to be drilled. The company spent USD 13.8m spent on exploration last year so this isn't a tiny programme - it's also quite tightly defined, which I like, compared to many rather scatter-gun exploration programmes I've seen elsewhere.

With the share price hovering around 90-100p I notice that most of the brokers have 98p to 105p price targets, so it seems the shares are pretty much up with events. Is there anything that is likely to make the price move in the near term?

Well, there are new resource estimates due for Penjom. They were supposed to come out in December, but seem to have been put off to March 2010 to enable more intensive drilling to be carried out.

There's also Inata's first gold pour. That's due in January, but management has suggested it might be earlier - if it is, there may be some action in the shares. So far, the market seems to be assuming there's still a fair bit of execution risk left.

So what we have here is, potentially, a stock with the downside protection of a producer, and the valuation of a rather boring and accident prone producer, but the upside potential of an explorer. Well, I could easily tuck a few away. But it may not be the most exciting ride.

By the way, the annual report was quite amusing in place. I particularly like the fact the CEO had his picture taken in a hard hat and sunglasses. It should make it very easy for him to visit his local Waitrose without shareholders asking him to sign autographs...