Romarco Minerals Has Run Too Far, But Keep It On Your Radar

The bear market in gold miners was particularly brutal to Romarco Minerals, although so far in 2014 the stock has made up a lot of ground. Year to date the stock has nearly doubled, and it has largely avoided the correction we have seen in the past couple of months. This is compared with the Market Vectors Junior Gold Miner ETF (GDXJ), which has risen just 7% for the year, and which has given back nearly all of its year to date gains since peaking in March. The following chart illustrates the relative performance.

(click to enlarge)

The outperformance in Romarco shares doesn't have any specific catalyst. What is likely happening is that investors have been favoring companies that have low-cost producing projects in that are approaching production. Romarco's Haile gold project in South Carolina is going to be highly profitable, and it is slated to begin production in less than two years. With permitting moving along and with management confident that it will be able to get debt-based financing for a large chunk of its initial capex needs the Haile project is moving forward without a hitch.

But with this being the case the stock has gotten ahead of itself. The Haile project is a high grade surface mine that will generate a lot of cash-flow, but there are several factors that detract from its overall NPV such as an initial capex expense of $360 million. The mine will also lose a lot of cash-flow to taxes, which effectively come to over 38%. Finally, for a company that is valued at over $450 million (and this will be higher once management issues stock as part of its capita-raising effort) 150,000 ounces of production simply isn't a lot.

With these points in mind I think investors have become too enthusiastic, and it is time for a sizeable pullback. Depending on which valuation matrix you use the stock has 10% - 25% downside in a relatively optimistic scenario. In coming up with this figure I have given the company the benefit of the doubt on many issues, and the downside is still substantial.

With that being said the stock is on my radar. I think that later this year we can see a sizable pullback as the company issues stock as part of its capital-raising effort. If the pullback is sizable enough Romarco will look like a compelling investment considering that its Haile mine will generate a lot of cash-flow in the near future, and considering that it has the potential to produce more gold than the company is currently anticipating.

Haile

The Haile gold project contains a multi-million ounce surface deposit in South Carolina.

(Source: Haile's 2011 Feasibility Study)

The mine has a very large high grade gold deposit exceeding 4 million ounces at over 2 grams per tonne, or 0.05 oz. per short ton as stated in the resource estimate as English measurements are used for the analysis of an American project.

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(Source: Haile Feasibility Study)

However of these 4.2 million ounces only about 1.7 million have been classified as mineral reserves and deemed economical to mine. Note, however, that the reserve ore is of higher grade than the total deposit (0.06 opt. vs. 0.053 opt.). Resources are inclusive of reserves.

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(Source Haile Feasibility Study)

As a high grade mine the Haile project will have extremely low production costs. According to the company's most recent presentation costs should be $380/ounce, which makes sense for a surface mine with ore grades of > 2 gpt. With an average of 150,000 ounces of gold production per year the mine should generate a lot of cash-flow.

Added costs from sustaining capital should also be relatively low except in a couple of years in which the company has one-time expense. They are negligible after year 8.

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(Source: Haile Feasibility Study)

With sustaining costs added the company's effective cost of mining an ounce of gold on an annual basis is given in the following chart assuming 150,000 ounces mine per year and $380/ounce cash-costs.

The company is estimating that it will need $320 million in order to develop the mine. If we add in other expenses this should come to a total of $360-$380 million. As of the end of March the company had $38 million so clearly management has to raise capital. According to its presentation management is targeting 40% - 60% in debt financing with equity issuance making up the difference. Given that this project will be economical, and given that the its high grade means that it will be cash-flow positive even at a low gold price I suspect that this shouldn't be a problem. Since I am making the case that Romarco is overvalued I will be optimistic and assume that the company will get financing for 60% of the low-end ($360 million) that it needs--$216 million. The remaining $106 million will come from a secondary offering which I discuss presently. Regarding an interest rate I should note that Torex Gold (OTCPK:TORXF) recently received financing of nearly $400 million for its low-grade project in Mexico at about 5% (LIBOR dependent). Again since I am being optimistic here 5% seems like a best-case scenario within the realm of possibility. Assuming a 10-year financing deal goes through that would add a $10.8 million annual expense from 2015 - 2024.

As I said the remaining $106 million will come from an equity financing, which shouldn't be a problem considering the company's $475 million valuation. While it is customary to assume that such a financing deal will occur at a lower-than-market price (i.e. lower than C$0.74/share) I will again be optimistic and assume that the company will raise the $106 million at the current market price. This means that the company will have an additional 156 million shares outstanding, or 815 million shares in total, plus $144 million in cash. This also gives the company an effective current valuation of $555 million.

Taxes should come in at 38.25%, which includes South Carolina's 5% corporate income tax plus the U. S. 35% corporate income tax, with state taxes deductible from the income tax assessment. Amounts are in millions of dollars.

Valuing Romarco Minerals

In addition to the Haile mine the company has $36 million in additional assets--mostly in cash with a couple of minimal liabilities. In our hypothetical financing situation we also throw in an additional $106 million in cash, keeping in mind that we are also upping the effective share-count and the effective valuation that we are paying in today's market. With that being said we need to add $142 million to each of the above figures, giving us the following.

With these figures versus the company's effective valuation of $555 million the stock is clearly overvalued.

Possible Extension of the Mine Life

However we have to keep in mind the possibility that the company can mine additional gold at the Haile project. After all we saw the resource estimate exceeds 4 million ounces versus the 2 million ounces that are mined in the above scenario. With that being the case let us assume that the mine's life is extended by 7 years, representing about half of the gold on the property that isn't included in the mine plan. But since the ore grade is lower for the resources not in the mine plan we have to cut the amount of gold mined by about 10% to 135,000 ounces, as the resource ore contains about 10% less gold. We also have to increase the mining cost by about the same amount, so this rises to $420/ounce. With this added gold mined we get the following valuation matrix.

Even in this scenario, where we make assumptions that go above and beyond the mine plan, without adding in any additional expenses, at best the company offers some upside at the current gold price using an 8% discount rate. But considering the amount of optimism we have to assume to get to this valuation, and considering that there are plenty of undervalued gold miners in today's market, this hardly seems like a reason to buy the shares now.

Conclusion

While Romarco Minerals isn't a clear-cut case of a significantly over-valued stock we have to make a lot of very generous assumptions in order to justify the current valuation. In this context the stock's outperformance this year seems to be largely unjustified.

With that being the case there is little doubt in my mind that Romarco Minerals' Haile project has a lot of potential. Even if it is over-valued now it is a low cost surface mine in a stable jurisdiction, and this means that it may be a worthwhile investment on weakness. Predicting such weakness may not be so far-fetched considering that the company is planning on issuing stock in the near future. While 150 million shares or so won't be extremely dilutive it has the potential to put near-term pressure on the stock price. With that being the case I think that interested investors should watch the stock and look out for an announcement of a secondary offering. If this brings the valuation down so that it is more in line with the first valuation matrix I put forth it may be worth buying. But with that being said keep in mind that I made some optimistic assumptions in composing that valuation matrix.

1. I assumed that the company will be able to borrow 60% of what it needs.
2. I assumed that it will be able to borrow money inexpensively.
3. I assumed that there will be no charges related to financing--both for the debt issuance and for the secondary offering.
4. I assumed that initial capex won't exceed estimates.

Considering these points it might be wise to wait for the stock to retreat to a valuation below those put forth in the above matrix. It really depends on the particulars of the company's financing arrangements, of which we will know more about in a few months.

With that being said Romarco Minerals is a stock to watch, but certainly one to avoid for the time being.