Published October 8, 2014
This week, we highlight a breakout performer in the gold mining sector. During one the most challenging gold markets in recent years, Kirkland Lake Gold (KGI) has taken the difficult steps to bring the company back to profit and they are poised to build on the success they are experiencing as a reward for their efforts. This intermediate gold producer has increased year-on-year production by 18% since 2011, achieved cost-cutting to the tune of $23M CAD annually and slashed the All-In-Cash-Cost (AICC) per ounce of gold produced by 40% since Q1 FY 2014. Also, the company finished last quarter with its first profit in five quarters registering $4.98 M CAD in profits. With increasing production and decreasing costs, increased cash flow will follow. Kirkland Lake Gold’s convertible Loonie bond, couponed at 7.5% and maturing December 2017, is currently discounted to below 90, giving it an extremely desirable yield that’s over 12.25%. The convertibility feature, explained in more detail below, has the possibility of adding additional capital gains to this already impressively high yield.
Kirkland Lake Gold is pulling away from the competition. It has discovered the path that will not only let the company survive in tough market conditions, but thrive in spite of them. Portfolio analysis models have shown time and again that diversifying through multiple industries and multiple countries greatly reduces investor risk. It has also been shown that including some exposure to precious metals within a portfolio also helps to decrease risk. In light of this, we are targeting these high 12.25% yielding, short 38 month convertible debentures from Kirkland Lake Gold, denominated in Canadian dollars, for our global fixed income FX2 and FX3 portfolios.
About the Issuer
Kirkland Lake Gold is an operating and exploration gold Company in Kirkland Lake, Ontario. The Company owns five former high grade mines (Macassa, Lake Shore,Teck-Hughes, Wright-Hargreaves, Kirkland Minerals) that produced 22 million ounces of gold at an average grade of 15.1 grams per ton. Six years ago an exciting high grade geologic discovery was made in what is now called the South Mine Complex (SMC). The company’s main goal is to create a profitable and long-lived intermediate gold mining company. In order to do this, it plans to maintain a Canadian focused asset base and optimize mining efforts by mining the new high-grade South Mine Complex as well as its reserve and resource base. The focus is to grow yearly production while lowering costs.
In January 2009, Kirkland Lake Gold initiated a low capital expenditure, five-year expansion program designed to increase gold production and lower costs. This expansion program has now been completed, on budget and has resulted in upgrades and improvements to the mining and production equipment as well as capital development. Results from this program were outstanding as the company has seen 18% year-on-year increases in gold production since 2011. Also, with the mine expansion and equipment upgrades, the infrastructure is in place for the company to continue increasing their production levels toward their goal of 250,000 to 300,000 ounces of gold annually.
In late 2013, Brian Hinchcliffe, chief executive and co-founder of Kirkland Lake Gold, resigned, and was replaced by George Ogilvie, a 24-year mining veteran. A short time later, Mr. Ogilve implemented a mine optimization program aimed at raising the company’s mining cut-off grades and head grades. (The cut-off grade is the minimum amount of gold needed to mine, whereas the head grade is the grade of ore that is processed by the mill). In tandem with this initiative, the company undertook an aggressive plan to reduce costs across the company, through cutting staff, retiring inefficient equipment, cutting non-essential capital spending and cancelling employee incentive programs. The results of this effort will yield ongoing annual cost savings of $23M CAD to the company.
The mine optimization plan, expansion program and cost cutting program have begun to yield results as evidenced by KGI’s declining all-in-cash-costs (AICC) per ounce of gold produced. For FY 2013 (KGI’s fiscal year is May 1st to April 30th), Kirkland Lake Gold’s AICC per ounce was $2,432 CAD. This dropped to $1,986 CAD per ounce in FY 2014. For the most recent quarter recorded, Q1 2015, AICC now stands at $1,250 per ounce. This represents a 40% decrease from Q1 2014.
Some of the most recent excitement for Kirkland Lake Gold surrounds the discovery in August 2014 of incredibly high grades of gold near the surface at its South Mine Complex. The grades for this discovery are nothing short of extraordinary, at over 400 grams per ton near the surface and almost 600 grams per ton deeper below the surface. To get an idea of how significant this discovery might be, consider that KGI is already regarded as a high-grade mining company (they get more gold per ton of earth moved and mined) at an average grade of 15 grams per ton. It follows that 400 and 600 grams per ton are astronomical numbers by comparison. While further drilling of the area around these relatively small intersections are needed to develop a more accurate resource estimate, the potential to the company is enormous.
While it’s too early to add any numbers from this discovery to company reserves, earlier this year, Kirkland Lake Gold did release figures for its current proven and probable reserves. Proven reserves for the entire Kirkland Lake complex is 401,000 ounces, while Probable reserves total 984,000 ounces, for a total Proven and Probable Reserves amount of 1,385,000 ounces.
Kirkland Gold’s expansion program coupled with its cost cutting measures and mine optimization plan have put the company back in the black for the first time in five quarters. For Q1 2015 (which ended 31 July 2014), the company generated a $4.98 M CAD profit. For comparison, the previous quarter registered at $1.1M CAD loss.
Revenues have also shown amazing growth since 2013. For FY 2013, total revenue was $151.6 M CAD, increasing to $173.2 M CAD in FY 2014, an increase of 14%. And in Q1 2015, revenue was $54 M CAD. This represented an increase of 24% over Q1 2014, and a 27% increase over Q4 2014.
The financial markets have taken notice of Kirkland Gold’s increasingly impressive numbers. Since the first of the year, shares of KGI are up a staggering 78%, while many other gold companies are down for the year. This stock has had a 52-week range of $2.21 to $6.19 CAD per share. As the stock price continues to improve, the possibility for profit taking from the convertible feature of this bond increases.
Kirkland Lake Gold’s interest coverage ratio as of Q1 2015 (period ended July 31. 2014) was 3.65. As of July 31, 2014, the company had cash on hand of $40.2 M CAD and total bond debt of $120.6 M CAD.
With AICC per ounce of gold dropping, overall costs decreasing and production increasing, Kirkland Lake Gold has been put in the enviable position of increasing cash flow. From an investment standpoint, this translates to a more solid position from which to pay interest to bondholders, as well as attract additional investment from investors seeking to buy stock in a strong, profitable gold producer.
The conversion feature
The recent news of an impressively rich, high-grade gold deposit near the surface of its South Mine Complex is likely to add significant value to the KGI portfolio and it bodes well for the company’s long term future. The news of this discovery in August rallied the company’s stock up 14%, with year-to-date gains of 78%. The full value of this deposit has yet to be measured, but it appears to have the potential to drive a higher stock price. If the stock price were to rise significantly before the maturity date in 2017, and exceed the conversion option (at $13.70 CAD), it will likely push the bond price into even higher capital gains territory.
This convertible feature is similar to other convertible notes the we have reviewed previously, allowing the note holder the option to convert at any time prior to maturity, and only allowing the company to convert it to stock at maturity, at a 5% discount to the average market pricing for the stock at that time. This option significantly lowers the default risk of the note.
The risk is Kirkland Lake Gold’s ability to perform. We feel this risk is decreasing with each quarter as KGI continues to bring down costs and increase production. Production has steadily increased each year since 2011, and the company’s cost to produce gold has continued to come down. Rising production plus falling costs equals increasing positive cash flow and happy investors.
Since the company’s only business is the mining and production of gold, the company is heavily exposed to market gold price fluctuations. During the past 12 months, gold prices have ranged from just above $1,200 to just below $1,400 USD per ounce. This translates to a range of $1,340 to $1,563 CAD per ounce. At the most current quarter, KGI’s cost per ounce to produce gold was $1,250, which means that the company is profitable. If gold prices continue to decline, this would have an adverse effect on the company’s operations and profitability.
There is currency risk, as this is denominated in Canadian dollars and it exposes note holders to the strength of the Canadian loonie relative to the US greenback. Depending on the Canadian economy and its currency performance, this could add to or subtract from potential returns. Since KGI has all of its operations in Canada and pays all of its expenses in Canadian dollars, and its product (gold) is priced in US dollars, a weak loonie might therefore result in higher profit margins for the company and lower risks elsewhere.
Geopolitical risk isn’t much of an issue with this company as it is based in and has all of its mining operations in Canada. With many gold producers operating in politically challenged / risky regions, KGI’s concentrated operations and production give them improved oversight as well as access to a skilled and knowledgeable work force. This convertible bond has a 7.5% coupon, paid semi-annually and matures on December 31, 2017 and carries similar risks to other Canadian based bonds we have reviewed such as Brigus Gold and TransGlobe Energy.
Summary and Conclusion
Kirkland Lake Gold is becoming more profitable. They have successfully navigated through decreasing gold prices and have come out a leaner, more efficient producer. As production continues to increase and operating costs decrease, increased cash flow will follow. The recent high-grade gold discovery in their South Mine Complex adds significant value to their mining portfolio and has the potential to drive more value for both stockholders and bondholders. We believe Kirkland Lake will continue to increase its profitability each quarter and recommend these bonds for investors seeking international diversification and increased yields.
Issuer: Kirkland Lake Gold
Ticker: KGI (Toronto Exchange), KGILF
Price: $5.19 CAD (10/10/2014)
Conversion Option Price: $13.740 CAD
Yield to Maturity: ~12.3%
Disclosure: Durig Capital and certain clients may have positions in Kirkland Lake Gold’s 2017 convertible debentures.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.