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Equity Focus: Time to Shine for Kirkland Lake Gold?


In this article, I’m going to be discussing the merits, as well as some of the potential risks, of investing in Kirkland Lake Gold. I’ve tried to simplify it as much as possible, so that anyone can follow this equity research report, even with no prior knowledge of the company, financial ratios, or analysis. If you have any suggestions or feedback, please leave them in the comments section below, and remember, this article is written for educational purposes only. It is not intended to be taken as investment advice, and The Student Investor takes no responsibility for any investment decisions made by the reader.

What is Kirkland Lake Gold?

Kirkland Lake Gold Ltd (NYSE: KL) is a Canadian-based mining company involved with the development and exploration of gold-mining projects. The business operates four key mines - three in Northern Canada, and a fourth in Southern Australia, 150km from Melbourne. Kirkland first caught my eye when I was looking to gain exposure to gold prices because of bullish conviction (positive sentiment) on the commodity, and also to help diversify my portfolio. Kirkland is growing its gold production quickly and sustainably, it has a strong financial grounding, and is well-positioned to benefit from any increase in gold prices. In the following article I am going to analyse Kirkland’s business environment, financials, and valuation, in addition to where gold prices could be heading, to evaluate if this stock would make a good investment.

Business Model:

How do mining companies operate?

The business model for gold mining companies is relatively intuitive, and can be broken down in layman’s terms as follows:

1. Locate a site where geologists think the precious metal could be found and extracted.

2. Work out if this is a profitable site to mine from.

3. Obtain government permission to mine.

4. Purchase relevant Plant, Property, and Equipment (PPE) such as drills and trucks, and hire a labour force (these are the most significant operating expenses of mining companies).

5. Extract gold from the mine and purify the metal.

6. Sell the gold on to a merchant who will then sell it to the open market.

7. When there are no more gold reserves, close up the mine and return the land to its original state.

What does this tell us?

From this brief summary, we can infer a few interesting observations about how these companies operate. Firstly, there are a lot of upfront costs such as drills, trucks, and other specialist equipment. These costs are predominately in the form of debt to finance these purchases, since companies haven’t even made a dime of revenue yet. These expenses also don’t vary much with gold output, which means that these companies often have a high ratio of fixed costs to variable costs (this is also known as operational gearing). This makes mining a risky business, because when revenue falls, they still have a large amount of fixed costs to cover, which causes their profit to be very sensitive to changes in revenue from gold sales.


One positive for Kirkland is that it is one of the only major mining companies to not have any debt on its balance sheet, meaning that they are less operationally geared than a lot of these other firms (Note: for this article I’m comparing 16 major mining companies that comprise most of the gold stock in Exchange Traded Funds (ETFs)). If Kirkland was in debt, I’d typically first check a metric called Interest Cover, which tells you how many times over a company can use its earnings to pay interest back on debt. They have an ample amount of cash, which is a good margin of safety for when one of their mines run out of reserves. This also gives them sufficient funds to buy up smaller companies (also known as an acquisition) or pay out profits to shareholders in the form of dividends.

Speaking of dividends, Kirkland started paying one in 2017. Whilst the yield (for the last 12 months, also known as TTM-trailing twelve months) is currently only at around 0.5% (on the lower side of the 16 mining companies) Kirkland’s dividends are growing quickly and are covered by earnings 16.1x over (this metric is also called dividend cover) which gives us a huge safety net. The pay-outs have basically been doubling every year. This is not something I usually see as sustainable in the long-run, and it has to be supported by VERY high growth rates. Typically, I like to see earnings to be at least 2x of dividends (meaning that 50% of the profit gets paid out as dividends, and no more). So, in theory, Kirkland could still increase the dividend eight-fold (and realistically more since earnings are growing too) before it reaches the point where I see their dividend growth as unsustainable.

Another advantage Kirkland has is that a lot of its growth has been organic (meaning most of its increase in profit has come from production growth rather than the increase in gold prices). Kirkland’s annualised 5yr EBITDA has grown at 74%/year (median for mining companies was 9.2%).

Below you can see part of my investment model where I built a revenue sensitivity analysis for Kirkland. Don’t worry if this looks a bit complicated - what it’s basically telling us is that in the most recent 3 months, 73% of growth in turnover can be explained by the volume of gold mined from the ground, and only 27% of it was down to an increase in gold prices. This implies that the gold price would have to fall 23% all the way down to $1333.15/oz just for revenue to stop growing. This is a huge margin of safety, and many of the other companies which aren’t as profitable and more leveraged would be in dire straits if the gold price fell to this level.

One other factor at play for here is that Kirkland’s mines contain very high-grade gold (this basically means there is a lot of gold situated in each ounce of rock mined) and therefore you’ve got more gold to sell relative to the expenses you paid to mine it, which is what translates into the higher margins I mentioned earlier. If we look at one of my favourite metrics, lease-adjusted return on capital employed (ROCE), Kirkland comes out at 44.6%, almost twice as high as any of its competitors. This calculation is basically telling us that for every $100 of assets being used to mine gold out the ground, the firm makes $44.60 in operating profit (or EBIT).

Management

It’s always very important for a company to have a strong leadership team, which promotes a positive culture. From the reading that I’ve done on company profiles and listening to the earnings calls, I like Kirkland Lake’s senior management team. CEO Tony Makuch has been involved in the gold mining sector his entire career and comes across as very straightforward and transparent. My view is that this transparency is partially why Kirkland removed their 3-year earnings guidance (how successful they think the firm will be in the next three years); they don’t want to give investors’ false expectations over their operations which might be adversely affected by the coronavirus pandemic that they have no control over. Management is clearly aligned with shareholder interests, which is demonstrated by the increased dividend payments and recent share buybacks, in addition to being a very financially responsible company that isn’t fuelled by debt.


What other factors should we look at that determine profitability, and what are the risks?

It is essential to look at mine gradings, as well as the quantity of gold mined by Kirkland. Therefore, I have included a financial breakdown of their operations, below:

We can see here that Kirkland is doing very well, with its total confirmed mineral gold reserves increasing almost four-fold to 20.47 million ounces between December 2018 and 2019. However, it’s important to note that 73% of these reserves are coming from a new mine, Detour Lake, which Kirkland now owns as part of an acquisition they completed in January 2020. This is a potential risk, as it shows that the majority of the company’s revenue is being derived from a new mine that Kirkland has not previously operated. This is a further risk because it is a much larger open-pit mine, that contains a lower grade of gold. As a result, it will take a higher operational expense to mine each ounce of gold, and this could erode Kirkland’s high-profit margins.

Another potential risk is currency depreciation. Since gold is bought and sold throughout the world principally in U.S. Dollars, any company that operates a mine in a country outside the U.S is exposed to currency risk. Because Kirkland’s mining expenses are paid for in CAD and AUD, but it generates revenue in USD, any weakening in the USD relative to CAD and AUD will have a negative effect on profits. Deprecation of the USD is something that has occurred since March relative to these two currencies so it’s worth keeping an eye out for as we get closer to the next earnings season.

One positive from Kirkland’s operations is the geography of the mines. Below, we can see a list of countries that produce the most gold in the world. Kirkland only mines out of Canada and Australia, which are two of the most economic and geopolitically stable countries on this list. This reduces a whole multitude of risk factors attached to gold miners such as governmental and legal instability, as well as crime and sabotage of equipment. It is still possible that these issues could occur, but it is much less likely than in developing countries such as Sudan and Brazil, where these matters are rife.


How has Kirkland been affected by Covid-19?

One final short-term benefit of Kirkland operating in Canada and Australia is that these two countries haven’t been as adversely affected by COVID-19 as other areas of the world. Their strong healthcare systems, government responses, geographical location, and low population density, has meant that businesses haven’t been devasted in the same way that millions of others have across the world. Kirkland’s mines have continued to operate throughout the pandemic, although many at a reduced capacity. As of 6th May 2020, Kirkland is operating at a usual capacity, and its management team has implemented strict procedures health and social distancing measures to keep its employees safe. As aforementioned, Kirkland has removed their three-year guidance for mining production. This may seem unnerving, but I understand why they did this, given the uncertainty of the current Covid-19 situation, and how it will progress. As a result, I’m going to be using the very lowest of this guidance to help us value the company later on in this article.

Gold Prices

Changes in gold prices aren’t affected by what Kirkland is up to, but rather the conditions in the wider macroeconomy. Part of the reason Kirkland came up on my radar in the first place is that I was bullish (optimistic) on gold prices and looking for some exposure, so here, I’ve done my best to give a very concise summary of some of the key factors that are affecting gold prices at the moment:

1. Low Interest Rates- Around the world, central banks have cut interest rates close to zero (or even negative in some countries) to try and stimulate the economy as a result of the adverse consequences of coronavirus. When interest rates are low, the risk-free treasury yields you can obtain on your cash go down, and rates on savings accounts follow, therefore there is less opportunity cost of storing wealth in gold instead of currency.

2. Safe-Haven Status- Gold has historically been recognised as holding a safe haven status when everything else goes pear-shaped, and tends to increase in value in periods of economic contraction. This is what happened in the recent Gold Bull Market of 2008-2011. The asset prices of investments such as property and stocks are tied closely to the performance of the overall economy. Therefore, again, there is little opportunity cost of not purchasing gold when these returns turn negative. With many economists’ forecasting the worst downturn since the Great Depression in 1929, investors are flocking to what has worked in the past, and hence, we see gold prices begin to appreciate.

3. Erosion of the purchasing power of currency- There has also been some concern regarding the unprecedented levels of quantitative easing (abbreviated to QE, this is where central banks print new money to stimulate the economy). Typically, the means of QE is through central banks giving other banks liquidity through creating new debt for them in the form of bonds. However, in 2020, we’ve seen a much more direct form of QE through furlough schemes and government grants, which is putting money directly into the pockets of consumers. Since all of this new money has been created without the economic growth to back it, this is eroding the purchasing power of each individual unit of currency and has the potential to cause a lot of inflation. This is going to be very tricky to explain without going into a deep economic discussion, but the bottom line is that gold protects investors by acting as an inflationary hedge since gold’s value is not being eroded by QE.

This is all sounds great, but how we do know if shares in Kirkland are a good deal at current prices on the stock market?

First things first, let’s go back to why Kirkland stood as a company in the first place by comparing it to the gold mining sector. Here are some metrics that I’ve looked at which suggests Kirkland might be cheap:

1. P/E ratio: This stands for the Price/Earnings Ratio, and measures how much it costs to buy the stock for each dollar of profit. Kirkland is currently the lowest of the 16 companies, where P/E=13.5. This is especially low when considering how fast the company’s profits are growing (128%/year annualised over 3 years). Furthermore, the P/E is at a historic low (back in 2017 it was 21.3) suggesting the market may not have recognised Kirkland’s full growth potential yet.

2. Price/Book Value: This metric basically tells us the price as a multiple of all the company’s assets minus liabilities. Kirkland is a bit on the high side of the group here at 4.1 (median is around 2.7), and we should be wanting a lower metric. One potential reason I found for this is that Kirkland tends to be more efficient at selling gold they’ve already mined, meaning less gold inventory shows up on the asset side of the balance sheet. Since this is a positive of Kirkland’s business model, we shouldn’t be too quick to discard the company for having a high P/B multiple.

3. P/FCF Ratio: This stands for the price to free cash flow, which is effectively the money that the company is free to do what it wants with after it has paid for its capital expenditures (maintenance of plant, property and equipment etc). Again, Kirkland is the lowest of the pack, trading at just 16.7x FCF, and this is also on the low-side when you compare it to historical metrics.

But how did you actually value the shares?

Now, I’m going to show you how I came up with an intrinsic value for Kirkland. Describing the technicalities of these models isn’t a topic for today (and I am aware this article is already quite long) but I will show you what they look like and explain some of the basic assumptions I have used:


Very briefly, what you can see above are the results of an Earnings Power Value (EPV) model for Kirkland. This is a conservative model that uses the current value of earnings, depreciation, debt, capital expenditure, and cash from the latest annual report. In layman’s terms, what this is telling us is that in the company’s current state, with no future growth, Kirkland is worth about $28.53/share, with 74.5% of the share price based off current financials and 25.5% off future growth expectations. Just to give you some context, for a company growing at a market average of ~8%, I’d want to see future growth pricing of less than 50%. For a company such as Kirkland that is growing this quickly, this is looking cheap as only 25.5% of the pricing of stock comes from growth expectations.

And what about their cashflow?



Again, don’t worry if a lot of this spreadsheet doesn’t make much sense to you. The basic idea is I am working out how much cash Kirkland is expected to generate in the future, discount this cash back to present value, add them up, then divide by the number of shares to work out the total amount of cash expected to be generated per share. And that’s what the company is worth! This is the most common method of valuation, used widely amongst analysts around the globe and popularised by legendary investors such as Warren Buffet and Seth Klarman. For most of these projections, I’ve taken the average estimates from 14 research analysts that cover Kirkland. Remember, I said we were going to discuss Kirkland’s guidance that it removed earlier? Well, now we’re going to use it make sure analyst estimates aren’t too unrealistically high:



If we take the lower end of the guidance and multiply by current gold prices, we get:

1,470,000 oz’s x $1731.37/oz = $2545.1M which is actually slightly higher than the analyst forecast revenue of $2374.7M. This leads me to believe the analysts are being conservative and therefore I’m happy to use an average of their estimates in my model. I’ve used the analysts’ expectations for future profit margins in my model and subtracted a couple of percentage points to be on the safe side. In case anybody is wondering, part of the reason that free cash conversion (FCF/profit) is so high is a result of Kirkland’s low capital expenditure (spending on fixed assets to maintain business operations) and small inventories that I talked about earlier, meaning they are quick to sell their gold once they’ve purified it.

The discount rate of 7.12% is based on the Weighted Average Cost of Capital (which is all equity financing and calculated through the Capital Asset Pricing Model since Kirkland has no debt). Again, this is a topic for another day but it’s important I explain to you where it came from. I’m also assuming Kirkland can only sustain above-average growth for 4 more years to be conservative, and then the company just grows at the long-run rate of GDP (I’ve used 2.5%) for the businesses’ remaining life.

Plug all of this in, and we get an implied intrinsic value of $81.07/share. This is what my discounted cash flow model tells me the stock is worth. Since at the time of writing, it is trading at $38.29/share, it implies that shares in Kirkland are undervalued current market prices. Premium/Discount tells us that if we bought the stock today, then the market realised its true value and Kirkland went up to $81.07/share, we would make a112% Return on Investment (ROI).

But what will actually cause the market to recognise Kirkland’s true value?

With investing, there’s no point in owning a good company that’s undervalued if the market is never going to recognise that value, because then the stock price won’t increase and you’re not going to make any money on your investment! Here are three catalysts that I think could cause the market to see Kirkland’s potential and therefore increase the stock price:

1. Gold price increases: This is without a doubt the most likely catalyst. I mentioned earlier that Kirkland was not hedged against the gold price. Well, part of the reason for this is that the company’s management team is bullish on gold and want to be in a position of taking advantage of gold price increases. Looking at the graph below, you can see the gold price from January 2019 in red, with the share price of other major mining companies (Kirkland is in orange). Notice how when there is a small change in the price of gold, there are big swings in the share prices of these miners, and they are all highly correlated. Investing in these miners often acts a bit like a leverage position, meaning that if the gold price goes up by X%, the stock prices tend to go up by 2X%. However, I see a more limited downside with Kirkland because as I mentioned earlier, it’s able to grow organically without these increases in gold price (this is why you can see Kirkland outperforming in 2019). This implies gold prices fall, a lot of other miners whose organic revenues aren’t growing as fast as Kirkland (or even shrinking) will go bankrupt, and Kirkland could even take more market share. All this being said, I think that since Kirkland looks undervalued, it won’t be so long before a gold price increase encourages investors to revaluate the fundamentals of the stock, purchase the shares, and we’ll see a price action that is even greater than these other miners moving in correlation with the gold price.


2. Dividend Increases: We discussed earlier that Kirkland is a company that pays dividends to its shareholders, and this dividend is growing quickly. However, this wouldn’t be the most ideal catalyst for the market to recognise the company’s value. The yield of 0.5% isn’t going to be exciting anyone, and even if it carried on doubling every year, it’d take 3 years to get a yield of 4%. This is the level where income investors would become interested. Still, this is a factor to bear in mind, particularly if Kirkland has a good year and announced they will be rewarding shareholders with special dividends.

3. Kirkland makes it into the S&P500: The S&P500 is one of the most well-known and followed stock market indexes in the world, comprising of the largest 500 companies in the U.S. by market capitalisation. When a company enters this index, it gets a lot more coverage by analysts, and becomes more interesting to investors. Kirkland currently has the 584th largest market cap in the U.S. If Kirkland’s market capitalisation increased from $10.6bn to around $12.8bn (either from an increase in the share price or the issuance of more equity) then it can be of sufficient size to qualify. This would subsequently result in a lot more coverage, which could be the catalyst that unlocks Kirkland’s value.

Closing remarks:

In summary, Kirkland Lake is a financially healthy gold mining company with a great low-cost, low-leverage business model, operating in stable locations under good management. Their key risks include eroding their margin through mining lower- grade gold at Detour Lake going forward, and foreign exchange appreciation in Canadian and Australian currencies against the U.S dollar. They appear to be undervalued from multiple standpoints and with a decent margin of safety. They are also well-positioned to take advantage of the current bullish sentiment on gold, whilst having the ability to offset any decrease in prices through sustained their organic growth.

Disclaimer:

Please note that the opinions expressed by the author in this article do not constitute financial advice and are solely for educational purposes only. When buying shares, the value of your investment may go down as well as up and you may get back less than you invest.

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