Description

Brazauro has a 2.3 million ounce gold deposit in the Brazilian Amazon. Eldorado Gold has options to acquire up to 75% in exchange for a series of payments totaling $90-$100mm. I believe the value of the project exceeds the option price and that Brazauro shares are a bargain regardless of whether or not Eldorado exercises its options.

BASIC FACTS

TOCANTINZINHO PROJECT (TZ)

Brazauro's corporate presentation does a good job of explaining the background and appeal of the project. The financial projections in that report were from an independent Preliminary Economic Assessment released in December 2007. The key facts were:

• 123,000 ounce/year production for 13 year mine life

• $367/ounce cash operating cost

• $128mm initial capex

Some additional points worth noting:

1. The deposit has a consistently attractive grade. At a cut-off of 0.2 g/t, the indicated resource was 24.4MT holding 1,047,000 ounces of gold. At a cut-off of 1.0 g/t, the indicated resource was 13.8MT holding 819,000 ounces of gold. Most of the ore has a grade over 1 g/t, currently worth $36/tonne.

    

2. The PEA conservatively assumed that Brazauro would have to spend $10mm on building 82km of roads and bridges to reach the project, even though only 10km costing $1.7mm would actually be on Brazauro's property. Since 2007 logging roads have reached closer to the property, meaning less overall new work is required. It is also probable that the state government would assume some responsibility for the infrastructure.

    

3. The PEA conservatively assumed that Brazauro would spend $19mm building a 201km power line to the property. A private company has announced a hydro project that would provide all season power from 2012 only 65km from the property. This would reduce the cost of the power line by about $13mm and it is probable that the state government would assume some responsibility for this infrastructure.

    

4. The power plant would also be connected to the national grid providing Brazauro with the option to increase the production rate, shorten the mine life, and generate faster payback.

Based on these developments I updated the economic model in the 2007 study using these assumptions:

• 25% inflation of operating costs for mining and milling. This is in line with industry averages, but hopefully will be proven conservative.

   

• 10% increase in capex. I assume that some inflation is offset by lower infrastructure requirements.

   

• 0% increase in life of mine production. Drilling in the past two years has better defined the resource (now nearly all Measured & Indicated), but has not significantly expanded it. The mine plan could incorporate more deep resources if they were willing to steepen the pit wall from 50% to 55%, but I'm not sure if that's going to happen.

This generated the following pretax NPVs at various gold prices and discount rates:

I believe that $1000 gold and 5% discount rate best conforms to the way gold stocks are currently valued in the market.

Alternatively, the Total Cost of Acquisition provides another metric for evaluating gold projects:

So $413mm by NPV or $412mm by TCA. That's some pretty neat bean counting...

While both valuation approaches indicated a value just over $400mm, Eldorado Gold has options to purchase up to 75% of the project for $90-$100mm. If my numbers are right then Eldorado should exercise those options.

THE ELDORADO TRANSACTION

Eldorado signed a two-year option agreement for the Tocantinzinho project in July 2008 (press release). Eldorado has met or exceeded all its obligations under the agreement.

• Eldorado committed to spend $9.5mm on exploration and development. Eldorado has already spent $10.2mm and continues to fund 100% of drilling and other work at the property.

   

• Eldorado purchased 8.8mm shares of BZO when the agreement closed in July 2008. Shortly thereafter Eldorado purchased an additional 3.5mm shares in the open market. Eldorado recently purchased an additional 1.0mm shares in Brazauro's October secondary offering.

   

• Eldorado has included Tocantinzinho as part of its development plans in all presentations made to investors. (see page 21 of presentation)

• Eldorado has an experienced Brazilian management team supervising its efforts at Tocantinzinho. After closing its Brazilian open pit Sao Bento mine in 2007, Eldorado retained its senior staff and searched extensively for a new project within the country, eventually selecting Tocantinzinho.

However, Eldorado has not yet committed to exercise its options. At September's Denver Gold Forum, CEO Paul Wright said:

"Turning to Brazil,

We have an option agreement with a company called Brazauro in Para State in the Tapajos region. This is a project that we've selected having looked at a number of different projects in this region. And we are of the opinion that this is the project that has the best chance of being developed in the region giving the remoteness and given the necessity to have a project of size.

The owner, when they operated the property, stated a resource of approximately 2 million ounces, the bulk of which was in an inferred category at the time of their classifications. The work that we have done to date, I think has largely verified that 2 million ounces and certainly upgraded the nature of those ounces. Our view is that for a project in this locale to be developed, really you need to have a resource closer to 3 million ounces. We feel that's attainable and we're continuing to drill to satisfy that objective. I think that realistically we're probably another six months away from having a reasonable handle as to whether this project is going to go to the next step."

At this point it's clear that the resource (12/08/09 update) is not getting closer to 3mm ounces. So what are they thinking?

• It's possible that Eldorado could conclude that a 2mm ounce Brazilian deposit was no longer a good strategic fit following its big and successful expansions in China and Turkey.

   

• It's also possible that Eldorado could conclude that the remainder of the TZ property is likely to provide sufficient extra ounces to reach its target. The remainder of the property has had aerial surveys and soil sampling, but no drilling.

   

• It's possible that Eldorado could conclude that 2mm ounces of $1000 gold are at least as good as the original goal of 3mm ounces of $800 gold.

   

• It's possible that Eldorado would prefer not to define 3mm ounces of gold because that would increase the total price of the option agreement from $90mm to $95mm or $100mm (depending on how many ounces are discovered).

   

• It's possible that Eldorado does not want to increase interest in Brazauro shares prior to a potential Eldorado acquisition offer in 2010

• It's possible that Eldorado could exercise its first and cheapest option to acquire 60% for $40mm, then slow down development. The project might become more attractive in future years if gold prices rise or regional infrastructure improves.

Ultimately I believe that Eldorado is likely to exercise the options, but Brazauro shares are undervalued even if that does not happen. If Eldorado exercises its options and intends to develop the project then I believe it makes sense for them to acquire the whole company.

VALUATION SCENARIOS

The current enterprise value of $47mm really only reflects the optionality value of a 2mm ounce gold resource. Under nearly any development scenario the shares have significant appreciation potential, although they are quite leveraged to the price at which Brazauro ends up raising equity.

I believe that Brazauro shares have been held back by two factors:

1. for the time being Brazauro's main asset is under the control of another company (Eldorado)

2. It's tough to get analyst coverage in Canada if you're not raising money and doing deals. Brazauro is covered by a small firm (M Partners) that placed some of the $5mm October financing.

RISKS

The biggest risk in these valuation numbers is that they are derived from a Preliminary Economic Assessment. The consultant used benchmark costs from other mines in the region rather than conducting a more detailed (and expensive) feasibility study that would estimate the exact cost of operating this particular mine in this particular location.

INSIDER ACTIVITY

Aside from Eldorado's recent participation in Brazauro's October placement, insider buying has been notable.

It seems particularly interesting that Director John Segner has raised his stake to 750,000 shares.

Mr. Segner is a former Managing Director and Global Partner of Invesco PLC where he worked from 1997 until 2009. During his time at Invesco, he was the lead manager of the Invesco Energy Fund, AIM Energy Fund, AIM Gold and Previous Metals Fund, AIM Utilities Fund and co-manager of the AIM Multi-Sector Fund. Mr Segner has received numerous industry related awards for the consistent performance of his funds. When he left Invesco in January 2009 he was managing approximately $2 Billion (US).

Catalysts

1. An updated economic assessment will be released by Brazauro in January

2. Ongoing news of development work by Eldorado (exploration and infrastructure)

3. Option decision by Eldorado (by July 2010)

4. Financing & Development of the Tocantinzinho project

Catalyst

1. An updated economic assessment will be released by Brazauro in January

2. Ongoing news of development work by Eldorado (exploration and infrastructure)

3. Option decision by Eldorado (by July 2010)

4. Financing & Development of the Tocantinzinho project