Question:  When is a gold miner a value investment?

Answer:  When management does not operate the company like a gold miner.

Company Overview

Comstock Mining (LODE) is a Nevada-based gold and silver miner which operates in the historic Comstock District situated between Carson City and Reno, Nevada.  The Comstock District gained fame near the completion of the California Gold Rush, as prospectors moved from California to Virginia City, Nevada after silver ore was discovered in 1857.  By the 1920’s, most of the mining and production had waned.  The land and mineral rights were held by a handful of owners whose activity in the region ebbed and flowed in relation to the price of silver and gold and the politics of the time.  Starting in 2003, Comstock Mining began to revitalize the Comstock District with its initial purchase of the Lucerne mine, followed by the Plum Mining company.  John Winfield, who had independently purchased land in the same area, began working with the company on consolidating the Comstock District and providing financial support in the form of loans to the company.  This money was used for land acquisitions and exploration drilling.  By 2010, the company’s future became uncertain and the decision was made to realign the company’s management and corporate structure.  A new CEO, Corrado De Gasperis, was brought in to lead the company with a deliberate and simplified operation plan: To move methodically to sustain production without overtaxing the balance sheet.  As part of the corporate restructuring, John Winfield agreed to convert his loans into preferred equity shares.  With this new structure, Winfield currently has a personal equity stake equal to 32% of the company and controls 68% of the voting shares. 

With over 150 years of data, the Comstock District is probably one of the best mapped, surveyed and geologically studied mineral resources in the United States.  Adding to this extensive historic data, Comstock Mining provided its own geological surveys, surface mapping, exploration drilling and NI 43-101 reports (an independent report used to provide standardized mineral measurements).  In 2013, Comstock Mining’s NI 43-101 report validated qualified resources (measured and indicated) and reserves (proven and probable) of 3.2 million gold equivalent ounces in 2 of its 7 resource areas (Lucerne and Dayton).  This doubled the results from its previous survey of 1.6 million gold equivalent ounces in August of 2010.  Over the last 5 years, the company has been building out the necessary infrastructure: Power & water supply, mining & processing equipment, heap pads and roads, in order to begin mining, processing and production.  In 2012, Comstock Mining commenced commercial mining operations achieving its first pour.  By 2013, permitted to mine only 1 million tons of mineralized ore, Comstock Mining produced over 20,000 gold equivalent ounces.  Recently, the company received the necessary permits to increase the amount of mineralized ore it can mine to 4 million tons as well as expand its Lucerne mining footprint to include the east side of the resource area.  In its latest quarterly earnings report, Comstock Mining announced that it had achieved a run rate of 40,000 oz/year.  With its new permits in place, Comstock will be able to leverage its established infrastructure, ultimately increasing its run rate beyond 80,000 ounces. 

There are a number of key metrics to focus on when evaluating a gold miner:  The cost of mining, the company’s strip ratio, the average metallurgical recovery (recovery rate), and the metals average grades.  The cost of mining is a direct cost of doing business and is correlated to the amount of ounces that are extracted and poured at the end of the year.  Miners break down their mining (and processing) costs as the cost/oz poured.  Comstock’s costs have been steadily declining since Q1 ’13 when they were as high as $2200/oz.  In its most recent quarter, those costs have fallen below $840/oz and are expected to continue to decline well below the company’s short-term target of $750/oz as their run rate improves. 

The remaining metrics: Strip ratio, average metallurgical recovery and average grade provide an indication of whether the cost of mining will be increasing or decreasing in the future.  A strip ratio indicates the tons of rocks needed to be mined to deliver a ton of ore.  Comstock is forecasting that its strip ratio will continue to decline, leveling off between 3:1 and 2.5:1.  The metallurgical recovery indicates the percentage of gold that can be extracted from the ore.  And the average grade measures the concentration of gold or silver within the ore.  The concentration level within the ore only tells part of the story.  What is just as important is how far down those grades are found and whether the grades reside in oxide or sulfide ore.  Heap leaching is a very cost effective way to process oxide ore as the rock is more porous and can achieve metallurgical recovery rates between 70-80%.  Sulfide ores are more solid and require a milling process for extraction.  The higher cost of the milling process can be more than offset by the higher grade and recover rate of 90-95%.  Overall, a miner would want to see declining strip ratios, increasing average metallurgical recovery yields, and high grade oxide ores close to the surface.  Comstock relies primarily on surface mining (with a selective amount of underground mining) and heap leaching to achieve its 40,000 oz/year run rate.  The company’s exploration drilling program has indicated that high grade oxide ores can still be found less than 700 ft below the surface.  Given the steady amount of oxide ore available and indications from it exploration drilling, it is unlikely that Comstock will be forced to switch to a milling process in the near future.

The one metric that I have failed to mention is the cost of gold/oz.  As one would expect, a miner’s profitability is highly levered to the price of gold.  If gold and silver prices were to decline from their current levels, Comstock’s profit margins will be negatively impacted.  Currently, at a run rate of 40,000 ounces, Comstock’s all in (includes operations and maintenance capital expenditures) breakeven price of gold/oz is $850.  As the company increases its production run rate, the breakeven price will continue to fall, especially as the company is able to leverage its infrastructure and higher grade ores.  At a run rate of 60,000 ounces, the breakeven gold price fast approaches $680/oz.

Competitive Edge

Even though Comstock Mining is a junior gold miner with a very small market share, it still has a number of opportunities that provide it with a competitive edge.  Any venture where real estate plays a major role, the old adage still applies:  Location, Location, Location.  It is no different for Comstock as their future profitability is driven by the rich mineral resources located on their land.  Additionally, the state of Nevada provides one of the friendliest and most secure environments for miners.  Comstock’s permit requests have been approved on a timely basis, often receiving permission beyond the scope of what was originally requested.

As mentioned earlier, the Comstock District is probably one of the best geological surveyed mineral resources in the United States.  This treasure trove of mining data has been instrumental in helping Comstock accurately map out and determine which permit requests, drilling and mining sights would yield the highest concentration of high grade ore.  This, in turn, is helping the company lower its strip ratio while increasing its metallurgical yield and produce higher amounts of gold equivalent ounces from lower amounts of mined ore.  In the past, 1 million tons of ore has produced approximately 20,000 gold equivalent ounces.  Going forward, Comstock can generate 50,000 ounces from 2-2.5 million tons of ore.

Together, Comstock’s proven mineral location, its strong partnership with the state of Nevada, and its 150 years of mining and geological surveys are the reason its exploration costs have been below $6/oz.  A lower cost of exploration gives the company flexibility to explore continually and not be dependent on the price of gold or silver.  Going forward, management is optimistic that it can continue to lower exploration costs between $4-$6/oz.

Scarce Resource

Comstock Mining’s entire business model revolves around managing scarce resources.  Whether those resources are in the ground or on the balance sheet, the company’s management is focused on extracting value for its share holders.  Unlike many in the industry, Comstock’s management team is patient, operates in a methodical manner, focuses on sustainable free cash flow and is unorthodox by all industry standards.  Most mining companies are run by industry insiders, people who have spent their lives working with and learning from the previous generation of miners.  The mining industry has seen very little technical change over the years – the tools may have been updated, but the process is still the same – and it is understandable why management executes the “if it ain’t broke don’t fix it” business plan.  Comstock Mining is in a very unique position; they have the historic data and brand of a company that has been in the business for over a century but the tools, technology and culture of a start-up.  This combination of historic data mixed with a contemporary operating model has created a novel approach to a stagnated industry.  Comstock has the flexibility to adjust its business model quickly to improve the company’s margins, strengthen its capital structure, or reinvest in a new drilling, mining or processing program to expand production.

Another scarce resource that Comstock is growing each year is the leached ore on its heap pad.  Over the next couple of years, Comstock’s heap pad is going to increase by 2-4 million tons every year.  When the company makes the decision to begin a milling operation, it will become even more economical as Comstock can immediately begin reprocessing the millions of tons of leached oxide ore, extracting the final 15% of grade not realized by heap leaching.  This will help offset some of the financial burden, allowing the company to run the milling process 24/7 as it mills both sulfide and oxide ore.

Valuation

There are a number of ways to value a gold miner, but I think the most accurate way is based on a combination of its free cash flow and valuation of its resources.  In its most recent quarter, Comstock Mining became cash flow positive and expects to be free cash flow positive by the end of the year.  As the number of ounces it produces per year increases, the cost per ounce will continue to decline leading to better margins and higher cash flows.  The majority of infrastructure spending has already occurred leaving approximately $3 million maintenance capital expenditure and another $2-$3 million in operational expenses per year.  At a 40,000 oz/year run rate, a $750/oz mining cost and a conservative $1000/oz gold price, Comstock Mining would be generating approximately $5 million in free cash flow.  This cash generation is nothing remarkable, but it can be immediately used to clean up the debt on the balance sheet and fund future exploration drilling.  At a 50,000 and 60,000 oz/year run rate while still using a conservative $1,000/oz gold price, Comstock will generate between $12 and $18 million in free cash flow.  By the time Comstock gets to 80,000 oz/year, the company should be generating in excess of $25 million in free cash flow still assuming $1,000/oz gold.

Currently, Comstock Mining has validated qualified mineral resources of 3.2 million gold equivalent ounces.  Its new drilling program is expected to increase the company’s qualified mineral resource to approximately 5 million ounces by 2015.  Gold miners are often valued based on the price paid for validated qualified mineral resources.  Recent acquisitions of miners/producers have generated a range from $130/oz to $220/oz.  The reason for the wide disparity comes in part from whether the acquiring company would need to inject new money to upgrade or expand the mining/production process.  In March of 2014, Primero Mining purchased Brigus Gold for $220 million dollars.  At first blush, it appears that Brigus Gold received a $105 value for its 2.1 million validated gold equivalent ounces.  But when digging deeper into the deal, it is revealed that the 2.1 million ounces are divided between The Black Fox operating mine (1.36 million validated gold qualified ounces) and The Grey Fox development project (770,000 validated gold qualified ounces with no mining or processing infrastructure).  The Black Fox mine operation is expected to produce between 65,000 and 75,000 ounces in 2014 at an all in cash cost of $875/oz.  When Comstock achieves a 70,000 oz/year production level, the all in cash costs are expected to be below $675/oz.  Using the same $1,000/oz gold price, Black Fox’s $875/oz all in cost and interest payments, at best the operation would be generating approximately $4.0 million in free cash flow.  Additionally, The Black Fox mine is in need of a capital injection for its underground development and has approximately $83 million in debt coming due in a couple of years.  It is unclear how much money Primero Mining would need to spend to take Grey Fox from development into production.

Adjust the Primero/Brigus Gold deal only for the capital injection needed for the Black Fox mine and the debt on the balance sheet, the deal would easily cost over $150/oz.  With that in mind, taking the bottom end of the acquisition range of $130/oz and assume that Comstock does not validate any new resources, we can conservatively arrive at a market value of $416 million.  If we continue to use $130/oz and assume that Comstock increases its validated qualified mineral resources to 4 million (below its projection), then the company can be valued at $520 million.

In its most recent 10-Q, Comstock Mining lists its common shares outstanding to be approximately 80 million.  With the addition of Winfield’s preferred shares, the total outstanding shares would increase to 135 million.  Additionally, Northern Comstock LLC, a joint venture between Comstock Mining and an entity controlled by John Winfield, agreed to provide drilling rights to land in the Comstock District that it owns for 39 years in exchange for preferred shares that can be converted into approximately 50 million shares of common stock.  Adding all of these preferred shares to the common shares increases the share count from 80 million to 185 million.  This is a significant dilution to common shareholders.  Management indicated that the board is well aware of the dilution and the possible overhang it may be having on the share price, mentioning that discussions are on-going about finding a “solution.”  If 185 million common shares are used to value the company, then Comstock Mining has a market capitalization of approximately $230 million.  This market capitalization is still well below the $416 million and $520 million valuation based on $130/oz, representing an 80% and 125% increase from today’s level.

Summary

“A gold mine is a hole in the ground with a liar standing next to it.”

                                                                                                -- Mark Twain

Many people are skeptical about investing in gold mines and gold miners, in particular, and rightfully so.  The industry has been rife with scams and scandals.  Probably the most memorable was in 1997 when the Canadian company, Bre-X Minerals, gold reserves were found to be fraudulent and over $6 billion of market capitalization was completely wiped out.

What makes Comstock Mining different stems from its CEO, Corrado De Gesperis.  He is not a gold miner or an industry insider.  He is a business operator, and as such, has an unorthodox way of operating Comstock Mining.  Instead of focusing on revenue generation, he focuses on free cash flow.  Instead of proving reserves when gold prices are high, he explores when it is most opportune for the company.  Instead of leveraging up the balance sheet in order to increase production, De Gesperis is focused on self funding its mining and drilling operations and reducing debt.  In short, Comstock Mining and its management are focused on creating value for its shareholders.  This is not to say that an investment in Comstock Mining is free of risks or challenges.  There are plenty of things not to like both on an industry and company level – the falling price of gold and the excessive dilution of common shares quickly come to mind.  However, I believe that the company’s location, mineral reserves, its improving cost structure, increasing quality grades and recovery yields, its management, and cheap stock price more than make up for this uncertainty.  As Comstock Mining continues to increase the number of ounces it produces each year, the more free cash flow it generates.  At a run rate of 80,000 oz/year, Comstock will be generating a sustainable free cash flow of over $25 million.  That is money that can be used to fund new drilling programs, repurchase common or preferred shares, or issue a dividend.

• Increased validation of qualified mineral resources
• Continued increase in the production of gold equivalent ounces
• Continued reduction in mining costs
• Favorable reduction in the outstanding shares with limited dilution
• More favorable environment for gold and gold miners