Did Yamana Gold Inc Make the Right Deal?

Yamana Gold (NYSE: AUY  ) and Agnico Eagle Mines  (NYSE: AEM  ) purchased precious metals producer and explorer Osisko Mining for $3.9 billion. The two companies outbid Goldcorp's (NYSE: GG  ) hostile offer to acquire Osisko Mining for $3.6 billion by 11%. This purchase offers several benefits, but also risks for Yamana Gold. 

Production, costs, and balance sheet
This deal may improve Yamana Gold's operations, mainly because Osisko Mining has lower cash costs than Yamana. This year, Osisko Mining expects its cash costs to reach $550 per ounce, which is roughly 20% lower than in 2013. This lower cash cost could reduce Yamana Gold's average cash costs, possibly as much as 3%, according to some analysts. In 2014, Yamana Gold expects its all-in sustaining cost to fall below $850 per GEO. 

Osisko Mining is also able to translate a higher portion of its revenue to operating cash flow: Last year, its operating cash flow-to-revenue ratio was 0.39, while Yamana Gold's ratio was 0.35. In terms of production and growth, Osisko Mining expects to increase its gold production by nearly 16%, year over year. It also plans to augment capital expenditures by 20% to 148 million. The higher capex and expected rise in production will benefit Yamana Gold via increased operations. 

Osisko Mining's balance sheet is also in good shape. The company has more than $200 million in cash, low debt (its debt-to-equity ratio is only 17%), and no deficit in its equity. These conditions suggest the company won't impose on Yamana Gold's balance sheet. 

Price, loans, partners
Despite those strong numbers, this deal raises several questions. First, is the price right? Without a detailed valuation it will be hard to answer this question, but consider the following:

  1. Osisko Mining's market value, before Goldcorp tried to take over the company, was below $2.5 billion. This doesn't mean the company isn't worth more than $2.5 billion, especially to be the majority owner of such a company, but this also raises the question of whether such a spike in its tag price is prudent. 
  2. Since Osisko Mining has low debt, which could be mostly covered by its cash on hand, the main value of this company comes from its mines. The company's three resources -- Canadian Malartic, Hammond Reef, and Upper Beaver-Kirkland Lake -- are expected to produce roughly 550,000 ounces of gold this year. Assuming the company generates free cash flow of $200 million in 2014, steady 10% growth in the next 20 years, and a cost of capital of 8.5% (the precious metals sector average), the discounted cash flow valuation of the company comes to $2.3 billion. This is a very rough estimate, but it isn't far off the initial market value of the company at the beginning of the year. 

Therefore, the price Yamana Gold and Agnico Eagle Mines paid for Osisko Mining might have been too steep. 

Besides the price of Osisko Mining, the two main factors to consider are the debt Yamano will take to pay for deal and the partnership with Agnico Eagle Mines. 

In order to make this transaction, Yamana Gold entered into a two-year, $750 million loan. Some analysts believe the company's debt burden will reach over $1.6 billion. This loan alone could bring the company's debt-to-equity ratio to 0.3, compared to 0.19 at the end of the first quarter. This higher debt poses a financial risk on Yamana Gold. Moreover, considering the gold market has yet to recover, taking another mining company focused on gold (instead of other precious metals) could also further raise Yamana Gold's operational risk. 

Finally, the partnership with Agnico Eagle Mines means some of the burden of this purchase will fall on another company, but the rewards and decisions will also be made together. Keep in mind also that any partnership poses a risk of the entities failing to agree on key issues down the line. 

Takeaway
Yamana Gold's purchase of Osisko Mining raises several questions regarding its valuation, and the added risk the company took to make this deal. Despite these risks, Osisko Mining seems to offer benefits such as growth in operations, low debt, and low production costs, which could serve Yamana Gold well. 

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