This week, we've seen two exploration-stage miners release preliminary economic assessments (PEAs) for their respective gold projects. On Monday, International Tower Hill Mines (AMEX: THM ) unveiled the numbers for its large Livengood project in Alaska. The following day, Fronteer Development Group (AMEX: FRG ) did the same for its 51%-owned Long Canyon property in Nevada.
While both operators are busily expanding their respective resource bases, these PEA numbers still hint at the profitability we might expect from a future mine. Let's step through several key questions to ask of such assessments -- which, I should mention, are prepared by independent consultants -- and see how the two projects stack up.
What is the base case IRR?
For those who skipped Corporate Finance 101, internal rate of return (IRR) is an estimate of the annualized return a company can earn on capital invested in a given project. Looking at some mines recently put into production, Goldcorp's (NYSE: GG ) Penasquito project showed a 17% IRR in its December 2007 technical report, and the main ore body at Yamana Gold's (NYSE: AUY ) Gualcamayo project sported a 32.3% IRR in previous owner Viceroy's PEA dated January 2005.
Some companies provide both a pre-tax and an after-tax number, but the difference shouldn't be significant. Agnico-Eagle Mines (NYSE: AEM ) sported an IRR of 14.3% pre-tax and 15% after-tax on its Goldex property, according to an assessment issued in September 2005.
International Tower Hill reports Livengood's IRR at 14.6%, while Fronteer's project is a much fatter 64%. While both PEAs envision heap-leach, open-pit operations, there's quite a big gap here. Let's dig deeper before we jump to conclusions, though.
What are the gold price assumptions underlying these IRRs?
A mine's IRR is driven in part by metal price assumptions. That's why PEAs typically present a sensitivity analysis, showing how the IRR varies at different commodity prices.
Based on the IRRs above, you might assume that Fronteer has an aggressive base case, but the PEA actually models gold at $800 per ounce, versus International Tower Hill's $850 per ounce. Long Canyon boasts of both a higher average gold grade and metallurgical recovery rate. These sorts of factors, rather than gold price assumptions, drive its superior IRR.
Interestingly, International Tower Hill's report only shows Livengood's sensitivity to higher gold prices; the IRR pushes north of 30% at $1,050 gold. Fronteer's PEA, meanwhile, provides IRR calculations at both higher and lower prices, with $700 gold bringing the IRR down to a still-impressive 45%.
Would Livengood be built in a $700 gold environment? I have my doubts. International Tower Hill underlined its project's "considerable leverage" to the gold price. Leverage cuts both ways, though.
What are the start-up/sustaining capital costs?
Livengood's initial capital costs are pegged at $665 million -- 10 times those of Long Canyon. I guess that's fair, given that expected life-of-mine production at the Alaskan project (5.8 million ounces) is a bit over 10 times higher as well.
Still, this is a heavy load anyway you slice it. Livengood's capital expenditures stand at more than 150% of the project's pre-tax net present value (NPV). This $665 million figure is also bigger than International Tower Hill's entire market cap. Long Canyon's start-up costs come in at less than half of the project's pre-tax NPV of $145 million, and at a fraction of the company's market cap.
Livengood's sustaining capital costs are also significant, at $297 million, or 45% of initial costs. That's quite high, even compared to a big mine like Penasquito. At Long Canyon, sustaining capital comes in at 9% of initial capital expenditures.
When's payback time?
As you might guess, the payback period tells you how fast a mine's cash flow will pay back initial capital expenditures.
The Livengood PEA is silent on this matter, with no mention of payback or cash flow in the 144-page report. With a mine life of 12.6 years, I would hope to see payback achieved by year six or so. That would line up with Agnico's Goldex figures.
Long Canyon's payback is pegged at 1.3 years, versus a six-year mine life. That is super speedy.
Adding it up
Many of my concerns about Livengood's seemingly less-than-robust economics are mooted if you accept the argument put forth by investing guru Marc Faber, who believes we've got a new floor established at $1,000 per ounce of gold. Economist David Rosenberg makes a similar case, pointing to the Reserve Bank of India's recent purchase of 200 metric tons of gold at $1,045 per ounce.
As to Livengood's unwieldy size relative to International Tower Hill's modest financial capabilities, this issue would best be alleviated by a takeover. Maybe investors are counting on a larger player like Gold Fields (NYSE: GFI ) or Harmony Gold (NYSE: HMY ) to swoop in and do the heavy lifting. This is how the industry generally operates, so it's not an unreasonable expectation.
A clear point in Livengood's favor is that it's of sufficient size to potentially attract such a buyer. If gold stays above that supposed $1,000 floor, then the economics may be sufficiently compelling as well. Long Canyon, at least at this early stage, is not big enough to tempt a major.
For my money (and I mean that quite literally), Fronteer's Long Canyon project looks far more compelling.