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Why Yamana Gold Inc. Shareholders Have Something to Worry About

By Matthew DiLallo - Jul 24, 2017 at 3:06PM

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The gold miner is currently in the midst of a significant organic growth phase, which will only pay off if precious metals prices cooperate.

Yamana Gold Inc. (AUY 1.61%) sees better days ahead for its investors. With the upcoming completion of its Cerro Moro project in Argentina, the company has clearly visible gold and silver production growth on the horizon. That output increase should supply the gold miner with a growing stream of cash flow, which will help get the company's balance sheet into better shape. That improvement would do wonders for its stock, which has crashed more than 80% over the past five years due to the impact of weaker precious metals prices on its financial situation.

That said, while the Yamana Gold's plan makes sense, it needs precious metal prices to cooperate. Given their unpredictability, that should be a major concern for investors, especially since the company's financials aren't yet back on solid ground.

3D illustration of gold ingots over black background with a chart.

Image source: Getty Images.

Digging into Yamana's plans

In 2015, Yamana Gold sanctioned its Cerro Moro project in Argentina, which it expected would cost $265 million. To help pay for the project, the company struck a silver streaming agreement with Sandstorm Gold (SAND 3.60%). Under the terms of the deal, Sandstorm paid it $70 million up front in exchange for 20% of the mine's future silver production at 30% of the spot price of silver until Yamana delivers 7 million ounces to Sandstorm. After that, Sandstorm Gold will receive 9% of the mine's silver production until Yamana has exhausted the supply.

That agreement with Sandstorm provided Yamana with some of the cash it needed to finance the development of Cerro Moro. The company complimented that deal with two others with Sandstorm, as well as completing several non-core asset sales that have brought in additional cash. These transactions enabled the company to avoid adding any more debt to its balance sheet during the construction of Cerro Moro.

Because of these strategic initiatives, Yamana Gold is on pace to increase its gold production by 20% through 2019 while also delivering a 200% increase in its silver output as a result of the addition of Cerro Moro to its portfolio in early 2018. According to the company's projection, the expected reduction in capital spending and the increase in production from its upcoming project completions positions it to "generate significant increases in cash flow and free cash flow beginning in 2018." That would mark a notable shift for a company that didn't generate any free cash flow last quarter. Furthermore, because that production should provide a significant boost to earnings, it would also push Yamana's leverage ratio to a much more comfortable level of 1.5 times net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization). 

An underground tunnel of a gold mine.

Image source: Getty Images.

The potential problem with the plan

That said, the company's plan to deliver increasing free cash flow, which would de-lever its balance sheet, requires the cooperation of gold and silver prices. For example, in its base case assumptions for Cerro Moro, Yamana estimated that it would earn an after-tax return in the range of 23% to 26% on the project and payback within three years. However, underpinning those assumptions is that gold would average $1,265 per ounce and silver would be $17.60 an ounce, which the company said at that the time it "believe[d] to be conservative" estimates. That said, at the moment the prices of both precious metals are below those levels at $1,260 for gold and $16.50 for silver. That gives investors a reason to worry, because if prices remain weak, or worse yet, fall significantly, Yamana might not earn its desired rate of return on the project and its deleveraging plans could get upended depending on the severity of the decline.

Several factors could impact the price of gold. For example, while a rising dollar would benefit gold, its fall could have an adverse impact on its price. Meanwhile, a rapid rise in interest rates could spook gold investors and cause a sell-off. In addition, unlike other commodities like oil and copper that get consumed by a growing global economy, the bulk of the world's gold gets stored for investment purposes, which limits the need for recurring purchases. In other words, driving the price of gold are changes in sentiment, which are harder to predict than industrial demand. 

A higher-risk gamble on gold

Yamana Gold made a big bet when it sanctioned Cerro Moro two years ago, hoping that the project would enable the company to grow into its stretched balance sheet. It's a gamble that needs the cooperation of precious metals prices to pay off, which makes its stock a higher-risk option for gold bulls than some other gold miners. That said, given the stock's slump over the past few years due to its balance sheet worries, it certainly has ample upside if prices rise, though investors are taking on an extra helping of risk for that potentially higher reward.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Yamana Gold Inc. Stock Quote
Yamana Gold Inc.
$5.05 (1.61%) $0.08
Sandstorm Gold Ltd. Stock Quote
Sandstorm Gold Ltd.
$6.05 (3.60%) $0.21

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