I am convinced that Primero Mining (NYSE: PPP) is the greatest gold stock in the world.

In Part 1 of this discussion, I set the stage for Primero's remarkable story by revealing the underappreciated treasure beneath its San Dimas mining operation in Mexico, and by highlighting the accomplished group of industry executives that are committed to realizing the mine's full potential. Here in Part 2, we'll discuss some of the factors that have contributed to recent weakness in the shares and assess the resulting stock valuation. Throughout, excerpts from my recent conversation with Primero CEO Joe Conway will punctuate our analysis.

Down for the moment, but not down for the count
While I do consider the market's failure to comprehend the enormous geological potential of San Dimas a major factor behind the stock's underwhelming performance to date, Primero does also carry something of a lead weight around its neck. I'll let Conway explain:

Christopher Barker: Clearly, the unfortunate tax issue relating to the silver stream agreement with Silver Wheaton (NYSE: SLW) continues to weigh upon the shares. Could you take a few moments to explain the nature of the issue and update my readers on the company's strategy and progress toward securing a permanent solution?

Joe Conway: The issue arises from the fact that the corporate structure we inherited with the acquisition of the mine results in the company paying taxes on the spot price of silver (i.e., $40), while it actually only receives $4 for around 75% of our production. This was not a big issue when silver prices were $15 and below, but has become the reason for the deep discount in our stock. We have put in place an integrated approach to solving the issue. Firstly, we have limited the potential liability to the company by purchasing call options that protect us against the silver price running. Secondly, we have put in place some tax planning structures that provide interim relief while we work on our primary goal of restructuring our affairs such that income taxes are based on realized prices, that is that we pay tax on what we get. We expect to be providing an update on this strategy in the next few weeks.

With a powerful force like Goldcorp (NYSE: GG) in its corner as a 36% stakeholder, and gold's executive dream team prioritizing a permanent solution to this rather unusual tax treatment, I have maintained every expectation that this lead weight will ultimately be lifted. In the meantime, I have been content to acquire these discounted Primero shares to build what has become a core position of my personal portfolio.

Three-part prelude to the ultimate bargain in gold
Without ever setting out to do so, I have discovered that spotting powerful turnaround stories in the making may be one of my strengths as an investor. Over the years, I have steered my readers toward Silver Wheaton at its multiyear low of $2.51 per share (currently $32.31), Yamana Gold (NYSE: AUY) at $3.93 (currently $13.72), and Great Panther Silver (AMEX: GPL) at $0.82 (currently $2.75). More recently, I could be found hailing the inevitable resurgence of Northgate Minerals prior to AuRico Gold's (NYSE: AUQ) dramatic acquisition.

In fact, AuRico's winning bid for Northgate brings us straight into our discussion of the factors contributing to Primero Mining's recent share price decline. The latest slide can be seen on the chart to consist of three distinct stages of retreat from the Aug. 26 close of $4.22 per share. Now at $2.30, the stock has shed 45% in precisely one month! Stage one began when AuRico snatched Northgate from Primero's jaws, as the market erased all the gains it had given in anticipation of Primero's strategic pairing. Noting Primero's receipt of a $25 million break-up fee, and its launch of a U.S.-listing on the NYSE in the interim, I argued at the time that the sell-off looked overdone. Then came Primero's downward revision to 2011 production guidance, where again I considered the stock's associated stage two decline a classically myopic overreaction (see my discussion from the CAPS blogs here). I sought Conway's take on the sell-off:

Barker: Since traders are clearly focusing upon that 11% reduction in anticipated 2011 gold production -- punishing the shares by some 15% or more over the days that followed -- could you speak to the longer-term outlook for production growth at Primero?

Conway: We see ourselves doubling production from 2010 of 100,000 GEO to 200,000 in 2013. We do not expect that the slight revision we had to make this year impacts our medium- and longer-term growth plans in any way. We encountered a specific situation this year with a monthlong strike combined with lower-than-expected gold grades. This was a direct result of there not having been sufficient infill drilling historically, something we have already begun to change. We understand the market's disappointment in our revised guidance, but are confident that given the excellent exploration results seen throughout the property, this was an isolated incident.

And finally, stage three of Primero's dramatic share price decline appears to be associated with the acute correction in gold prices that has annihilated precious metal mining shares over recent days. I believe Primero's three-stage collapse has yielded an extremely compelling entry point for the shares. But don't take my word for it!

Fun with numbers: pondering the valuation
At the time of this writing, Primero's $2.30 share price yields a current market capitalization of $203 million. Please keep that figure firmly in your mind as we consider Conway's summary of Primero's financial position: "We have around $100 million in cash, an expected average $90 million in after tax operating cash flow over the next five years and only $110 million in total debt." Meanwhile, like all producing gold miners, Primero sits atop a buried treasure in gold that must also figure heavily into any comprehensive valuation equation.

Now consider this: Primero's existing gold reserves of 866,090 ounces would fetch nearly $1.4 billion in today's gold market. Therefore, the stock is trading for less than 15% of the market value of its gold reserves. For comparison, I consider Goldcorp shares a screaming bargain today at more than 35% of the market value of proven and probable reserves.

But wait ... it gets far better! Remember that major disconnect we discussed in Part 1 between the stated reserves and the mine's anticipated geological potential? If we apply the 90% conversion rate of resources to reserves that San Dimas has delivered over the past 30 years, as strongly corroborated by Goldcorp's confident pledge of cumulative silver production well in excess of current silver reserves, I consider it entirely reasonable under the circumstances for investors to base their valuation of Primero Mining on an implied economic resource of approximately 2.7 million ounces of gold!

At $1,600 gold, that would amount to more than $4.3 billion worth of high-grade gold, and the current market capitalization would then equate to less than 5% of that value. Fools may recall that I recently touted an incredible bargain in the shares of explorer Paramount Gold and Silver (AMEX: PZG) when that stock traded for 7% of measured and indicated gold. But Primero Gold is no mere explorer. This is a profitable gold producer under well-proven management, with plans to double gold production within two years from some of Mexico's most legendary, underexplored, and expansive vein deposits! At $203 million, moreover, the market has stripped nearly 60% of the $500 million value of Primero's founding transaction (transacted with gold near $1,220 per ounce).

I have observed every single tick of this gold market for the past several years, and I for one have not seen a valuation disconnect this severe since the darkest days of the brutal correction of 2008. Although some investors may find it difficult to maintain bullish expectations in the face of the latest sell-off, I firmly agree with Conway that: "Once investors become more aware of the margin expansion and have increased confidence in the gold price itself, we may see a very rapid and dramatic increase in the gold equities." I spy plenty of compelling bargains in gold in the midst of this latest correction, but only one standout bargain that simply commands primero place.