Is This Stock a Gold Mine?

LONDON -- Avocet Mining (LSE: AVM.L) is a gold miner with its principal assets based in Burkina Faso, West Africa.

Here are the usual fundamentals that I see as particularly relevant to the initial appraisal of a value play.

Unlike some of the small-cap value shares I have reviewed recently, Avocet does not have a large spread in its price -- less than half a penny when I checked. It's not that small, either, with a market cap even at the current depressed price of well over 100 million pounds.

The key ratio here is P/TB at 0.55, which is pretty low. Additionally, it had substantial net cash of 48 million pounds, which has arisen mainly from the sale of its Southeast Asia assets last year. The forward P/E at 7.9 is fairly low, but not spectacularly so, while the forecast yield is attractive at 9.1%.

Recent poor news regarding equipment availability for the second quarter has hit the price, but this may be just a temporary dip assuming it is not a longer-term problem, making the shares quite attractive.

Gold rush
However, this is gold mining we are talking about, and there are two specific types of additional risk associated with this kind of play, over and above the kind of risks that accompany all shares of a value bent.

The first is the political. This depends on the region of the mining activity, and in this case the company's major interest is the Inata mine in Burkina Faso. A lot of Africa is either currently or potentially unstable. This country borders Mali, which has seen a lot of trouble recently, and that could spread in some way to Burkina Faso, disrupting Avocet's main operation.

The second specific risk is the gold price. Mining share prices are a geared play on their principal ore, and thus Avocet's share price is related strongly to the gold price. The reason the share price is so geared arises from the large element of operational gearing, which is an accounting term for the level of fixed costs. The higher those costs are as a proportion of the selling price, the higher the operational gearing and the narrower the gross profit margin, with the consequence that the profit is more sensitive to a change in the selling price.

To illustrate this, imagine a product that costs 80 pence to produce and sells for 100 pence. The gross margin is 20 pence, and a 1% rise or fall in the selling price means a 5% rise or fall in gross profit. This is the operational gearing.

Compare that with a product that has the same selling price but costs 60 pence to produce with a 40 pence gross margin. Here, the same 1% change in the selling price results in a 2.5% change in gross profit because the operational gearing is lower. The lower the operational gearing, the less sensitive gross profits are to a change in selling price.

Gold is expensive to produce -- it has high operational gearing. In its first-quarter report for 2012, Avocet tells us that its cost per ounce was $800 to $850. Clearly, then, it can be profitable only where the price is decently above that, and currently it is at about $1,565. But the difficulty for miners is that gold fluctuates constantly -- unlike widgets, where the manufacturer has some control over the selling price. Miners have no control over the selling price, and instead it is the gold market that fixes it.

In the short term, the gold market price is not related directly to miners' costs but to supply and demand for the metal. Mines that were unprofitable at lower gold prices can become attractive if it rises substantially. But it works both ways, and the less profitable miners can easily become marginal or loss-making if the price falls sufficiently.

This is why gold miners are, to a large extent, a geared play on the gold price. Gold has risen in price substantially over recent years, although over the last 12 months it rose to about $1,900 before falling back to the current level.

Note that not only profits would be affected by changes in the gold price; assets would, too, and that is especially important for value investors relying on P/TB. This is because the mine valuations that form the leading asset here must also be based on the gold price. Clearly, whatever the quantitative estimate of the gold still left to be mined, its value at any point will fluctuate with the market price.

So it's an interesting but high-risk play, in my opinion. You have to believe that gold has a lot further to go before Avocet is attractive, and that may be questionable after the rise of recent years. On the other hand, further financial difficulties or other major problems in the world could deliver another big upward move. If you think gold is headed down, don't touch it. And you also have to be willing to discount the political risks.

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