Eldorado Gold Unmoved by Greek Drama

Greece’s Ministry of Environment and Energy said last week that it will be pursuing arbitration proceedings against

We’re confused by the announcement, as Stathakis himself granted Eldorado a permit for the Skouries mine in November 2016, a week after assuming his position as minister. Also, Eldorado has released a statement that it has not received any formal notification or any details on any potential arbitration. However, such unexpected and dramatic moves have been all too common in the history between Eldorado and Greece.

Despite this news, we are maintaining our fair value estimates of $4.10 and CAD 5.60 per share as well as our no-moat rating. This isn’t the first time the Greek government has introduced an unexpected road block. But, like the previous 18 cases that went before Greece’s highest court, we think this too shall pass.

Our expectations for the opening of the Greek projects are unchanged. We think Eldorado’s shares look undervalued; nevertheless, we reiterate our very high fair value uncertainty rating. Though we expect the mines will open, we think there is still potential for a delay depending on what happens from here.

Cost Position Good but Weakening Eldorado Gold's leading cost position has weakened as currency devaluations favored peers with exposure to locations such as Canada, Australia, South America, and Russia, but the company still boasts a small portfolio of decent long-life mines. However, it will have to carefully manage its development plans if it intends to continue to fund them with internally generated free cash flow.

Under lower gold prices than in prior years, the firm has taken a more prudent approach to capital expenditures than in the past, spreading its development projects over time to manage cash. The company also sold its Chinese mines, helping fund its announced acquisition of junior miner Integra Gold ICGQF.

Problems with the Greek government have hampered development and could threaten Eldorado’s ability to capitalize on its growth pipeline. This reflects the risks to its strategy. By targeting countries immature to gold mining, the company has largely avoided the high prices that plague competitors’ balance sheets and ability to earn economic return. However, this strategy exposes the company to geopolitical risks that mines in stable jurisdictions are unlikely to run into.

Our long-term nominal gold price forecast is $1,300 per ounce in 2020. We expect investor demand to weaken further as the Federal Reserve raises interest rates, weighing on near-term gold prices. However, we believe Chinese and Indian jewelry demand will ultimately fill the gap left by fading investor demand. Strong preferences for gold in these countries drive high income elasticity, and rising incomes should result in robust jewelry demand growth over the next few years. Strong demand will lead to a production shortfall, requiring a higher incentive price to encourage additional mine production. However, cost deflation caps the potential price upside from an otherwise strong demand story. Depreciation in producer currencies, lower oil prices, and general mine cost deflation stemming from the end of the Chinese-driven commodity boom have helped drive cost reductions, lowering the marginal cost of production.

Not Enough Cost Advantage for a Moat Historically, Eldorado boasted some of the lowest-cost mine production in our coverage universe. However, after the fall of gold prices from roughly $1,800 per ounce to $1,200 per ounce in 2013, gold miners shifted their focus from maximizing production to maximizing cash flow, driving the shutdown of some of the highest-cost production in the industry. In addition to cost-reduction initiatives, miners benefited from falling oil prices and the strengthening U.S. dollar.

Oil prices have declined by roughly half since 2014. With diesel (an oil derivative) a key input for gold mining, this decline has benefited production costs. However, it roughly affects gold miners equally and represents a general downward shift of the entire cost curve. As a result, a lower oil price has little impact on relative competitive positioning.

Many global currencies have seen significant depreciation relative to the U.S. dollar. This benefits gold miners, as they generally sell their product in U.S. dollars but pay production-related expenses in each mine’s local currency. As a result, a strengthening dollar will generally lead to falling costs, all else equal. Major gold-producing countries Australia and South Africa saw the value of their currencies fall 30%-40% relative to the U.S. dollar from 2012 to 2015. Turkey, which represented roughly 60% of Eldorado’s gross profit in 2014, saw its currency fall roughly 40% during the same period. However, not all currencies have seen as dramatic of a decline. Over the same period, the euro declined roughly 10%. Expansion projects in Greece are expected to drive a significant portion of production growth in the future. In all, we think the currency impact affects the cost curve differently, leading to changes in relative positioning. Given Eldorado’s heavy reliance on Greece for future production, we think the firm no longer carries a cost advantage low enough to warrant a moat.

Historically, Eldorado has distinguished itself through its ability to develop mines in immature markets. Despite the execution and political risks this entails, Eldorado has generally been successful navigating in new countries. For example, it was the first North American gold producer to build and operate a gold mine in China. Success in operating in countries where few competitors have entered has resulted in access to mining assets with attractive natural resource advantages, such as Kisladag, the largest gold mine in Turkey. Furthermore, as one of the few gold miners in some of the countries in which it operates, Eldorado faces little competition, allowing it to enjoy an advantage in bargaining power with suppliers. This translates into relatively lower costs, such as labor, compared with countries with numerous mining operations, such as South Africa. However, since the Syriza party took power in Greece in early 2015, Eldorado’s expansion efforts in the country have been met with significant opposition. While we expect the mines to open, the Greek government has attempted to revoke permits and halt development, which has delayed development and pushed back opening dates. Eldorado’s experience in Greece is a reminder that in countries with higher geopolitical risk, a change in government (and support) can come quickly. Further, it exemplifies the riskiness of Eldorado’s strategy.

We believe many of the firm’s advanced-stage projects such as Olympias and Skouries will exhibit below-average production costs, helping entrench Eldorado’s current position on the lower end of the cost curve. However, we don’t expect these new mines to drive Eldorado’s costs lower or faster enough to drive a significant change in Eldorado’s relative cost position.

In light of the lower gold price environment, gold miners across the industry have changed their focus from production to cash flow generation. Miners have focused on development projects that can generate positive cash flow even with lower gold prices. We believe this increased industry focus on low-cost production means Eldorado’s advanced-stage projects simply protect its position on the cost curve rather than improve it.

Risks Include Metal Prices and Geopolitics Like most gold producers, Eldorado is highly leveraged to gold prices; this is partially offset by its position on the lower end of the industry cost curve. However, sustained, weak prices will seriously hamper the firm's earnings power. Furthermore, with the Vila Nova mine in Brazil and Stratoni mine in Greece producing other metals, the company would suffer from a drop in iron ore, lead, zinc, or silver prices.

Eldorado faces meaningful geopolitical risk, as it operates chiefly in Turkey and Greece. Despite the company’s success in working with national and local governments and communities, these countries continue to represent heightened risk to operations. The firm could be subject to higher taxes or royalties and fees. For example, in early 2013, Greece increased its corporate income tax rate from 20% to 26%. Eldorado’s growth pipeline also has significant exposure to Greece, where the current government has hampered mine development.

With a number of projects in development and under construction, investors should be aware of Eldorado’s execution risk, as operational difficulties could arise in bringing these various mines on line.

Eldorado uses modest leverage. Following the decline in gold prices in 2013, the company took additional steps to protect its balance sheet. It slashed its exploration budget and capital spending, postponing some projects until gold prices improved and extending other projects’ timelines to reduce annual capital needs. Eldorado also suspended its dividend, which was only just reintroduced in 2017.

Although it has taken steps to control cash flow, we believe Eldorado will probably need additional debt financing to fund its growth projects. Delays in its Greek developments have slowed the addition of new cash flow, while its older mines face slowing production amid mine sequencing. Nevertheless, given the low current debt load, we don’t expect additional fundraising to significantly affect Eldorado’s currently stable financial health.