“Buy when there’s blood in the streets, even if the blood is your own.” Baron Rothschild

“When I was young people called me a gambler. As the scale of my operations increased I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time” – Sir Ernest Cassell, Banker to Edward VII

 “Equity is the sliver of hope between assets & liabilities”  Russel Napier

Yukon Nevada Gold (YNG) is a substantial holding in my portfolio currently and has been the cause of much heartache and distress to its shareholders over the last couple of years. I think I’m risking 5% of my portfolio for an asset backed shot at spectacular returns. My write up here is heavily influenced by various other far superior write ups and research reports I have found dotted around the internet from the last 2 years and listed at the bottom. I am standing on their shoulders to write this report. The story is changing constantly so I imagine this will be out of date by the 30th of January.

Yukon-Nevada is a deeply under-valued US-based small-cap gold miner with operations in Nevada, USA and British Columbia, Canada. I believe YNG is approaching an inflection point where it may begin to realise something approaching its “true value”. I will try to convince you below that there is the strong possibility that YNG is not worth $224m at today’s price of $0.24 per share but instead is almost certainly worth $1.00, is probably worth $2.50 and could even be worth $7.00+. If you can’t handle 7% daily swings in the share price – Stop Here.

In its current form Yukon Nevada Gold was created via a merger in May 2007, between Yukon Gold Corp and Queenstake Resources Ltd. As a result of the combination of the businesses and assets of the two companies, Queenstake became a wholly-owned subsidiary of YGC, and YGC changed its name to the current Yukon-Nevada Gold Corp.

YNG is in the later phases of a turnaround and thanks to an arduous 2011 is now a substantially de-risked (but certainly not without risk!) proposition. By 2013, the company is planning to produce at a run rate of 300,000 ounces of gold per year. This is a long way from the current run rate of circa 80,000 ounces per annum. The production rate of 300,000 ounces of gold per year was achieved before, from 1987 to 2002. In its last full year of production under AngloGold, it produced 338,000 ozs of gold. There is no reason why they cannot achieve it again with its newly renovated roaster and 3.5 million ounces of gold in the ground.

What makes YNG different to other smaller gold miners is that its assets have a history of production and secondly that it has in its possession one of only three refractory mills in the state of Nevada. Not only does Yukon Nevada have the prospect of having three of its own mines in operation on its Jerritt Canyon site by 2014, but its key asset is the only refining mill with any spare capacity in the state of Nevada.

YNG is in the process of proving they have around 6m ounces of Gold in the ground currently according to a recent interview with the CEO.

Above Average Odds Investing said that at $0.25 “YNG is also trading at a market cap per resource oz of gold of approximately $35 per oz compared to a peer average of $150-200 per oz (peer group comprised of Alamos Gold, Aurizon Mines, Centamin Egypt, Kingsgate, Kirkland Lake, Mineral Deposits, Capital Gold and Semafo)

If YNG were re-valued to simply trade on a market cap/resource oz in-line with its peer group, YNG would currently be valued at $1.25-1.50/share.

Note that YNG has historically converted resources into reserves at a 120% rate.”

Since this time YNG has made several additional discoveries adding to their resources. That is a big discount.

History

At first, newly merged company seemed successful because during the first two quarters (Q3 and Q4 2007) the company was producing gold profitably. Then, by Q1 2008, problems started to emerge. During this quarter, the company shut down its operations in Jerritt Canyon to address myriad infrastructure, environmental (dangerous mercury emissions), cash flow and safety concerns. It was an unmitigated disaster. As just one example of prior management’s incompetence, the Jerritt Canyon property at the time of shut-down was operating with over 500 employees while current management is running nearly the same throughput was fewer than 150 employees.

The situation became so severe that the company was 24 hours away from declaring Chapter 11 bankruptcy. The stock price went from $2 per share to 2 cents causing investors to lose almost their entire capital. Anytime a stock price falls almost 100 percent like it did with Yukon-Nevada due to the fear of declaring Chapter 11 bankruptcy, it creates emotional scars investors. YNG has done the round trip from $2.70 in Dec 2006, to $0.02 at the end of 2008, to $0.95 at the end of 2010 and now to $0.24 at the start of 2012. Face Smelting Volatility!

In early 2009, a European shareholder group called Orifer saved YNG from declaring bankruptcy by injecting an emergency overnight financing. Over the next several months, this same Swiss Group along with Eric Sprott of Sprott Asset Management put nearly $60 million into YNG, fired the old management team who lost the permits and the engineering firm that was assisting with operations and brought in a new CEO named Robert Baldock who has a 30-year track record of overseeing turnarounds in the mining sector.

Jerritt Canyon

The wholly owned complex that YNG has at Jerritt Canyon consists of an array of open-pit and underground mines that have been exploited to various degrees over the last 30 years. There are further unexplored areas of the property that they intend to drill over time. The property is 120 square miles with 3 current / former operating gold mines—the Smith mine, SSX/Steer and Starvation Canyon and the strategic asset of the processing mill.

The Jerritt Canyon property in Nevada has produced 8m ounces of gold since 1981. If Nevada was a separate, stand alone country it would be up there with the top producing countries in the world.

Jerritt Canyon is located just North East of the prolific Carlin Trend in Nevada. One of its key assets is its roasting capacity used to process Sulfide Ore and turn it into Gold. Currently, there are only 3 roasting facilities in Nevada, owned by YNG, Barrick Gold and Newmont. It is a widely held belief that there will never be another roasting facility permitted in Nevada due to their lack of popularity with environmentalists. With roasting capacity constrained and finite, producers naturally err to processing only their highest-grade ore, while stockpiling their low and medium-grade ore.

The Last Year or so….

Many investors learned about Yukon-Nevada in the middle of 2010 and during that time, the stock price was at $0.25 per share. Within six months, the stock had rocketed to $0.90 per share. It was all playing out just as expected, the gold price flying was helping too. Management and shareholders were geniuses; turning the company around, operations showed profitability, and future growth productions targets were stunning.

The new CEO Bob Baldock took over in 2009, he told the Board that the plant was in need of more than $100 million in capex in the form of winterization and refurbishment. However, at that time, the controlling shareholders strongly opposed the issuance of more shares which was the only real access to capital. It was decided that without the capex, the management would restart production with the hope of producing enough cash to pay for the capital expenditures. This was Unmitigated Disaster 2.0. “As a result of this, the company began production without having winterized the plant. In this respect an avoidable dilemma was charged at full head-on and the dilemma won.”

Production plunged as soon as the non-winterised plant ran into highly foreseeable problems with the first batch of wet ore. Then, in Q1 2011, the company announced YNG lost money in Q4 2010. Only when it became clear that the company’s existence was in question did the board of directors give the management the green light to raise enough money to fix the malfunctioning plant.

The COO responsible for this mistake has now shifted to “corporate development” and was replaced with the current COO Randy Reichert (whom I have heard good things about from the sell side).

A plan was put together to engage Deutsche Bank to provide the company with a total of $179 million from private placement, warrant exercises, and pre-paid gold forward facility. On May 24th 2011 Yukon-Nevada reported that it had raised $59 million. only part of the $179 million in financing required. The day after the announcement, the stock price increased to $0.56 per share which represented a 40 percent jump in one day – this is an example of what can happen to spring loaded, event driven value stocks.

Remember, they raised $179m to finance the refurb of their mill. The whole company, gold in the ground and the entire 95% completed refurbed mill sells for $220m today. This seems like a blatant mispricing to me. In the middle of the year, before they actually had raised the money and there were huge question marks over where it would come from; the stock was trading between $0.30 and $0.50!

Ketza River

YNG also owns a separate mine at Ketza River in the Yukon Territory, British Columbia. Ketza River is another former producer since it was closed down in 1990 when it became un-economic to mine at ~$300 gold prices. Ketza River was producing 100k oz/year when it was closed down.

Most of the infrastructure is in place at Ketza River including, power distribution, wells, exploration camp, main camp, office buildings, truck shop, warehouse, satellite communication, water and sewage treatment, all in sound working condition. YNG management estimates that C$21 million will be required to enable Ketza to start producing once again. This relatively small investment is required in order to bring a fairly substantial operation back on line.

In late September 2011, Yukon-Nevada announced that it had submitted its Yukon Environmental and Socio-economic Assessment Application for the Ketza River Project to the Executive Committee of the Yukon Environmental and Socio-Economic Assessment Board. An assessment is a first step in gaining the necessary approvals in order to bring the Ketza River Mine back into production. The timeline for review is a minimum of one year from the date of submission.

From this they expect a 70k oz/year mine up and running sometime in 2013. The mine would have a cost profile of less than $400 per ton and would be capable of generating approximately $50mm of annual FCF for 7 years before further exploration.

This would bring 2014 production for YNG as a whole to 400k oz plus if Jerritt Canyon also hits it’s targets, assuming no contribution from incremental oxide processing capacity, acquisitions or contributions from further successful drilling and mining on YNG properties.

Management previously talked about spinning off Ketza River and then have subsequently reneged on this, another example of their miscommunications. However, Christopher Ecclestone of Hallgarten & Company, who covers YNG and wrote a great note in October 2011, believes that if Ketza River was marketed properly and spun off as a separate company, it could bring a value of $100 million or $0.10 per share because the Yukon is a very attractive region.

The Roasting Mill – This is your Margin of Safety

CEO Bob Baldock claims that the roasting facility is what gives Yukon-Nevada its value. They estimate that the roasting facility has a replacement cost of $1 billion or $1 per share. Christopher Ecclestone at Hallgarten & Co estimates $500m or $0.50 a share. Ultimately it’s only worth what someone is willing to pay for it either in a takeover situation or in a liquidation situation – and they are vastly different prices!

However, I take comfort from the fact that you couldn’t build a roaster like this in the region because you couldn’t get it permitted, and even if you could, it would take you 8 to 10 years to complete the construction.

Yukon-Nevada’s roaster is one of only three roasters in Nevada and the surrounding region. The other two roasters are owned by Newmont and Barrick and both are running at full capacity. Roasting is currently the only economic method of processing refractory sulfide ore, which is most prevalent in Nevada. Obtaining a permit for new roaster capacity in Nevada and the surrounding region is extremely difficult and time-consuming due to environmental concerns. No new roasters have been permitted in the past 12 years, and none are currently proposed or in the feasibility stage.

In theory, Newmont or Barrick should seek to acquire YNG purely for the roaster and take the gold assets they would get for free as a bonus. With excess capacity in Nevada being highly sought after, the Jerritt Mill as part of YNG offers the easiest way for any player in Nevada to increase processing capacity. Because the board of directors foresaw the potential threat of a hostile takeover, on October 4, 2011 they approved a poison pill to prevent it from happening. (does anyone know the details of this?) As a result, it would now apparently be difficult for Newmont or Barrick to attempt a hostile takeover.

As output at Jerritt Canyon ramps up, Yukon-Nevada is sure to draw attention of institutional investors, large cap miners hungry for acquisitions and sell side analysts.

The mill has been appropriately dubbed the “Hungry Monster” by management. Keeping the mill going is an extremely expensive process and therefore you want it running at close to full capacity to keep the average fixed costs down. The current capacity on Jerritt Canyon’s dry line is 6,000 TPD. This rate was previously attained when there was more feed being derived from open pit operations, but there has been excess capacity because the underground mines cannot meet output of such levels. As a result, stockpiles and the purchase of raw ore from Newmont have been used to supplement the feed to the mill, which carry a lower grade than the ore extracted from Yukon-Nevada’s underground operations. This has had the effect of depressing margins and increasing the cash cost per ounce because Newmont were charging a lot for the ore.

The engineered processing capacity on the wet line has a maximum daily throughput of 5,000 TPD. The company’s excess mill capacity has been used to process bought-in feedstock from Newmont at marginal profitability. The strengthened financial position of the company will put “the boot on the other foot” in these types of transactions. Randy Reichart said the type of deal would be very different going forward on the latest conference call.

Winterization – We Are Nearly Done

The weather at Jerritt Canyon gets to minus 35 degrees centigrade! That’s pretty cold – no wonder stuff breaks!

Management initially promised to complete the winterization and refurbishment of the plant by Sept 2011. Another example of Over Promise, Under Deliver from the team at the top; it seems ludicrous to suggest a $170m refurb project of what is potentially a $1bn asset would take just a month and a half.

I have been informed by management of the company that the final construction shutdown was schedule to start on the 9th of Jan and they anticipated re-starting the mill by Jan 20th. All planned refurbishments should be completed by then. The aim was stated to be at steady state production of 10,000 oz per month with the refurbished plant straight out of the gate before ramping up gradually.

Photo of the new completed dryer as of Jan 2012.

 

Look How Far We have Come!

It’s important to get some perspective and see what has accomplished with Yukon-Nevada since 2008 – and what’s been done in the time since it was last at these prices (Jan and June 2010). Bob Baldock has restarted production, raised money to winterize and refurbish the plant. YNG has gone from polluter to environmental award winner. They are on the cusp of returning to profitable production. Furthermore, they have consolidated the records of all previous drilling into one database so they can better assess and exploit their assets. It has been a very bumpy ride and communication of the (mixed) messages has been poor. But we are in a much, much better place now with a Gold price that is 25% higher! The only thing that’s gotten worse is sentiment towards the stock.

I’m not sure what I think about management, I’ve not met Bob Baldock but I’ve found Richard Moritz of Investor Relations incredibly helpful when I’ve asked questions. I’m willing to give them Q1 to prove to me that they can do as they say they are going to do. You probably don’t get Jack Welch for 25% of Intrinsic Value, but a man who turns a company like Yukon around could claim to have some of his qualities.

I will quote from Mariusz at Classic Value Investor….he sums it up beautifully.

“Between everything that I wrote and all the comments that I made there is one common denominator – malfunctioning plant. When this thing is fixed, 99 percent of the problems go away. Until this happens, nothing matters. Production targets will be missed. Revenue projections will be missed. Gross profit margins will disappoint.”

Where does Production Come From?

The SSX deposit was discovered in the early 1990s, and mining commenced in 1997. The deposits occur 450 to 1,000 feet below the surface. It was, in the recent years, the main gold producer at Jerritt Canyon. By the end of the first quarter of 2012 the hope is that it will be contributing 1,200 tons per day. The grade is 0.189 ounces per ton. To get the ounces we multiply one by the other.

Smith   –  1,000 tpd x 0.235 = 235 oz per day x 365 days = 85,775 oz per year

SSX/Steer   – 1200 tpd x 0.189 = 226 oz per day x 365 days = 82,500 oz per year

Total      – 85,775 + 55,188 = 168,275 ounces per year

So it’s possible we hit the previous target of 150,000 Oz or the one Randy hinted at on the Q3 call of 170,000 with production from their own mines – at much higher margins.

The 300,000 ounces target for 2013/14 can come from bringing Burns Basin or Ketza River online alongside the Starvation Canyon mine.

Cash Cost of Gold Production

This has been distorted higher because of poor execution, insufficient scale and because they have been taken advantage of in their ore purchase deals with Newmont who knew they had a weak hand. The hope is that by the end of Q1 2012 they will only be accepting ore from Newmont if they have spare capacity and if they do it will be on their terms, ie. At better pricing.

Mining at the Smith Mine is currently outsourced and costs about $140 per ton of ore, on the most recent investor call Randy Reichart said this will be brought in house in the first half of the year and they expect costs to fall to $80.

In H2, mining at Burns Basin starts which they expect to provide up to 2,000 tons per day at relatively low cost due to its open pit nature. The size of this contribution will help maximise economies of scale and they have set a target of below $600 per Oz. To be conservative in my valuations I have used $700.

Valuation

This is all very rule of thumb because for the next 6 months this is going to be a news flow driven stock. But for what it’s worth its nice to know what ballpark we are operating in. Mid-cap gold miners typically trade for 10-15x operating cash flow.

Annual Production Target – 150,000 Oz

Price of Gold = $1,500

Cash Costs = $700

Revenues (150,000 x $1,500) =  $225,000,000

– Mining and Processing Cost (150,000 x $700) = $105,000,000

= Gross Profit = $115,000,000

– General & Administrative Expenses  $5,000,000

– Exploration Cost $5,000,000

= Operating Cash Flow $105,000,000

Divided by Number of Shares Outstanding 1,001,675,000

Cash Flow per Share = $0.105

$0.24/$0.105 = 2.3x 2012 CF!

Applying a lower end multiple of 10x Operating Cash Flow to YNG gets them to $1.05 on the low end of their own 2012 forecasts. This takes no account of the fact that their roasting mill may be worth something like $0.50 to $1.00 or that their forecasts for 2014 or so have them producing 300,000 ounces at the same or lower cost per ounce. This could take OCF to around $0.23 which might equate to a $2.30 share price.

These forecasts also conservatively assume they receive only $1500 per ounce for their gold rather than current spot of upwards of $1600.

Some Extra Details….

Ownership

Yukon-Nevada is substantially under-valued and has probably infuriated everyone that still owns the shares. So everyone that owns it resents it and anyone that doesn’t own it isn’t yet paying attention. The market cap is small and with large insider ownership of around 57% from across Orifer. Sprott Asset Management, Deutsche Bank after the fund raising, board members and senior management – there is a limited free float.

 

Mercury Emission Technology

YNG has developed a unique and protected patent which has enabled them to reduce mercury emissions from 10,000lbs per year into atmosphere down to just 10lbs per year. A reduction of 99.9%! I don’t know how I would even attribute a value to this, and the CEO Bob Baldock only mentioned it in passing but I’m sure it’s worth something if it is so effective and furthermore it probably demonstrates a level of technical competence/expertise that we can take comfort in. They are now award winning industry leaders in this field and in concert with the regulators they have been seeking to demonstrate the scalability of this technology.

Expanding Resources

The Mahala discoveries reported this month (January 2012) are significant and are proving out the company’s theory that the entire area in between the Smith and SSX mines (approx. 1 mile underground) is all mineralized with good grades and large intercepts. Management have believed all along that this is all the same mineral system. There are further drilling results to report in the next while as well.

Cash flow permitting, this success in Mahala will allow greater emphasis on the southern district of the property, which is relatively under-explored. A source of further potential upside in the long-term pertains to exploring the southern region which is within economic distance of the mill and contains the same mineralization that is present on the northern half of the property.

Corporate Action

Re-initiation of research coverage, several analysts covered YNG prior to the management turnover and permit suspension in 2008/2009. Current management believes that some former analysts would consider picking up coverage again after YNG announces that they have returned to the target of 150k oz production.

The fully diluted share count is just in excess of 1 billion! This is ridiculous! It would make a lot of sense to do a 10 for 1 consolidation taking the share price to $2.50 on today’s prices. Because the stock is trading at a low price per share it will struggle in obtaining an AMEX listing, which requires $2.00 minimum. This was addressed on the Q3 call and will hopefully be on the agenda for H1 2012 capital markets permitting. This would potentially allow the company to be added into gold ETFs and indexes, which would be very positive and “force” many managers into owning the stock.

Ridiculous as it sounds, the low share price scares institutional investors off, no-one wants to be seen holding “penny stocks” – look at Citigroup’s 10 to 1 consolidation last year.

Bibliography

http://www.aboveaverageodds.com/2010/08/03/investment-analysis-yukon-nevada-gold-yngff-pk/

http://classicvalueinvestors.com/i/2011/11/yukon-nevada-gold-corp-the-drama-is-about-to-end/

http://www.gowebcasting.com/events/denver-gold-group/2011/09/21/yukon-nevada/play

http://www.scribd.com/doc/64774982/Edison-Investment-Research-August-17-2011

http://classicvalueinvestors.com/i/2011/05/yukon-nevada-gold-corp-the-nightmare-is-over/

http://www.edisoninvestmentresearch.co.uk/research/company/yukon-nevada-gold

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