EURO Resources Is Overvalued At The Current Gold Price And Could Be A Good Short Candidate

Introduction

In this article, I'll have a closer look at EURO Resources SA (GM:EROFF), which is a royalty company holding two royalties on gold projects in South America (Suriname and French Guiana). I will start with a brief overview of the two South American projects where after I will calculate the Net Present Value of both royalties. This will be extrapolated to calculate the total value of the company and I will also explain the risks about investing in EURO Resources. This will result in my investment thesis at the end of this article.

As the trading volume on the US exchanges is very limited (as its main shareholder is IAMGOLD (IAG) which owns 86% of the shares), I'd recommend to trade through Euronext Paris, where the company is listed with ticker symbol EUR.

Executive Summary

As a lot of investors are interested in royalty companies and streaming companies during this difficult time in the gold sector, I decided to calculate the fair value of EURO Resources. The result of my sum of the parts valuation is interesting, as it points out that the company is currently trading at exactly its fair value.

Unfortunately EURO Resources has a very strict dividend policy which states all cash flow will be used to pay dividends to its shareholders, and as there is a 15% withholding tax on French dividends (EURO is incorporated in France), the effective fair value is approximately $2.65/share, compared to the last closing price of $3.11/share.

I also re-calculated the value of both royalties using a gold price of $1500/oz, and even after using this gold price, the fair value (corrected for the 15% withholding tax) is less than 10% higher than the current share price. This leads me to the conclusion that EURO Resources is currently overvalued, and if the overvaluation increases even further, a short position in this company might be an excellent hedge for long positions in the same sector.

Royalty 1: The Rosebel Mine in Suriname

The Rosebel mine in Suriname is a producing mine owned by senior producer IAMGOLD. The mine has been in production for over ten years now, and is currently producing at a rate of 395,000 ounces of gold per year. The royalty on this project could easily be considered EURO Resources' main asset as it's the company's only producing mine it has in its royalty portfolio and is the company's only source of income.

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In a later paragraph, I will make a calculation of the net present value of this royalty.

Royalty 2: The Paul Isnard project in French Guiana

EURO's second project is the Paul Isnard project in French Guiana which is operated by Columbus Gold (OTCPK:CBGDF) in a joint venture with NordGold (NORD.L), which is the gold division of the Severstal conglomerate. The project is currently in the advanced exploration stage, as Columbus has announced a total resource estimate of 5.4 million ounces at an excellent average grade of 1.43 g/t. Even if one would use a much higher cutoff grade of 1g/t, the Paul Isnard project has 4.2M ounces at an average grade of 2.2g/t. This has attracted a lot of senior producers and Columbus Gold was able to strike a deal with Nordgold.

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Per the terms of the agreement, Nordgold will have to spend $30M and complete a feasibility study within three years. This is a very favorable agreement from Columbus' perspective, as the company wouldn't have been able to raise $30M for further exploration given the state of the junior market.

Columbus Gold has recently announced the start of the Phase II exploration program at Paul Isnard which will be aimed at upgrading and increasing the current resource estimate. As several zones in between the different parts of the resource estimate have never been drilled, I think the resource estimate could increase pretty fast, and I am convinced this project will ultimately contain in excess of ten million ounces of gold.

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It's also interesting to note that EURO Resources holds a 19.1M shares in Columbus Gold, so if the project gets permitted, EURO will make a lot of money from its royalty ànd from any share price appreciation on its shares of Columbus Gold. It's also interesting to remind investors that Nordgold usually prefers to buy out its minority partners in projects, and if the Paul Isnard project effectively turns out as good as I expect it to be, I wouldn't be surprised at all to see Nordgold make a move to acquire 100% of the Paul Isnard project, which could mean a huge re-rating for the Columbus shares which would obviously add value to EURO Resources' assets.

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As for the royalty, EURO Resources holds a 1.8% NSR on the first two million ounces and a 0.9% NSR on the subsequent three million ounces. So the company will not receive any royalty payments for the production in excess of five million ounces on this project.

What's the value of these royalties? A Calculation

1. Calculcations based on a gold price of $1250/oz

Let's start with a calculation of the value of the Rosebel royalty. EURO receives a 10% royalty based on the gold price minus $300-350/oz on the first seven million ounces. As the project will already have produced 3.5 million ounces by the end of this year, my NPV calculation will be limited to another 3.5 million ounces, using a gold price of $1250/oz. I will use a discount rate of 5%, because firstly, the project has been in production for more than ten consecutive years and has thus proven to be quite stable and predictable. Secondly, Suriname is a relatively decent country to operate in, and thirdly, the Rosebel mine is operated by IAMGOLD, which is a very well respected senior producer (and also EURO Resources' 86% shareholder).

As the project is currently producing at a rate between 385,000 and 405,000 ounces of gold, I will use an average production rate of 390,000 ounces of gold for the first 8 years and 380,000 ounces of gold in the final year of operation. The tax rate used in this model is 30% increasing to 35% in year five, and the gold price $1250/oz. The overhead costs for the company are included in this model.

Cash Flow per year	Corporate tax at 30%	after tax	Discount rate (5% per annum)	NPV 8%
0	0%	0		0
35100000	30%	24570000	1,00	24570000
35100000	30%	24570000	1,05	23400000
35100000	30%	24570000	1,10	22285714
35100000	30%	24570000	1,16	21224490
35100000	35%	22815000	1,22	18769957
35100000	35%	22815000	1,28	17876149
35100000	35%	22815000	1,34	17024904
35100000	35%	22815000	1,41	16214195
34200000	35%	22230000	1,48	15046139
				176,411,548

So by using these parameters, the value of the Rosebel royalty is approximately $176.4M. As the company currently has 62.5M outstanding shares, the NPV/share of the Rosebel royalty is approximately $2.82.

Let's now make some assumptions for the Paul Isnard project. These are just rough calculations based on my personal experience, and can only be seen as back-of-the-envelope calculations as no PEA/PFS/FS has been prepared on this project.

I think an annual production rate of 250,000 ounces at a cash cost of $700/oz is quite a reasonable and financeable assumption. This would mean that at the current gold price of $1250/oz the royalty will bring in $2.5M per year in the first 8 years of production and $1.25M per year in the subsequent 12 years. In this calculation I will use a discount rate of 10%, as this project is in a much earlier stage. This is also the reason why I will use a tax rate of 35% throughout the mine life.

Cash Flow per year	Corporate tax at 35%	after tax	Discount rate (10% per annum)	NPV 10%
0	0%	0		0
2500000	35%	1625000	1,00	1625000
2500000	35%	1625000	1,10	1477273
2500000	35%	1625000	1,21	1342975
2500000	35%	1625000	1,33	1220887
2500000	35%	1625000	1,46	1109897
2500000	35%	1625000	1,61	1008997
2500000	35%	1625000	1,77	917270
2500000	35%	1625000	1,95	833882
1250000	35%	812500	2,14	379037
1250000	35%	812500	2,36	344579
1250000	35%	812500	2,59	313254
1250000	35%	812500	2,85	284776
1250000	35%	812500	3,14	258888
1250000	35%	812500	3,45	235352
1250000	35%	812500	3,80	213957
1250000	35%	812500	4,18	194506
1250000	35%	812500	4,59	176824
1250000	35%	812500	5,05	160749
1250000	35%	812500	5,56	146135
1250000	35%	812500	6,12	132850
				12,377,088

So at this point, I consider the value of the gliding 1.8-0.9% NSR on the Paul Isnard project just $12.4M ($0.20/share), which is quite low. One would start to wonder why EURO Resources (and its main shareholder IAMGOLD) were interested in revising the original deal. It's not unthinkable IAMGOLD decided to already take a double-digit stake in the company to acquire it entirely in a later stage.

2. Calculations based on a gold price of $1500/oz

When recalculating the Rosebel royalty NPV using a gold price of $1500/oz, the value of this royalty increases substantially to $225.4M.

Cash Flow per year	Corporate tax at 30%	after tax	Discount rate (5% per annum)	NPV 5%
0	0%	0		0
44850000	30%	31395000	1,00	31395000
44850000	30%	31395000	1,05	29900000
44850000	30%	31395000	1,10	28476190
44850000	30%	31395000	1,16	27120181
44850000	35%	29152500	1,22	23983834
44850000	35%	29152500	1,28	22841747
44850000	35%	29152500	1,34	21754044
44850000	35%	29152500	1,41	20718137
43700000	35%	28405000	1,48	19225622
				225,414,756

This results in an after-tax NPV5% per share of $3.61, which shows the leverage EURO Resources has on the price of gold. If the price of gold increases by 20%, the NPV of the Rosebel Royalty increases by 28%.

Let's now do the same for the Paul Isnard royalty. This will increase the annual cash flow to $3.6M in the first 8 years of operation and $1.8M in the subsequent 12 years.

Cash Flow per year	Corporate tax at 35%	after tax	Discount rate (10% per annum)	NPV 10%
0	0%	0		0
3600000	35%	2340000	1,00	2340000
3600000	35%	2340000	1,10	2127273
3600000	35%	2340000	1,21	1933884
3600000	35%	2340000	1,33	1758077
3600000	35%	2340000	1,46	1598251
3600000	35%	2340000	1,61	1452956
3600000	35%	2340000	1,77	1320869
3600000	35%	2340000	1,95	1200790
1800000	35%	1170000	2,14	545814
1800000	35%	1170000	2,36	496194
1800000	35%	1170000	2,59	451086
1800000	35%	1170000	2,85	410078
1800000	35%	1170000	3,14	372798
1800000	35%	1170000	3,45	338907
1800000	35%	1170000	3,80	308098
1800000	35%	1170000	4,18	280089
1800000	35%	1170000	4,59	254626
1800000	35%	1170000	5,05	231478
1800000	35%	1170000	5,56	210435
1800000	35%	1170000	6,12	191304
				17,823,007

So by using a gold price of $1500/oz, the value of this royalty increases by 44%, even though the gold price has increased by 'just' 20%.

The Dividend

EURO Resources uses its entire incoming cash flow to pay dividends to its shareholders. The company paid a dividend of 0.29 EUR in 2012 and 0.36 EUR in 2013. Keep in mind that EURO Resources is a French company, and there will be a 15% dividend tax payable in France, which obviously reduces the returns on this dividend.

As I will explain in the next paragraph, because of this dividend tax and the company's policy to distribute all incoming cash flow, the fair value of the sum of the parts comes in lower than the current share price and is a real handicap for investors.

What's total fair value of EURO Resources?

Let's now see how much the company is worth in its entirety. In my base case assumption I will use a gold price of $1250/oz. At that gold price, the Rosebel royalty has a value of $2.82/share and the Paul Isnard royalty a value of $0.20/share.

Now we also have to add the shares in Columbus Gold EURO holds. As per the latest filing, EURO holds 19,095,345 shares in Columbus Gold. As Columbus is trading at C$0.31/share ($0.30), the total value of the position in Columbus Gold is $5,728,603, or $0.09/share.

By using a sum-of-the-parts valuation at the current gold price, the fair value of EURO Resources' projects is $3.11/share which is exactly the current share price.

If I would apply an optimistic scenario using a gold price of $1500/oz, the theoretical value of the royalties and the position in Columbus Gold increases to $3.97 per share. But as I said before, I will use the current gold price as the base case.

Unfortunately the company uses almost all the incoming cash flow to pay a dividend to its shareholders. As there's a minimum dividend tax of 15% on French dividends, the real fair value of EURO Resources today is just $2.64/share, which is 15% lower than today's share price. So at this moment and using this gold price, EURO Resources is trading almost 18% more expensive than its calculated fair value.

What are the risks involved?

The first obvious risk is the gold price. As EURO receives a 10% royalty based on the formula (gold price - $300-350/oz), every $100 drop in the gold price reduces the company's cash flow profile by more than 11%. So investing in EURO Resources is in fact a call on the gold price as its cash flow will react on the gold price with some leverage.

A second risk is the fact that EURO Resources currently is a 'one trick pony' as only the Rosebel mine is in production. It's uncertain if the Paul Isnard project in French Guiana will ever be built, and investors should wait to cheer until Columbus Gold and NordGold have all permits in their hands. At this moment, nobody can guarantee the Paul Isnard royalty will ever produce cash flow. I'm actually glad to see Columbus Gold partnering up with NordGold, as I can imagine the Russians will put some pressure on the French government to get the project permitted after it spent $30M to gain a 50.01% interest in the project.

Investment Thesis

Unfortunately the company is trading at exactly its calculated fair value, so I fail to see any potential for an increasing share price at a stable gold price. As a matter of fact, because EURO pays all incoming cash flow out to its shareholders as a dividend, investors will always lose at least 15% on the dividend tax in France. This has lead me to correct the fair value of EURO Resources by 15%, which results in a price target of $2.65/share, or approximately 15% below the latest closing price.

There's a lot of potential in an investment should the gold price suddenly increase. Should we see a gold price of $1500/oz, the fair value (corrected for the 15% dividend tax) will be $3.37/share, which is also just 8.5% higher than the current share price, so EURO Resources is only interesting if the gold price will move substantially higher than $1500/oz.

There's one thing that might be beneficial for EURO Resources to create value. Nordgold has the 'reputation' to buy out its partners in projects and go at it alone. I wouldn't be surprised at all to see Nordgold launch an offer to acquire all outstanding shares of Columbus Gold to consolidate the ownership of the Paul Isnard project. This would mean there would be an easy exit strategy for its shares in Columbus Gold, and the value of its stake could easily double.

After calculating the value of the royalties, it becomes clear that EURO Resources is more than fairly valued by the market using a gold price of $1250/oz. There's no short case to be made (yet), but I'll keep a close eye on EURO Resources and might use a short position as a hedge against my long position in other gold companies.

Source: EURO Resources Is Overvalued At The Current Gold Price And Could Be A Good Short Candidate

Disclosure: I am long OTCPK:CBGDF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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