I’ve been following the gold miner Caledonia Mining (CMCL) since last October when it was trading at $8 per share. Since then, the stock has risen to $18 reaching a peak of $28 recently as gold made a new all-time high. The stock is trading at a significant discount from this price today, so let’s take a closer updated look at the company to gauge whether it is still headed for my original price target of $35 or higher.
Caledonia’s value opportunity remains compelling. The company mines gold at an all-in sustaining cost of around $800/oz which is among the lowest in the world and grants considerable margins with gold being at $2000/oz. The company is currently expanding production from around 55k oz this year to 80k by 2022. If we assume the company will produce 65k oz over the next year due to the opening Central Shaft project at an AISC of $800 and sell at $1900/oz (slightly below the market price), then the company will generate around $60M-$70M in profits. This gives the company a forward “P/E” of merely 3-4X.
While many believe that CMCL has risen too high and is perhaps in a bubble, its forward valuation remains practically unchanged from its level last year when it was trading at $8. The difference is the 25%/$500/oz rise in gold which nearly doubles its cash-flow from its level last year.
CMCL has had a solid run higher, but it is not in a bubble. In fact, it remains extremely cheap compared to nearly all other equities, gold miners in particular. Due to this, the recent decline in price is likely due to normal profit-taking. I know this because I took profits on the stock as it rose from $25-$28. This was not because I thought CMCL was overvalued, but because I expected gold to hit a short-term peak as initially explained in “The Gold Rally Is Approaching A Speed Bump“.
Still, CMCL has important and valid risks that investors should know. There are reasons it trades at a much lower valuation than gold miners. Notably, political and economic instability in Zimbabwe where it operates. The company also recently decided to sell $13M in shares in order to invest in solar power for its mine. This is good since it will lower production costs and, more importantly, ensure power is always available. However, the shares will be sold at such a low valuation that it may cause CMCL to decline.
Should Investors Fear Zimbabwe?
The most common argument against Caledonia is its concentration in the Blanket Mine in Zimbabwe and the country’s historical interest in mine nationalization and land seizure. Zimbabwe has also been unable to stabilize its currency and has run a triple-digit inflation rate since 2018. Fortunately, Caledonia had a currency hedge in 2019 that resulted in a $29M FX gain.
Still, an unstable currency usually ends in an unstable political regime which is bad for business. Luckily the inflation rate has edged lower in recent months and the post-Mugabe Zimbabwean government is making an effort to reestablish credibility over property rights by compensating those who had their property seized two decades ago.
Quite frankly, I do not believe Zimbabwe itself is a major risk to Caledonia. The country certainly has instability, but at least we know very well from recent history what those instabilities are. As we’ve recently seen, developed countries can be quite unstable for businesses, however, due to a lack of historical precedent, we do not know what they are until it’s too late.
In short, frontier countries like Zimbabwe are the “devil you know”. Caledonia’s consistently low valuation also manages to offset that risk with rewards. Even more, since most major gold miners avoid Zimbabwe, the country remains highly underexplored which leaves Caledonia with considerable growth potential in the country. In fact, Caledonia’s long-term goal is to increase exploration and expansion into other mines in Zimbabwe in order to take advantage of the “last frontier“.
Overall, I believe CMCL’s Zimbabwe-related risks are easily translated into rewards. Despite COVID-19, the company has been able to operate at nearly full production and has continued to make expansion efforts. In my opinion, the biggest risk for CMCL is the price of gold.
Gold Due for a Correction But Likely Headed Higher
The rally in precious metals has resulted in very strong gains for those invested in precious metals miners. Many miners are now at long-term highs and investors have recently taken profits. See below using the gold miner ETF (GDX) and gold ETF (GLD):
The primary reason for the rise in gold prices over the past year is the decline in real interest rates and, more recently, the rise in forward inflation rates. This is best measured using inflation-indexed bond yields which are watched very closely by the Federal Reserve. This is also called the “real interest rate” since it is the yield in terms of purchasing power (-1% means investors should lose 1% of their purchasing power every year).
As you can see below, the inflation-indexed 10-year yield (purple) has a very strong negative correlation to the price of gold (orange):
Fundamentally, gold has a theoretical real interest rate of zero since it has no yield and is an inflation hedge. Therefore, gold rises in value when real-rates on Treasuries decline. In the long-run, the inflation breakeven rate (blue) will need to rise for gold to continue higher.
The 10-year “real”/inflation-indexed interest rate recently hit an all-time low of -1% which corresponded to the peak in gold. The real-rate has since spiked slightly higher which has caused gold to correct lower. Going forward, I expect the real interest rate to continue to decline until the inflation breakeven rate crosses well above 2% in line with the Federal Reserve’s aggressive inflation goals.
The dollar is declining, but it is still too soon to say if there will be an all-out currency collapse. Still, because the Federal Reserve can essentially set real-interest rates (buy buying long-term bonds) they have the power to dictate the general trend in gold. As long as the economy remains weak the Federal Reserve is highly unlikely to stop suppressing rates, thus I would not be surprised to see gold reach $2300+ by year-end.
The Bottom Line
Overall, I believe the dip in CMCL is another solid long-term buying opportunity. The company has been very resilient to COVID-19 and continues to make efforts to expand production. It also has low production costs that will likely decline further with the implementation of solar power as well as considerable exploration opportunities. Most of all, CMCL trades at a significant discount to other miners and will likely see increasing institutional interest as it grows.
Caledonia is subject to risk due to its location in Zimbabwe. However, this risk comes with many rewards and may not be as significant as many investors believe. If anything, the Zimbabwean government would want to support its mining sector in order to strengthen its struggling economy and currency.
Finally, we have the price of gold. I would not be surprised to see gold correct further from here as real-rates spike. However, I believe the correction will be short-lived as the Federal Reserve continues to take every option available to try to promote inflation. The U.S. dollar is in a bear market which sends a signal that these efforts will be successful.
I’ll continue to be keeping a close eye on Caledonia. Feel free to “follow” my account if you’d like to stay updated.
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Disclosure: I am/we are long CMCL. 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.