SA PRO Recommended Buy Article

Medusa Mining - A Low Cost Gold Miner Poised For A Big October Re-Rating
Oct. 2, 2014 Subscribers to SA PRO had an early look at this article.
Medusa Mining continues to deliver on its operational turnaround and make inroads into reducing costs and improving grade and recoveries.
A recent reclassification of reserves to JORC 2012 significantly de-risks future production.
Progress made over the last 6 months has not been acknowledged by the market and is not reflected in the current price.
Septembers quarterly update will likely show a marked improvement and could be a catalyst for a significant re rating of the stock - possibly doubling it over the short term.
(Editor's Note: Investors should be mindful of the risks of transacting in securities with limited liquidity, such as MDSMF. Medusa Mining's listing in Australia, MML.AX, offers stronger liquidity.)

Medusa Mining is an ASX listed junior gold miner with mining operations based on the Philippine island of Mindanao. Last year it produced 60k oz of gold at an average C1 cost of US$418/oz - which even in this lower gold price environment is still a good result, especially in the context of its peers - many of which have costs up to double this.

Despite this though, over the last 3 months, the stock is down 57% making it the worst performing junior gold miner listed on the ASX and significantly underperforming Oceanagold, Newcrest and the ASX resources index. Current valuation multiples bear this out, P/BV of 0.37x, EV/Resources of $67/Oz, EV/EBITDA (2014A) of 3.0x and EV/EBITDA (2015E) of less than 2.0x according to some brokers.

Reading through the company's releases and some broker research over the course of the last year, a picture emerges of a series of unfortunate and negative events which impacted the company's financial and operating performance last year. This lead to a fall in forecast production for 2014 which was below management's guidance, higher unit costs and the spectre of a revision in the company's reserves as it moved to the 2012 JORC code.

Fast forward to now, and I believe a very different picture emerges - one of a company which continues to take steps successfully address each of these issues but for which the market seems reluctant or fails to understand the impact of these steps on the company's financial position - notwithstanding the progress. As a result, the company continues to trade at a very depressed valuation multiple vis a vis its peers.

Medusa has provided a number of releases these past few weeks which should give investors a great deal of comfort that its performance this quarter will deliver lower cost and higher production, grade and recoveries than it did over the past couple of quarters. These releases include the Operations Update of September 9 and the recent JORC statement last week and the June quarterly results - all of which continue to reinforce progress made these last few months. Below I summarize the company's guidance for the September quarter in context with recent quarters. Whilst no cost guidance is given, its clear that costs are likely to be significantly below last quarter's $431/oz when considering the guidance below plus the other factors management mentions in its recent releases. Some brokers are still forecasting costs around $370/oz for the year to December 2014 which is still significantly more than the company averaged last year, ie $313/oz and, I think, points to the fact that there is considerable upside in Medusa's share price.

So what are the elements of the recent releases which gives me comfort and convinces me that the September quarterly results - when they are released later this month - will take the market by surprise and lead to a significant re rating of Medusa?

1. New JORC reserve statement

One of the major uncertainties relating to Medusa was the lack of clarity around its reserve and resource base. Whilst some reduction was expected owing to the fact that the new JORC code was more conservative regarding vein width, most commentators were surprised at how little reduction there was. Also pleasing was the fact the that reserve and resource grades (7.22 g/t and 10.1g/t respectively) are much larger than the grade from last years production (4.76 g/t) and than the current grade (5.0 g/t) - pointing to significant future upside. It was only a year ago or so that Medusa was hitting grades of 7.8 g/t (for the first half of fiscal 2013) and so its likely it will be able to match these grades again judging from the new JORC report. Indeed based on these new resource figures, Medusa's EV/resource multiple of $71/0z still puts it well below the industry average of circa $90/oz. Its also worth noting that whilst Medusa's new estimates for reserves and resources are done at a gold price of $1250/oz; many other gold companies still have their estimates done at significantly higher historic prices - making Medusa's analysis more conservative relative to peers.

2. New mill operating and higher proportion of stoping ore into the mill feed

Medusa experienced a litany of problems with its new mill (commissioned in the first quarter 2014), which it has described in its recent operational update earlier this month and its full year results (together with the steps it has taken to address them). Not only was the new mill delayed (due to a failure in its power cells) but when it was operational, a problem with the crusher meant that only oversized material could be fed into it for the first 6 months; through its emergency feed station. The result of this was that recoveries were well below design and the costs were well above for that period. According to management, the problem with the crusher was fixed in early July and it has since been recording recoveries "above 90%"; significantly above the 85% averaged last year. This, together with the fact that the company has now increased the proportion of richer grade stoping ore into the mill mix (thus increasing the mill feed grade), should help reduce unit costs.

3 Lower manning levels

During the June quarter, Medusa reduced the number of contractors by 1000 and also cut some of its managers and supervisors as part of an exercise to reoptimise its operations. Whilst the true effect of this on the company's cost will indeed be shown up in the September quarter update, I would expect it to contribute to a significant drop in unit costs below the average for the June quarter (ie below US$431/oz) - possibly lower than US$375/oz - due to the fact that notwithstanding the steep reduction in manning, management STILL expects production for this quarter to be "over 20moz" - at least 15% higher.

So what does all this mean for Medusa's EBITDA? Building it up using what I believe are reasonably conservative assumptions gives my EBITDA estimate of US$66m for the year to June 2015, giving a current EV/EBITDA (Jun 15) multiple of 2.3x. I would note that some brokers are forecasting EBITDA higher still, with one major broker forecasting US$69m.

Conclusion and Potential Re Rating

I believe Medusa Mining is a company on the verge of delivering a marked improvement in its operating and financial performance - potentially as early as the end of this month with the release of its September quarterly results. It has made inroads into addressing many of the issues that plagued its performance last year and earlier this year but I believe the market is, as yet, not reflecting any of this progress in the company's current valuation - as demonstrated in its current low EV/EBITDA multiple. Whilst the proof of this will be in the September quarterly update, there is a window, prior to the update, to realise what will be a re rating of the company post its September quarterly update.

In attempting to quantify this uplift, I would look to a couple of data points. Oceanagold is an ASX listed gold producer with operations in NZ and Philippines, with operating cost and AISC broadly similar to where I believe Medusa is operating at now (ie C1 cost US$313/oz for the year to December 2014), albeit on higher production volumes. It trades on an EV/EBITDA multiple (Dec 2014) of circa 3.0x - Medusa should trade at least in line with this. To give some context, the average EV/EBITDA (Dec 2014) multiple for the ASX junior gold miners is currently circa 4.7x. For reference, Newcrest is trading around 8.0x. Below I set out what price this implies for Medusa.

Lastly, if a re rating of 105% for Medusa to $1.71/share sounds like a lot to you, remember its the same price Medusa was just 10 weeks ago. And since then, the company has : 1) confirmed its progress in addressing its operational issues last year in its Operations Update 2) removed the risk and uncertainty surrounding its resource base and grade by releasing its JORC statement last month.