Eldorado: An Option on Gold

09/10/2013 7:00 am EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

Our latest play on gold is a bit speculative, but in my view, this miner has an excellent risk-to-reward profile, asserts Jack Adamo, editor of Insiders Plus.

Mining is an inherently lumpy business, with year-to-year results less predictable and more subject to risk than most other industries.

Quarterly results are a real crap-shoot. With that in mind, let's examine the good and bad points at Eldorado Gold Corp. Ltd. (EGO).

Eldorado has mines in Greece, Turkey, Brazil, China, and Romania. However, as of year-end 2012, 53% of production came from Turkey and 45% from China.

The others are in development and their production made up only about 2% of the company's total. Overall, I'm satisfied with Eldorado's geographical profile.

The mines in Greece are thought to be particularly promising. Ore grades vary radically between mines, even in the same country, with assessed mineralization of less than a gram per tonne in one Turkish mine and nearly eight g/t in another.

Eldorado produced 650,000 ounces of gold in 2012 and expects to produce between 705,000 and 760,000 ounces in 2013, roughly a 12% increase. The highlight here is that it claims it will double production to the 1.5 million ounce range by 2016.

That growth is mostly from Greece and is heavily back-end weighted, since the development projects won't come on line in force until 2015.

Analysts' estimates for EPS growth from 2013 to 2014 average just 5%, recently reduced from 10%. Only two analysts cover the stock, according to Briefing.com.

The company's balance sheet is rock solid, thanks in part to a recent secondary stock offering, which the stock market took in stride. Goodwill comprises a bit less than 11% of assets, which is a positive. Write-downs have been minimal in the last few years.

The dividend yield is low at 2.1%, but the payout ratio is also low at 32%, allowing room for future growth. Accounting is pretty clean, with minimal differences in recent GAAP and adjusted earnings, and some of the adjustments were justified in my view.

Eldorado's Q2 earnings were a pleasant surprise. It was among the very few gold miners that actually reported positive net earnings, though EPS fell about 14% year-over-year. Results were boosted by higher revenues on a 31% increase in gold sales volumes, offset by lower gold prices.

The company declared a dividend of $0.05 Canadian and announced a change in dividend policy to pay dividends based on a range of gold prices.

The company reported no asset impairments, which took me aback, but management said it used a $1300 price assumption for its impairment test, meaning that the long-term price outlook would have to sink below that level to trigger any write-offs.

It is my impression from its accounting, and its frank discussion on conference calls, that management is trustworthy.

The one area where conservatism is clearly lacking is the $1700 per ounce gold price assumption the company used for its 2013 profit guidance. That is aggressive to say the least, and carries risks of disappointment that can materially affect profits.

However, I would think that, since management is using $1300 for impairment testing, it is not operating under the delusion that pricing will average $1700 for the rest of the year.

In any case, regardless of the outdated published price assumptions, the company made decent money in Q2 with an average sales price of $1,382 per ounce, so I expect the full year to be satisfactorily profitable.

Rather than buying the stock, we are recommending the Eldorado Gold Corp. January 2015 $10 call option up to $1.75. You should be able to get it for closer to $1.60.

Clearly this is not an investment that widows and orphans should feel comfortable with, however, that can be said of any option purchase.

We are using this options position in our portfolio to limit exposure to the metal, while allowing for the great possible upside. If you chose to buy the stock instead of the option, I wouldn't be against that.

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