Fiscal and operational disciple set Gran Colombia on the right path

"It's really easy to get into the penalty box. It's very hard to get out of it. Just ask [hockey tough guy] Tie Domi." This candid statement from Gran Colombia Gold (TSX:GCM) CFO Mike Davies sums up the situation that Colombia's largest gold and silver producer has faced since 2013, when the crash in precious metals prices derailed the company's plans to progress two historical gold mining districts in a country whose mineral riches have captivated both Colombians and outsiders for centuries.

Thanks to an innovative restructuring that satisfied both investors and Gran Colombia's need to pay off debt, GCM has a new brand that is poised for growth. This is the story of that turnaround.

The war on gold

In the 1980s and '90s, Colombia was considered one of the most dangerous countries on the planet. Run by a corrupt government and military, the South American nation was ground zero in the U.S.-led war on drugs, with the DEA working with Colombian police forces to stamp out the drug cartels that had gained so much power that Pablo Escobar, the charismatic kingpin of the Medellin cartel, nearly succeeded in becoming President - all colourfully documented in the Netflix series "Narcos".

Back then, Colombia's main export, and the chief source of hard currency, was cocaine. While Colombia still produces a lot of blow, with the rise in gold price during the 2000s, illegal gold mining has largely replaced cocaine and the "war on drugs" is now the "war on gold".

"We spent three years convincing the government the fight was no longer about drugs. A kilo of coke is worth $2,000. A kilo of gold is worth $40,000 and it's not illegal. Which one would you produce?" asks Serafino Iacono, executive co-chair of Gran Colombia.

Consider this: out of the 3 million ounces of gold that are mined from Colombia every year, only 10% is legally produced. The rest comes from loosely organized artisanal miners who mine without regulations in dangerous conditions, often separating the gold from the ore using mercury, a universally-banned substance due to its nasty effects on human health and the environment.

The Colombian government has been working to get a handle on illegal mining, recognizing the billions of pesos of lost revenue and the steady stream of laundered cash it provides for narco-terrorist organizations like FARC.

In 2016, the government passed Decree 142, which makes it illegal to mine gold and sell it without an explosives permit, a permit from the concession owner, and a certificate of origin from a legitimate gold mine.

Gran Colombia was the first company to organize the illegal miners into cooperatives that work jointly with GCM employees to mine its gold and now there are no illegal miners within the company's concessions, according to Iacono.

But that wasn't the case in 2011 when Gran Colombia started raising cash for developing its Marmato gold mine, a 14.95 million ounce elephant (11.806 million measured and indicated, 3.151 million inferred) that the company's previous board figured was a cinch to attract investors to, considering the gold price was just under $1700 an ounce and silver prices were a heady $35.

When Gran Colombia bought its producing Segovia gold mine [through the acquisition of Frontino Gold Mines] for about $200 million, the company found an entire town of illegal gold miners living underground in the formerly state-owned operation, located in the Department of Antioquia.

Top-of-the-market promise

At the time, GCM investors knew that illegal mining was a problem throughout Colombia, but they were willing to cut Gran Colombia some slack given the lofty promises of its two historic mining districts: Segovia and Marmato.

The Segovia-Remedios mining district - a series of high-grade veins - has been mined for over 150 years and is estimated to have produced over 5 million ounces throughout its history.

The grades are remarkably high - between 9.9 and 19.1 grams per tonne contained in 1.1 million ounces of measured and indicated resources (2017 figures) - which caught the attention of GCM's early investors, including Frank Holmes, CEO of U.S. Global Investors. Holmes told CEO.ca it was the high grades that first prompted him to consider investing in the company. "They're way above average grade. That was probably the biggest reason for it."

Although Segovia would represent a reliable producing asset given its history, high grades, and the fact the Colombian government had been running it for 40 years, in the early days Gran Colombia was focused on Marmato, which it acquired in 2011 through a merger with Medoro, a former Iacono-run company that had consolidated the "mountain of gold" located in the heart of the Middle Cauca gold district in the Department of Caldas.

Marmato's mining history goes even further back than Segovia, to pre-Colonial times, when it was worked by the Quimbaya people. The Spanish colonists assumed control of the Marmato mines in 1527 and they have been in almost continuous production ever since. Local history recounts that Simon Bolivar, the revolutionary leader who liberated much of South America from Spanish rule, used the mines as collateral with British banks to secure funding for a war of independence against Spain.

The grades are lower than Segovia - between 2.8 and 4.7 g/t, but the M&I resource is impressive - a whopping 3.897 million gold ounces, as of the latest estimate. In 2011, Gran Colombia charted a course for building out Marmato, particularly unlocking its silver resources, and relocating the town of Marmato, population 10,000, to do it. The idea was to build a large open-pit mine to exploit the low-grade ore, and the company completed 325,000 metres of drilling to delineate the resource, which made it to prefeasibility, along with $50 million spent on studying how to move the town to get at the ore body.

The company knew it would take a few years to execute its plan, but with gold and silver prices at all-time highs, it decided on a financial instrument that would give investors exposure to high gold and silver prices while they waited. In 2011, it offered 80,000 notes of the company at $1,000 apiece, for a raise of $80 million. The notes, due in 2018, would pay a 5% coupon and upon maturity investors would receive the dollar equivalent of 66.7 ounces of silver per note, or $1,000, whichever was higher.

"We feel this is a creative and innovative financial instrument that provides investors an attractive opportunity to benefit from the long-term cycle in silver prices and is a reflection of our view that precious metals prices will continue to increase in the long term," Iacono said in the 2011 press release announcing the silver-linked notes.

Investors mopped them up, seemingly a no-lose investment, considering that silver was around $35 at the time. If that continued, in seven years they'd double their initial $1,000 payment per note, and get interest on it to boot.

Encouraged by the success of the silver notes, GCM did the same thing in 2012 with an offering of gold-linked notes, this time hoping to raise $120 million to expand gold production at Segovia, including a new 2,500 tonnes per day mill. In this offering, for every 1,000 units that investors bought, they received a 10% coupon and 250 warrants.

According to Holmes, the "double optionality" of the silver notes was a no-brainer.

"In Latin America or Africa you've got these two risk factors, either social instability, in the communities, or you have fiscal policies or the tax regime changing, which hurts these companies. But in the interim it's okay, I get something convertible into silver, they're going to start storing it, and the stock, if it takes off during that period, so I have double upside opportunity."

Meanwhile, insiders were buying the stock in droves. In 2012, Iacono alone purchased 8.55 million shares - providing a huge boost of confidence for retail and institutional shareholders in Gran Colombia and its plans.

But the viability of the gold and silver notes depended on gold and silver prices rising, or at least staying flat, and as we all know now, the precious metals bubble burst. That had a four-year negative effect on the fortunes of Gran Colombia.

Gold price crash forces a pivot

Mike Davies, GCM's chief financial officer, recalls what happened in those black days of April 2013 when gold fell off the shelf - dropping over $200 in just two sessions.

Gold note holders that were up by $300 an ounce when gold was trading at $1700 - with a gold price-linked guaranteed payout of $1400 - found themselves holding an instrument that would only pay them the floor price, plus interest. For the company, it was much worse. Gran Colombia had to make up the difference between the $1400 floor price and the gold price, which in 2015 dropped to $1100 an ounce - a $300 gap.

Meanwhile the stock price was in free-fall, plummeting from $142.50 a share in December 2013 to around $2 at the end of 2015, as investors fled the equity, scared off by the uncertainty in gold and silver prices, the company's plans to develop an open-pit mine in a region over-run by illegal miners, cash costs nearing $1200 an once in 2013, and a board that seemed to have lost its direction.

"We were racing against perception that, with gold going down, we were going out of business," said Davies. "We found ourselves behind the eight ball with two commodity-linked instruments that, economically, were just way off where the markets were, repayments facing in front of us, and we needed to restructure those."

At the end of 2014, GCM went into default on both commodity-linked notes. The company took a break on paying interest for two months to re-group and by March 2015 resumed monthly interest payments on both debt instruments while it forged ahead to restructure its debt.

Led by GMP Securities out of Toronto, the debt restructure essentially resulted in either paying out the silver notes [renamed "2018 debentures"], or converting them into shares. If the share price is below US$1.95 (about CAD$2.40 at current exchange rates), Gran Colombia will pay bondholders 19% in cash - which it is saving for between now and next August - and the rest in shares.

The gold notes were renamed "2020 debentures". In May 2017 Gran Colombia extended the maturity date of $47 million of the 2020 debentures by four years, to 2024.

Whatever excess cash Gran Colombia accumulated, would go towards paying out the 2020 bondholders, while the 2024 bondholders, including Iacono, Frank Holmes and other high-net-worth investors, would keep theirs another four years, enticed by an 8% interest rate.

Davies said the restructure had to satisfy the three sets of bondholders, which is why there are quirks in the arrangement such as the 19% cash payout in the silver notes.

"We were fortunate that we had a number of investors that had confidence in the assets. They could see the long term view on gold was good, so I think that played well into our restructuring, that people were willing to get in and negotiate. The challenge was trying to come up with something that met everybody's desire."

"What we ended up with was a set of unsecured convertible notes in place of the silver notes and a set of secured convertible notes in place of the gold notes. It was about the only way we could restructure and keep everybody whole and give them an upside. But this time, not an upside in commodity. It was an upside in the shares of the company."

In December 2015, Gran Colombia shareholders in excess of the required 75% threshold approved the debt restructure plan; it was completed in January 2016.

The restructure left the company with $71.1 million in 2018 debentures, $103.1 million in 2020 debentures, and just over 113 million shares outstanding. (see Table 1)

The effect of the restructuring wasn't immediate. Even though Gran Colombia had several good quarters, some shareholders felt burnt after coming out of the restructuring, and hadn't seen any share price gains for their decision to stay with the company. The stock bumped along at between $1.20 and $1.50 for a year.

Davies said the company also had to contend with stock dilution due to the convertible note structure, and an arbitrage opportunity some bondholders took advantage of between the 2018 debentures and the common shares. That added another 200 million shares in 2016 to the 113 million GCM had at the end of restructuring.

"I think that played havoc with our stock through much of 2016," said Davies, who noted that the problem has largely been corrected since the company did a 15-to-1 stock consolidation in April 2017 (one post-consolidation share for every 15 pre-consolidation shares). Gran Colombia now has about 20 million shares in the float. (see Table 2)

"In 2016 we were flat where everybody was starting to rise. This reflected things such as people still trying to get comfort in the story, regain confidence after coming out of a restructuring, and contending with the dilution overhang," added Davies.

Focus on Segovia

The restructuring had the effect of re-positioning Gran Colombia on its key producing asset: Segovia. Large open-pit mines envisioned by the Marmato project were out of favour with investors. The company needed cash, and a way to regain shareholder confidence. The first step was to bring costs down at the Segovia operations. The Colombian government asked management not to slim down the labour force, which had thousands of workers when Gran Colombia took over the mine in 2010.

Both parties knew that making drastic cuts to its Segovia payroll would result in social turmoil in the impoverished region, so Gran Colombia came up with the idea of forming cooperatives. Composed of formerly illegal miners, the new mining co-ops would work in Gran Colombia's concessions and deliver ore to its mill for processing. After four years, nearly all the illegal miners are organized into co-ops; the only difference between them and the GCM workers is the colour of their coveralls. At Segovia the co-op miners bring an average 15 grams per tonne material, for which they receive $450 per ounce in payment.

"This has been one of the biggest misconceptions of the market. People that work in our mine are like any other contract miner that we hire. But because it's a Colombian contract miner, everybody thinks it's a bunch of camperos (campers). This is an organized operation," said Iacono.

That $450 an ounce figure is key because before the restructuring the major contract mining company was being paid $600 an ounce. How did Gran Colombia sell that to the contract miners? The Colombian peso had fallen significantly in value against the dollar, meaning the co-op miner's costs also dropped.

"We negotiated a reduction that took them from $600 down to $450 an ounce. So $150 an ounce of savings on, like, 50, 60,000 ounces a year. It was a major cost savings," Davies recalled.

General and administrative (G&A) expenses were also slashed, from around $20 million in 2011 to the current $6 million. Then there was the production. Increased output at Segovia - 75,000 ounces a year in 2014 to 125,000 oz in 2016 - helped drive down fixed costs on a per ounce basis, from close to $1300 an ounce in 2013 to $652 an ounce during the first half of this year. Total cash costs between Marmato (16% of gold sales) and Segovia (84%) in H1 averaged $709/oz.

The turnaround

While debt restructuring and cost control were undoubtedly two main factors behind Gran Colombia's turnaround over the past four years, another key component in regaining the confidence of investors was adding some new, technical people to the board, according to Frank Holmes.

"Serafino's always working hard, he's fixing this problem and that problem, but the board needed some independent technical people to support him. Fino won't like me saying that but he knows it in his heart," said Holmes.

For instance, the company brought on Mark Ashcroft, a senior mining executive with expertise in debt financing to lead its technical committee of the board and recruited Lombardo Paredes Arenas to become the new CEO. Holmes praised Lombardo as a competent operator, aided by his background in the Venezuelan oil business, including successfully building and running the $2.6 billion Cardon Refinery Conversion Project.

"What's really good about the story is they had lots of pain, and they went through some positive restructuring and it showed up. And more important than the stock going up is the production went up. And that made the costs drop. So you did two significant things. The more quarters you do that people are going to start trusting the Fino factor," he said.

The Davies factor is even more important when talking about Gran Colombia's improved balance sheet. As part of the restructuring, any excess cash that GCM accumulates every quarter gets swept into a "sinking fund" that will be used to pay out the 2020 debentures ahead of maturation - in other words, retiring the debt, which is currently sitting at about $142 million; in July, the company reduced $3.6 million of the 2020 debentures. Bondholders can convert their debentures into shares at any time before maturity at an exercise price of US$1.95.

Perhaps the more important figure is the increased EBITDA. Due mostly to cost cutting, Gran Colombia's earnings before interest, taxes, debt and amortization rose 8% from 2016 to 2017, and now stands, on an annualized basis, at $71 million. Davies said the company's 2017 goal is to generate excess cash flow of $15 million, of which $5.5 million has already been realized in the first half. All that money will go into the sinking funds to retire more debt.

"2017 is our first year of demonstration that we're converting this improved EBITDA into excess cash. Which people really haven't seen from Gran Colombia in the past because of the cycles we've gone through," he said.

The tables below show the levels of equity and debt in the company immediately after restructure (Table 1) compared to its current capital structure (Table 2). They show Gran Colombia paying down $33.3 million in debt between January 2016 and September 2017, and cutting the number of common shares from 113.5 million to 20.5 million.

Table 1

Table 2

The opportunity

What level of opportunity does the new Gran Colombia present to investors wanting to get a piece of the upside in precious metals prices and the improved mining climate in Colombia, particularly the crack-down on artisinal miners?

According to Holmes, GCM has employed a successful business strategy in cancelling debt and compounding annual growth. While most mining companies promise and fail to deliver, all that Gran Colombia needs to do is maintain production levels, keep buying back the notes, and stop their conversion into shares, thereby preventing stock dilution.

"When I did a pro forma, this stock could have a 15% CAGR. Mining companies don't deliver that. A private equity guy loves a 15% CAGR over 5 years. They salivate over that. That's their whole nirvana they go for."

Indeed the successful formula seems to be steady as she goes. "Every time it increases its production it means it's going to be less shares outstanding. I don't think a lot of people understand their business model, of shrinking shrinking shrinking," Holmes added. And it's working. With EBITDA up, costs down, debt repayments, and the issue of illegal miners seemingly resolved, GCM's stock is up 29%, year to date.

As the company likes to point out, compared to its peers, it is significantly undervalued. Using the metric of enterprise value divided by EBITDA, Gran Colombia has a 2.5x multiple versus 7x for its junior-mining peers.

"If $70 is our latest EBITDA if we got out competitors' evaluations, we should be sitting as a $500 million enterprise value if it's seven times, and we're sitting there probably at $200 million," said Davies. "So there's quite a gap."

Valid comparisons include Continental Gold - whose flagship Buritica project has proven and probable reserves of 3.71 million gold ounces and 10.72 million ounces of silver - and Red Eagle Mining's San Ramon gold mine. Both projects are located in the same Antioquia Department as Gran Colombia's concessions.

But Holmes likes GCM not only for its slow-burn growth model but the income its debentures pay, noting that they beat the GDXJ hands-down.

"The dividend's been cut but we've got back 80% of our money so it's pretty compelling, the idea of owning a gold note like this. It's a great investment for gold investors. If shit goes wrong, if difficulties take place, net net you never collapsed like other people and look where you are today. So when you do a chart comparing when the gold note was launched, and compare the GDXJ, it just shocks you," he said.

Black swans?

Of course, the junior gold market is rife with unexpected problems that have sunk even the most cashed-up companies with the best projects in the safest of jurisdictions. What could go wrong with Gran Colombia? The first scenario would be another crash in precious metals prices, which would impact margins at both Segovia and Marmato, as well as the company's ability to generate cash to repay the debt. While few people can accurately predict what will happen to gold, even if it takes another hit, debenture holders will still get income on their investment until 2020 or 2024 - even if the market becomes uneconomic to convert them into shares.

Failure to execute is another possibility. But Gran Colombia's plans all involve expansions of existing operations, so at worst, the capex gets pulled in and the mines just continue to run as-is without any improvements. Previously, the contract miners were a major wildcard in expansion plans, but with most miners now organized into co-ops, the possibility of a major disruption such as occurred earlier this year appears unlikely.

The third black swan is the Colombian election next year. While FARC, now a left-wing party, is participating for the first time, according to Iacono, who has close ties to government officials, the possibility of a left-leaning coalition winning the election is remote. He said the more likely outcome is a centre-right coalition led by German Vargas, a former minister who served as a senator from 1994 to 1998. Polls conducted in May showed Vargas as the leader in the race to succeed Colombian President Juan Manuel Santos. Asked whether a leftist coalition could un-do mining reforms such as the drive to make illegal miners legal, Iacono said it's virtually impossible.

"There's no way it's going back to that. It's going in the direction of legality, openness, you're going to start seeing great stuff after the elections," he said.

Success should also come to Gran Colombia if the company sticks to its debt reduction mantra and continues to grow production through optimizations and exploration at Segovia and Marmato.

Davies concluded that, for Gran Colombia, gaining traction is not only about being a steady and reliable operator, but educating investors and in some cases, changing minds about what GCM used to be compared to what it is now.

"When you go into something like restructuring, everybody takes you off their radar because they don't want to look at you. It's like rebranding and then getting it back out to consumers to say, we're back on shelf. Take a look at us now. We're new and improved."

Follow GCM on the TSX and CEO.CA.

Visit Gran Colombia Gold for more information.

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