It depends, right?

It depends on how sure this stream of income is. If it were as sure as a U.S. government T-bond, the income would be worth an investment of over $4-6 billion at today’s apparent 4% yield.

Mining assets are a little riskier, so investors demand a fatter return.

For a typical mining asset that promises an income stream of this magnitude in a politically stable part of the world, and from a company with a track record in production, the market currently pays as much as 20 times its expected near-term cash flow, especially if it promises some growth. This valuation comes pretty close to the so-called risk-free rate of a T-bond, but it includes optimism for metal prices.

Today, I am going to tell you about a company with a claim to just such a future stream of income, with a market value less than two times its expected annual free cash flow (starting in 2010) and less than one time its long-term average annual cash flow — thus implying a yield of something like 40%.

I am not going to tell you, however, that it is risk free.

The implied yield says it all.

However, I believe those risks can be calculated and are known and that the market is overstating them.

My own assessment of the risks calls for a 12-15% yield — or a $2 billion valuation. That is still three times the yield of a “risk-free” investment, and twice the average equity yield.

If I am right, it means that this stock has the potential to be a ten-bagger from today’s price.

What’s the Deal?

A Canadian mining company in 2003 made one of the largest and richest discoveries of gold and base metals over the past decade. Nevsun Resources Ltd., which trades on the TSX and Amex under the symbol NSU, discovered the Bisha deposit in Eritrea, northeast Africa — near the cradle of civilization.

Thanks to a completed feasibility study, we now know that the 20 million ton deposit contains over one million ounces of gold, 10 million ounces of silver, nearly 800 million pounds of copper and over one billion pounds of zinc — at grades that yield an average rock value of well over $200 per ton at current prices.

That is about five times the cost of extracting the metal.

Why So Cheap?

Nevsun’s shares originally soared to $10 on the Canadian TSX in 2003 on this discovery, and that of the smaller Tabakoto deposit in West Africa, which Nevsun thought contained one million ounces of gold.

It is typical for a stock to go into hibernation after the initial excitement of discovery wears off.

Following this phase, the company must spend a great deal of time and money proving the economics of the asset by conducting a feasibility and environmental impact study, acquiring the requisite mining licenses and other approvals, etc. Then it takes time to build the production facilities.

This period can bore speculators looking for instant gratification from the next drill hole. However, in Nevsun’s case, events conspired to depress its shares further than usual. Since peaking in 2003, its shares have slid from over $9 to a recent low around $1.50 — despite a quadrupling in copper and zinc prices, and more than a doubling in gold and silver prices.

In 2004, the government of Eritrea shut down, according to the company, all “mineral prospecting and exploration work and related activities in Eritrea until further notice. No reason was given for this instruction.” The stock dropped to less than $2 by late 2005 following this news:

Click here for a larger view.

Up until then, the country’s mining laws allowed the government a 10% free participating interest in all mining projects. The market speculated that the government was out to grab more.

When, early in 2005, the government announced a change to its mining law that allowed it to acquire a larger interest (up to 40%), it proved the market half-right: for at least it was willing to “pay” fair value for those interests. Still, other political events stoked the anxiety of investors.

While the government’s attitude toward property is respectful, it has jailed religious dissidents, as well as journalists promoting democracy; defied the U.N.; evaded its promise of free democratic elections; and become embroiled in renewed strife along the Ethiopian border. During this period of uncertainty, Nevsun proceeded with the construction of mining facilities for its smaller mine in Mali, West Africa, and in 2006 began mining there. However, the shares resumed their slide when the company began reporting trouble at the Tabakoto mine shortly after startup.

After six quarters of losses driven by lower-than-expected grades and throughput, the company shut the mine down in September 2007 and wrote off its investment, causing the shares to plunge.

The experience reflected badly on management, but it was probably prudent to make the decision sooner, rather than later. Something could be said for cutting losses early.

The Bisha Deposit Is the Richest New Mine in Africa

The Bisha deposit has been Nevsun’s flagship asset since 2003. That is where the market’s focus will be in the future, and it is worth 10 times the value of the Tabakoto mine in Mali. The Eritrean government has agreed to purchase its additional 30% interest (in exchange for one-third of the capex required to develop the Bisha deposit), has signed a tax stabilization agreement, has issued Nevsun a mining license and is in the final stages of issuing the remaining approvals.

Nevsun has taken steps toward the construction of production facilities, which it estimates will take 24 months and require a capital investment of about $200-250 million. Management pegs annual operating costs at roughly $65-85 million for Bisha, as well as a further capital investment in years three and six as it moves from one zone to another, lower in the deposit.

The mine will produce 447,000 ounces of gold per year in years 1-2, 175 million pounds of copper annually in years 3-5 and 218 million pounds of zinc in years 6-10 — after the second year, the gold and silver production tapers off to byproduct credits.

Nevsun has calculated a 10-year mine life for Bisha, but the deposit has much more potential. It is open at depth, and the company believes that the conversion of inferred ounces and additional prospects could add up to another eight years of life.

That’s the blue sky. But there is lots of blue sky in Eritrea, as it is one of the least explored and developed mining regions in Africa. And Nevsun has a head start on its competition.

Remaining Risks

A formal construction decision is still outstanding, as are the terms of financing Bisha’s development beyond the government’s upfront investment. There are risks in both of these processes for the share price. The company could experience delays and cost overruns, and the financing could be dilutive.

I have factored that into my analysis. The stock is still worth $10 — even after the government’s 40% interest, after inflating the estimates for capex and operating costs and accounting for a share issue.

Regional instabilities may resurface, as Eritrea lies just across the way from Saudi Arabia, along the west bank of the Red Sea, and in between the Sudan and Ethiopia on the horn of Africa.

But the government appears to be friendly to foreign investment — contract and mining, in particular.

The risk of nationalization is low.

The worst is probably behind the company.

Nevsun is about to make the transition from exploration junior to intermediate producer, with operations on par with companies like Glamis Gold, Randgold Resources, Meridian Gold and even Agnico-Eagle — companies recently fetching from $3-8 billion in market value.

With a market cap of just $400 million, there’s lots of room for Nevsun to realize higher valuations.

The stock is a must-own speculative investment for investors bullish on the metals and looking for a turnaround story in a sound asset selling at bad news prices willing to hold onto it for up to two years.

Sincerely,

Ed Bugos
January 14, 2008

P.S.: A fellow Sleuth editor recently recommended another junior mining company back in December. Currently, it’s up over 19%. But, you didn’t miss your chance there. You can still catch an opportunity to own this beauty on the dips.

A Great Junior Mining Opportunity was originally featured in the Penny Sleuth.