Top Picks for 2010: Eldorado Gold (EGO)

Hutchison continues, "There hasn't really been a commodity bubble like the current one since the late 1970s. It will end, as these things always do -- but only when the world's central banks decisively tighten monetary policy and turn off the spigots flooding the system with cash.

"That's unlikely to happen until consumer inflation has shown itself rising sharply. In relative terms, gold's price is still far below its all-time highs -- the 1980 top at $875 per ounce is equivalent to $2,400 today, roughly double the current price.

"Supply is also becoming an ever-larger factor -- the total global supply of new gold in 2009 was valued at under $90 billion, with another $35 billion or so available from recycling.

"That first number is unlikely to change as mining output has been declining by about 1% per annum in volume terms, in spite of the recent surge in gold's price.

"This means that if the big boys -- such as the hedge funds (global assets of $1.9 trillion) or China (official reserves of $2.3 trillion) -- get involved, demand is likely to quickly exceed supply by a huge margin.

"Even though all the gold ever mined is still with us, it has a value of only about $5 trillion -- a lot of money, but not huge in light of global investment flows.

"So, if the money really pours into gold, the price could again take off. After all, $2,400 an ounce is still some distance away, and there's a lot more speculative capital around today than there was in 1980.

"There's no money tightening in the works currently. The Fed has kept monetary policy extremely loose for a year now, and has said it has no intention of raising rates in the near term.

"The European Central Bank, the Bank of Japan and the Bank of England have also indicated they do not intend to tighten, while China's M2 money supply has risen by 29% in the past year.

"Given all this money supply sloshing around, it's not surprising that gold prices have zoomed upwards -- and will continue doing so as long as the Fed and its central bank brothers maintain a loose-money policy.

"Rather than gold itself, I'd recommend gold mining shares -- first choice, Eldorado Gold -- for two reasons:

• First, there's the leverage. A gold mining company with extraction costs of $600 per ounce doubles its profits when gold goes from $900 to $1,200.
• Second, commodity speculation pushes up share valuations, so chances are you'll make even more money. After all, the earnings growth rate becomes pretty spectacular, which can make a very simple company look like a Google!

"As a bonus, Eldorado is not just in gold, it's in Chinese gold -- both internally and through a takeover it recently executed.

"That means it benefits not only from any rise in gold prices, but directly from increases in Chinese wealth. Chinese investors, when they buy gold, will naturally turn first to domestic output.

"Eldorado plans to double current production by 2013 (even without its recent acquisition) -- no decline here. What's more, it's reasonably valued -- actually quite cheap -- considering its earnings potential.

"The company was founded in 1992, and has come a long way in a relatively short time, building to a recent market capitalization of $5.15 billion.

"It owns the Kisladeg gold mine in Turkey, which produced 58,000 ounces of gold in the third quarter of 2009, and the Tanjanishan gold mine in western China, which produced 31,000 ounces.

"In addition, its Efemcukuru project, with projected reserves of 1.7 million ounces of gold in Turkey, is expected to begin production in the fourth quarter of 2010.

"Eldorado also has gold-development projects in Greece and Brazil and an iron-ore project in Brazil. Its current gold reserves, proved and probable, total 7.6 million ounces.

"In September 2009, Eldorado made an agreed-share-exchange offer for Sino Gold, the largest international gold mine in China. The offer values Sino Gold at approximately $2.2 billion and will give Sino shareholders approximately 25% of the combined group.

"Sino has two operating mines in China -- Jinfeng, the country's second-largest mine with production of 151,000 ounces, and the White Mountain Gold Mine, which began production in January 2009. The Eastern Dragon project in Heilongjiang province will become Sino's third mine.

"The combined companies will have gold reserves of 12.7 million ounces, with annual production expected to reach 850,000 ounces in 2011. In the third quarter, Eldorado earned $30.2 million, or 8 cents a share -- up from 5 cents a share in the third quarter of 2008.

"That's at an average gold price received of $957 per ounce, compared with a total production cost, including overhead, of $430 per ounce. Based on third-quarter earnings, EGO has a P/E ratio of about 35 times -- steep, but not excessive given the growth potential.

"That should become obvious in the year-end figures, which will show the rise in gold prices we saw in recent months dropping straight to Eldorado's bottom line.

"Just estimating, if the gold price for the fourth quarter averages $1,100 an ounce, that will send an extra $150 per ounce or so in profits to shareholders, adding about 35% to EPS and reducing the P/E correspondingly.

"Yes, labor and energy costs could rise a bit, but not much -- Eldorado's costs were only $402 per ounce in the third quarter of 2008, when oil was at $147 a barrel.

"Bottom line: Increasing gold production -- check. Contained costs -- check. In the middle of the world's fast-growing Chinese gold market -- check. Decent balance sheet and profitability -- check. What's not to like?"

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