Will GORO Ever Find That Magic Pot of Gold?

by Melissa Davis and Janice Shell - 9/22/2011 9:29:03 AM

After years of practice, Gold Resource Corporation (AMEX: GORO) has clearly perfected the art of delivering well-spun news that works magic on the company’s generous share price.

Despite a sea of potential red flags -- ranging from undocumented gold reserves to closely related executives to relentless insider sales -- GORO has managed to become one of the hottest gold stocks on the market, even though the company has produced very little of that glittering treasure at all. Rather, since going public in the fall of 2006, GORO has spent most of its time making big promises (sweetened by a handy surge in gold prices) that it consistently fails to keep. The company has nevertheless seen its stock skyrocket from its original price of $1.15 to an all-time high of $31.38 earlier this year, settling near $25 currently, with insiders cashing in millions of dollars worth of profits along the way.

GORO has soared 80% over the course of the past 12 months alone, handily outperforming far more established and successful gold miners – including industry heavyweights Barrick Gold (NYSE: ABX), Goldcorp (NYSE: GG) and Newmont Mining (NYSE: NEM) – that have racked up much smaller gains, ranging from 3.6% to 23%, on the steady explosion in gold prices. With a market value of $1.29 billion, GORO is currently trading at a stunning 28 times its prior-year sales. In contrast, GORO’s three giant peers – which measure their profits in the billions – all sport traditional single-digit price-to-sales ratios instead. 

Moreover, despite the eye-catching gold label included in its name, GORO actually counts silver – a less illustrious metal that sells at a tiny fraction of gold’s price – as its biggest product by far. Last quarter, for example, GORO sold just 2,384 ounces of gold – less than Barrick produces (on average) every 15 seconds -- while relying on cheaper silver for 99% of its overall production during that three-month period. In a rather curious feat, however, GORO somehow managed to report incredibly high prices for the small pile of gold that the company did happen to sell. 

Specifically, GORO pegged its average gold price at $1,576 an ouncea peak seen only one day throughout the entire second quarter -- even though the company has traditionally sold all of its gold to a single customer that, with any business savvy at all, could have requested volume discounts or simply purchased that gold at cheaper prices on the regular spot market. In contrast, despite their marketing muscle, the industry’s three largest miners all reported lower average gold prices (ranging from $1,501 to $1,516 an ounce) for the mountains of gold they sold during that same period.

To skeptics, including bears who have placed big bets against the company’s stock, GORO has always looked like a risky highflier powered almost entirely by hype. After all, they note, GORO started out as a subsidiary of an obscure miner in the penny-stock arena – where shady promoters regularly tout worthless microcap shares – before emerging as a stand-alone public company. Moreover, they point out, the same brothers who co-founded that original junior mining company have long filled key executive positions at GORO as well.

From the start, in fact, GORO has always stood out from traditional players in the mining space. First and perhaps foremost, throughout its five-year history, GORO has stubbornly relied on generous production estimates that insiders have assigned to its core mineabandoned by its previous owner due to lack of potential -- instead of seeking out independent feasibility studies that would officially establish the company’s proven and probable reserves. GORO has further insulated itself by constructing an extremely incestuous management team, with three members of the same family – CEO William Reid, President Jason Reid (the CEO’s son) and Vice President David Reid (the CEO’s brother) -- filling every full-time executive position at a company that can count its entire U.S. staff on a single hand. 

That tiny crew works from a $1.73 million townhouse that GORO, long financed by stock proceeds, purchased as its corporate headquarters before the company had even reported a single quarter of sales. Meanwhile, GORO leisurely waited years to register its stock under modern rules normally adopted as a matter of routine, records show, allowing insiders to conceal early stock sales that preceded the flurry of documented transactions that have followed – generating roughly $10 million for the Reid family in the span of seven months – since that time.

GORO has repeatedly missed its lofty targets all along the way, with the company blaming a mysterious 10-inch downpour in drought-plagued Mexico for its latest production shortfall. To its credit, with the help of the remarkable price that GORO reported for its gold, the company still managed to post a modest second-quarter profit and – for the first time ever – finance a controversial dividend (portrayed as “Ponzi-like” payments by its critics) without further reducing a cash pile largely generated through stock sales to investors. Even so, with that profit serving to establish a 12-month run rate (after generously excluding hefty costs attributed to the freak rainstorm), GORO still sports an incredibly high price-to-earnings ratio of almost 70 that’s more than triple the P/E ratio commanded by the red-hot gold sector overall.

While GORO insiders have never interrupted their selling spree to actually buy some of the highflying stock – and its largest outside shareholder bypassed the opportunity to purchase more stock priced in the mid-teens – the company continues to find plenty of eager buyers lured by the soaring value of gold. GORO has seen a boost in institutional ownership as a new addition to the Russell index, records indicate, and has long enjoyed a cult-like following among gold fans in the retail crowd. GORO has also attracted a noteworthy crowd of skeptics along the way, however, with critics regularly challenging its rosy forecasts by contrasting them with its lackluster results.

One Latin American-based securities analyst, who has nicknamed himself “Otto Rock” (and quickly pounced on another breakout mining stock that has since totally collapsed), recently took direct aim at GORO after reviewing the company’s latest quarterly report. In the end, he portrayed GORO as blatantly deceptive and ridiculously expensive to boot.

“It’s a silver miner pretending to be a gold miner, end of story,” Rock concluded. “It’s profitable now, which is good, but it’s hugely overvalued for what it is, even what it promises to be later. And finally, let’s remind ourselves that GORO hasn’t bothered to put together a 43-101 (independent engineering report), and nobody really knows whether what they say about their PM (precious metal) deposits is true or not.

“But what ‘Silver-with-a-Bit-of-Gold Resource Corp.’ does have,” he added, “is a legion of fanatical gold-bug loopheads as shareholders … people who give gold bulls like myself a bad name.”

GORO did not respond to messages, including a detailed list of questions, seeking input for this story.

Recycling Bin

Almost a decade has passed since GORO first secured the key asset that would magically transform the bleeding miner into a $1 billion company

Apex Silver -- a company founded by billionaire “Gold Evangelist” Thomas Kaplan – originally controlled that same Mexican mine, records show, before ultimately abandoning the property in 2002 because of disappointing test results. As the new owner of that discarded lease, however, GORO quickly began to trumpet the valuable gold that it expected to recover from the mine.  

Within a year, GORO had landed the first of two early financing partners that would eventually lose their enthusiasm – and curtail their funding – for that celebrated gold mine over time. GORO initially teamed up with Canyon Resources in 2003, records show, securing $500,000 that originally looked like a mere down payment on a much larger $3.5 million funding deal for shared ownership of the company’s Mexican gold mine. Although GORO reported impressive drilling results in the months that followed, however, the company never scored another dime from Canyon Resources and soon found itself hunting for a brand-new source of cash.

GORO located its next partner on the opposite end of the globe, with Australian-based Heemskirk stepping forward with $1 million in exchange for 2 million shares of GORO stock in 2005 and becoming the largest outside shareholder of the company. To further sweeten the deal, GORO promised Heemskirk first rights to purchase all or part of any future stock that the company issued over the course of the next three years.

GORO followed up with even more favorable news this time around, including a formal decision to pursue commercial production at its Mexican gold mine, but Heemskirk – like Canyon Resources before it – chose to stick with its original investment (ultimately selling even that) and watch from the sidelines. 

By then, however, GORO had already adopted a more dependable financing strategy that would help support the bleeding company for years. GORO officially went public in the fall of 2006, records show, gaining access to the capital markets with the help of a new boardroom director who recently caught the attention of Barron’s for backing several doomed penny-stock outfits in the past. 

GORO looked like another typical microcap company at first, corporate records show, spending mere weeks on the OTC Bulletin Board before hiring glorified promoters to tout its brand-new stock. Loudly celebrated by the company and its paid cheerleaders alike, GORO quickly took off and managed to triple in price before the company even formally committed to pursuing commercial gold production. GORO announced that celebrated decision in late 2007 and, within months, had miraculously detected enough gold in its faraway mine – somehow overlooked by its former owner – to more than double the estimated production that it expected to achieve.

Six weeks later, armed with those higher estimates, GORO successfully raised more than $20 million – shattering its previous records – by selling more of the company stock that has long served as its primary source of funds. By the end of 2010, the year that GORO finally launched commercial production (originally targeted for mid-2008 instead), the company had issued $152.4 million worth of stock while producing less than $15 million worth of gold and constantly losing money in the process.

Creative Math

Despite the net loss and negative cash flow reflected on its financial statements last year, however, GORO boldly proclaimed that its gold mine not only generated a profit but also provided enough money to finance a generous dividend to boot.

By carefully excluding key expenses related to its business – including the costs of overhead, exploration, construction and development – GORO has managed to create its own metric known as “mine gross profit” that suggests the company is operating in the black. Using that selective measure, GORO reported a mine gross profit of $9.8 million last year that more than covered the $7.74 million that it spent on dividends. 

GORO’s official financial statements tell a different story, however. According to those filings, which are subject to standard accounting rules, GORO actually lost $23 million (while generating a paltry $14.75 million in revenue) during 2010 instead. Moreover, a notable chunk of the cash that GORO raised by selling stock last year – very close to the sum spent on dividend payments -- disappeared from the company’s bank account as well.

Nevertheless, GORO somehow assumed that it could afford that hefty dividend from the start. Just four weeks after it began commercial production, GORO declared its first dividend and has continued to issue those dividends on a monthly basis ever since.

If GORO attracted a new class of investors with that move, the company also sparked a fresh sort of attack. Critics pounced after reviewing GORO’s cash flow statements, accusing the company of operating a classic Ponzi scheme by using the proceeds from stock sold to new shareholders for payouts to investors that it already had.

GORO kept issuing those generous tax-exempt dividends, anyway, (actually raising the payout from 3 cents to 4 cents a share), with insiders – who own 12% of the company’s stock – pocketing a big slice of that cash.

Paper Gains

At the time that GORO carried out its last major stock sale, the company had just escaped from the microcap arena by moving from the OTC Bulletin Board to the more respectable American Stock Exchange. Less than a month after landing on the AMEX in the summer of 2010, GORO successfully raised $55.6 million with the help of Jefferies – the only research house to ever follow the stock (before dropping the name from its coverage list) – by selling 3.475 million shares of restricted stock priced at $16 a share. 

Although GORO set a new record with that September private placement, the company found itself snubbed by one potential customer -- yet another financing partner -- that ranks as its biggest shareholder of all. In 2008, GORO forged a new “strategic alliance” with Hochschild (LCC: HOC) – one of the largest silver producers in the world -- that would go on to supply the company with a growing pile of cash. GORO repeatedly sold stock to Hochschild in the years that followed, with the price climbing from $3 to almost $10 a share, until the big silver miner ultimately wound up with a 30% stake in the company.

When Hochschild suddenly installed new leaders in the spring of 2010, however, the company also adopted a new business strategy as well. Instead of heavily investing in other miners (such as GORO), Hochschild announced that it would pursue organic growth through mines that it actually controlled instead. 

At that time, records show, Hochschild owned big minority stakes in two miners – Lake Shore Gold (Toronto: LSG.TO) and GORO itself – that could both be liquidated for sizable returns. Hochschild bypassed the opportunity to buy more stock in the first company a few months later, choosing to simply accept the dilution hit instead.

“Hochschild remains supportive of Lake Shore Gold,” the company said at the time. “However, the board and management team see organic growth through investment in Hochschild’s extensive and rapidly expanding exploration pipeline as the company’s key priority. As a result, Hochschild will not be participating in the proposed financing, and its current 37% holding in Lake Shore Gold will be diluted to approximately 35%.”

Within three months, Hochschild had slashed its stake in Lake Shore to just 6% before going on to shed that investment entirely. Since Hochschild sold off that position in 2010, pocketing a return of approximately 35%, Lake Shore has seen its stock steadily decline from roughly $4 to its current price of less than $2.50 a share.

Meanwhile, Hochschild treated GORO the same way the next time it sold stock, recycling the original press release that it had used for Lake Shore by simply changing the names and numbers in that announcement. With its $69.5 million investment in GORO exploding in value to roughly $365 million, Hochschild could score jackpot-like returns by selling that stock as well (and persistent market rumors suggest that it has tried). 

However, unless Hochschild can find a buyer willing to purchase that huge chunk of stock in a prearranged “block” deal – a real challenge since GORO, unlike Lake Shore, has never formally established any gold reserves – the company faces a serious dilemma. Hochschild can hold onto the stock and settle for enormous gains on paper, the strategy that it has chosen so far, or the company can risk selling its stock on the open market – almost assuring a devastating hit to the share price – and simply hope to collect as much money as it possibly can. 

Desert Storm

Either way, Hochschild can hardly depend on GORO to boost its deteriorating operational results. Since Hochschild does not lean on a convenient metric like “mine gross profit” to bolster its own numbers, the company must record its share of any losses that GORO suffers and book only the modest earnings that GORO can muster after covering its operating costs. 

While GORO finally managed to report real net income this year, the company still looks marginally profitable at best. Indeed, so far, GORO has yet to generate big enough profits to simply cover the costs of its generous dividends.

During the first quarter, for example, GORO reported net income of $2 million and dividend payments that came to almost 2.5 times that amount. While GORO narrowed that gap in the second quarter (and even boosted its cash for a change by almost doubling the amount owed for outstanding bills), the company still generated net income of $3.06 million that covered less than half of the $6.36 million that it spent on those dividend payments. 

For its part, GORO chose to emphasize a higher net-income figure that excluded costs associated with the bizarre rainstorm blamed for its latest production shortfall. On April 21, three weeks into the second quarter, GORO suddenly warned that a freak storm  – which reportedly dumped more than 10 inches of rain on Mexico in the span of three short hours – had slammed its gold mine and would likely hurt its financial results. 

Yet, according to an official crop report compiled by the U.S. Department of Agriculture, the heaviest rainfall recorded in Mexico came to barely one inch for the entire week when that massive storm reportedly occurred. Moreover, since then, Mexican newspapers have indicated that the country was suffering through an “extended dry spell” in April – which began last October and relentlessly continued through the middle of this year – that threatened to become one of the most extreme droughts the nation has ever seen.

“The current situation is critical because rainfall has not been as scarce at any time in the past 70 years,” Mexican weather authorities told the press in late June. “There are years that the country will be wetter than usual, like last year, and years that will be drier than usual. This is a rain deficit.”

After an extensive search, TheStreetSweeper finally managed to uncover limited news coverage of a “freak hailstorm” that hit Mexico in April of this year. But the storm that sparked that media attention surfaced days before GORO reported its own downpour, a translator determined, while producing just three inches of rain (in a different region of the country) after it arrived. 

In fairness, GORO has supplied photographs showing that its mine indeed suffered an eerie spring storm that left a thick layer of hail on the ground. While that scene looks somewhat dramatic on its own, however, it seems downright peaceful when compared to the powerful floods documented after downpours like the one that GORO reported.

According to GORO’s own corporate filings, the company’s core mine is actually located in an arid region of Mexico that normally receives just 17.5 inches of rain over the course of an entire year (and almost none of that before the month of June). Even so, GORO has blamed heavy rainfall for weak results in three of the four quarters since the company finally began its long-overdue commercial gold production in the middle of last year.

This time, however, GORO reported its biggest weather-related hit by far.

"The mine was shut down for over a month (after the April 20th storm), as crews had to turn their attention to cleanup and repair," the CEO told investors during the company's latest conference call. "The months of April and May were very much subpar because of the natural disaster, with only the month of June getting back on track."

Notably, gold prices hit a quarterly peak of $1,576 an ounce on May 2 -- with GORO's mine reportedly shut down -- and never once achieved that high again before the quarter came to an end. Yet GORO miraculously reported that peak as the average price it received for its gold during the period, even though the company indicated that it produced much of its second-quarter gold in the month of June (when the peak came in almost $20 lower) instead. 

Bean Counters

Meanwhile, GORO spent most of the recent quarter without a trained CFO who could double-check its numbers. 

In mid-April, about a week before GORO reported news of the mysterious rainstorm, the company revealed that its hourly CFO Frank “Monty” Jennings had resigned to accept a full-time position at another company. Jennings now serves as the finance chief at Synergy Resources (AMEX: SYRG), a tiny energy company that that does not even mention his past role at GORO – where he worked the previous five years -- in his official corporate bio at all.

When Jennings left, GORO appointed William Reid – already the chairman and CEO – to fill yet another critical post by serving as interim finance chief of the company. The next day, his brother Vice President/Treasurer David Reid began selling enough stock to dump $1.5 million into his bank account over the course of less than a week. He cashed in again a month later, right after GORO reported its first quarterly profit ever, scoring an even bigger payout of $1.8 million this time around. GORO President Jason Reid, the son of the CEO, joined his uncle by selling stock as well.

In mid-June, about two weeks before the second quarter ended, GORO finally hired another contract CFO to replace its top executive – a geologist with no reported background in accounting – as its finance chief, but the company still stopped short of adding a full-time outsider to its incestuous management team. GORO has long preferred to hire its CFO on an hourly basis instead, while relying on the same tarnished auditing firm throughout its entire history as a publicly traded company.

In fact, records show, GORO actually tapped StarShenkein (formerly Stark Winter Shenkein) as its independent auditor the year before the company joined a crowd of penny stocks on the OTC Bulletin Board. StarShenkein has since been flagged for shoddy work by the Public Company Accounting Oversight Board (PCAOB), records show, which uncovered major deficiencies in all four of the audits it reviewed during a 2006 inspection of the firm and more than half of the eight audits that it examined during its latest visit. 

This spring, just months after the PCAOB released the disturbing results of its most recent inspection, GORO nevertheless asked shareholders to approve StarShenkein as the company’s auditing firm once again. Two weeks ago, during its second-quarter conference call, GORO continued to embrace that firm despite the suggested need for a change.

“I think we said that we’re going more mainstream over time,” the CEO responded. “Yeah, we’ve considered that. (But) at this point, we’re fine, and we’ll take a look at that as time goes on.”

Permanent Scars

By now, GORO is no stranger to skeptics who second-guess its numbers. 

Five years after going public, GORO has still yet to supply even a basic 43-101 report that – while short of U.S. regulatory standards for establishing official reserves – would at least add some credibility to the company’s internal production estimates. Although GORO has announced plans to secure a 43-1010 report, a standard requirement for northern miners before they can even trade on Canadian stock exchanges, the company has shown no sense of urgency despite the nagging doubts that it keeps raising.

“We chose to put this into production in the shortest amount of time possible, so we did not go some typical routes,” President Jason Reid (the son of the CEO) explained when fielding another inevitable question about the company’s lack of established reserves about a month ago. “Now, in the interim, we always had this third-party pushback, where I would go out and tell the story, and they say, ‘I love your story … (But) no offense, I don’t believe you.’

“It behooves us now to go more mainstream,” he continued, “and so we’re working on a third-party, or a more formal, resource report … But it’s solely for the market. We don’t need it for any other reason, other than it’s another box for funds to check.”

Basically, with that report, GORO can list its stock in Canada – and potentially expand its institutional shareholder base in the process – but the company still cannot meet the more rigorous standards for establishing reserves in its home country.

At this point, investors have already witnessed one massive fraud orchestrated by a gold miner with little independent oversight. In the mid-1990s, The Independent newspaper reported, Bre-X became a multibillion-dollar company (based on market value) after loudly celebrating the “gold find of the century.” But when outsiders actually conducted their own tests of that same mine, the newspaper noted, they found only “insignificant quantities of gold” and declared that Bre-X had falsified its results on a scale “without precedent in the history of mining.” After that, the newspaper added, the former highflier – which had impressed even the likes of Barrick with glowing reports of its mine -- wound up virtually worthless overnight.

Back then, the Reid brothers were still running the original mining company – US Gold Corp. (NYSE: UXG) – that would eventually go on to spawn GORO itself. While there, the duo began to establish an ongoing pattern of making impressive promises they could not keep.

In 1988, Dow Jones reported years ago, US Gold announced plans for a big expansion project designed to increase production and install the first commercial “bio-leaching” facility the industry had ever seen. Two years later, however, US Gold found itself facing “significant liquidity problems” due to cost overruns and repeated delays stemming from that ambitious project. Although US Gold barely escaped bankruptcy by selling off its interest in a Nevada gold mine, industry coverage has revealed, the company emerged from that liquidity crisis with unshaken faith in its future success.

“The mill’s design capacity is 50,000 ounces annually,” US Gold told a trade publication at the time. And “we see no reason to believe the mill won’t reach full capacity within a matter of months.”

Instead, the Wall Street Journal later reported, US Gold produced just 2,000 ounces of gold with its bio-leaching process over the course of the next six months. The bleeding company eventually lost its coveted listing on the Nasdaq in the fall of 1998, just weeks after GORO quietly surfaced as a brand-new miner, and eventually changed hands on down the road. Only after US Gold installed its current leader, who reportedly paid the grand sum of $12 million for a controlling stake in the company, did the former penny stock go on to achieve any real measure of success.

Meanwhile, even with that company on the brink of bankruptcy, its original top executive (now the CEO of GORO itself) displayed a haunting mixture of cheerful optimism – still intact today – and reckless disregard for investors susceptible to his contagious faith.

“If you’re not worried, you’re not risking enough,” he nonchalantly told the Wall Street Journal in the midst of his first company's liquidity crisis. “I believe life should be an adventure. And we’re having a hell of an adventure right now.”

* Important Disclosure: Prior to the publication of this article, TheStreetSweeper (through its members) has effected a “short sale” of 74,246 shares of GORO stock at an average price of $25.28 a share with the intent of profiting from decreases in the share price. TheStreetSweeper has also purchased 50 September 2011 $30 "put" options priced at $5.80 apiece, hedged by the sale of 50 September 2011 $25 "call" options priced at $1.15 apiece, as well. TheStreetSweeper may choose to make additional trades in GORO securities, potentially covering part or all of its short position in the stock, and will fully disclose the details of those transactions as they occur. 

Update: TheStreetSweeper covered 3,200 shares of GORO stock at a price of $23.23 a share on Aug. 23. It covered an additional 24,825 shares, including 4,156 shares purchased under a "forced buy-in," at an average price of $22.34 on Aug. 24. It covered another 17,790 shares at $22.19 a share on Aug. 25 and 10,310 shares at $21.43 a share on Aug. 26. It covered the remaining 17,621 shares at $22.88 a share on Aug. 29, closing out its short position in the stock. It sold its 50 September 2011 $30 put options at $8 a share as well. 

Update: TheStreetSweeper began establishing a new short position in GORO on Aug. 30, when it sold 2,000 shares of the company's stock short at $24.03 a share. TheStreetSweeper covered that position at $23.35 a share on Aug. 31 and then sold another 75 shares of GORO short at $23.83 a share. It sold an additional 4,525 shares of GORO short at $23.47 a share on Sept. 1 and another 8,401 shares at $23.20 on Sept. TheStreetSweeper repurchased 75 shares of GORO under a "forced buy-in" at $22.47 a share on Sept. 6, and it sold another 4,600 shares of the company's stock short at a price of $22.48 a share on that same day. It sold an additional 9,080 shares of GORO stock short at $21.12 a share on Sept. 12 and another 4,000 shares at $21.39 on Sept. 13. Following those transactions, TheStreetSweeper had sold a total of 30,606 shares of the company's stock short at an average price of $22.28 a share. TheStreetSweeper has increased its short position to 40,506 shares, sold at an average price of $22.08 a share, since that time. Due to "forced buy-ins," however, TheStreetSweeper repurchased 3,389 of those shares at $21.60 a share on Sept. 15 and another 3,922 shares at $20.78 a share on Sept. 22. Since then, on Sept. 23, it purchased 8,394 shares at $19.35 a share and 14,300 shares at $18.29 a share in two separate transactions. It covered another 7,601 shares at $17.93 a share on Sept. 26. It covered the final 2,900 shares at $20 a share on Sept. 27 and no longer holds a short position in the stock. Going forward, TheStreetSweeper may choose to establish a new short position in GORO and will fully disclose the details of any future transactions as they occur. 

As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in any of the companies that they cover. To contact Melissa Davis – the editor of this website and the primary author of this story –please send an email to editor@thestreetsweeper.org.  



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