The Gold Report: In late November, BMO Chief Economist Doug
Porter warned that interest rates could move higher sooner rather than later
in 2015. What's your 2015 outlook for gold given that information?
Andrew Kaip: Our 2015 outlook for gold is that it will trade,
broadly speaking, where it is today. Our assumption for next year is $1,190
per ounce. Do we look to Doug Porter's view on interest rates rising and that
potential? We do. If the market perceives inflation is becoming a concern, we
see that as constructive for the gold price.
TGR: You have extensive experience covering junior gold companies.
In your time as an analyst did anything prepare you for this cycle investors
are witnessing?
AK: When we look at what has changed over the last couple of years,
I think that in general BMO Research understood that the direction was
changing. Several years ago we began putting out reports cautioning investors
that metal prices had downside risk and we were concerned with structural
issues in the sector that continue to play out. And while we certainly
understood the direction, I don't think any of us fully understood the
magnitude of the shift.
TGR: Do you now have a better understanding of where we're headed?
AK: Metal prices have lost roughly one-third of their value
compared to where they were in a peak price environment—even more for silver.
If we step back and think about a cycle and how a sector moves from bull to
bust, I would say we're really part way through the consolidation that takes
place when a sector is out of favor and has to deal with structural issues.
That's difficult to hear, but I see the gold space moving through a down
cycle. We had a good run from 2010 through 2012, but we're now in a
consolidation phase, with the risk of lower precious metals prices.
TGR: There have been casualties along the way. What are you telling
your team?
AK: We've always been realistic. Our focus over the last two years
has been to steer clients toward mining companies that have strong management
teams managing quality assets and building them into stronger businesses.
TGR: You suggested earlier that there are structural problems in
the precious metals space, especially among the smaller companies. Could you
give us some examples that help illustrate your point?
AK: There are a number of issues that we have focused on. The first
is that the operating cost structure for a number of companies is not
structured for today's metal price environment. We are looking closely at
smaller companies and some larger companies to see how they're responding to
lower metal prices. They started by cutting discretionary spending, but now
companies are looking more closely at sustaining capital in an attempt to
reduce their overall cost structure and maintain profitability. But if you
take too much sustaining capital out of the business, how is that going to
impact the business in two or three years?
TGR: One hot topic on cutting costs is executive compensation. Has
it become unrealistic?
AK: In the context of this current market there needs to be a
healthy discussion as to what is appropriate compensation for executive
teams. In some instances, levels of compensation are significant relative to
a company's production. One thing that our clients are telling us is that
they would prefer to see the old business model where executive teams had
significant ownership of the companies that they were running. They benefited
from their success through share price appreciation. Investors want
management aligned with their interests.
TGR: Is there a tangible way investors can determine what is
reasonable and what's excessive?
AK: If a management team has significant share ownership—an amount
at least comparable to their base salaries—then investors should begin to
feel comfortable that those individuals are trying to create wealth and make
decisions that will benefit all shareholders.
TGR: What is your view on high grading?
AK: The reality of lower metals prices, particularly in the
precious metals space, is that companies have to move toward higher grade to
maintain profitability. But that comes at the expense of reserve life. We saw
that at the beginning of 2014, but our expectation is that we will see
further declines in reserves when reserves are restated at the beginning of 2015.
For some companies, that's going to precipitate a decline in reserve life to
the point where it could become motivation for consolidation. Some of these
companies will have to look to acquire smaller companies with new projects in
order to maintain their production profile. In fact, some of these companies
are going to have to look at consolidation if they are going to continue
operating.
TGR: That is going to place greater importance on exploration.
AK: Exploration is an important aspect of regeneration in mining.
Consolidation is really a short-term way for these companies to get out of
their current predicament. If we take a longer-term view, exploration has
been key to companies reinvigorating existing mines by expanding reserve
bases over time. We're not seeing exploration at the level we think it needs
to be to replenish reserves in today's market. That's why we think
consolidation in the short term has the potential to take hold. And that's
constructive from an investor standpoint.
This sector needs to go through a consolidation to create stronger mining
companies—and consolidation allows companies to grow their reserve bases and
operational flexibility. Then we can look toward a future where investors
will want to begin investing in exploration companies again for the prospect
that they might make impactful discoveries.
TGR: What is consolidation going to look like in 2015?
AK: Consolidation makes for an interesting discussion. For example,
David Haughton, our senior precious metals analyst, says that many of the
senior producers he covers are not in a position to acquire and that only a
handful have a mandate for acquisition. Our view is that we're not really
going to see the large mining companies participate in a round of
acquisition. Mergers and acquisitions will mostly be the domain of the small
to intermediate gold and silver producers.
TGR: Will consolidation come in the form of cash-and-share deals?
AK: Cash is scarce in this sector. If a company is going to make an
acquisition, it is going to make an acquisition primarily with shares. One of
the biggest questions for junior companies right now is cash. There is an
ongoing debate among exploration company management teams: Are shareholders
better off in a larger entity that has the means to develop its assets or are
shareholders better off sticking it out in the current environment and hoping
for better days?
TGR: In other interviews you have suggested that investors should
stick to outliers in the gold space. Please describe an Andrew Kaip outlier.
AK: Outliers are those companies that we believe are well run. They
have quality assets that can generate cash at current metal prices or lower.
They have management teams that are well regarded, are technically strong and
make decisions in the best interest of shareholders. Often those management
teams are significant investors in their companies, too. That's the
combination we're moving toward.
TGR: What are some examples?
AK: We view Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), a royalty
company, as an outlier. In the silver sector, we look toward Tahoe Resources
Inc. (THO:TSX; TAHO:NYSE) as an outlier given its strong management team,
high-quality assets and significant management ownership of the company.
These are the leaders of our industry.
TGR: Franco Chairman Pierre Lassonde says his company is very much
undervalued. Is he correct?
AK: David Haughton, our senior analyst who covers Franco-Nevada and
who has covered royalty companies for a long time, noted recently that over
the last couple of years valuations of royalty companies have come down
significantly relative to those of precious metals producers. In that context,
Pierre is absolutely correct.
TGR: Tahoe was among three "flight to quality"
recommendations in a recent BMO report on the silver sector. The other two
names were Fresnillo
Plc (FRES:LSE) and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE). Why did Tahoe
make your short list?
AK: Tahoe made the short list because it has asset quality that's
comparable to Fresnillo, a London-listed silver company with operations in
Mexico. Fresnillo is a high-quality operating company with first-quartile
cash operating cost mines that are run with a conservative approach toward
execution—good execution. Tahoe doesn't have the depth of assets that
Fresnillo has, but it certainly has a primary asset that will be the company
cornerstone for many years to come.
I put Silver Wheaton in that group because Silver Wheaton is a precious
metals streaming company, a naturally defensive name. Any royalty company
carries some operational risk from the standpoint of production from its
underlying streams or royalties, but royalty companies don't deal with the
capital or operating cost escalations that mining companies incur. All three
companies, in the context of value relative to their peers, are more
attractively priced.
TGR: Tahoe President and CEO Kevin McArthur just cashed in several
tranches of shares worth about $10 million. Should that give potential
investors pause?
AK: Investors are always asking why management teams do what they
do, but most investors who have been following the story realize that Kevin
has had a decent amount of his capital tied up in Tahoe for a number of
years. From my discussions with the company, it sounds as if there were
personal reasons for Kevin to sell those shares but he's still a significant
Tahoe shareholder.
TGR: Do investors go with an exchange-traded fund like the SPDR
Gold Trust (GLD:NYSE.A) or with companies like Franco and Silver Wheaton?
AK: The one advantage that Franco and Silver Wheaton have that the
SPDR Gold Trust or even holding precious metals doesn't is that both
companies have portfolios where significant discoveries can still be made.
It's those significant discoveries and the crystallization of that value
creation that distinguishes them from holding a basket of equities or the
underlying metal.
I cover Silver Wheaton and investors are starting to understand that a
couple of the streams that Silver Wheaton owns are beginning to add value
that they had not considered. For example, Goldcorp Inc.
(G:TSX; GG:NYSE) is considering adding another processing circuit at its
Peñasquito operation in Mexico. That would amount to another 1 million ounces
of silver annually. Another example is the impending expansion of Vale S.A.'s
(VALE:NYSE) Salobo copper mine in Brazil, where Silver Wheaton owns 25% of
life-of-mine production. Salobo is already producing at a higher rate than
what was originally expected, something that when Silver Wheaton acquired
that stream investors had completely discounted. Over time royalties can grow
from a reserve perspective, but they can also grow from a production
perspective. That's the advantage that both Franco and Silver Wheaton bring
to the table.
TGR: You provided the basics of your current investment thesis for
gold and precious metal equities. Is there anything you would add?
AK: We've been talking to investors about what they want and that
is highly leveraged names. We much prefer investors take into consideration
financial leverage versus operational leverage. Operational leverage is
looking for high-cost miners. If you invest in high-cost miners, you could
see a significant return if metal prices rebound rapidly. But we tend to find
that the high-cost operators continue to be high-cost operators because once
metal prices begin to rise, those high-cost miners have to reinvest capital
in their operations because they've been starving them to maintain profitability.
Most of the financial leverage in the gold sector today is long-dated
financial leverage. For investors, that's a lower-risk profile because they
don't have the prospects of debt renegotiation and uncertainty. Investors are
looking at decent quality assets that are hampered in the current market by
debt. Once metal prices move higher, investors can add significant value with
lower risk.
TGR: What are some companies you're tracking at the top of the
precious metals food chain?
AK: The biggest question with the senior producers right now is
direction. The market is looking for the seniors to map out a strategy. Many
are working on those strategies, but not all of those strategies are coming
in a timeframe that investors favor. Investors are gravitating toward seniors
with coherent strategies like Goldcorp, Agnico Eagle Mines
Ltd. (AEM:TSX; AEM:NYSE) and Randgold Resources
Ltd. (GOLD:NASDAQ; RRS:LSE).
TGR: Where is the primary growth going to come from in those three
names?
AK: Goldcorp is ramping up to commercial production at two
mines—Éléonore in northern Quebec, and Cerro Negro in Argentina. That amounts
to significant production growth. Agnico, of course, joined forces with
Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) to acquire Osisko Mining.
Agnico just went through a round of consolidation that has resulted in
production growth but Agnico is a company with a mandate for further
acquisitions. It's been specific about what it's looking for and we expect it
to be looking for new opportunities.
TGR: What are some names in the midtier or small producer category
that should participate in the next round of consolidation?
AK: A number of intermediates are quite acquisitive. Some of the
names we expect to lead future consolidation of the sector include B2Gold Corp.
(BTG:NYSE; BTO:TSX; B2G:NSX), which has been very active on the
acquisition front; Primero Mining Corp. (PPP:NYSE; P:TSX), a name that we
cover that has been acquisitive; Rio Alto Mining
Ltd. (RIO:TSX; RIOM:NYSE; RIO:BVL), which acquired a junior company
earlier this year and that was viewed as a sound acquisition; and Argonaut Gold
Inc. (AR:TSX), which has grown through acquisition and will likely do so
again.
TGR: Rio Alto climbed well above $3/share in September as rumors of
an impending takeover carried the share price higher. Were those rumors
unfounded?
AK: They're never unfounded, but during that period Rio Alto was
consolidating its Sulliden Gold acquisition. Once investors understood what
the acquisition was all about, we started to see the share price
appreciation. Sometimes a well-timed acquisition, even though investors
aren't expecting it, can really reinvigorate a company's prospects.
TGR: Primero increased production at Black Fox by 30% in Q3/14
versus Q2/14, but the mine still requires capital improvements that will
likely siphon money away from the development of Primero's Cerro Del Gallo
project in Mexico. Is Black Fox worth it?
AK: When we look at Black Fox there is a large capital requirement
and a longer runway to get that project to where Primero wants it to be.
Primero is committed to moving that project forward and there are very good
indications that the mineralized structures that host gold at Black Fox
continue at depth. Brian Quast, the intermediate analyst here at BMO, would
point out that the real driver for Primero at this point is very much San
Dimas and the growth opportunity there.
TGR: Another company you listed, B2Gold, has received some
criticism for some recent takeovers but consensus on the Street seems to be
that the Papillon Resources Inc. (PIR:ASX; PAPQF:GREYS) acquisition will be
accretive. Your thoughts?
AK: That's our view. The Papillon Fekola gold project in Mali is a
good quality asset. It provides increased geographic concentration for the
company and certainly has the potential to be an accretive acquisition.
TGR: What about the developers and explorers?
AK: There are some interesting themes taking place in the junior
space. We have a lot of data from junior takeovers dating back to the
mid-1990s. One thing that is apparent is that the actual value of junior
companies (using enterprise value per ounce of reserves) has never been
cheaper—even in the context of today's gold price. We see a number of junior
companies with credible assets that will be developed at some point and those
companies are going to be acquisition targets.
TGR: What are some likely names?
AK: Lydian
International Ltd. (LYD:TSX), one of the companies that I cover, recently
received its final permit to construct a mine at the Amulsar project in Armenia.
Romarco
Minerals Inc. (R:TSX): even though Romarco has seen a delay in permitting
at its Haile gold project in South Carolina, it's only a matter of time. My
view is that the permit will come sometime in 2015.
Rubicon Minerals
Corp. (RBY:NYSE.MKT; RMX:TSX) is a junior company that's constructing the
Phoenix gold mine in Red Lake, Ontario, that will enter commercial production
in 2015.
And Guyana
Goldfields Inc. (GUY:TSX) is building the Aurora gold project in Guyana.
Quite a number of junior companies offer good opportunities. I believe we're
moving to a stage where consolidation will be well received by investors.
TGR: Leave us with one thought that precious metals investors can
chew on.
AK: One thing that I believe has been forgotten is that smart
business decisions by both mining companies and junior exploration companies
are at the heart of opportunity for investors in this sector. For instance,
it was a smart decision by the management team at Aurelian Resources Inc. to
say that its shareholders would be better off in Kinross Gold Corp. (K:TSX;
KGC:NYSE), a larger entity. A lot of value was created for shareholders
through that deal. Did political issues sideswipe the project over the last
couple of years? Absolutely, but from a junior perspective that was a wise
decision for Aurelian shareholders. The sector needs to get back to the key
principles of opportunity. One of them is a healthy transactional environment
for precious metals companies. That requires acquirers to see that they can
make acquisitions that are accretive to their businesses, as well as junior
company management teams that see acquisition as part of their business
strategy. We've diverged from that. My hope is that we'll move back into an
environment where value can be created for shareholders.
TGR: Thank you for your insights, Andrew.
