Modest Tailwinds Could Blow Life into Mining Equities in 2015: Shane Nagle

The Gold Report: Gold producers have seen their fair share of headwinds in recent years. Is this sector in for more of the same in 2015?

Shane Nagle: I think an important distinction for precious metal equities in 2015 in contrast to previous years is a sustainable improvement in operating costs. We've seen deflationary pressure on oil prices and mining contracts so far this year, while previous years were characterized by escalating capital and operating costs compounded by deteriorating commodity prices. Approximately 25% of ongoing costs at mining operations are energy related and we're looking at a material decline in those input costs for the foreseeable future.

We've also taken a close look at the impact of currency devaluation versus the U.S. dollar in mining jurisdictions like Mexico, Australia and Canada. Operators in these jurisdictions have seen an approximate 20% increase to their top line so far this year, which helps improve operating margins, all else being equal. We could see a substantial increase in operating profits in comparison to 2014, helping lead to a rally in precious metal equities.

TGR: Silver producers witnessed even more commodity price weakness than gold producers last year. What are the key themes for primary silver producers in 2015?

SN: Primary silver producers like First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE), Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE) and Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) have been focusing on reducing all-in operating costs. First Majestic's production comes entirely from underground operations that typically carry a larger sustaining capital component than open-pit mines. Its 2015 guidance suggests a material improvement in operating costs for 2015; however, continued optimization and reducing all-in cash costs will continue to be a primary focus for all silver companies going forward.

TGR: In previous interviews you have said that investors should stick to companies with a strong balance sheet, strong management team and exploration potential. Strap on your Nagle-vision goggles and tell our readers about the types of precious metal equities you expect to perform in 2015.

SN: As we mentioned previously, producers that were a bit tight in terms of free cash flow in previous years should be able to realize improved operating margins in 2015. This should afford them an increased budget for exploration and/or capital projects to deliver incremental production growth.

TGR: What are some companies having success with the drill bit?

SN: Aside from Pilot Gold Inc. (PLG:TSX), I don't follow many exploration companies.

Pilot has hit some promising copper-gold porphyry mineralization at its TV Tower project in Turkey. The key to unlocking the value there is a higher copper price. There are several large-scale copper porphyry discoveries in recent years that trade at lower valuations in the current market given the lack of potential acquirers for these projects at current copper prices.

TGR: Are there indications that these porphyry discoveries are part of a major system?

SN: When you look at Pilot's entire TV Tower land package, there's certainly a larger system tying these different areas of mineralization together. There's the high-grade KCD gold-silver deposit in the north, an oxide gold cap adjacent to the porphyry targets in the south and several other high-grade gold targets—at more than 90 square kilometers it's quite an extensive land package.

TGR: Pilot recently published a revised preliminary economic assessment (PEA) for its Halilaga copper-gold porphyry project, also in Turkey. What did you make of that report?

SN: The Halilaga project is a joint venture with Teck Resources Ltd. (TCK:TSX; TCK:NYSE), where Pilot owns 40%. The revised economics were based on a smaller, higher-grade operation, focused on reducing capital costs to a more reasonable size for a midtier mining company. Our opinion is that the project is non-core to Teck and the revised PEA is a way to find a value for Teck's 60% share. We'll likely see a sale of Teck's 60% share this year to either Pilot or a third party.

TGR: Is the market more excited about what Pilot is doing in Turkey or in the U.S.?

SN: Most of the value for Pilot, in our opinion, is with its Kinsley Mountain project in Nevada. The deposit itself is more structurally complex than the company initially thought back in early 2014 after following up some good early-stage drill results. However, management has had an opportunity to reinterpret all of the data this winter and should have some success identifying the extension of that deposit in its spring drill program.

TGR: You cover some other gold companies with Outperform ratings. Please share some of those.

SN: Lydian International Ltd. (LYD:TSX) is a highlight on the gold side. It is developing the Amulsar project in Armenia. The company just raised enough money to do some initial development work and complete further land acquisitions there. Once it gets its Environmental and Social Impact Assessment approval, Lydian should be able to secure debt project financing by the end of the year and drive forward with development.

One caveat is that Centerra Gold Inc. (CG:TSX; CADGF:OTCPK), a company that had long been rumored to be a potential suitor of Amulsar, announced an agreement to acquire 50% of Premier Gold Mines Ltd.'s (PG:TSX) Trans-Canada project in northern Ontario for CA$300 million ($300M). Lydian may now be considered less of an acquisition target and more of a project development company.

TGR: What's the market's view of Armenia?

SN: It's mixed. Lydian has financial backing from both the European Bank for Reconstruction and Development (EBRD) and the International Finance Corporation (IFC). Both institutions have been supportive of Lydian as it is the first to advance a project in Armenia to current international standards. These relationships are a big vote of confidence in the company and its relationship with the local government and people.

TGR: What are some silver equities that you follow with Outperform ratings?

SN: Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), a royalty/streaming company, and MAG Silver Corp. (MAG:TSX; MVG:NYSE), a silver developer.

TGR: In a recent report you estimated that Silver Wheaton had over $300M in cash. What is it likely to do with that money?

SN: Not only Silver Wheaton, but the entire royalty space— Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX), as well as Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) —each company has approximately $1 billion ($1B) of available liquidity to put toward acquisitions. Most of the deals in recent years have been in the small-cap gold space; however, so far in 2015 junior gold developers with promising projects have greater access to capital and less need to sell a stream or royalty.

We believe the real opportunity is with the more leveraged large-cap gold and base metal companies. We're seeing balance sheets of large-cap mining companies leveraged at 2.5x debt to earnings before interest, taxes, depreciation and amortization (EBITDA)—it was less than 1x before 2008.

There is a significant opportunity to help deleverage these larger companies by acquiring by-product precious metals production from base metals assets—deals that would generate cash flow immediately. That's the most likely use of proceeds for a lot of the royalty companies.

TGR: Silver Wheaton missed its guidance last year. Is that a concern for investors?

SN: A couple of the streams in its portfolio are a bit unpredictable in terms of timing of sales, which creates some inconsistency in quarterly results, I don't see any structural issues with any of its existing portfolio. Over 75% of Silver Wheaton's streaming/royalty sales come from mines operating in the lower half of the cost curve. With production increases at mines like Goldcorp Inc.'s (G:TSX; GG:NYSE) Peñasquito mine or Primero Mining Corp.'s (P:TSX; PPP:NYSE) San Dimas gold-silver mine (both in Mexico), as well as new production coming on line from HudBay Minerals Inc.'s (HBM:TSX; HBM:NYSE) Constancia operation in Peru, we see significant production growth for Silver Wheaton in the years to come—all of it coming from streams within its existing portfolio.

TGR: What's the narrative for MAG Silver in 2015?

SN: MAG Silver has a 44% interest in the Juanicipio project in Zacatecas, Mexico, which is being built by Fresnillo Plc (FRES:LSE). 2015 is going to be another year of development there with little news flow; however, that also means limited capital commitments for MAG Silver. The company has about $85M in cash and will spend about $5M at Juanicipio this year on development of the decline. MAG Silver's capital commitments won't ramp up until mill construction starts in the back half of 2016. The company also has a secondary asset, Cinco de Mayo; a potential resolution to certain land access issues and future success with the drill bit could add additional long-term value.

TGR: What is more likely, Juanicipio enters production and MAG Silver takes its 44% of the silver or MAG becomes the subject of a takeover bid by Fresnillo?

SN: In our opinion, it makes more sense for Fresnillo to own 100% of Juanicipio. The project sits on trend with the Fresnillo silver mine where the company produces about 40 million ounces (40 Moz) of silver per year. Fresnillo is targeting about 50–55 Moz silver/year by 2018, primarily by focusing on areas of higher grades—similar to Juanicipio. If we look at the land package, Fresnillo has developed a shaft and has been mining the same vein on its adjacent 100%-owned property. The most logical timing for a takeover bid in our opinion would be before mill construction is complete.

TGR: What are some other equity stories you'd like to share with us?

SN: Our two top base metal picks for the year are Lundin Mining Corp. (LUN:TSX) and HudBay Minerals. Lundin has one of the strongest balance sheets in our coverage universe. Its net debt to EBITDA is around 1x, the company has approximately $250M in cash and should have about $100M in free cash flow in 2015, increasing to $300M in 2016. It has $1B in debt from the acquisition of the Candelaria open-pit copper mine in Chile, but that's not due until 2020 and 2022. Lundin continues to trade at a discounted valuation and could look even more attractive on net asset value following an updated resource estimate and revised mine plan at its recently acquired Candelaria mine in Chile.

HudBay has a more leveraged balance sheet to start the year, but offers one of the best growth profiles in the base metals space. Its EBITDA should go from about $50M in 2014 to as much as $500M in 2016 once its Constancia mine in Peru reaches full-scale operation. Commissioning an 80,000 tonne per day operation doesn't come without risk; however, softer than expected ore and positive grade reconciliation to date should be helpful in the early stages of commissioning. Lundin and HudBay offer good contrast: one has a relatively strong balance sheet, while the other offers near-term production growth in a politically stable jurisdiction.

TGR: Are those strengths a reflection of their respective management teams?

SN: Both management teams have proven track records and have taken a similar approach of leveraging operational expertise to deliver growth. Lundin's President and CEO Paul Conibear has chosen the more conservative approach of acquiring operating assets, or nearly completed assets like Eagle, while David Garofalo at HudBay has acquired large-scale development assets and is looking to leverage operational expertise from its mines in Manitoba to build both the Constancia and Rosemont projects to provide growth.

TGR: Do you have some words of wisdom for investors in the precious and base metals spaces as we move deeper into 2015?

SN: In previous years the focus has been on balance sheet strength and conserving cash through what could be a prolonged downturn. There appears to be renewed interest from investors looking for value in both the precious and base metal space. That's been largely due to currency movements and what could be more sustainable lower operating costs with the downturn in oil prices. That will continue to be a key theme that plays out in the precious metal space throughout 2015.

With base metals, we continue to see some near-term commodity price weakness; however, in the current market environment there is a significant lack of large-scale mines being brought into production. If a structural deficit builds in copper over the next few years as expected, many of these companies are going to trade higher on the run up in prices. Although profits may deteriorate somewhat in 2015, it might not be a bad time to pick away at some base metals names, especially for long-term investors.

TGR: Thank you for your insights, Shane.