The Gold Report: The gold price can't seem to climb back above $1,300/ounce ($1,300/oz) despite several geopolitical hotspots making headlines. What's underpinning the price weakness?
Raj Ray: The issue is that despite the geopolitical backdrop, the fundamentals still appear weak. The big drivers—demand from India and China and gold exchange-traded funds—have been more or less flat year-over-year. China is still digesting the gold it purchased last year. And, although price premiums have declined in India following the recent Bank of India's move to permit trading houses to import gold again, further relaxation of the import tariffs is not forthcoming. If not for geopolitical conflicts providing support, gold could have moved much lower than $1,300/oz. I don't see a big driver to push gold higher over the next six to eight months.
TGR: India has imposed high tariffs on gold imports and those have resulted in a marked increase in gold smuggling. How is that influencing the gold prices?
RR: I don't think there has been a marked impact on gold prices in India due to smuggling. The World Gold Council says about 250 tons of gold are smuggled into India each year. If you add that to the official gold imports of roughly 800–850 tons, you still have a shortfall of around 200–300 tons based on average annual imports. What might be something to look out for heading into the wedding season is the rainfall and its impact on food production. Rural India accounts for 60–70% of India's gold demand. The rainfall outlook has improved slightly, but a rainfall shortage could make the government reluctant to reduce the import duties anytime soon. It would also mean that people have less money to spend on gold.
TGR: You said China is still digesting its 2013 gold hoard. How long before China is consuming gold as it did in 2013?
RR: Given the lack of transparency, we don't know if the 2013 gold-buying frenzy was driven by consumers or the state. If most of it was consumer-driven, there could be several possible explanations as to why demand has been muted this year. One is the slowing economy, which in turn has contributed to the depreciation of the yuan. There is lower demand for luxury goods. People are still holding on to a lot of gold inventory following last year's purchases. Chinese consumers could return to the market soon but I expect this to play out for another 6–12 months.
TGR: Your forecast for gold is $1,325/oz for the remainder of 2014. What numbers are you using into 2015?
RR: We are using $1,325/oz in 2015, then we ramp it up to $1,400/oz for 2016.
TGR: A recent National Bank Financial report suggested that the poor equity performance of producers in Q2/14 had more to do with high expectations and inflexible mine plans than with static gold prices. Would you explain?
RR: When the gold price plunged in 2013, a lot of gold producers went through a period of mine optimization. The expectation was that they could get to higher-grade, low-cost ounces quickly. The initial drop in costs that we saw was a result of cutting nonessential spending, but the companies eventually found out—as did the market—that it's much harder to decrease operating costs by reworking mine plans. These things take time. The second quarter results from some companies are starting to show the benefits of mine optimization plans initiated last year. But it's still early.
TGR: In the same report, you note that one reason for optimism is that there are signs that "pervasive back-end loaded production profiles among our producer universe are playing out." Could you elaborate?
RR: For producers, the move to eliminate economies of grade also impacted throughput as companies realized that they were not able to replace lower-grade ore with higher-grade material fast enough. We might see that change in the second half of 2014 as companies gain access to higher-grade zones as a result of mine optimization. We're seeing some of that impact in Q2/14 but we expect an even greater impact in the second half.
TGR: Would you give us the essentials of your investment thesis for producers and junior developers for the second half of 2014?
RR: My investment thesis for producers hasn't changed much from the beginning of the year. I still like companies with operational flexibility and the ability to generate cash even in a muted gold price environment. Operational flexibility means companies that have completed sufficient development to easily access higher-grade ore if and when gold prices drop. Companies with high cash costs will still find it difficult to navigate this market environment given our forecast for muted gold prices for the rest of the year and into 2015.
For development plays, the market likes advanced, low-capital intensity projects with permits in place. One example of an advanced-stage development play that was acquired recently is Sulliden Gold Corp., which was bought by Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL; RIOM:NYSE; MS2:FSE). The market still doesn't have the appetite for large-scale, capital-intensive projects.
TGR: Sandstorm Gold Ltd. (SSL:TSX; SAND:NYSE.MKT) and Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) recently got together to provide True Gold Mining Inc. (TGM:TSX.V) with $100 million ($100M) to advance the junior's Karma gold project in Burkina Faso. Could you outline the basic elements of that agreement?
RR: Under the terms of the agreement, True Gold will deliver 20,000 oz (20 Koz) gold annually over the first five years, beginning March 31, 2016, followed by 6.5% of gold production thereafter. The gold purchase price is set at 20% of the spot price. True Gold also has the option to increase funding by another $20M during the next 18 months, with an additional delivery of 30 Koz. There are two important considerations here: One, True Gold retains some upside to the gold price because the ongoing payment is based on a percentage of spot. Second, there's a provision to defer gold deliveries up to 12 months at a cost of 1.2% per month. This is important because heap-leach operations sometimes take a while to reach projected recovery rates. It is also interesting to note that this is the first time two royalty companies came together to bid for a single project.
TGR: After the deal was announced, Sandstorm Gold Senior Executive VP David Awram said, "Streaming finance has become a mainstream source of funding in the mining industry." Is the True Gold deal a case of investors being well served by the growing popularity of streaming in exchange for project development cash?
RR: When Awram says that the streaming is becoming a mainstream source of funding, there's some truth to that. True Gold management went through the various term sheets and selected the best available offer. Royalty companies are getting more competitive as good-quality projects become increasingly rare. Traditionally, streaming was considered a last-trade resource financing, but we are seeing more and more deals competing on even terms with project financing facilities.
TGR: There have been some mistakes made in the streaming space, but for an investor is it as simple as saying, "If it's good enough for Franco-Nevada, it's good enough for me?"
RR: I think you can say that to some extent, given the project evaluation expertise at the disposal of streaming companies. Don't forget that streaming companies have been around for a number of years and have their own teams with very credible understanding of the mining space.
TGR: What are your thoughts on Karma as a gold asset?
RR: I like the project. It's a relatively high-grade open-pit, heap-leach project in Burkina Faso, one of the most stable jurisdictions in West Africa. With every heap-leach project there's a portion of operational risk that investors shouldn't discount. True Gold's metallurgical recoveries look good, but we'll see the numbers when the project comes on-line. The average recovery at operating heap-leach projects is around 70–75%. There's an element of risk in project execution, but at this point it looks to be a good project. Karma sits on an 856 square-kilometer land package. There's huge exploration potential there.
True Gold expects to start commissioning in 2015, with commercial production starting in 2016. Based on the feasibility study, the mine life is 8.5 years. But the company recently discovered a new deposit called North Kao. That will allow True Gold to either extend the mine life or boost throughput, which I think would have a much bigger impact on net present value. If that were to happen, I don't expect True Gold to expand throughput before year three of production.
TGR: What is your rating and target on True Gold?
RR: I have an Outperform rating and a $0.65 target price. At this point it's trading around 0.6 times our net asset value. By the time this project gets built we could see it re-rate to 0.8–0.9 times. That's where the upside is.
TGR: Earlier this year you launched coverage on some smaller names in the gold space. Would you share some of those narratives with us?
RR: I launched coverage on OceanaGold Corp. (OGC:TSX; OGC:ASX) and Kirkland Lake Gold Inc. (KGI:TSX) early in the year. OceanaGold is a great example of having a high-quality mine—Didipio in the Philippines—generating strong cash flow in a weaker gold price environment. Management has also done a good job of reworking the mine plans for the relatively higher-cost Reefton and Macraes operations in New Zealand. The stock could be a headed for a rerating as OceanaGold continues to build a cash balance and pay back debt.
One concern among investors has been the limited exploration potential in the Philippines till now. The government declared a moratorium on exploration a few years ago pending the introduction of a new fiscal regime. With the cash that OceanaGold is generating, it could be well positioned to acquire other assets in more stable jurisdictions. That's something to watch out for in the next 6–12 months.
TGR: Would the company stick to the South Pacific or would it venture as far afield as perhaps Africa or even North America?
RR: The map in OceanaGold's investor presentation highlights potential areas and the Americas is definitely an area where the company would like to invest. There are not many opportunities in Asia-Pacific at this point, but Europe could be another jurisdiction that the company might be willing to invest in. I don't think the company will be too keen on getting into Africa at this point.
TGR: What's your target and rating for OceanaGold?
RR: I have an Outperform rating and my target on OceanaGold is $3.80. It's trading at about $2.90. It had a pullback after the Q2/14 results, but that was mostly due to mine plan sequencing. The company will get into the high-grade zones in Q3/14 and we will see better results in Q4/14 and in 2015. Despite a weak Q2/14, the company still generated around $22M in free cash flow.
TGR: What about Kirkland Lake?
RR: Kirkland Lake's turnaround will depend on management successfully implementing its higher-grade, lower-throughput strategy. We have seen it work so far. Q1/15 results show a marked improvement in grade. The mined grades were 0.4–0.5 oz/ton whereas historically they have been around 0.3–0.35 oz/ton. Investors would likely need to see a few more quarters of consistent performance before they decide to jump in. We have seen an initial rerating happen over the last few weeks on the back of strong operational results, but there's not a lot of room for operational errors.
The real upside for this story is the near-surface mineralization the company discovered last year. The development of that is at least 18–24 months away and could require around $20–25M. It's not a big capital cost, but it might go a long way to filling the company's 2,200-ton-per-day capacity mill. Right now it's operating at close to 1,050 tons a day. The near-surface potential provides Kirkland with additional ore to fill the mill, but at a lower cost because it's within 1,000 feet from surface.
TGR: What's your current target?
RR: I have a Speculative Risk/Outperform rating and my current target is $5. The stock is trading above that but I'll wait for the next round of financial results before I decide to look at my valuation.
TGR: What are some other small producers under coverage?
RR: Some names that I cover have witnessed successful turnarounds in operations over the last year or so. Lake Shore Gold Corp. (LSG:TSX) and SEMAFO Inc. (SMF:TSX; SMF:OMX) are two great examples. SEMAFO is one of the better stories out there with robust free cash flow yield and a strong balance sheet. However, the company seems fairly valued at this point.
Lake Shore has also had a great run and I expect the company to continue to rerate as it pays down debt. There's been some concern about the mine life at Timmins West, but the ongoing exploration program there should deliver some positive results by year-end. That could provide a boost to the stock price.
TGR: What's your target and rating on Lake Shore?
RR: I have an Outperform rating and $1.40 target. My investment thesis is not only about Lake Shore's ability to generate cash flow, but also the potential for a rerating. It is now trading close to five times. In our coverage universe the average price to cash flow multiple is around 10 times. I expect it to reach seven or eight times cash flow. But a more sustained rerating would also depend on the company increasing its mine life, which I think could happen by early 2015 when it publishes a new reserve and resource estimate.
TGR: Some pundits have suggested that SEMAFO could be a takeover target. What are your thoughts?
RR: It is too expensive for the return at this point. There have also been talks about whether SEMAFO could acquire something but management would not want assets with a lower return than the recently discovered Siou deposit, which SEMAFO started mining in Q2/14. Siou is an open-pit deposit at over 4 grams gold per ton—that has really driven the change in SEMAFO year-to-date. There's a lot of exploration potential at Mana and closer to Siou. The company would rather put its capital into developing those deposits as opposed to paying a premium for an acquisition. Until a project jumps off the page, I don't think SEMAFO would be interested in acquiring anything. I'm still positive on the company given its ability to perform well in a weaker gold price environment.
TGR: What's your current target and rating on SEMAFO?
RR: I have a Sector Perform rating and my target is $5.15.
TGR: As an analyst in this business you're probably traveling 10 times a year to different projects. What are some that you visited recently?
RR: Recently I've visited Kirkland Lake, Lakeshore and Seabridge Gold Inc. (SEA:TSX; SA:NYSE.MKT). Seabridge has the Kerr-Sulphurets-Mitchell (KSM) copper-gold project in northern British Columbia. Over the last year and a half, this went from a gold project with copper byproduct credit to a copper project with a gold credit. Seabridge basically discovered the core zone of the porphyry with much higher copper grades at Deep Kerr.
There are some concerns regarding the $5.3 billion capital cost. On potential partners, large base metals companies like Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE), Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK) and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) have the technical expertise and are in a better position to finance a project like KSM than large gold producers. We typically see a 30–50% jump in stock price with the announcement of a joint-venture partner.
Given their respective issues in other countries, the companies I listed want to invest in projects in mining-friendly jurisdictions. The concern with investing in North America is always permitting. Seabridge has, to some extent, derisked the project for permitting. The provincial approval is already in place. The federal approval is expected October.
TGR: What are your top picks in the producer and developer spaces?
RR: Among the producers, my top picks are OceanaGold and Lake Shore Gold. In the developer space I like Seabridge and True Gold.
TGR: Parting thoughts?
RR: The gold space is still going through a period of operations consolidation. Companies have reworked their mine plans and are starting to see the benefits. We will see that play out further in H2/14. We still believe that the gold price environment could be muted over the next 6–12 months. Companies that would perform well in this environment are companies that have low cash costs and operational flexibility.
TGR: Thank you for your insights, Raj.
