Everyone loves good management, but Ralph Aldis, portfolio manager with
U.S. Global Investors, argues that few in the mining industry understand that
the proper allocation of capital and the valuation of assets are the two
criteria that separate the winners from the losers. In this interview with The Gold Report,
Aldis highlights a dozen gold miners that get it and are likely to flourish
even with continued low gold prices.
The Gold Report: The price of gold is flirting with a
five-year low. Do you attribute this solely to the strength of the U.S.
dollar, or are there other factors at work?
Ralph Aldis: There are other factors. Most important is the
strength of the equity markets. Looking at a six-year window, we have seen,
for the third time in the last hundred years, the highest returns for such a
period. This happened before in 1929 and 1999. These phenomenal returns have
been fueled not by fundamentals but rather by the U.S. Federal Reserve, which
is trying to jumpstart the economy.
All this has taken people's eyes off gold, but it won't go on forever.
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TGR: The bear market in gold equities is now four years old. This
means lower gold production and less exploration. Gold production from South
Africa has collapsed. Shouldn't lower gold production result in a higher gold
price?
RA: Yes, but it's not always linear. The amount of gold mined
annually is relatively small compared to total gold supply. That is one of
the reasons some people argue that the mines don't matter that much. But I
think on the margin they do.
South African gold production has fallen. And not that long ago, the
central banks were selling 400–500 tons per year of gold to the market. Now,
they're buying 400–500 tons. China is the world's largest gold producer, but
it's not exporting. We can see what's happening and be invested for it, but
we don't know when lower supply will lead to higher prices.
TGR: How do you see the mining industry adjusting to lower gold
prices?
RA: I look at the income statements from all the mining companies
and calculate their break-even point. Right now, it is about $1,149 per ounce
($1,149/oz). The forecasted average 2015 gold price remains about $1,200/oz.
If the gold price continues to fall, companies will adjust. Some projects
won't be built, but that is good because those are marginal projects.
About 40 CEOs in the mining industry have lost their jobs in the past
couple of years. The new generation of mining CEOs is focused more on profit
than growth. They know that even if the gold price falls more, the suppliers
to them must drop their prices. If the gold price goes $100/oz lower, the
smart companies will survive. Meanwhile, gold miners now benefit from lower
energy prices, while the stronger U.S. dollar has been very positive for
Canadian and Australian miners.
TGR: Why do you believe gold stocks can still deliver favorable
returns?
RA: Because of the mindset of some of these new CEOs. One company
doing the right things is Klondex Mines Ltd. (KDX:TSX; KLNDF:OTCBB). It was up 29%
in 2013, while the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.Arca) was
down 61%. In 2014, Klondex was up 21%, while the Market Vectors Junior Gold
Miners ETF was down 23%.
Investors will need to buy very selectively, and they will need to buy
those companies that are not growing ounces at thinner margins. Companies
that know how to, if necessary, shrink production in order to get acceptable
margins.
TGR: Could you explain the "Five Principles of Capital Allocation" and how they
pertain to mining, given that mining companies typically have no revenues for
years after their founding?
RA: These five principles are the work of a Credit Suisse writer,
Michael Mauboussin. They apply to some companies in the exploration and
development phase but obviously more so to producers.
The first principle is "Zero-Based Capital
Allocation." This means, for instance, that you don't give your
exploration department $20 million ($20M) this year solely because they got
$20M last year. Companies need a strategy to determine the proper amount of
capital spending.
The second principle is "Fund Strategies, Not Projects." In
other words, capital allocation is not about assessing and approving
projects; it is about assessing and approving strategies and then determining
the projects that support those strategies. It is a common mistake for
explorers to continue to push a project forward—particularly if it is its
only project—even though it lacks the potential for great returns.
Randgold
Resources Ltd. (GOLD:NASDAQ; RRS:LSE) is a good example of the proper
approach. When it evaluates a project, it's looking for grade sufficiently
high that it can produce a good margin at a $1,000 pit shell or even an $800
pit shell. Restricting your return calculation to the pit shell is more
conservative, as you are only including those ounces contained within the
mine's engineering plan.
TGR: Don't companies with only one project face a particular
problem? Given that the market demands constant news, if a company does an
internal evaluation that suggests that its sole project is marginal and then
reorganizes to seek new projects, won't the disappearance of news about the
original project lead to the market concluding that the company has
essentially closed up shop and then valuing it to zero?
RA: I agree. Look at Allied Nevada Gold Corp.'s (ANV:TSX;
ANV:NYSE.MKT) Hycroft mine. It was premised on a higher gold price, but there
were probably things Allied Nevada could have done to maximize wealth as
opposed to merely moving forward. It might have closed down Hycroft sooner
and perhaps salvaged some value as opposed to being forced into bankruptcy.
TGR: What is the third principle?
RA: "No Capital Rationing." Typically, miners believe
that capital is scarce but free. They believe that profits are free money, or
if they're raising equity, they sometimes don't seem to care enough about
dilution. Properly speaking, capital is plentiful but expensive. Profits need
to be spent in a manner that results in future profitability. And equity financing
is only plentiful if you have a good project.
No. 4 is "Zero Tolerance for Bad Growth." In other words, don't
throw good money after bad. Barrick Gold Corp. (ABX:TSX; ABX:NYSE) fell into that
trap with its Pascua-Lama project in Argentina. Long before its price tag
reached $8.5 billion ($8.5B), the company should have thought hard about
whether it would ever generate good returns. Mining companies should always
seek to upgrade their portfolios.
TGR: And what's the final principle?
RA: No. 5 is "Know the Value of Assets and Be Ready to Take
Action to Create Value." So many people in the mining industry don't
know the value of their assets. We value companies based on their resource statements,
and we get a very high correlation to where these stocks trade. But we
constantly see companies decide to spend, for example, $1.8B on a project
that the market values at only $800M. It makes no sense to spend that much
because similar projects could be acquired for less capital.
To sum up, the proper use of capital allocation is to maximize long-term
value per share.
TGR: Besides understanding capital allocation, what else do you
look for in management?
RA: A significant ownership stake. You get a much higher standard
of care when you're an owner instead of a mere manager. Investors need to
look at a company's general and administrative expenses, whether it is in
production or not. If those expenses are too high, this tells you that the
managers' interests are not aligned with the shareholders' interests.
TGR: Let's talk about specifics. Which are your favorite Canadian
gold producers?
RA: Those that are focusing on profit. If they have debt, they pay
it down; they maximize their returns. Kirkland Lake
Gold Inc. (KGI:TSX) is one example. CEO George Ogilvie has really done a
great job in turning that company around.
Another example is Claude Resources Inc. (CRJ:TSX). Its CEO is Brian
Skanderbeg. Claude has been around for a long time, but its new management
understood that it had to change its mining method, which has made a big difference.
Another company with new management doing the right things is Richmont Mines
Inc. (RIC:NYSE.MKT; RIC:TSX). Recently, Renaud Adams joined Richmont as
president and CEO, and he is highly respected on the street. In addition,
Renaud is a board member of Klondex Mines where he has helped oversee its
success. With the higher grades Richmont is encountering at Island Gold Deep,
I believe the company has a much more robust asset to work with now.
TGR: Kirkland Lake announced March 11 year-to-date free cash flow
generation of $22M. Were you impressed by that?
RA: Yes, I was. Lake Shore Gold Corp. (LSG:TSX) is another company that
really seems to have figured it out. It repaid $45M in debt in 2014 and now
has $60M in cash and bullion.
TGR: Can you comment on any major Canadian gold producers?
RA: Goldcorp
Inc.'s (G:TSX; GG:NYSE) bid for Osisko Mining Corp. ran the risk of
buying a great company at the wrong price, so I'm glad that CEO Chuck Jeannes
walked away. Since it announced its takeover attempt of Osisko, Goldcorp has
sold its Wharf mine in South Dakota to Coeur Mining Inc. (CDM:TSX; CDE:NYSE)
and its Marigold mine in Nevada to Silver Standard Resources Inc. (SSO:TSX;
SSRI:NASDAQ).
TGR: What's your opinion of Goldcorp after these deals?
RA: Goldcorp has done a really good job of capital allocation. It
looks at the cash that it's generating, and it looks at how to maximize the
assets on its balance sheet. It created Silver Wheaton
Corp. (SLW:TSX; SLW:NYSE) and Tahoe Resources
Inc. (TAHO:NYSE; THO:TSX) out of existing assets. It helped create Primero Mining
Corp. (P:TSX; PPP:NYSE). So I give it kudos. It is a little bit
undervalued on our models but not terribly.
TGR: Can Barrick rescue itself?
RA: The company is talking about returning to the old Barrick
model, but I don't know if it can do that. It certainly faces a lot of challenges.
TGR: What's your favorite junior gold producer in the U.S.?
RA: I've already mentioned Klondex in Nevada. It is my favorite
junior producer anywhere. Considering what it has achieved and what it is
likely to achieve, I think it probably offers at least a double of its
present share price. Some people might say it has a short-life resource
statement, but the recent discoveries at Fire Creek are not yet in the
resource statement. And the free cash flow it generates will pay for its
exploration program at Midas. I expect more discoveries from Klondex and a
bigger resource statement. Its very robust ore body will allow it to produce
gold at even lower prices, should the market demand that. I talk to its
management team, and they understand capital allocation.
TGR: What's your favorite gold producer elsewhere in the world?
RA: I like Mandalay Resources Corp. (MND:TSX). Its management is
very experienced in rescuing assets that have been mismanaged. Mandalay has
turned around the Cerro Bayo silver-gold mine in Chile and the Costerfield
gold-antimony mine in Australia. Last year, it bought the Björkdal gold mine
in Sweden from Elgin Mining, and I think Mandalay will turn that around too.
Management owns a lot of stock. Mandalay pays a healthy dividend: 5.4%.
The market has not yet completely woken up yet to this stock. We still think
it's easily a 100% gain. It's one of our top five holdings.
TGR: You mentioned earlier that you admire Randgold.
RA: CEO Mark Bristow, as ornery as he can be, deserves all the
respect in the world. We download all the data, taking the quarterly net
income or net operating profit after tax provisions (NOPAT), multiply that by
four and divide it by the investment capital base to get a quarterly return
on invested capital. We did that with the Market Vectors Gold Miners ETF
stocks, and Randgold came in with a 10.32% median return on invested capital.
That's for 8+ years. We also measured the volatility of these returns over
time, and Randgold's was only 6.4%.
Over the same time period, Barrick had a median return on investment
capital of 7.09% with a quarterly volatility of 24.4%. So Randgold gets about
twice the returns with half the volatility. That's management skill for you.
TGR: What are your favorite silver producers?
RA: There are two that really stand out to us based largely on
management skill and management ownership of stock. The first is Tahoe
Resources. Kevin McArthur is the CEO. It recently bought Rio Alto Mining
Ltd. (RIO:TSX; RIOM:NYSE; RIO:BVL), which has two run-of-mine heap-leach
mines in Peru. One is in production. Alex Black will be the new CEO of the
new company. He put Rio Alto in production for very little capital and
achieved tremendous returns for shareholders.
The combination of McArthur and Black results in a team that really
understands the value of assets and has the ability to deliver. We like high
grade, but adding those heap-leach mines gives Tahoe more flexibility. That's
one of the things we look for in companies.
TGR: And what's the second?
RA: Fortuna
Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE). The Ganoza
brothers have done a great job, especially with the San Jose mine in Mexico
and the discovery Fortuna has made there. This is a management team that
understands capital markets.
TGR: What are your favorite near-term production stories?
RA: The one with the biggest potential is Pretium
Resources Inc.'s (PVG:TSX; PVG:NYSE) Brucejack project in British
Columbia. If its resource matches its published results, this is one of the best
discoveries we've seen in the last decade. Its initial bulk sampling
delivered 10% more ounces than expected. It is now drilling to confirm that
the ore body is pretty well mathematically modeled. We anticipate substantial
value correction based on our models. Pretium probably leads the pack in that
category right now.
In Northern Ireland, Dalradian Resources Inc. (DNA:TSX) and CEO Patrick
Anderson have a very good, well understood, high-grade gold project at
Curraghinalt. Patrick also has a successful track record in selling Aurelian
Resources, which was one of the best gold discoveries in the prior decade, to
Kinross Gold Corp. (K:TSX; KGC:NYSE) in 2008. It is important to us that management
understands capital markets.
We also like Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) in Nevada.
CEO Bill Howald staked the unpaid mineral rights at Coeur Mining's Rochester
mine. As a result, Rye Patch got about a $21M settlement in the form of a
royalty on Rochester. Rye Patch's Lincoln Hill deposit is within kilometers
of Rochester. Howald has about a $26M budget to bring that into production,
but I expect that after he does all the technical work and gets his
permitting, Coeur will take it out and thereby extend Rochester's mine life.
Because Howald has funded Rye Patch with that royalty, and Lincoln Hill is
such a simple, cheap operation, he doesn't need to come to the market and
dilute shareholders, so Coeur taking it out should be a slam dunk. In
addition, Rye Patch has two other targets quite close to Lincoln Hill.
TGR: What about a gold project in South Carolina?
RA: Romarco
Minerals Inc.'s (R:TSX) Haile project is fully funded. What was
interesting about that company's last financing is that I think that a major
gold mining company may have participated in the placement, which speaks to
the company as a potential takeout target in the near term. Haile is
completely derisked, and so for a bigger producer with production drop-offs
or operations in less-safe jurisdictions, Romarco makes a lot of sense.
Haile has great potential to grow over time. And management was smart not
to supersize the project. This goes against the history of the 20 years,
where investment bankers see a net asset value (NAV) model with cash flows
extending into years 10–20. They believe these cash flows aren't worth
anything, and so the project size is doubled to move the cash flows forward
and maximize NAV. That's the worst thing you can do, and Romarco hasn't done
it.
TGR: What's your favorite royalty company?
RA: Osisko
Gold Royalties Ltd. (OR:TSX) probably has the safest royalties. It has a
lot of room to grow but not so much as to draw the attention of Franco-Nevada
Corp. (FNV:TSX; FNV:NYSE), Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) or
Silver Wheaton. Osisko's royalties might be too small for the big players,
but royalties such as the 5% on Malartic and the 2.2–3.5% on Éléonore are
tremendously valuable to Osisko. These Canadian mines will continue to produce
for a long time.
TGR: Do you approve of its takeover of Virginia Mines Inc.?
RA: Yes. CEO Sean Roosen is a marketing genius, and this takeover
complements the Canada-centric powerhouse he has put together. The company
owns a significant stake in Falco Resources Ltd. (FPC:TSX.V). It has
royalties on a portfolio of projects Agnico Eagle Mines Ltd. (AEM:TSX;
AEM:NYSE) and Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) control after
their takeover of Osisko Mining.
Plus there is a whole suite of Canadian assets it would make a lot of
sense for it to get involved with. Maybe it does something with Integra Gold
Corp. (ICG:TSX.V; ICGQF:OTCQX). One of the advantages Osisko Gold
Royalties has is that its assets are not dependent on other commodities.
Franco-Nevada has oil exposure, and maybe oil prices don't go up very soon.
Royal Gold has base metal exposure in some of its assets, and if prices of
those were to drop tremendously, some of its assets could be shuttered.
Osisko doesn't have those worries.
TGR: What's your favorite junior gold explorer?
RA: The one that really stands out to us is Orex Minerals
Inc. (REX:TSX.V). It's not well known now, but everybody would know the
deal that its management was last involved in, the sale of Orko Silver Corp.
First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE) tried to buy Orko but
was outbid by Coeur. Now management has returned with a new company with four
assets.
Orex has just signed a joint venture (JV) on its Barsele project in Sweden
with Agnico Eagle. It took a year to negotiate. At the time the deal was
announced, Orex had a $30M market cap. Agnico gave it $10M and will spend a
further $7M into exploration. As you know, Agnico already has assets in that
area, and if Barsele meets the test, Agnico will probably do something
serious with it.
Orex also has a JV with Fresnillo Plc (FRES:LSE) on one of its two Mexican
properties. Fresnillo late last year was moving more rigs on that, so I think
it liked what it saw. Orex has an asset in Canada that it will probably be
able to JV. This company has great geologists, and its management knows how
to make deals.
TGR: Realistically, how many gold producers are prudent
investments?
RA: Of the 80 or so producers that Western investors can buy into,
there are about 20 that get it and have the flexibility to be able to adjust.
Not so much the seniors. It's the smaller, midsized companies that have a
better handle on their operations.
TGR: Ralph, thank you for your time and your insights.
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