EQUITY RESEARCH

Royal Bank of Canada - Sydney Branch

Cameron Klutke (AVP)

+61 3 8688 6551

[email protected]

Paul Hissey (Analyst)

+61 3 8688 6512

[email protected]

May 12, 2016

Australian Golds: Trading focus on free cash flow as bull market gains momentum

Rewarding near-term free cash flow as trading outlook shortens

With the recent rally in the underlying gold price, gold equities are moving well beyond our fundamental valuations (NAV). We view some of the recent trading events, especially for Resolute Mining (RSG) up c.290% so far in 2016, as highlighting the increasing emphasis on companies' abilities to generate free cash flow.

Our preferred picks in regards to improved free cash flow moving forward are:

• Saracen Mineral Holdings (SAR, Outperform; price target A$1.40) - We continue to see the extensions to known mineralisation at all current operations to show increased confidence in mine life extensions and therefore valuations. From a cash flow prospective, the recent commissioning of Thunderbox should provide greater free cash flow as capex is expected to be reduced significantly. We also see the growth of the company to be a stand-out in our domestic peer group.

• Silver Lake Resources (SLR, Outperform, Speculative risk; price target A$0.60) - Despite the next three to six months providing generally flat free cash, the development of both Maxwells underground and Imperial/Majestic should provide for increased head grades to the Randalls mill and therefore strong free cash generation into the later half of 2016. Like SAR, SLR's near mine exploration potential looks very attractive, where this strong free cash flow should aid ongoing exploration spend.

  Valuing gold producers purely on NAV is becoming a trap...

  We continue to see the ongoing disconnect from fundamental valuation to current market valuations of gold equities.

  The current bull market in gold equities has resulted in greater emphasis on free cash flow, and although we respect this current trading environment, looking further ahead we caution towards the companies which cannot sustain these strong cash flows and high valuations.

  Organic growth still remains a key factor in our preferred stock picks...

  Although companies have benefited greatly from M&A, providing production growth for the business, we believe the longer-term outlook for organic growth will provide us with greater confidence that current valuations can be maintained.

  Since gold equities have recently clearly outperformed both the underlying USD and AUD gold prices, and if this discrepancy is to be maintained, it is the companies that can demonstrate ongoing replacement of mine ounces and that can grow their inventories which we prefer against those who may need to further acquire assets to maintain current output. We also believe this market is now providing less opportunity for acquisition of value adding assets in the gold space.

  Connor O'Brien (Associate)

  +61 3 8688 6519

  [email protected]

  Priced as of prior trading day's market close, EST (unless otherwise noted).

  All values in AUD unless otherwise noted.

  For Required Non-U.S. Analyst and Conflicts Disclosures, see page 15.

  Forget about NAV, a bull market rewards free cash flow multiples…

  As part of the sharp increase in gold equity valuations over the last five months we explore what we believe to be the market's preferred valuation methods in the current bullish gold environment. With most fundamental valuations now well below current trading levels, we believe the market is now more heavily focused on:

  • Valuing stocks with a higher emphasis on near term cash flow, and potentially

  • Factoring in a higher gold price environment - as gold continues to show strength

    Moving toward a cash flow based valuation

    Although we generally value companies using a blend of cash flow and NAV (taking in the longer-terms projections of a business), we believe that with the ongoing strong rebound in gold equities, the market is now looking more firmly towards those with stronger or increasing free cash flow.

    The best example of this would be the dramatic appreciation in value delivered by Resolute Mining (RSG). The stock has surged c.290% since the beginning of the year.

    We believe the market's excitement in the stock is largely due to the dramatic turnaround in the free cash flow generated recently, however the longer-term aspects of the company have not changed significantly since the beginning of the year, potentially outlining that shorter-term trading strategies are being employed (see Exhibits 1 and 14).

    Cycles within cycles; trading for free cash flow turnaround…

    We focus on which stocks in our domestic coverage have the potential to significantly increase their near-term free cash flow and which may struggle to grow in this regard. (Although Resolute has been the stand-out here, we believe the company may have already hit peak free cash ability from its operations.)

    The winner -

  • Saracen Mineral Holdings (SAR; Outperform; price target A$1.40) - We expect SAR's free cash flow to see a strong turnaround from the JunQ'16 onwards. The company has now completed the build of its newest asset Thunderbox, and should see a significant drop in the investing cash outflows (capex). We expect it to generate c.300koz Au p.a. from FY17 onwards, and so the group all-in sustaining costs should still generate good margins of c.A$500-600/oz Au. We continue to like the

    near-term cash flow ability, but perhaps more importantly, SAR has a number of extensional targets which should provide the company with increased mine life, which the market may not be factoring in at this time.

    The loser -

  • Perseus Mining (PRU; Sector Perform; price target A$0.40) - Although efforts are now being made (with the deferral of some pits in the longer-term mine plan) we think the capex required by PRU at Edikan may leave the company with relatively flat to negative free cash flow over the next 12-months. We do expect this to pick up at Edikan, however the company is committed to developing both its Sissingue project (RBCe c.A$90m) and Yaoure project (RBCe c.A$270m), applying more pressure in this regard out to FY18. We like the longer-term prospects of the company (mainly Yaoure); however with what we believe to be a higher trading emphasis on near term cash flow, PRU may be left in the shadows until Yaoure comes on line.

A broader look at cash flow…

Using P/free cash flow and P/cash flow multiples, we can understand the broader market valuations.

Despite OGC currently building Haile, producing a negative free cash flow in the near term, the market is looking straight through this as providing great value to OGC once Haile enters first production (MarQ'17) against the remainder Tier II group with RRL the next highest price gold producer.

Again, we believe SAR harbours potential here is SAR, since it may not be a higher recognise as the likes of RRL, it will soon be producing gold at a similar rate to RRL, of c.300koz Au pa. The exhibit below outlines clearly the discount that SAR is receiving using this metric and is also showing growth in FCF/share over the next 12-months.

Exhibit 1: Our base case cash flow assumptions across our gold coverage; looking for declining P/CF to hold current valuations.

P/FCF P/CF

120

100

P/FCF and P/CF

80

60

40

20

DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E JunQ'17E DecQ'15 JunQ'16E DecQ'16E

JunQ'17E

0

BDR EVN NST OGC PRU RRL RSG SAR SLR NCM

Note - where P/FCF bars are not shown indicates negative value Source: RBC Capital Markets estimates

This gold market may still have legs yet, but who is best positioned to hold these values?

We look towards companies that can display a declining P/CF and/or P/FCF profile moving into the next 12 months. (We highlight that OGC, PRU and to a lesser extent SLR show a negative FCF due to higher capex from mine builds.)

Since we believe valuations are now moving towards a cash flow based outcome and further away from more fundamental valuations such as NAV, if companies are to at least maintain these levels of trading we must identify the stocks with upside (in cash flow).

We view SAR, NST, OGC and SLR as the strongest contenders to provide the market with increased confidence over the next 12-months to display potential growth from the current reserve base (after mining deletion).

Since many of the Australian producers now display smaller and smaller mine lives (largely as a factor of more underground production), the emphasis on mine life to value companies becomes more prominent.

Exhibit 2: Share price performance for 2016.

350%

Share price growth since 1 Jan 2016

300%

250%

200%

150%

100%

50%

0%

RSG SLR BDR SAR PRU OGC NST NCM EVN RRL

Source: RBC Capital Markets estimates

As we expected, the smaller gold names have outperformed the larger companies so far for 2016. The clear stand-out in performance is Resolute Mining (RSG), which has experienced the largest turnaround in free cash flow, and we expect the company to be debt-free by SepQ'16.

Valuing stocks purely on NAV is becoming a trap in this market…

Looking at valuing gold companies purely on NAV can provide a greater longer-term outlook for the business; however recently the market seems more inclined to take a shorter-term view, with a strong focus on cash generation.

Resolute Mining (RSG) is a classic example here where the longer-term prospects of the business have changed little over the last six months (we already knew the longer-term play with Syama Underground etc), however the stock has had a significant run-up since the company decided to defer the next two stages of pit cut-backs and simply process the sulphide stockpiles. Although this deeper ore will still be mined (now via underground), the only major change in the business is much greater free cash flow in the near term, with little change to NAV.

The current cash flow kings need to put the cash to good use, but where?

Although we recognise the current trading environment is heavily exposed on near-term cash flow, the companies which have bolted ahead of their more fundamental NAVs need to provide confidence in where the cash will be spent.

We view Evolution Mining (EVN) and Resolute Mining (RSG) as the two prime examples of this scenario, both with significantly higher valuations against our base case NAV.