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The Gold Sector Is On Sale: Michael Fowler

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Michael Fowler, senior mining analyst with Loewen, Ondaatje, McCutcheon sees small- and mid-cap junior producers and developers as the "sweet spot" in the gold equities space, and provides a basket of names to consider in each space. In this exclusive Gold Report interview, he also shares his views on the irresponsibility of the "new paradigm" of large-scale financings now in vogue.

The Gold Report: Let's start with the changing risk picture in the gold space. Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) and Kinross Gold Corp. (K:TSX; KGC:NYSE) are down by about 50% and 75%, respectively, from their 52-week highs. Both would once have been considered low risk. Are there no low-risk companies in the gold space today?

Michael Fowler: I think that is correct, Brian. Right now, any gold stock is fairly risky due to a combination of factors. First off, gold stocks and the gold price are very volatile. Second, gold mining is a tough business, subject to unforeseen circumstances. Despite the size of Agnico-Eagle, Kinross, even Barrick Gold Corp. (ABX:TSX; ABX:NYSE), I would attach a fair degree of risk to each.

TGR: If investors have to assume risk with gold equities, does it make sense to go with small- and mid-cap companies where the rewards can be higher?

MF: Yes, I think investors should be more focused on junior producers and, to some extent, explorers. That is where you will get the most gain.

For example, since 2004, Barrick's share price has risen 12%/year, whereas the share price for Randgold Resources Ltd. (GOLD:NASDAQ), a junior producer, rose more than 40%/year.

TGR: Before we leave the large caps, will companies like Agnico and Kinross get takeover bids this year?

MF: I do not think Agnico or Kinross will be taken over because the senior gold companies are learning that mega-mergers do not make much sense; they have not brought superior returns for shareholders.

The other thing having an impact on the mergers and acquisitions space is that the share prices of the potential acquirers are declining. They no longer have currency for acquisitions.

TGR: On March 14, the gold price dropped $40/ounce (oz); in late February it crashed $110/oz in one day. Is this due to the perception of a strong U.S. economy, or is that too simplistic?

MF: I think that is correct and somewhat simplistic. Before the recent release of good economic data, the feeling was that the Federal Reserve would enter into a third round of quantitative easing (QE3), to increase its balance sheet and monetary liquidity. Now that the U.S. economy is moving along at a reasonable, although slow, clip, the Fed is hesitant to go the QE3 route. As a result, gold has sold off.

TGR: Should we expect more of the same in 2012?

MF: While gold will be difficult in the short term, my thesis on gold is very bullish. The whole world is involved in increasing both the money supply and liquidity. Interest rates are very low and it seems as though the Federal Reserve will not increase them for the time being. Countries around the world are engaging in almost competitive devaluation of their currencies. For the longer term, this is very good for gold.

TGR: When do you expect that uptick to occur, perhaps when the next battle over raising the U.S. debt ceiling starts?

MF: That would help, I suppose. When the U.S. presidential election gets closer, there will be more fuel for gold. For the next month or so, gold will have a problem but after that, it will turn around.

TGR: Your varied coverage in the gold space generally consists of small producers and near-term developers. Are they the sweet spot in the gold space in terms of risk versus reward?

MF: Yes, in particular the junior producers. Eventually, the developers and explorers will catch investors' interest. We focus on this area because: number one, we see ourselves delivering service to our clients; number two, we believe the returns in the smaller cap names will outperform the larger caps.

I think the whole of the gold sector is on sale at the moment, although you have to be selective in where you invest.

TGR: What is the risk profile of the one-mine miners and developers versus the majors?

MF: Quite frankly, it is high. In general terms, a multi-mine company has lower risk than a one-mine company. However, if you have one really good mine, that is better than having a number of very poor mines.

Among developers, their biggest hope is to be taken over because the history of developers going on to be producers is not very good at all.

I would recommend having a basket of junior producers and developers, such that you are not dependent on one particular company that could blow up.

TGR: For developers, is this the best place to be just before they bring the mine into production?

MF: No. I'll expand on the answer to that question; there are various stages. The first place to be is in companies that have one or two mines and look to be growing by 20–25%/year.

The next place to be is in an emerging producer with good grades that could work out well. Lastly, I would suggest a developer that is likely to be taken over in one or two years.

TGR: Why are producing companies performing so poorly, given that most of the feasibility studies on their mines were done using a gold price of $1,000/ounce, hundreds less than the current price?

MF: I think there are numerous factors behind that. One, investors can avoid all of the issues producers present by putting money into exchange-traded funds. Two, there have been some production hiccups recently, Agnico-Eagle among them. Three, some equities have been over-diluted. I have been critical of deals made where the company did not need the money, but nonetheless diluted its share base when the performance was not there. Four, there has been cost and capital inflation in the sector.

TGR: One example of that is Lake Shore Gold Corp. (LSG:TSX). It just cannot get its price above $1.60/share, although it was well above $3/share not that long ago.

MF: Lake Shore has been underperforming in terms of production expectations, and it is a very good example of what is going on in the industry right now, but Lake Shore is not alone. Kinross blew up because it paid too much for an acquisition. There have been all sorts of disappointments, which is one of the big reasons gold stocks look very cheap right now.

TGR: Do you remember another time when gold equities performed so poorly versus the gold price?

MF: The 2008–09 debacle comes to mind, but that was less to do with gold equities and more to do with the risk environment in the general market. Gold prices stayed fairly firm then, but gold stocks got clobbered in the risk-averse trading that went on.

TGR: Should investors be concerned?

MF: They certainly should take account of what is going on. The good news is that many gold producers are showing margin increases because the gold price has gone up faster than cost inflation.

There is a ray of sunlight coming through. We will not return to the same multiples we were at in the 1990s and mid-2000s. Instead, we will go back to something closer to the mean. Longer term, margins will continue to increase, earnings will go up and, eventually, so will stock prices.

TGR: Let's get to some of the companies you cover. Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.A) operates the Casa Berardi gold mine in Québec, which is scheduled to run until 2020 or 2021. How does Aurizon plan to augment its production profile between now and then?

MF: The main factor is its Joanna development project, located on the Cadillac break in Québec. It is going through a feasibility study right now, and indications are that it could be producing more than 100,000 ounces (100 Koz) out of Joanna by 2014. This would augment production from Casa Berardi, which produces about 160 Koz/year.

Aurizon can also increase production at Casa Berardi, whose many potential working faces give it flexibility. In total, Aurizon's potential production is in the 240–270 Koz range, compared to the 160 Koz it is now producing.

TGR: Its Marban exploration property also looks interesting.

MF: Whether Marban will be a mine is a little bit up in the air at this moment. The interesting area at Marban is something like 200–300 meters below the surface. I think Aurizon would dearly love to see something closer to the surface in an open-pit scenario. I think the jury is still out on Marban.

TGR: Does Aurizon have any upcoming catalysts for investors to look forward to?

MF: I think its Q411 financial results would be one. [Ed. note: after the interview Aurizon released Q411 financial results, including earnings of $21.8M, up from $7M in Q311.] It has been doing pretty well at Casa Berardi. That is not an easy mine, but Aurizon is cranking cash flow out of it.

The main catalyst will be the feasibility study at Joanna. The company lowered the expectations for Joanna close to a year ago. A robust number out of Joanna will catalyze Aurizon's share price.

In addition, Aurizon Mines is a fairly cheap stock for a producer compared to others.

TGR: What is another store in your coverage universe?

MF: We like Northern Freegold Resources Ltd. (NFR:TSX.V). A lot of the Yukon plays are limited to helicopter trips into their properties, while Northern Freegold benefits from a road and a nearby power line. The property is a large, porphyry-style project. It hosts about 6 million ounces (Moz) gold equivalent (Au eq), 2.8 Moz gold per se, with copper in the deposit. The stock trades at $5/oz on an Au eq basis, which is exceedingly cheap, compared to an average of around $50/oz or so. There is a lot of potential to increase the resource.

TGR: Why is it meaningful that this is a porphyry system?

MF: In this case, it means it is a large, open-pit, fairly low-grade deposit. You have to be a little careful with this type of deposit, making sure it is near infrastructure and that the geometry and metallurgy of the deposit are good. Northern Freegold has gone some way down the path of assuring those things. It also has new management, which is making great efforts to make people aware of its story.

TGR: This is a copper-gold-molybdenum deposit. Large copper-gold deposits have been developed in British Columbia (B.C.) before, but not in the Yukon.

MF: Correct. Some B.C. mines have fewer infrastructure advantages than this one, so there's no reason why the Yukon couldn't have a large open-pit type of operation.

Western Copper and Gold Corp.'s (WRN:TSX; WRN:NYSE.A ) Casino project is just down the road. It is going through a final feasibility study and the company is very optimist about bringing its porphyry deposit into production. I think Northern Freegold actually has infrastructure advantages over Casino.

TGR: Can you give us another name?

MF: We like Fortune Minerals Ltd. (FT:TSX), with two very large projects. One is NICO, a cobalt-gold-bismuth-copper deposit. It has about 1 Moz gold. That project has a full feasibility study and is going through a permitting study now. I think the company would like to joint venture NICO into production.

The other is the Mount Klappan coal project. It is anthracite, better known as metallurgical coal. Because our focus is gold, I will be brief. Metallurgical anthracite can be used in producing steel, and there is a tremendous market demand right now. The company's partner at Mount Klappan is Pohang Iron and Steel Co (PKX:NYSE), also called POSCO.

If you add the net present values of those two projects together from the feasibility studies, you arrive at close to $5/share for each Fortune Minerals share, at an 8% discount rate. It is now trading around $0.96/share. I see a lot of value here. I think that joint venturing the copper-gold deposit at NICO will take out the financing risk and the share price should gain as a result.

TGR: You are on a roll, Michael. Do you have any other names you want to discuss?

MF: Clifton Star Resources Inc. (CFO:TSX.V) is trading around $1.75/share. It has a project close to Rouyn-Noranda, Québec. To my mind, Québec is almost the best place in the world to find a deposit. Its Duparquet project has already outlined 3 Moz gold in several NI 43-101 reports and will release a revised resource in April. I think it may be closer to 5 Moz gold at 0.5 gram per tonne cutoff.

Earlier, the B.C. Securities Commission cease-traded this stock because it found disclosure deficiencies. Now, new management is in place and the fundamentals and the resource are still there. We feel it has good potential for becoming a mine and for a joint venture or being taken out in time.

I should mention that Osisko Mining Corp (OSK:TSX) was in a joint venture with Clifton Star, but Osisko walked from the project because it didn't see it as a Malartic bulk-tonnage situation. The mineralization is more discrete, but that does not take away from its mineability.

TGR: Is Clifton Star undervalued given the recent changes?

MF: I think so. We like to see valuations below $25/oz in the ground, and to some degree, that is why we picked Northern Freegold and Moneta Porcupine Mines Inc. (ME:TSX.V). Clifton Star trades at $25/resource ounce, based on a $5 Moz project. That valuation includes the fact that Clifton Star will have to raise approximately $50 million (M) to fulfill its obligations as an option to buy 100% of the property.

TGR: Tell us about Moneta Porcupine and its project on the same fault line as Clifton Star's.

MF: Aurizon Mines, Clifton Star and Moneta are all on big, east-west fault lines. Moneta Porcupine is on the Ontario side of the border with Québec, on the Destor Porcupine Fault. Moneta recently came out with a very pleasantly surprising resource on what it calls the Golden Highway project of 3.14 Moz gold. It trades at roughly $10/oz in the ground, which is cheap. Moneta seems to be successfully tying up some of the pits outlined in its resource study.

TGR: Is it difficult for juniors like Moneta Porcupine and Clifton Star to raise money, given that they are pure exploration plays?

MF: The financing environment is a bit eclectic at the moment and probably is getting worse as we speak. But there is money out there, focused on selective companies or selective deposits.

We usually find that the time to invest in a company is when essentially nobody likes the sector. You do not want to be buying when every institution is buying; that is a good signal that you are on a high.

I want to emphasize that we have seen a lot of companies raise $20M or $30M when they did not need the money. There is a new paradigm going on. We used to raise money for one or maybe two field seasons, and the amount raised was $5–10M, maximum. Today, some of these guys are raising $30–40M. Quite frankly, I think that is irresponsible.

TGR: That's a pretty brash statement.

MF: Over-equity dilution depresses the company share price. From the companies' perspective, managements are running scared. They say that they have to raise money now to take care of themselves for many years.

But you have to ask why institutions are giving juniors money every time they come back to the well. If you give a company $40M, you will not see that company for the next five years; it can do anything it likes with the money. Management no longer has any incentive to perform on the exploration programs. There is no accountability in the one- to two-year time horizon.

I do not think that is a good thing.

TGR: Do you have any other parting thoughts for us?

MF: I realize that I have talked a lot about problems, but essentially I believe the gold price will rise. In particular, junior producers will be the first to start moving, their cash margins will increase and their earnings will rise. Then, some of these junior explorers and developers will participate in the upcoming bull market.

TGR: Michael, thank you for talking with us today.

Michael Fowler, senior mining analyst with Loewen, Ondaatje, McCutcheon Ltd., has worked in the investment industry since 1987 as a base and precious metals mining analyst for numerous high-profile firms. His coverage list included the major North American gold mining companies, but is now focused on small- to mid-sized companies. Previously, Fowler worked as a geophysicist involved in mineral exploration for 10 years. He was involved in the discovery of the high-grade Cigar Lake uranium mine in Northern Saskatchewan in the early 1980s. Fowler holds a Master of Business Administration from Cranfield University, UK; a Master of Science in mineral exploration from Leicester University, UK; and a Bachelor of Science in geology with geophysics from Liverpool University, UK. He is a member of the Institution of Materials in the UK and a member of the Canadian Institute of Mining and Metallurgy.

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1) Brian Sylvester of The Gold Report conducted this interview on 3/14/12. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Aurizon Mines Ltd., Northern Freegold Resources. Streetwise Reports does not accept stock in exchange for services.
3) Michael Fowler: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
4) Loewen Ondaatje McCutcheon Ltd. has acted in an underwriting capacity for Northern Freegold, Moneta Porcupine Mines, Fortune Minerals and may own shares in these companies.

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