The Gold Report: The major gold producers have ceded market share to gold exchange-traded funds and royalty companies and are vastly underperforming those investment vehicles. If you were running a major gold producer, how would you go about restoring the appeal of your company's shares?
David Baker: Mining companies need to restore trust and give more clarity. They are confusing investors because on the one hand they tell us they have so many ounces of gold in reserves and are producing so many ounces of gold, and then they confuse us by benchmarking all this to dollars—a depreciating asset. We believe the mining companies should be consistent and report in gold; this would then give investors a clearer picture on how much gold it is costing to mine the resource and how many ounces of gold are added to the shareholder vault.
"Holding gold instead of dollars will also preserve the purchasing power of the company."
There are a number of challenges out there; first is the issue of the dollar cost inflation. When measured in dollars, the capital and operating costs of a mine have gone up, but when measured in gold, costs are fairly stable. Back in 2008 when gold was $800/ounce ($800/oz), a 100,000/oz per annum gold mine would typically cost $80 million ($80M) or 100,000 oz, today that same mine will cost around $170M, again around 100,000 oz. In dollars, costs are up by over 100% but in gold ounces they are steady.
We are using the wrong measure of costs; we are using a depreciating asset—dollars—to measure costs instead of a real asset, gold. So by mixing dollars and gold we are confusing investors. Now if costs in ounces had risen, we would have a serious problem! To compound the issue, analysts are forecasting higher dollar costs and lower future gold prices. Put these together and this spells a potential margin squeeze. Under this scenario, a new gold project has little value, and the shares get de-rated.
Second, the gold exchange-traded fund (EFT) has outperformed the gold equities; how do we reverse this trend and convince investors to sell some of their EFTs to buy a gold share? As it stands today, if you sell your gold ETF to buy a gold share, what you get is a company who digs gold out of the ground, brings it to surface and then converts it back to dollars, which when you think about it, is not what the EFT holder wants. We believe gold miners need to give investors gold, not dollars, and they could start doing this by reporting in gold, holding gold on their balance sheet instead of dollars and paying a gold royalty or gold dividend.
TGR: Even if companies do put their gold production on the books, they're still going to need to liquidate some of that gold in order to meet day-to-day expenses.
DB: That is exactly right, but the balance should be held in gold. When we analyze a typical gold mine, it takes about 10% of the deposit to build the mine, 40–45% of the deposit to mine it, about 15% to pay government taxes and maybe 5% for sustaining capital. The balance, 20–25%, is the return and instead of selling this for dollars, the mining company should hold these gold ounces on its balance sheet.
"Gold is a currency that can't be printed."
Why is this a good idea? First, it makes no sense to sell an appreciating asset for a depreciating one; second, holding gold instead of dollars will also preserve the purchasing power of the company. A mining company with gold in its vault and lucky enough to discover a new gold project will no longer face a problem of capital cost inflation. As explained, capital costs are fairly stable in ounces and account for around 10% of reserves. Holding gold on the balance sheet will also act as a new source of demand, keeping more gold off the market. Gold producers should then start to emulate the ETF.
Companies should review their mission statements; they should change it ''to build and grow shareholder value expressed in ounces of gold.'' This will give management more focus and investors greater clarity.
TGR: When you bring up this idea to boards of gold companies, what's their response?
DB: I would say that overall we are getting a very positive response; they like the logic and it is certainly stimulating debate.
There is clearly an appetite for gold projects: Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) recently raised $1.9 billion to buy a gold stream off Vale S.A. (VALE:NYSE); it risked that amount for a gold stream at a fixed cost. So we can conclude there is a market for this model. Unfortunately, when gold companies sell a royalty to the royalty companies, they have been giving real margin to the royalty companies, and shareholders have ended up with less. Just look at the difference in share price performance of the royalty companies and the gold miners—it says it all. The gold companies don't give away much and they hope shareholders hardly miss the 1.75–2% of the gold they sell, but the royalty companies have made a great business out of this.
"We're looking for well-managed companies and companies that are diversified and well capitalized."
There is an understanding that something has to change, that the business model isn't exactly working for gold equity investors—we are giving our margin to others. We argue that royalties should also be paid to current shareholders of the mines. It doesn't have to be much, say 2–2.5% of the gold mined, but this will link the gold in the ground to what the shareholders get; there is then a tangible way to define what an increase in reserves means to the value of the company. After all, I tell the mining companies, "When you're going down to your pit and you do 20 shovels to put to the mill, all you have to do is one-half to one shovel to shareholders. It's not too much to ask."
TGR: How far off is that?
DB: We're starting small. Korab Resources Ltd. (KOR:ASX), an Australia-listed company, has just announced a gold reporting, gold strategy and gold dividend policy. We have others in mind. We have confirmations that the strategy will be discussed at board level for a number of companies with the view that they will adopt these policies, so we are getting traction. They are listening, but it is hard being the first mover. Our aim is to allocate funds to those companies who adopt our strategies.
In a nutshell we need to restore the trust between the mining companies and investors and we believe our strategies are one way to do just that. The miners have to be held to account.
TGR: There's precedence for this. After gold reached its all-time high in early 1981, a number of companies started forward-selling their gold so they could better control their costs. Shareholders ultimately were the benefactors of that. They've done it once before, so it can be done again.
DB: In the 1980s and 1990s, the gold price was falling and the dollar was rising. It made every sense that once you dug your gold out of the ground, you converted it straight into dollars. It was such a convincing trade that people were selling gold they had yet to mine to convert into dollars, and that was the advent of forward selling. It took about 10 years to get it entrenched that the gold price was falling, and the dollar was rising. We then took 10 years, from 1990 to 2000, for everyone to get on the trade and forward sell. At the bottom of the market, there were well over 3,300 tons gold forward sold.
TGR: Practically all production.
DB: It was over one year's annual production. Now the situation has reversed; the gold price is rising and the dollar is depreciating, and this should continue as long as the central banks carry on printing more and more money. Over the last 10 years, gold has been rising at around 15% per annum, so we are now just getting the hang of this trend. We have to become gold centric; the miners need to be forward buying gold (holding gold on the balance sheet) instead of forward selling gold. The dollar period was the 1980s to the 2000s; now we're in a gold period.
TGR: Some countries are doing that. China has dramatically increased its gold imports from Hong Kong, putting it ahead of India as the world's largest gold consumer.
DB: Many central banks are printing money. They're trying to get their currencies cheaper than others so they can capture market share and generate growth, the so-called currency wars, but they all know that if everyone is printing money, they cannot all devalue against each other. They have to devalue against something, and gold is a currency that can't be printed. So these central banks are starting to see the writing on the wall, and they're buying physical gold, converting dollars and buying gold. That's a positive. That's going to carry on. But nothing goes up in a straight line. At the moment, we're going through this consolidation, which has felt as if it's lasted forever. It's probably been about two years. Hopefully, we're coming to an end of it.
TGR: In early February, a story in Canada's Globe and Mail suggested that IAMGOLD Corp. (IMG:TSX; IAG:NYSE) could soon be the subject of a takeover bid. Do you believe there's any substance to that idea?
DB: I'm not convinced. IAMGOLD has purchased a project in Canada that is very low grade with low returns. Maybe that's the opportunity, but not in our book. Baker Steel separates the wheat from the chaff by looking at the quality of the projects. We analyze returns and how the company is going to finance the development—will it use debt or equity? In a high inflation environment, debt would be the logical choice, but we're very reluctant to go down the bank route as this normally entails forward selling part of future production. Recently an Australian company raised $50M of debt and had to forward sell over $300M worth of gold to do that. That didn't seem logical to us.
In the last 10–12 years, we've seen cost inflation of 12–15% and the gold price running up at a similar rate. If you forward sell $300M of gold, and gold continues to rise at the same pace it has over the past 10 years, then in a couple of years, the cost of this debt is going to be greater than 100%, simply in the lost opportunity cost of not being able to sell gold at market. A disproportionate share of our projected returns will either end up in money heaven through the lost opportunity of forward selling or to the bank through fees—again shareholders are short changed. Investors have cottoned on to this and are deserting the developers in droves.
TGR: Baker Steel funds have underperformed in lockstep with gold equities. What approaches are you employing to offset the recent dismal performance in gold equities?
DB: The market is very cheap. A lot of resource companies are trading on single-digit multiples, whereas the market as a whole is trading at 15–20 times multiples. Gold equities used to trade at a premium to the general market but are now trading at a significant discount. That's the opportunity. We're looking for well-managed companies and companies that are diversified and well capitalized.
Our focus is the mid-cap, 400,000–600,000 oz (400–600 Koz) gold producers that have two or three operations, with potentially a growth asset as well. We've built up a nice portfolio of these. Unfortunately they still haven't caught traction in the market; you can buy these companies for around 6–8 times price-earnings ratio. They're very cheap.
TGR: Do you visit the companies?
DB: Yes, last year I went to Chile, Sudan and the Democratic Republic of the Congo (DRC) and others in our investment team travelled to Papua New Guinea, Africa, Indonesia and other sites. We do a lot of due diligence.
TGR: You have investments in what would be classified as safer jurisdictions, like Canada, Mexico and Australia, but you also have investments in places with greater risk, like South Africa, Eritrea and Zimbabwe. Would it be fair to say that when Baker Steel is evaluating a potential asset, it doesn't put as much emphasis on jurisdiction risk as it does on potential return?
DB: We risk adjust all of our investments; we are interested in risk-adjusted returns. For example, we would place a higher discount rate on a mine in Zimbabwe. Zimbabwe producers have been completely de-rated by the market, to the point it probably couldn't really get much worse. In an effort to survive, many of the Zimbabwean companies have had to modify the way they do business in an effort to make their model work. They're starting to produce gold at relatively good costs. There are still some political issues, but you can buy these assets for 10 cents on the dollar. We're putting in just enough money that if we get it right, investors will be glad. And if it doesn't go right, it's not going to be so big a deal for us.
South Africa has been a challenge, but Harmony Gold Mining Co. (HMY:NYSE; HAR:JSE), which has been totally de-rated, came out with a result this week that shows that the company is actually performing quite well. We see great value in a number of South African companies.
AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) produces about 42% of its gold in South Africa yet has been sold down as if all its ounces were in that country. And even those South Africa ounces are generating very good cash flow. Those are the opportunities that we're looking at. AngloGold is trading at a projected seven times earnings; its yield could be higher but it is currently in a capital intensive phase.
Endeavour Mining Corp. (EDV:TSX; EVR:ASX) is one of our bigger holdings; the company is a diversified producer that recently acquired Avion Gold Corp. It's a low-cost producer that has a reasonable balance sheet and looks interesting.
TGR: Most of Avion's producing assets are in Mali.
DB: There is obviously a risk, but we believe this is somewhat discounted by the market. Take Resolute Mining Ltd. (RSG:ASX), for example; the company operates the Syama gold mine in Mali and gold mines in Australia and has a market capitalization of $840M. It has $100M worth of gold/cash and investments on its balance sheet and is generating probably $60–70M/quarter—now that is cheap. There's been no production lost at Syama but the market has sold it down as if the mine faces major disruption. Now, admittedly, the costs have had to increase because Resolute has had to add to security, but the stock does look very cheap.
Also, we manage a diversified portfolio. It's not as if we're putting everything into these names. We have around 4% in both Endeavour and Resolute. We can live with the individual company-specific risk, particularly for the price. And while we are waiting for the market to recognize the opportunity, Resolute is paying us a good dividend yield as well, and it is holding some of its profits in gold, which, as we have discussed, matches our strategic objectives.
We have a position in Ivanplats Ltd. (IVP:TSX) across some of our funds. Founder Robert Friedland used to be in Ivanhoe Mines Ltd. Ivanplats has three world-class assets; it just increased its resources at its Platreef project, an ore-body that is around 14 meters in width, compared to 40–150 centimeters for the typical Merensky reef mine, both with similar grades. Ivanplats is going to be a game changer in this industry.
TGR: Are you bullish on platinum?
DB: You have to be positive on platinum, given the problems in South Africa and the challenges that the platinum producers have there. Anglo American Platinum Ltd. (AMS:JSE) has recently cut production. I don't think there can be a lot of downside in the platinum price. If there's not a lot of downside, presumably there's some good upside.
TGR: Do you have any holdings in the DRC?
DB: We have a very small holding in Banro Corporation (BAA:TSX; BAA:NYSE).
TGR: Is its Namoya project on track to begin production later this year?
DB: That is correct but we understand that the company will need $35–45M to complete this. With Banro's Twangiza project, we're getting there, but we're not there yet.
TGR: It produced about 20 Koz gold in Q4/12.
DB: Twangiza needs to be doing much more than that, at least 35–40 Koz/quarter and we need to see some consistency of production. Having said this, we did note that the increase in the resources and the oxide is a positive for that company.
TGR: Let's move to the South Pacific and New Zealand.
DB: Evolution Mining Ltd. (EVN:ASX), OceanaGold Corp. (OGC:TSX; OGC:ASX), Kingsgate Consolidated Ltd. (KCN:ASX), Silver Lake Resources Ltd. (SLR:ASX), Archipelago Resources Plc (AR:LSE) and St. Barbara Ltd. (SBM:ASX) are our key holdings in this region. They all have decent balance sheets and are generating cash. You can buy Evolution under single-digit multiples. It seems incredible.
TGR: What sort of growth should investors expect from Archipelago in 2013?
DB: Archipelago is producing around 120–140 Koz with potential going up to 165 Koz and even maybe 200 Koz per annum, all self funded. It is getting some good results from recent drilling and this will allow the company to upgrade its plant and increase production and profits. Archipelago is generating good cash at the moment, although I would like to see that reported and held in ounces. The challenge for Archipelago is whether the major shareholder allows it to grow through acquisition.
TGR: What's on your list in North America?
DB: Lake Shore Gold Corp. (LSG:TSX) and AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE), which owns the Young-Davidson mine. Lake Shore reduced its 2013 capital expenditure budget by about $18M, but we need to start seeing some returns. When we see Lake Shore this month at the BMO Conference in Miami, this is what we're going to be discussing. It sold a royalty to Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), so maybe the company should consider a royalty to shareholders in return for all our patience. AuRico sold off some assets to focus on Young-Davidson, so now it has a better balance sheet. It is looking at potentially paying a high yield. We'd like to see that as a gold royalty as opposed to a cash yield, but that's a discussion we have to have with the company.
TGR: What about your silver holdings in North America? You have a position in First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE).
DB: We used to, we made a good return on that and moved on. Our main silver holding is Polar Silver (privately held), this company owns a share of a very high-grade silver project in Russia, which we're valuing at about $0.25/oz silver. We think we can bring that to market for at least $1/oz, if not more.
TGR: Thank you for your insights.
David Baker is a managing partner at Baker Steel and heads the company's Sydney, Australia, office. Prior to founding Baker Steel in 2001, Baker was part of the award-winning Merrill Lynch Investment Management natural resources team, successfully managing the Mercury Gold Metal Open Fund, the largest precious metals fund in Japan, from its launch in 1995 until his departure in 2001. Prior to joining MLIM in 1992, Baker was a gold and mining analyst for James Capel Stockbrokers in London from 1988 and held a similar role at Capel Court Powell in Sydney from 1986 to 1988. Baker started his career in 1981 as a metallurgist at CRA Broken Hill, Australia. He holds a degree in mineral processing and a master's in mineral production management from Imperial College, London.
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1) Brian Sylvester of The Gold Report conducted this interview. 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: Franco-Nevada Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) David Baker: I personally and/or my family own shares of the following companies mentioned in this interview: Kingsgate Consolidated Ltd., Resolute Mining Ltd. and OceanaGold Corp. 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 interview.