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International Gold Analyst Christos Doulis Names Four Miners that Could Make Money at the Margins—and One that Probably Won't

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Christos Doulis Christos Doulis travels the world for Stonecap Securities looking for mining companies that can contain costs; companies that can't contain costs because of rising labor and energy bills are not profiting from higher gold prices. From Mexico to Europe and Canada, he has singled out four companies that could actually make money for shareholders—and one that probably won't. And for those not ready to pick one company, Doulis, in this Gold Report interview, names his first small royalty company selection that could profit from the current challenging financing environment.

The Gold Report: Christos, in a recent research report, you referred to "pressure on margins as the chief impediment to increased shareholder value." Please explain what you mean by that.

Christos Doulis: In the last 10 years, the operating margin for mining companies has not kept up as expected with the price of gold, which has more than quadrupled. Costs are going up at a similar pace to the rise in the gold price.

TGR: If mining input costs keep rising at current rates and precious metals prices can't keep pace, what's the ultimate result?

CD: Metals prices are unlikely to go down while input costs are going up. They should remain in lockstep, but if for some reason they do decouple, it would cause some marginal mines to shut down over the next five years resulting in a decrease in global gold production.

TGR: In percentage terms, which precious metal do you think is going to have a better 2013?

CD: It's very difficult to say in any calendar year which metal is going to have a better performance. We will see precious metals start to move upward in price again. Markets tend to overshoot, consolidate and then move up again. We reached a high for gold at $1,900/ounce ($1,900/oz) in September 2011. Gold has now settled back and has basically traded between $1,550/oz and $1,800/oz for a year and a half. Trying to predict the calendar date that the metals complex is going to start moving is a bit of a mug's game. When the precious metals complex starts to move up again I would not be surprised to see the gains in silver exceed the gains in gold on a percentage basis.

TGR: How are higher input costs affecting investors?

CD: It's a much less ebullient party for goldbugs and gold investors. Back when gold was $400/oz, investors were dreaming about what the share prices would be of their favorite mining companies if gold ever got to $1,250/oz or higher. Well, we've gone through that number and the returns for mining equities have been abysmal, although there have been a couple of good years. Last year and this year have been brutal, with reduced returns in the mining space.

TGR: How do investors make money in this space?

CD: By seeking out investment vehicles that limit exposure to input cost creep, but also deliver the benefits, assuming that the metal price continues to go up. Some of those investment vehicles may be royalty companies, which tend to pay a big lump sum upfront for a royalty stream and then receive a certain amount off the top of ounces produced every year after a mine begins production. They don't pay an ongoing cost associated with the ounces that are delivered to them and therefore avoid the creep of input prices.

"We will see precious metals start to move upward in price again."

One of the reasons that these royalties companies have tended to trade at a premium relative to mining companies on a net asset value (NAV) basis is that you do not pay for extended mine life. Even though mine planning can keep the margins constant and can reduce ounces produced from a deposit as the grade goes down, it also tends to lengthen the life of that deposit. It's a question of would you rather have a 1% net smelter return (NSR) on 100,000 ounces for 10 years or a 1% NSR on 80,000 ounces for 15 years? At the end of the day, the total ounces you receive under that second scenario is larger, though in any one period the total ounces received is less than the first scenario. Royalty companies offer investors exposure to gold without a lot of the risks associated with owning mining companies.

TGR: While you haven't covered many royalty companies in the past, you just launched on a company called Premier Royalty Inc. (NSR:TSX), which was spun out of Premier Gold Mines Ltd. (PG:TSX). Tell us about the company and your investment thesis.

CD: I've come out with a buy recommendation and a $1.80 target price. The stock is around $1.55/share. My valuation thesis and reason to own it are very simple. The comparable companies, Sandstorm Gold Ltd. (SSL:TSX) and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) and Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), are trading on average around 1.2 times NAV and 16 times forward-looking cash flow. Based on my estimates, Premier Royalty is trading at around 0.9 times NAV right now and 12 times forward-looking cash flow. As the company gains more visibility in the public market and attracts more investors, it should trade more in line with its peers.

"When the precious metals complex starts to move up again I would not be surprised to see the gains in silver exceed the gains in gold on a percentage basis."

I also like Premier Royalty because it's got $30 million ($30M) in cash. It's a very challenging market right now to raise money, so royalty companies have become a go-to source of capital for companies with good projects. Premier Royalty has the war chest to buy royalties on quality projects and the marketplace right now doesn't provide mining companies with a lot of other options.

One of the things I really like about Premier Royalty is it only has around a $100M market cap. It has a bunch of operating royalties right now that are generating about 7,000 oz gold per year to its account, so it's not as if it's just a pile of cash waiting to do business. The company actually has royalties under its belt, but it's also positioned to acquire new ones. It can also acquire royalties on a much smaller scale than its competitors because it just takes more to move the needle for a billion dollar company than it does for a $100M company.

TGR: Can you give us a ballpark figure for what Premier is going to be looking for in royalties?

CD: Some of its existing royalties are generating less than 500 oz/year to its account. When you look at 50,000 or 60,000 oz/year operations with a 1% NSR, these generate some 500 oz gold per annum with a value (today) of around $800,000. That certainly doesn't move the dial for a Franco-Nevada, but it can be meaningful to a company like Premier Royalty, especially if it can put a bunch of similarly sized deals together.

Premier Royalty is going to look at every opportunity in the royalty space that's out there and might compete with some of the other players in trying to bid on the larger ones. But on the smaller ones, which are less material to a Franco-Nevada or a Sandstorm, the company can actually bid on them because it is only a $100M market-cap company and adding hundreds of ounces of annual royalty production can move the needle. The space it is going to be most successful in is the sub-1,000 oz/year stream. That's 1% NSR on a 100,000 oz/year operation.

TGR: You follow a number of companies with operations in Mexico. Tell us about some of your favorites.

CD: One of the ones I cover is Argonaut Gold Inc. (AR:TSX), which operates a couple of mines in Mexico right now and is in the process of trying to build a third over the next year or so. It's been a big success story. The company's IPO was priced at around $3/share in 2009 or 2010 and it was up in the $10–11/share range for much of 2012. I had a Hold on it in early 2013 and it came down to the $8/share range, so I moved it back to a Buy. Argonaut is currently trading around $8.25-8.50/share. It's a company I like. It's got strong management and has really delivered into the expectations that it set.

While Argonaut has been experiencing margin pressure, it has done a very good job of keeping costs tight and has generated a very good return from operations. It's a company I've recently gone bullish on again. My current target on it is $10.75.

TGR: Last fall, Argonaut bought Prodigy Gold Inc. A lot of analysts didn't like that acquisition. We've seen the share price come off its highs since then. What's your view?

CD: It is a very different beast for Argonaut compared with where it has normally played. Prodigy's Magino asset is in Ontario, which is a different permitting and operating environment from Mexico. Although Argonaut paid a reasonable price for the asset on a per ounce basis, it is still a big change for the company jurisdiction-wise. It also will be the largest project from a capital expenditure (capex) and production standpoint. While many analysts may be negative, I'm taking a wait-and-see approach with a healthy dose of skepticism given that Argonaut has not been active in Ontario before.

TGR: But Argonaut is still very active in Mexico, right?

CD: The two assets the company has producing right now are in Mexico. The next asset to enter the production queue, San Antonio in Baja Sur California, is a Mexican asset as well. When I moved my rating to Buy at $8/share, one of the things I told clients was even if you strip out the Prodigy acquisition, the stock still is worth $8/share. You get what you pay for. If Prodigy works out, the stock should be worth more than $10/share.

TGR: Can you tell us about another Mexican play?

CD: I was the first to launch on Aurcana Corporation (AUN:TSX.V; AUNFF:OTCQX). The company is a silver producer that has two operating mines in Mexico including one called La Negra, which is a little cash flow machine. It's also got the Shafter project in Texas, which unfortunately has been more challenging. As a result, the share price has suffered recently.

"Resource investors need to seek out investment vehicles that limit exposure to input cost creep."

Shafter could be much bigger than La Negra: 3.5–4 million ounces (3.5–4 Moz) silver, compared with 1.5 Moz at Le Negra. Although the company has a plan to expand production at Shafter to 5 Moz, it still hasn't quite gotten to the 3.5 Moz stage yet, so the jury is still out on this asset.

My take on it is La Negra alone is worth $0.75/share and the stock is currently trading around that level. If you buy it, you're getting La Negra at the right price, and you're effectively paying nothing for Shafter. If Shafter works out, I see lots of upside and if it doesn't work out I don't see a ton of downside.

The biggest challenge the company has is manpower. Hiring skilled workers for underground mining in Texas is not easy. Aurcana has been mining Mexico, which has a strong mining culture and history. Finding people there to drive machinery underground is not a challenge. It's a different story in Texas. And bringing labor in from Mexico isn't as simple as you'd think. You have to prove that there's no American able to do the job. In my opinion, labor has been the single largest challenge for Aurcana at Shafter.

The company also had an issue with some filter presses. The presses should be installed by the end of the first half of the year. I have ramped down my assumptions on Shafter pretty aggressively. I only have it throwing off around 1 Moz silver this year as opposed to its potential 3.5 Moz annual production profile. Shafter probably won't come fully on-line until halfway through the third quarter or the fourth quarter although Aurcana did declare commercial production there in December 2012.

TGR: So Aurcana could be positioned to have a good 2014?

CD: Absolutely. But with Aurcana, the shares are going to remain in the $0.70–0.80 range until we get positive news on Shafter. Given the struggles the company has had at Shafter and the current market conditions, investors are unwilling to ascribe any value for Shafter.

TGR: What are some companies you're following outside of Mexico?

CD: One is Orvana Minerals Corp. (ORV:TSX), which is operating in Spain and Bolivia, and also has a development asset in the United States. This one has not had a great track record with its share performance since I initiated coverage. That unfortunately is tied to the fact that the El Valle-Boinás/Carlés (EVBC) mine in Spain was much more challenging than expected. It didn't have a great 2012 from a share performance perspective, but I think operations at EVBC have turned around. The Don Mario operation in Bolivia has value too, though it's a much smaller operation. Don Mario has turned around as well.

I've recently gone back to a Buy on it from a Hold. My only concern is the balance sheet needs some work. The company has a big debt facility with Credit Suisse coming due over the next four and a half years. As long as the operations continue to generate free cash flow it can pay that debt down, but it is going to be touch and go. Management doesn't have a lot of wiggle room. A couple of bad quarters or even one bad quarter might require tapping new sources of capital.

TGR: The Orvana assets have bounced around from a few different companies. What makes you think that Orvana has figured it out?

CD: EVBC has been operated by Rio Narcea Gold Mines Ltd. and others. It was shut down primarily due to metals prices. It's not as if Orvana has a magic formula here. The mine was acquired by Kinbauri Gold Corp. The company's drilling showed that there were more resources there in addition to what was left behind. Orvana came in, bought it for cash and then put it back into production. It was not a very smooth startup. The company went through a couple of mine managers in the process. Ground conditions ended up being much more challenging than anticipated. That took time and money. That's why the shares were moribund for quite some time. But on an operating basis, Orvana's management seems to have hit its stride. In the last year, the company put in a new shaft, which has dramatically increased the number of tonnes that can ultimately be pulled out of it on a daily basis, and reduced the cost per tonne. It spent a lot of money sinking that shaft and putting in the hoist, but it is now paying off and you can see that in the last couple of quarters that the operations have really turned around after the shaft came on-line.

TGR: I understand you have a sell story. Tell us about it.

CD: San Gold Corp. (SGR:TSX.V) is the only Underperform in my universe right now. It has the Rice Lake mine in Manitoba. The operation has just struggled and absolutely failed to deliver on the expectations company management set for the project. The capex budget that came out back in February was for me the death of this story. It showed that there is no free cash flow for at least a couple of years to come. It's just going to be a money pit. In fact that was the title of my note. Shares are trading around $0.25/share. I have an underperform rating on the stock. My $0.30 price target was set when the stock was at $0.50, so on paper it might not look to be a Sell right now, but I have a lot of fear here.

These guys just did a $50M convert, which will fund capital development. It's a Hail Mary pass. If management is successful using this $50M, it might in three years start generating free cash flow again in significant amounts. The $50M convert was the last kick at the can.

TGR: Do you have any other companies you want to talk about?

CD: Why don't I suggest the Canadian name that I think you should own instead of San Gold, which is St Andrew Goldfields Ltd. (SAS:TSX). The company is in the Timmins Camp. I had a Hold on it for quite some time and then I went to a Buy last fall. The company delivered three quarters in a row of free cash flow so it is adding to the treasury. St Andrew Goldfields also had some recent sexy exploration success beneath the Hislop pit. It's only one hole so it doesn't prove anything yet. But if it pulls a few more of those, it will start to define a high-grade ore zone. It's run by Jacques Perron who is a great operator. As much as it struggled in 2011, St Andrew Goldfields turned itself around in 2012 and it's very well positioned for 2013. I have an $0.80 target and the stock is currently trading at around $0.45/share.

TGR: Thank you, Christos, for your insights.

CD: Thank you.

Christos Doulis, before joining Stonecap Securities as a mining analyst in September 2010, spent 16 years in a wide variety of roles with a focus on the global mining sector. Most recently, Doulis was a partner at Gryphon Partners, a diversified global corporate advisory consultancy specializing in mining and resource company mandates. From 2006 to 2008, Doulis was a vice president in the Mining Investment Banking group at Blackmont Capital. Doulis began his professional career in 1994 with Scotia Capital as an equity research associate.

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1) Brian Sylvester conducted this interview for The Gold Report and provides services to The Gold Report as an independent contractor. He 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: Premier Gold Mines Ltd., Franco-Nevada Corp., Argonaut Gold Inc., Orvana Minerals Corp. and St Andrew Goldfields Ltd. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Christos Doulis: I or my family own shares of the following companies mentioned in this interview: None. I personally or my family am paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Premier Royalty Inc., St Andrew Goldfields Ltd., Orvana Minerals Corp. and San Gold Corp. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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