The Gold Report: In late November, BMO Chief Economist Doug Porter warned that interest rates could move higher sooner rather than later in 2015. What's your 2015 outlook for gold given that information?
Andrew Kaip: Our 2015 outlook for gold is that it will trade, broadly speaking, where it is today. Our assumption for next year is $1,190 per ounce. Do we look to Doug Porter's view on interest rates rising and that potential? We do. If the market perceives inflation is becoming a concern, we see that as constructive for the gold price.
TGR: You have extensive experience covering junior gold companies. In your time as an analyst did anything prepare you for this cycle investors are witnessing?
"Tahoe Resources Inc. has a strong management team, high-quality assets and significant management ownership of the company."
AK: When we look at what has changed over the last couple of years, I think that in general BMO Research understood that the direction was changing. Several years ago we began putting out reports cautioning investors that metal prices had downside risk and we were concerned with structural issues in the sector that continue to play out. And while we certainly understood the direction, I don't think any of us fully understood the magnitude of the shift.
TGR: Do you now have a better understanding of where we're headed?
AK: Metal prices have lost roughly one-third of their value compared to where they were in a peak price environment—even more for silver. If we step back and think about a cycle and how a sector moves from bull to bust, I would say we're really part way through the consolidation that takes place when a sector is out of favor and has to deal with structural issues. That's difficult to hear, but I see the gold space moving through a down cycle. We had a good run from 2010 through 2012, but we're now in a consolidation phase, with the risk of lower precious metals prices.
TGR: There have been casualties along the way. What are you telling your team?
AK: We've always been realistic. Our focus over the last two years has been to steer clients toward mining companies that have strong management teams managing quality assets and building them into stronger businesses.
TGR: You suggested earlier that there are structural problems in the precious metals space, especially among the smaller companies. Could you give us some examples that help illustrate your point?
AK: There are a number of issues that we have focused on. The first is that the operating cost structure for a number of companies is not structured for today's metal price environment. We are looking closely at smaller companies and some larger companies to see how they're responding to lower metal prices. They started by cutting discretionary spending, but now companies are looking more closely at sustaining capital in an attempt to reduce their overall cost structure and maintain profitability. But if you take too much sustaining capital out of the business, how is that going to impact the business in two or three years?
"Silver Wheaton Corp. is in the 'flight to quality' group because it is a naturally defensive name."
TGR: One hot topic on cutting costs is executive compensation. Has it become unrealistic?
AK: In the context of this current market there needs to be a healthy discussion as to what is appropriate compensation for executive teams. In some instances, levels of compensation are significant relative to a company's production. One thing that our clients are telling us is that they would prefer to see the old business model where executive teams had significant ownership of the companies that they were running. They benefited from their success through share price appreciation. Investors want management aligned with their interests.
TGR: Is there a tangible way investors can determine what is reasonable and what's excessive?
AK: If a management team has significant share ownership—an amount at least comparable to their base salaries—then investors should begin to feel comfortable that those individuals are trying to create wealth and make decisions that will benefit all shareholders.
TGR: What is your view on high grading?
AK: The reality of lower metals prices, particularly in the precious metals space, is that companies have to move toward higher grade to maintain profitability. But that comes at the expense of reserve life. We saw that at the beginning of 2014, but our expectation is that we will see further declines in reserves when reserves are restated at the beginning of 2015. For some companies, that's going to precipitate a decline in reserve life to the point where it could become motivation for consolidation. Some of these companies will have to look to acquire smaller companies with new projects in order to maintain their production profile. In fact, some of these companies are going to have to look at consolidation if they are going to continue operating.
TGR: That is going to place greater importance on exploration.
AK: Exploration is an important aspect of regeneration in mining. Consolidation is really a short-term way for these companies to get out of their current predicament. If we take a longer-term view, exploration has been key to companies reinvigorating existing mines by expanding reserve bases over time. We're not seeing exploration at the level we think it needs to be to replenish reserves in today's market. That's why we think consolidation in the short term has the potential to take hold. And that's constructive from an investor standpoint.
This sector needs to go through a consolidation to create stronger mining companies—and consolidation allows companies to grow their reserve bases and operational flexibility. Then we can look toward a future where investors will want to begin investing in exploration companies again for the prospect that they might make impactful discoveries.
TGR: What is consolidation going to look like in 2015?
AK: Consolidation makes for an interesting discussion. For example, David Haughton, our senior precious metals analyst, says that many of the senior producers he covers are not in a position to acquire and that only a handful have a mandate for acquisition. Our view is that we're not really going to see the large mining companies participate in a round of acquisition. Mergers and acquisitions will mostly be the domain of the small to intermediate gold and silver producers.
TGR: Will consolidation come in the form of cash-and-share deals?
AK: Cash is scarce in this sector. If a company is going to make an acquisition, it is going to make an acquisition primarily with shares. One of the biggest questions for junior companies right now is cash. There is an ongoing debate among exploration company management teams: Are shareholders better off in a larger entity that has the means to develop its assets or are shareholders better off sticking it out in the current environment and hoping for better days?
TGR: In other interviews you have suggested that investors should stick to outliers in the gold space. Please describe an Andrew Kaip outlier.
AK: Outliers are those companies that we believe are well run. They have quality assets that can generate cash at current metal prices or lower. They have management teams that are well regarded, are technically strong and make decisions in the best interest of shareholders. Often those management teams are significant investors in their companies, too. That's the combination we're moving toward.
TGR: What are some examples?
AK: We view Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), a royalty company, as an outlier. In the silver sector, we look toward Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) as an outlier given its strong management team, high-quality assets and significant management ownership of the company. These are the leaders of our industry.
TGR: Franco Chairman Pierre Lassonde says his company is very much undervalued. Is he correct?
AK: David Haughton, our senior analyst who covers Franco-Nevada and who has covered royalty companies for a long time, noted recently that over the last couple of years valuations of royalty companies have come down significantly relative to those of precious metals producers. In that context, Pierre is absolutely correct.
TGR: Tahoe was among three "flight to quality" recommendations in a recent BMO report on the silver sector. The other two names were Fresnillo Plc (FRES:LSE) and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE). Why did Tahoe make your short list?
AK: Tahoe made the short list because it has asset quality that's comparable to Fresnillo, a London-listed silver company with operations in Mexico. Fresnillo is a high-quality operating company with first-quartile cash operating cost mines that are run with a conservative approach toward execution—good execution. Tahoe doesn't have the depth of assets that Fresnillo has, but it certainly has a primary asset that will be the company cornerstone for many years to come.
I put Silver Wheaton in that group because Silver Wheaton is a precious metals streaming company, a naturally defensive name. Any royalty company carries some operational risk from the standpoint of production from its underlying streams or royalties, but royalty companies don't deal with the capital or operating cost escalations that mining companies incur. All three companies, in the context of value relative to their peers, are more attractively priced.
TGR: Tahoe President and CEO Kevin McArthur just cashed in several tranches of shares worth about $10 million. Should that give potential investors pause?
AK: Investors are always asking why management teams do what they do, but most investors who have been following the story realize that Kevin has had a decent amount of his capital tied up in Tahoe for a number of years. From my discussions with the company, it sounds as if there were personal reasons for Kevin to sell those shares but he's still a significant Tahoe shareholder.
TGR: Do investors go with an exchange-traded fund like the SPDR Gold Trust (GLD:NYSE.A) or with companies like Franco and Silver Wheaton?
AK: The one advantage that Franco and Silver Wheaton have that the SPDR Gold Trust or even holding precious metals doesn't is that both companies have portfolios where significant discoveries can still be made. It's those significant discoveries and the crystallization of that value creation that distinguishes them from holding a basket of equities or the underlying metal.
I cover Silver Wheaton and investors are starting to understand that a couple of the streams that Silver Wheaton owns are beginning to add value that they had not considered. For example, Goldcorp Inc. (G:TSX; GG:NYSE) is considering adding another processing circuit at its Peñasquito operation in Mexico. That would amount to another 1 million ounces of silver annually. Another example is the impending expansion of Vale S.A.'s (VALE:NYSE) Salobo copper mine in Brazil, where Silver Wheaton owns 25% of life-of-mine production. Salobo is already producing at a higher rate than what was originally expected, something that when Silver Wheaton acquired that stream investors had completely discounted. Over time royalties can grow from a reserve perspective, but they can also grow from a production perspective. That's the advantage that both Franco and Silver Wheaton bring to the table.
TGR: You provided the basics of your current investment thesis for gold and precious metal equities. Is there anything you would add?
AK: We've been talking to investors about what they want and that is highly leveraged names. We much prefer investors take into consideration financial leverage versus operational leverage. Operational leverage is looking for high-cost miners. If you invest in high-cost miners, you could see a significant return if metal prices rebound rapidly. But we tend to find that the high-cost operators continue to be high-cost operators because once metal prices begin to rise, those high-cost miners have to reinvest capital in their operations because they've been starving them to maintain profitability.
Most of the financial leverage in the gold sector today is long-dated financial leverage. For investors, that's a lower-risk profile because they don't have the prospects of debt renegotiation and uncertainty. Investors are looking at decent quality assets that are hampered in the current market by debt. Once metal prices move higher, investors can add significant value with lower risk.
TGR: What are some companies you're tracking at the top of the precious metals food chain?
AK: The biggest question with the senior producers right now is direction. The market is looking for the seniors to map out a strategy. Many are working on those strategies, but not all of those strategies are coming in a timeframe that investors favor. Investors are gravitating toward seniors with coherent strategies like Goldcorp, Agnico Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) and Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE).
TGR: Where is the primary growth going to come from in those three names?
AK: Goldcorp is ramping up to commercial production at two mines—Éléonore in northern Quebec, and Cerro Negro in Argentina. That amounts to significant production growth. Agnico, of course, joined forces with Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) to acquire Osisko Mining. Agnico just went through a round of consolidation that has resulted in production growth but Agnico is a company with a mandate for further acquisitions. It's been specific about what it's looking for and we expect it to be looking for new opportunities.
TGR: What are some names in the midtier or small producer category that should participate in the next round of consolidation?
AK: A number of intermediates are quite acquisitive. Some of the names we expect to lead future consolidation of the sector include B2Gold Corp. (BTG:NYSE; BTO:TSX; B2G:NSX), which has been very active on the acquisition front; Primero Mining Corp. (PPP:NYSE; P:TSX), a name that we cover that has been acquisitive; Rio Alto Mining Ltd. (RIO:TSX; RIOM:NYSE; RIO:BVL), which acquired a junior company earlier this year and that was viewed as a sound acquisition; and Argonaut Gold Inc. (AR:TSX), which has grown through acquisition and will likely do so again.
TGR: Rio Alto climbed well above $3/share in September as rumors of an impending takeover carried the share price higher. Were those rumors unfounded?
AK: They're never unfounded, but during that period Rio Alto was consolidating its Sulliden Gold acquisition. Once investors understood what the acquisition was all about, we started to see the share price appreciation. Sometimes a well-timed acquisition, even though investors aren't expecting it, can really reinvigorate a company's prospects.
TGR: Primero increased production at Black Fox by 30% in Q3/14 versus Q2/14, but the mine still requires capital improvements that will likely siphon money away from the development of Primero's Cerro Del Gallo project in Mexico. Is Black Fox worth it?
AK: When we look at Black Fox there is a large capital requirement and a longer runway to get that project to where Primero wants it to be. Primero is committed to moving that project forward and there are very good indications that the mineralized structures that host gold at Black Fox continue at depth. Brian Quast, the intermediate analyst here at BMO, would point out that the real driver for Primero at this point is very much San Dimas and the growth opportunity there.
TGR: Another company you listed, B2Gold, has received some criticism for some recent takeovers but consensus on the Street seems to be that the Papillon Resources Inc. (PIR:ASX; PAPQF:GREYS) acquisition will be accretive. Your thoughts?
AK: That's our view. The Papillon Fekola gold project in Mali is a good quality asset. It provides increased geographic concentration for the company and certainly has the potential to be an accretive acquisition.
TGR: What about the developers and explorers?
AK: There are some interesting themes taking place in the junior space. We have a lot of data from junior takeovers dating back to the mid-1990s. One thing that is apparent is that the actual value of junior companies (using enterprise value per ounce of reserves) has never been cheaper—even in the context of today's gold price. We see a number of junior companies with credible assets that will be developed at some point and those companies are going to be acquisition targets.
TGR: What are some likely names?
AK: Lydian International Ltd. (LYD:TSX), one of the companies that I cover, recently received its final permit to construct a mine at the Amulsar project in Armenia.
Romarco Minerals Inc. (R:TSX): even though Romarco has seen a delay in permitting at its Haile gold project in South Carolina, it's only a matter of time. My view is that the permit will come sometime in 2015.
Rubicon Minerals Corp. (RBY:NYSE.MKT; RMX:TSX) is a junior company that's constructing the Phoenix gold mine in Red Lake, Ontario, that will enter commercial production in 2015.
And Guyana Goldfields Inc. (GUY:TSX) is building the Aurora gold project in Guyana. Quite a number of junior companies offer good opportunities. I believe we're moving to a stage where consolidation will be well received by investors.
TGR: Leave us with one thought that precious metals investors can chew on.
AK: One thing that I believe has been forgotten is that smart business decisions by both mining companies and junior exploration companies are at the heart of opportunity for investors in this sector. For instance, it was a smart decision by the management team at Aurelian Resources Inc. to say that its shareholders would be better off in Kinross Gold Corp. (K:TSX; KGC:NYSE), a larger entity. A lot of value was created for shareholders through that deal. Did political issues sideswipe the project over the last couple of years? Absolutely, but from a junior perspective that was a wise decision for Aurelian shareholders. The sector needs to get back to the key principles of opportunity. One of them is a healthy transactional environment for precious metals companies. That requires acquirers to see that they can make acquisitions that are accretive to their businesses, as well as junior company management teams that see acquisition as part of their business strategy. We've diverged from that. My hope is that we'll move back into an environment where value can be created for shareholders.
TGR: Thank you for your insights, Andrew.
Andrew Kaip is managing director of mining equity research at BMO Capital Markets. Previously, he worked as a mining analyst at Haywood Securities, most recently covering gold and silver junior exploration and mining companies. Prior to that, he served as a project and consulting geologist for more than 10 years. Kaip received his Bachelor of Science in geology from Carleton University and his Master of Science in economic geology from the University of British Columbia and is a professional geologist.
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1) Brian Sylvester conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Guyana Goldfields Inc., Silver Wheaton Corp., Tahoe Resources Inc., Primero Mining Corp. and Argonaut Gold Inc. Goldcorp Inc. and Franco Nevada Corp. are not associated with The Gold Report. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
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