The Mining Report: National Bank Financial (NBF) said in an Oct. 7 report that, when combined with its cautious near-term outlook for commodity prices, elevated multiples suggest the base metal sector is overvalued. Are there exceptions to that statement?
Shane Nagle: Since that time, we've seen a retracement in the multiples. The mining index in general remains near the upper end of historical ranges, as investor interest has gravitated toward large and midcap names with stable cash flow and strong balance sheets. Those companies are the exceptions, not only just within the base metal space, but within the mining space in general. Looking past those elevated cash flow and net asset value (NAV) multiples and focusing on companies with balance sheets sufficient to weather a prolonged downturn are the names that stand out as being most attractive.
TMR: Do you think the downturn will last several more years?
SN: Maybe downturn is the wrong phrase, but I think we're still a few years away from another rally. If I can use copper as a specific example, there's been a lot of investment on projects in the copper space throughout the past few years. About 15% or so of the current global demand is coming on-line within the next two years from the addition of several large projects (Oyu Tolgoi, Sentinel, Toromocho etc.), this is seemingly going to keep the concentrate market oversupplied throughout 2014-2015. There will probably be some general weakness in copper and base metal prices as a result of this.
The good news is the supply cycle tends to come in waves. Copper prices now are relatively low compared to what price levels are needed in order to make a lot of new projects economical. Projects are being canceled, delayed or suspended. Meanwhile, political factors such as permitting challenges are also pushing out production several years.
So maybe not a downturn, but certainly weaker fundamentals for a couple of years. On the other hand, things are looking pretty good long term, as a lot of the projects that would be slated to come on-line by 2017-2018 are not going to materialize in the current market environment.
TMR: Are we going to see similar sideways performance for nickel and zinc?
SN: Both nickel and zinc markets are oversupplied as well, but appear to be trending in opposite directions. There's seemingly no end to the nickel supply, the wild card being the proposed export ban on nickel laterite ores from Indonesia.
People have made the case that there's a great deal of zinc supply coming offline with the closure of the Brunswick and Perseverance mines. However, there are several additional projects, albeit smaller, coming on-line, as well as the extension of the Century and Skorpion mines in Australia and Namibia, respectively. Both markets may stay well supplied in the near term, but long-term fundamentals appear to be more supportive for zinc (which I think is the consensus view).
TMR: What's your price deck for copper, nickel and zinc for 2014?
SN: For copper we're using $3 per pound ($3/lb); zinc is $1/lb; and nickel is $7/lb. We'll be taking a closer look at updating our estimates in the weeks to come.
TMR: Could base metal producers soon be ready once again to spend money on mergers and acquisitions (M&A)?
SN: I don't think M&A is going to heat up within the base metal space. There's been so much consolidation during the last decade that there's not much out there to buy. The type of M&A that could still happen would be optimization of projects within larger mega-cap companies, like Glencore Xstrata PLC (GLEN:LSE; GLEN.HK:HONG KONG; GLN:JSE), where they carve out assets to the mid-tiers.
TMR: You don't see companies like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) or Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK) taking advantage of the market for base metals projects that are undervalued?
SN: There are very few projects of that scale that would interest those companies. They also remain under considerable pressure from their shareholders to limit spending. Glencore's most recent comments were about curbing spending for the next few years in order to weather a downturn. Companies are still focusing on strengthening their balance sheets, limiting and reducing capital costs and optimizing their portfolios by shedding non-core assets. I think that's the type of acquisition we'll continue to see, not an increase in traditional M&A.
TMR: What will be the top performers among the base metals equities during the next 12–18 months?
SN: There's very few companies left in the Canadian mid-tier space, but we're focused on the ones that have stronger balance sheets and executable projects. Capstone Mining Corp. (CS:TSX), Lundin Mining Corp. (LUN:TSX) and First Quantum Minerals Ltd. (FM:TSX; FQM:LSE) are able to grow within their existing portfolios, have enough funding to complete those projects and still have some level of internal growth.
TMR: Capstone just put out its Q3/13 financials. Did they meet your expectations?
SN: They did. Capstone's story is mostly about what it can do with Pinto Valley in Arizona throughout 2014. If it does a good job with the transition of Pinto Valley and is operating at full scale, production should increase to in excess of 220 million pounds (220 Mlb) in 2014 from around 105 Mlb in 2013. There are always risks with operating a project of this scale, and we expect some elevated costs initially, but getting the asset from BHP with the keys already in the ignition helps reduce some of that risk.
TMR: First Quantum put out results, too.
"I don't think M&A is going to heat up within the base metal space. There's been so much consolidation during the last decade that there's not much out there to buy."
SN: First Quantum is also working on some transitional projects, namely Sentinel, a copper smelter and expanding the Kansanshi mine in Zambia. All those projects are all ongoing in tandem and are set to transition the production profile of the company. At the forefront of everyone's mind is what First Quantum can do with Cobre Panama, which it acquired as part of the Inmet Mining Corp. (IMN:TSX) acquisition earlier this year. There should be an update on the expected capital costs and timeline of that project early next year. We're confident in First Quantum's ability to deliver the project successfully, the only question is to what extent recent cost cutting initiatives created problems with local contractors and what impact that might have on timing/development costs going forward.
TMR: Lundin Mining was pursuing takeover offers a few years ago. Now it's looking at expanding its footprint. What turned that company around?
SN: There's been a change in strategy as Lundin focuses on increasing profitability at its existing assets. The current CEO, Paul Conibear, was promoted from his previous corporate development role and has helped in this transition. Of course, the main cornerstone is its 24% equity interest in Tenke Fungurume in the Congo, which is operated by Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE). At current prices, it is generating $40–50 million ($40–50M) per quarter net to Lundin. The free cash flow it provides to Lundin is very helpful in funding the development of its wholly-owned operations, including development of the recently acquired Eagle mine.
TMR: Gold fell $213 an ounce ($213/oz) in the Q2 and another $91/oz in the Q3. What's your forecast for 2014?
SN: Our bank uses a $1,300/oz forecast for 2014.
TMR: What's your outlook for silver?
SN: Our silver forecast is $21/oz, and again, we'll be taking a closer look at our metal price forecasts in the new year.
TMR: A Q3/13 report by NBF reported that "despite widespread cuts to exploration and more recently corporate general and administrative expense (G&A) even select high-quality names could yet again show an alarming rate of cash depletion, particularly those mid to late cycle on development projects." Is there a work-around solution for investors?
SN: I think the exceptions are those companies that aren't committing capital to a large-scale project or have all financing in place. That's why we continue to point to the royalty names as a defensive pick in the gold space. They may not necessarily be the cheapest, but you're not going to have a surprising cash strain on a quarterly basis.
"Large-cap base metal and royalty companies will offer exposure to a rebound in prices, but also limit losses should current market conditions persist."
TMR: Royalty plays are also trending lower. Why would an investor choose a royalty company over dividend-paying equities outside the mining space?
SN: Comparing them to outside the mining space is interesting, other sectors are paying better yields currently, but the mining royalty companies exhibit relatively strong growth and have the potential for some significant dividend increases in the future. I would say if you have to be invested in the mining space, you want to hold royalty companies because of the stability of their liquidity positions. If you ran spot prices and looked at which companies would have the best financial position at the end of next year, without question, it would be Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX), Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE). Current market conditions also make an ideal hunting ground for these large-scale royalty companies to put some of that cash to work and generate growth. Some fairly significant dividend increases should materialize as they harvest cash flow from acquisitions.
TMR: Royal Gold President and CEO Tony Jensen recently told an audience at the Goldman Sachs Global Metal and Mining/Steel Conference in New York that Royal Gold has more than $1 billion ($1B) in liquidity and that it is "well positioned" to take advantage of a "very attractive" market environment. What streaming or royalty targets could make sense for a company of that size with that much money to spend?
SN: There are several junior/mid-tier companies in need of additional capital, but I think the most interesting opportunities are carving out large-scale royalties or streams from the majors. The Vale S.A. (VALE:NYSE) transaction by Silver Wheaton changed the royalty landscape, carving out gold production from the Salobo mine in Brazil and operations in Sudbury, Ontario, in a $1.9B deal.
It's another way for those large diversified companies to carve out non-core assets or commodities and realize some value for them.
TMR: If I'm an investor in Royal Gold and I hear a speech like that, I say, "Well, why don't you take some of that liquidity and increase your dividend to attract more investors?"
SN: I believe Royal Gold has increased its dividend every year for the last 14 years. The share price has exhibited such good growth that the yield doesn't look as attractive. With operating cash-flow growing at a compound annual growth rate of 6% in the coming years, the share price should continue to benefit, as should future dividend growth.
TMR: In addition to that deal with Vale, Silver Wheaton reached a stream deal with Sandspring Resources Ltd. (SSP:TSX.V). Do those types of deals move the needle for a company like Silver Wheaton, Royal Gold or Franco-Nevada?
SN: This is a way for these companies to gain exploration exposure and strike deals for projects that could potentially be the next cycle's significant projects. Getting in on the ground level and striking a deal when gold prices are depressed doesn't require a great deal of upfront capital.
In terms of moving the needle with the current valuation: No, it doesn't. But fast forward 10 years down the line—each of these royalty companies will have a handful of option agreements that could materialize into something big—they've got attractive terms on a future stream, increased exposure to future exploration success and long-term growth.
TMR: What's next for Franco?
SN: The major catalyst for Franco is getting information on Cobre Panama from First Quantum. Franco had previously struck a $1B streaming transaction at that asset with Inmet Mining. The company will be looking for more visibility on production and possible scalability, as well as the timing of payments to First Quantum. With respect to counter-party risks, Franco is in pretty good hands with a company like First Quantum running its project.
Another royalty example is Sandstorm Gold Ltd. (SSL:TSX; SAND:NYSE.MKT). It has $100M in cash and $100M of available credit. Sandstorm's performance is being impacted currently by elevated counter-party risks, as there are concerns with the profitability of a few of its streaming agreements. About 70% of its future production is in relatively safe hands at current commodity prices; however, there could be downside risk to its production estimates.
TMR: The company announced that it had record gold sales in Q3. Is this going to be a regular occurrence?
SN: That trend should continue as its primary counter-party, Luna Gold Corp. (LGC:TSX; LGC:BVL), ramps up its phase one expansion at its Aurizona Project in Brazil next year.
It also has a stream on SilverCrest Mines Inc.'s (SVL:TSX.V; SVLC:NYSE.MKT) Santa Elena mine in Mexico, which is going into underground development next year. The record production headlines will persist late into next year, but then taper off if metal prices don't offer its counter-parties some support.
TMR: Do you have some parting thoughts?
SN: A lot of the people I talk to on a daily basis are saying it's got to turn around and are picking more leveraged ideas, which a select few will certainly pay off. A more conservative approach would be looking for names that may not necessarily be the cheapest right now, but may present the best opportunity for future growth through M&A, or those companies that have the strongest balance sheets going forward. These names tend to be the large-cap base metal and royalty companies, which will offer exposure to a rebound in prices, but also limit losses should current market conditions persist.
TMR: Excellent. Thanks.
SN: Sure. My pleasure.
Shane Nagle is a metals and mining analyst at National Bank Financial, covering base metals, royalties and junior gold companies. Prior to 2008, Nagle worked as a process engineer within the hydrometallurgy group at Hatch and has an engineering chemistry degree from Queen's University. In 2013, he received the StarMine award for top stock picker in Canada (Metals & Mining).
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1) Brian Sylvester conducted this interview for The Mining Report and provides services to The Mining Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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