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A veteran analyst, Kerry Smith of Haywood Securities covers a broad
range of companies in the mining sector, from juniors to mid-tiers to majors,
from explorers and developers to producers, from base to noble metals. In
this exclusive interview with The Gold Report, he covers a lot of territory,
discussing the outlook for gold, the next stage of sector consolidation and
the rough political terrain in some of the world’s most
resource-abundant geographies.
The Gold Report: How should investors play this market, and what's your
outlook for commodities, gold in particular?
Kerry Smith:
Big picture, I would expect the U.S. dollar to trend lower over time. That
should be positive for gold and to a lesser extent the commodities. Short
term, there’s so much uncertainty and scrambling to get liquidity and
cash, with hedge funds blowing up, that it tends to confuse the picture. To
me, the bigger picture hasn’t changed. I am neither a currency guy nor
an economist, but that’s my view of the world, so I’d say
commodities and gold are good places to be.
For commodities in general, the muted supply
response from producers in the last five years adds a bit more credibility to
this view. We haven’t seen much new production come on, whether
it’s copper, nickel or zinc mines.
While demand has softened in Europe and the U.S., demand is still growing in emerging
economies such as Brazil, India and China. Demand for metals
generally is still growing, so metal prices should be relatively well-supported.
The bigger issue is what commodity demand will be
on a go-forward basis. For the first time in six years, China
recently cut Central Bank rates by a quarter point. I think China is less
worried about inflation and more worried about growth, and cutting rates
suggests that they don’t want their economy to slow too much. As you
know, China
is the biggest consumer of copper, nickel and all the rest of it, and I think
will consume more and more metal every year. That should make up for any
demand destruction in Europe or North America.
So I like the base metals. The demand side of the
equation is good, despite these occasional hiccups during which people get
fixated on slowdowns and financial crises in North America and Europe. If you talk to the companies, they don’t
really see any slowdown on the demand side; they still see strong sales from
their customers.
TGR:
Any base metals in particular that you like?
KS:
Among the base metals, I prefer copper because the market is still in a
slight deficit. Zinc has a bit of a problem; surplus is likely to continue
through 2009 and prices probably won’t rebound much. We’d need
more mine closures to get the zinc market back to a more balanced position. On
the other hand, the Brunswick
mine—the world’s fourth largest zinc mine—will be mined out
in 2010. The surplus isn’t likely to exceed the 200,000 tons of metal
the Brunswick
shutdown will take off the market, so if we continue to see reasonable growth
in demand, maybe in 12 months’ time we will get to the point where zinc
prices start to pick up.
In addition to copper, I’d prefer to be
involved in iron ore, coal or some of the agricultural commodities. The
market for coal looks good.
TGR:
Do you have any preference regarding investing in explorers-versus-producers
in this environment?
KS:
In this market, the producers are quite cheap. With the producers’ cash
building up on their balance sheets and their stock prices depressed, you may
see some share buybacks. Another thing I think they will do in a market like
this is use cash and cash flow to add projects into the mix in their
pipelines.
Most of the easy acquisitions in the base metals
and the golds probably have been done, particularly for the large caps. The
next wave of consolidation probably will be the mid-caps. But at the same
time, I think you will see the large caps with cash also buying assets. The
CEOs of these companies don't worry about the metal price tomorrow or care
what the copper price does next week, but they want to add to their pipelines
because they’re planning for the next 30 to 40 years. What they care
about is having a pipeline of projects to maintain their production profile
and grow over time. In the current market I think most companies would rather
acquire development-stage projects, given the reasonable prices today in the
market, and then get those projects into production over the next five to 10
years.
Gold, of course, has potential to go a lot
higher, given that people will gravitate to gold as a safe haven as the
dollar keeps trending lower. Gold is a good hedge against currencies, and I
don’t think Europe’s economy is in much better shape than North America’s. It’s China and the
emerging countries that are now driving the global economy.
The big-cap gold producers look pretty cheap and
are not trading at expensive multiples, so I wouldn’t be afraid of
buying a Goldcorp (NYSE:GG, TSX:G), a Barrick (ABX), a Kinross (K.TO) or an
Agnico-Eagle (TSX:AEM). Those stocks would be the first places I think
everybody puts their money, and then over time it will filter down to the
next tier, which in my portfolio includes Eldorado Gold (ELD.TO, AMEX:EGO)
and Red Back Mining (TSX:RBI).
The big caps and mid-tiers are cheap enough that
I don’t think you have to go to the development-stage companies right
now, but that is where you’ll make the most money as the cycle
continues. Thus, I think you’d like to have a mixture of producing
companies that are relatively cheap on a cash-flow or earnings-multiple
basis—Barrick, Agnico, Goldcorp or Kinross, and then Eldorado and Red
Back in the mid-tier.
I’d think you’d also want to own some
of the development-stage companies because ultimately the bigger producers
will acquire them. It is not easy for producers to go out and find a 5
million ounce deposit, but there are three or four development-stage
companies with deposits of this size now and valuations are relatively
modest, making them attractive potential acquisitions. So you have companies
such as Detour Gold (TSX:DGC), with 12-plus million ounce gold resource in
Ontario, CGA Mining (TSX:CGA, ASX:CGX), Mineral Deposits (TSX:MDM, ASX:MDL),
Bear Creek Mining (TSX.V:BCM), which has a big South American silver deposit,
Apollo Gold (AMEX:AGT, TSX:APG), which is coming into production, Andina
Minerals (TSX.V:ADM), with 7-plus million ounce gold resource in Chile, or
Osisko Mining (TSX:OSK) with a deposit of 7 to 8 million ounces in Quebec. If
you are in a pretty stable first-world country, those companies are going to
get picked off at some point because it becomes cheaper to buy ounces than
explore.
TGR:
Can you talk a bit about Red Back
Mining Inc. (TSX:RBI), one of the mid-tiers?
KS:
I have 250,000 ounces
of production for Red Back this year, going to about 350,000 ounces
next year and north of 400,000
ounces by 2011. They have two mines in production in
West Africa, one in Ghana
and the other in Mauritania.
The company is generating cash. This is the kind of company that will
continue to grow, has production and a pretty good management team. They’re
in reasonably decent parts of the world, and they’re probably looking
at some acquisition opportunities out there as well.
CGA Mining
Ltd.(TSX:CGA, ASX:CGX) is also a good example; it has a mine being built in the Philippines,
fully funded, that will be in production by year-end, with a couple hundred
thousand ounces of annual production. CGA’s market cap is about $160
million, and they have a 5 million ounce resource. It’s quite a large
deposit and at some point an asset like that could get sold to the Chinese,
who are definitely in the market to buy production.
Any company looking to grow can find
opportunities out there. What you need is a turn in sentiment in the market,
because right now the market is only focused on liquidity through selling,
irregardless of the fundamentals.
There are opportunities for near-term producers
to cheaply acquire development-stage projects such as the ones I
named—Detour Gold, Osisko, CGA and Bear Creek Mining. Moto Goldmines
Ltd.(TSX:MGL) is another good example. It has about a $165 million market cap
and a nice gold deposit of about 8 million ounces. It’s in the Congo,
and there are too many political issues; so it’s not the best place to
be today. But at some point, something will happen there.
With big caps cheap and mid-caps cheaper,
that’s where you’d want to start today, in terms of building a
position. But some of these development-stage names are going to get
acquired, and when they are taken out, it will be at prices a lot higher than
today’s.
TGR:
You mentioned Crystallex
International Corp.(KRY) and the permitting issue in Venezuela.
KS:
Yes. It’s 16 million ounces of reserves and +25 million ounces of total
resources—so it’s big and it would be a long-life mine. It’s
simple mining and metallurgy, and it’s at sea level, not at 4,000 meters in the
Andes. It’s got good infrastructure; a lot of the things you’d
like to see in a project. It has incredibly cheap power because the
government subsidizes power. Power off the grid in Venezuela, all from hydro,
runs two or three cents per kilowatt-hour. You can buy diesel fuel and gas in
Venezuela for five cents a liter. So it’s going to have low cash costs.
The problem is it’s in Venezuela. The situation has gone on for so
long. I think if the government really wanted to nationalize the project,
they’ve had plenty of opportunity and would have done it long ago. My
simple view is that the government doesn’t want to nationalize it, and
will figure out a way to move this project along. So at some point, it will
get permits and go into development by somebody.
TGR:
Could you talk a bit about Anvil Mining
(TSX:AVM)?
KS:
Anvil’s run by an Aussie who’s done a really good job over the
last 10 years building this company up. His problem is that Anvil’s in
the Congo. It’s getting exceedingly more difficult over time to find
and permit deposits there, whether gold or base metals. It’s also tough
to finance them and get them up and running. Ultimately, we’ll need
more copper deposits, which is what Anvil’s involved in.
Companies aren’t really finding any new
copper deposits in Chile or North America, so a lot of the big new projects
will come out of places such as Africa. If you’re a producer and want
to be in the copper business for the next 100 years—I don’t think
it’s a question of whether you’d ever go to the Congo. I think
it’s a question of when, because nowhere else on the planet has such
very high-grade ore deposits.
The problem in the Congo is political risk and
high infrastructure costs, so security, transportation and supply line
logistics and everything else is very expensive. A 1% copper deposit in Chile
is probably just as good as a 2.5% deposit in the Congo, because you need
that higher grade to offset all these incremental costs you incur to mine
there. But the Congo has great geology and lots of big deposits, so
we’ll see deposits mined there over the years.
Anvil’s CEO, Bill Turner, recognized this
opportunity early, established himself there and built up a relationship with
the government. As a result, Anvil has three projects today, all in
production. He started modestly, but he’s reached the point where
Anvil’s going to produce about 80 million pounds of copper this year. When
it comes on-stream, the next project they’re building will move them to
150 million pounds by 2010. So Anvil has a nice growth profile and works in a
geologically very prospective part of the world.
In a place like the Congo, I think the companies
that survive over time will be those with critical mass and cash flow
already. They will need to be connected politically, and they need to know
how to operate there. While some of the exploration companies in the Congo
today have interesting projects, they don’t have cash flow and markets
are tough, so a lot of them will not be able to raise additional capital to
move their projects ahead. They’re not going to be able to raise money
under very favorable terms, so some consolidation is likely in the Congo.
Companies such as Anvil can be a part of that
consolidation because they have cash flow and critical mass. They’re
established there and know how to operate. A development stage company, in
contrast, might have a great project with nice resources, but still has to
figure out how to finance and build it, and how to get it into production. That’s
tough anywhere, but it’s more difficult in the Congo.
TGR:
Could you comment on Linear Gold
Corp. (TSX:LRR)?
KS:
Linear is an exploration company and in this cycle, few new greenfields or
grassroots discoveries have been made. We had Éléonore
(Virginia Mines (TSX:VGQ); Fruta Del Norte (Aurelian Resources (TSX:ARU),
Penasquito (with Western Silver, which became Glamis, which became Goldcorp),
Gold Eagle (which has just been bought by Goldcorp) and Ixhuatán (Linear’s
discovery in Mexico).
Out of all those deposits, the only company that
hasn’t been acquired yet is Linear, but Linear did a deal on that
discovery with Kinross Gold
Corp. (K.TO).
It’s not a big discovery—only a couple million ounces—but
it was one of the few new discoveries. So Linear is sitting there with about
28 million shares outstanding and about $25 million in cash and it’s
basically trading at cash. They still have a residual interest in
Ixhuatán. The deal is set up for Kinross to spend $15 million in
exploration by next October to earn 70% in the project and pay Linear $100
million in cash.
Kinross is continuing to drill, but we
won’t really know their intentions until this time next year. Linear
may wind up owning it all because I don’t think Kinross would exercise
their back-in option if they don’t find 3.5 million or more ounces
there. And if they don’t find anything else, Linear will get it back with
Kinross’s extra $15 million of exploration invested.
Ixhuatán isn’t the 4 million to 5
million ounces everybody thought when the stock went to $12, but 1.7 or 1.8
million ounces. That’s still a mineable deposit, and certainly at
$1,000 gold, you can make pretty good money. It would interest a mid-tier
gold producer, who for $100 million could build a mine that produces 100,000
to 150,000 ounces
a year for eight to ten years. So they could generate some nice cash flow
from it and bump up production.
But as I say, Linear has a lot of cash and has
now gone to Brazil looking to make another discovery. As an exploration
company, it’s pretty cheap—pretty much trading at cash, and
there’s residual value for the Ixhuatán project. Either Linear
will own a 100% of Ixhuatán or they will have a 30% free carry, and
they’re spending exploration dollars in Brazil, one of the better
geological areas of the world for gold endowment. It’s a good place to
be looking for gold, and they’ve got the cash to do it. They
don’t need to finance. But management is going to be careful with cash
in a market like this—not aggressive.
So I’d say Linear is one of the better
exploration plays, given where it’s trading at and what’s in its
portfolio. If you buy this one, you can buy it at cash and stick it away. Linear
is a cheap exploration play, and there could be significantly more value if
they were to get a $100 million of cash from Kinross on a
back-in—that’s almost $3.50 a share in cash incrementally.
TGR:
How about First
Quantum Minerals Ltd. (TSX:FM)?
KS:
First Quantum is another copper stock that seems ridiculously cheap. It’s
trading at about three times cash flow, which seems pretty low. And First
Quantum has a good growth profile, with a number of projects in the pipeline.
It holds a 65% interest in the Kolwezi copper-cobalt tailings project under
development in the Congo. It’s a very simple project and will generate
a great return. First Quantum also bought Scandinavian Minerals with its big
Kevitsa nickel-copper-PGE project in Finland. That’s probably the next
project they will bring on stream, probably three or four years out. They
also own 20% of Equinox, another copper producer in Zambia. They don’t
have to buy anything. In Q2, First Quantum generated $300 million in cash
flow, up from $270 million in Q1. That’s $1 billion of cash flow for
the year, and their current market cap is about $3 billion.
Freeport-McMoRan
(NYSE:FCX) also
seems ridiculously cheap to me. If I were to buy copper stock today, I
wouldn’t necessarily buy Anvil or First Quantum. I would just buy
Freeport.
TGR:
What fundamentals would make Freeport more appealing than First Quantum or
Anvil?
KS:
Freeport has big mines and two big operating centers; one in the southwestern
U.S. with the old Phelps-Dodge assets, and also Grasberg (Papua province,
Indonesia), the world’s biggest copper and gold mine. There’s a
higher level of political risk with Indonesia, but the stock was recently
trading at $60; about 3.5 times cash flow. I have First Quantum trading at
3.3 and Anvil at 3.0 times cash flow.
But Freeport is not trading at an expensive
multiple; so that’s probably my starting point.
It’s the same with the golds, such as
Agnico or Kinross or Barrick or Goldcorp—all those stocks look pretty
cheap to me. That’s where you could start, and then on top of that
you’d want to own some development-stage companies or near producers
such as an Anvil—which is trading at a pretty modest valuation, and
it’s not a big-cap company—or a Detour Gold, an Andean, an Osisko
or CGA Mining or Bear Creek. All those names seem pretty cheap to me. You
just have to buy them and be patient.
TGR:
With prices so beaten down, is this the time for a long-term investor to be
loading up?
KS:
Yes, I would agree with that. If I had a longer-term horizon, more than a
couple of years, I would want to own maybe a couple of the big-cap
golds—Goldcorp or Kinross, for instance—and a couple of mid-tiers
such as Eldorado and Red Back, and three or four of the emerging
producers/development-stage companies—CGA, Detour, Osisko, Bear Creek. Because
if somebody comes along and buys Detour, I can guarantee they won’t get
it for $10 a share. It will be double, $20. I don’t know when that will
happen, but it’s going to happen with a company like this, assuming the
gold price does not collapse.
The big-cap golds cannot find enough ounces to
replace their production. They’ve never done it historically, and I
wouldn’t expect them to do it on a go-forward basis. Certainly a lot of
these companies grow by acquisition—Barrick, Goldcorp, Eldorado.
And if you look at the value—Gold Eagle,
with a $1.2 billion market cap and not even one resource ounce in the ground,
got taken out at a pretty big price. Or even Aurelian, with a current market
cap of $750 million. It’s a great discovery—no question.
It’s in Ecuador, which isn’t as bad as people think. Another
interesting one is B2Gold (TSX.V-BTO), which has a really nice exploration
portfolio in Colombia and a really good VP of Exploration. At some point a
discovery will come out of that.
Detour, with a market cap is $400 million, is
easily worth a valuation similar to Aurelian’s, $750 million. So if you
own something like a Detour with a 12 million ounce gold deposit in Canada
that’s in feasibility; that deposit could be in production within three
years. That’s worth looking at if you’re in the gold business. A
number of companies would like to own a project like that it. It’s not
a question of if it happens, but when.
I don’t know how long these things will
take, but if you’re patient, I think that’s where the
opportunities are.
Analyst Kerry Smith has consistently ranked among
the top 15 for precious metals and diamonds research, and earned top analyst
ranking for junior mining companies in the Brendan Wood International Survey
in 1997. In
2001, he brought his 20-plus years of experience in the industry to Haywood
Securities, joining the firm’s Toronto office as a senior mining
analyst. Kerry focuses primarily on companies with production in the precious
metals, base metals and diamond sectors. Kerry holds a bachelor's degree in
mining engineering from the University of Alberta and a master's degree in
business administration from the University of Western Ontario.
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