The Gold Report: You recently wrote, "Gold mining companies are no different from any other company in that company managements must determine the most effective way to return capital to shareholders."
In an environment where there haven't been corresponding increases in equity prices to the price of gold, how does a management group effectively grow per-share value for shareholders?
Chris Mancini: If you're too big and don't think that you can grow on a per-share basis, the answer is to return some of the cash to shareholders through a dividend. If a company doesn't have high-quality, high-return-on-capital, low-risk projects to deploy that cash flow into, then a portion should be returned to shareholders as a dividend.
TGR: We haven't seen a whole lot of that.
CM: Take Barrick Gold Corp. (ABX:TSX; ABX:NYSE) as an example. It had a goal of eventually mining 9 million ounces (Moz) gold and should produce around 7.5 Moz in 2013, which is a difficult thing to do. Barrick has been focused on growing for growth's sake. It undertook two very capital-intensive projects, Pueblo Viejo in the Dominican Republic, which is complete and should be producing commercially sometime next year, and Pascua-Lama, which is an enormous, capital-intensive project in the Chilean/Argentinean Andes, which the company is doing a poor job of building. That being said, it will be very cash-flow generative once it's built.
"We are in a positive macroeconomic environment for gold."
The question becomes at that point, once Pascua-Lama is built, what does it do with its cash flow? We're getting a sense that it wants to be a leaner, meaner company and that it's not going to focus on growing its very big production base. That's a good sign that it might start distributing more of its cash in a dividend.
TGR: A lot of senior producers, and even midtiers, are focusing on grade. Irrespective of all things, the higher the grade, the better the economic return.
CM: That's the key. A higher-grade deposit means processing fewer tons to get out the same number of ounces without the capital intensity of a big, bulk-tonnage, low-grade operation. The cost per ounce is also lower given that not as many tons need to be processed to recover the same amount of metal.
TGR: You don't hear many pundits predicting a falling gold price in 2013, yet we continue to see volatility in the space. What's your forecast for the gold price in 2013?
CM: We're very constructive on the gold price in all currencies. All over the world, money is being printed, and gold is the one currency that can't be reprinted or replicated. The money that's being printed will ultimately lose its purchasing power, and gold should retain its purchasing power. Gold should continue to go up relative to currencies that will be losing their value. More debt leads to more money printing, and more money printing leads to continued devaluation of currency. It's a positive macroeconomic environment for gold.
TGR: Some investors don't view gold as a currency. They view it as a metal, a relic.
CM: Historically, gold has been the ultimate currency and, at some point in the future, will again be the ultimate currency. It's not legal tender, but that still doesn't mean it's not something that will hold its value over time relative to paper.
TGR: Utah and a couple of other states have actually passed legislation that gold is considered a currency.
CM: In some states, you can bring in gold or silver and get goods for that gold or silver. The problem with that is federal tax. If you buy gold and it appreciates in value and there's a gain on that gold, when you sell or transfer that gold, then there is a federal tax on that transaction. Until that goes away, it will be hard to use gold as a real currency in the U.S.
TGR: Even in a world that hasn't descended to a serious level of crisis, gold can still be appreciating as a currency.
CM: It is a currency war. Currencies are devalued against one another. Recently, the Japanese elected the Liberal Democratic Party leader Shinzo Abe. One of his talking points during the election was that the Japanese economy is uncompetitive because the yen is too strong. Abe's theme is more monetary and fiscal stimulus, and a weaker yen. He and the Japanese people think that the country needs a much weaker currency in order to be competitive in the world economy. That's also why the Swiss agreed to their money printing exercise—in order to stop their currency from appreciating more and more.
TGR: It does feel like a race down the hill when you talk about it like that.
CM: If the Japanese, Swiss, and other Europeans print more and more money to make their currencies less valuable, ultimately the U.S. is going to be uncompetitive from a manufacturing perspective. It gives the U.S. impetus to also print more money.
TGR: We're talking about trillions of dollars of deficit. It's almost beyond comprehension. Because you value gold as currency, why don't you hold any bullion in the fund?
CM: Gold miners are undervalued relative to bullion, and investors can get bullion cheaper themselves. They shouldn't be paying us to own bullion. Bullion is a savings instrument. Gold equities are investments.
TGR: The fund's No. 1 holding, at about 12%, is Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE), which is heavily involved in Africa. I've traveled to Africa and was very impressed with the mineral wealth there. Yet some investors are not comfortable with that location. Why are you?
CM: When a company comes into a community, builds a mine and employs people, it liberates those people from poverty. They're building skill sets that they have for the rest of their lives.
"While precious metals is an extremely volatile sector, it can be volatile on the upside, as well as the downside."
A well-respected institutional mining company like Randgold comes into a region, employs people, educates people, liberates people—those people want that company to be there. It greatly reduces jurisdictional risk when you have that much local support.
TGR: Yet, there are places in Africa without that support. There are roving bands of thugs that are creating problems in the Democratic Republic of the Congo and Mali. Do you see these as temporary blips in an otherwise bullish and opportunistic area, or do you see this as a long-term thorn in the side of companies working in those areas?
CM: They're not necessarily blips, but they're not meaningful to the operations of Randgold. A place like Mali or the Congo is vast. As long as there are no specific problems near Randgold's mines, it's a non-event.
TGR: There are hundreds of kilometers of distance between the places where the problems are occurring and Randgold's operations, and no connecting infrastructure.
CM: It's extremely remote relative to political circumstances that may be transpiring around the country.
TGR: Your second largest holding is Fresnillo Plc (FRES:LSE), the No. 1 silver producer in the world. In a report you wrote that one of the things you like about Fresnillo is that it acts like an owner. "Unlike many other large precious metals companies, Fresnillo is an owner-operator company that's 80% controlled by a family-owned Mexican conglomerate."
CM: You have to ask yourself, as an investor, what's the management's incentive? For a large institutional-type precious metal mining company, their incentives may not be directly with the shareholders, whereas the owner of a company focuses on maximizing returns and cash flow.
TGR: Do you routinely look for companies with a lot of management ownership?
CM: That's something that's important to us. We look for skin in the game in the form of shares, not options, because we do want to see companies paying bigger dividends. If managers own shares, then they'll benefit when dividends are paid out, too.
TGR: Is there another example of a company with vested management that you are particularly excited about going into 2013?
CM: Guido Staltari, the chief executive officer of Australia-based Saracen Mineral Holdings Ltd. (SAR:ASX), is the founder of the company, has an ownership stake in the company and is very invested in the company. Saracen should produce around 115 thousand ounces (115 Koz) gold at a cash cost of around $950/ounce (oz) this year. It's in the process of expanding its operations. With an incremental spend of around $40 million (M), it should be able to increase its production by around 75 Koz/year and it should also be able to bring its cash costs down to around AU$850/oz.
TGR: That's a name I've never heard of before.
CM: Saracen is producing now. It's relatively low-risk growth and relatively high return on capital. The company has built a mill that needs some modifications. It has leases on its mining equipment, so it can upgrade the size and benefit from economies of scale that will come with using the new equipment without having to make a large capital outlay.
It also has some very prospective land that is relatively high grade where it is exploring. We hope that it will be able to increase its reserves. One of its deposits, Red October, is a higher grade than what it is currently mining. If it can grow the Red October deposit through exploration, then its average grade should increase, its costs should decline and its production should increase even more.
TGR: Are there any North America-listed names that are piquing your interest?
CM: One that has been hurt this year but has the potential within the next 18 months or so to do well is Kirkland Lake Gold Inc. (KGI:TSX). Kirkland Lake operates a mine in its namesake Kirkland Lake, Ontario, which is along the Abitibi gold belt. It's an old mine in transition. As it increases its production, it should benefit from economies of scale. Kirkland is also exploring a new, high-grade portion of the deposit called the South Mine Complex. It won't be without its fits and starts, and it's not without risk because it's a very difficult expansion that it's undertaking. If Kirkland does succeed, its production should grow from around 100 Koz this year to around 250 Koz at full capacity. Its cash costs should decline from around $900/oz to closer to $600–700/oz.
TGR: Assuming operating costs stay the same.
CM: Kirkland Lake's operational costs are going to go up, but not to the same extent that its production should go up. Right now, it is mining from 800–1,000 tons per day (0.8–1 Ktpd). The goal is to produce up to 22 Ktpd. It has around 900 workers underground now and wants to grow to 1,200 workers. It can more than double its production by just increasing its workforce by about 30%.
TGR: It's trading near $6/share now, after trading as high as $18/share. This stock has been smacked.
CM: Kirkland Lake's management has miscommunicated its production goals to the market. It has consistently changed its production guidance. First, it was going to be 2012, then 2013, and then 2014. The market doesn't trust anything that it is saying. Yet, that's why, over the next 18 months, it could do well, because the mine will be at a point where we will be able to see whether the company has been able to execute on its plan. The market wants to see consistent growth quarter over quarter and consistent decline in costs quarter over quarter. But given the nature of its operations, it's going to be lumpy for a while until it gets to a steady state. The operations are at this point essentially paying for exploration and/or serving as a training ground for new underground miners at the operation.
TGR: Have you been there?
CM: Yes, I recently spent a day underground with Chief Operating Officer Mark Tessier getting a sense for the operations and the expansion project. It's striking how many people go underground every day. It's only going to ramp from there. A lot of the miners come to the operation without any mining experience. It takes a while for them to get up to speed and to productive capacity. Once they do, the company has the potential to be a midtier producing company in one of the best jurisdictions in the world, producing at reasonable unit cash costs.
TGR: With explorational blue sky.
CM: If the exploration does work out from the South Mine Complex, then its costs should be below average, at about $550–600/oz.
TGR: It did a $69M private placement in November.
CM: Yes, and it did another one in the summer for about $57M. Right now, it has around $120M of debt. That makes it more risky. The balance sheet is more levered. I still like it, but it's not for the faint of heart.
TGR: What's another company in a great jurisdiction you can tell us about?
CM: Another North America-listed gold name is Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.MKT).
TGR: That's another one that's had great success, but a few bumps in the road.
CM: Aurizon doesn't necessarily have the growth prospects that Kirkland Lake does. However, it does have downside protection. It has a rock-solid balance sheet with $200M in cash.
"Our hope is that in the coming year, precious metals move fast and furiously on the upside and the environment is more constructive for gold and for gold miners."
It has had some operational issues recently, but the market is not latching on to the essence of the story. It is mining an old area and it is going to start mining in a new area, Zone 123 at its flagship Casa Berardi mine. Once it starts mining the new area, it should get steady production and generate a good amount of cash flow. In 2014, the company should be producing 135–150 Koz/year gold at cash costs of $700–800/oz, generating a good margin, in a great jurisdiction in Northern Quebec.
TGR: Aurizon is not flashy or sexy, but it sure gets it done. It's been impressive to watch that company.
CM: It has. The fact that it hasn't done an acquisition yet with its $200M cash hoard speaks volumes.
TGR: One of the things that is compelling about a lot of midtier producers is that they are nimble. They can pare back a little bit. They're small enough to decide to stick to where they're having explorational success with their own assets. We're seeing that with several of these midtier companies. As an investor, it makes them more attractive in some ways than the seniors.
CM: Yes, I agree. They don't have the overhead of the seniors. The seniors almost have to buy something in Nevada, for example, because they currently have all of the overhead in Nevada and they have to sustain it. That's not the case with these small, single-asset companies.
TGR: Let's go to silver. Could you talk about a couple of silver names that you find compelling?
CM: The one that makes sense to talk about, given that we spoke about Fresnillo, is MAG Silver Corp. (MAG:TSX; MVG:NYSE). MAG Silver has 44% of the Juanicipio project, a property that is near Fresnillo's namesake mine. Fresnillo has the rest of the project.
Fresnillo is the highest-grade silver mine in the world. Juanicipio has a similar geological structure to the Fresnillo deposits. These are epithermal vein systems. At Juanicipio, the company has delineated a deposit that is around 230 Moz silver at very high grades. It's a silver equivalent grade of 700 grams per ton; this is an extremely high-grade deposit in one of the best jurisdictions in the world, Zacatecas state. Fresnillo is the best miner and developer of high-grade underground silver deposits in the world.
TGR: What needs to happen with Fresnillo and MAG Silver to unlock the value of MAG Silver for shareholders?
CM: Obviously, for Fresnillo to buy out MAG Silver's 44% stake of the Juanicipio project. That's the best-case scenario for both companies and for shareholders of both companies. They just have to sit down in a room, hash it out and come up with something that's reasonable.
If they can't agree to a price, MAG Silver could spin out the Juanicipio asset to shareholders, who would then get one piece of paper that's 44% Juanicipio and another piece of paper that is all of MAG's other exploration assets, some of which are very prospective. For that 44% in Juanicipio, ultimately the shareholders would get a cash call. They would have the option to either participate in the cash call to fund a portion of the capital expenditures for the project or get diluted down. Once Juanicipio gets built by Fresnillo, shareholders would still have the 44% stake in the cash flow from this operation that would be returned in the form of a dividend.
TGR: That's an interesting idea.
CM: Yes. I think that it would be valued very highly in that it would be like a royalty company. It would be 44% of the profit from one of the best silver mines in the world, operated by one of the best silver miners in the world.
TGR: It might be easier from both companies' perspectives if everything is separated that way.
CM: That's true, too. The first step is separating the assets out. But value can be surfaced for a MAG shareholder even if Fresnillo doesn't buy it.
TGR: Is this something that's already on the table?
CM: I've spoken about it with management. Director Peter Megaw is a relatively large holder of MAG Silver. He is motivated to do what's in shareholders' interests. If it does spin this out, it makes what's remaining a smaller company. It has to start over again, which is fine because Megaw is one of the best exploration geologists in the world at finding epithermal vein and carbonate replacement deposits.
TGR: It's not really starting over because what it has outlined in its exploration assets is actually pretty compelling.
CM: That's true. It's not starting from nothing. It has delineated some exciting prospects at its Cinco de Mayo project in Chihuahua.
TGR: Do you have some final thoughts for us on the mining space?
CM: It's been a difficult year. Yet, while this is an extremely volatile sector, it can be volatile on the upside, as well as the downside. Our hope is that in the coming year, it moves fast and furiously on the upside and the environment is more constructive for gold and for gold miners.
TGR: Excellent. Thanks for taking the time to speak with us today.
Chris Mancini is a research analyst at Gabelli specializing in precious metals mining companies. He has over 13 years of investment management experience, including research analyst positions at hedge funds Satellite Asset Management and R6 Capital Management. Mancini earned a bachelor's degree in economics with honors from Boston College and is a holder of the CFA designation.
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DISCLOSURE:
1) Sally Lowder of The Gold Report conducted this interview. She personally and/or her 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: Aurizon Mines Ltd. and MAG Silver Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Chris Mancini: I personally and/or my family own shares of the following companies mentioned in this interview: Randgold Resources Ltd., MAG Silver Corp., Kirkland Lake Gold Inc., Barrick Gold Corp. and Fresnillo Plc. 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.
