Barry Allan: Intermediate and Development Plays Are the Golden Ticket
Source: Brian Sylvester and Karen Roche of The Gold Report 5/14/10
In this exclusive and revealing interview with The Gold Report, Mackie Research Capital’s Barry Allan, always among Canada’s top-ranked mining analysts, says the European currency crisis and crippling debt problems will push gold—and the U.S. dollar—higher throughout the rest of 2010. But gold and the greenback may not be the biggest winners as a result of a faltering euro. Allan suggests other currencies could have the most to gain as investors seek other havens. Allan also sheds some light on why the best bets in the gold sector are intermediate and development plays.
The Gold Report: Barry, the last time we spoke, you told us gold typically has a rough first quarter. Tell us how the yellow metal fared in Q1.
Barry Allan: It’s typically the end of the first quarter where gold gets into problems, and then into the second quarter. We’re kind of still in that process. What we did see was a rather good gold price relatively speaking; it largely held, and the price went more laterally over the last short while with the whole potential bailout of Greece. By that, I mean it didn’t have a sharp correction, but it did go sideways.
TGR: And where do you see the gold price heading later this year?
BA: We will be looking at a better gold price environment. I think the variable that we now have, which we didn’t have previously in our discussion, is the impact of the potential desegregation of the euro, and the whole notion of what that will do for the gold price vis-à-vis the currency crisis. With the euro crisis, you’re going to get a flocking to the U.S. dollar and gold. With the rise of the U.S. dollar, you’re also going to get a rise in the gold price, which is a bit of an unusual feature—and we’ve already had that.
TGR: So you think the sovereign bailout of Greece is likely to fail?
BA: Certainly in my travels—I was just in London, England and New York—there’s a general belief that the whole concept of a bailout of Greece is going to fail, and it will take some time, but it will ultimately fail. And that will cause further dislocation of the euro and hence benefit gold and the U.S. dollar. So later this year, we fully expect a better gold price.
TGR: Do you see a dramatic rise?
BA: Certainly, the elements are there. I think we’re all dealing with the same hand to a certain extent, in the sense that what will ultimately happen with the euro remains to be seen. The indications are that Greece is definitely having issues. But there are also other weak parties in the euro that may show some problems. If that happens, that’s just going to accelerate the whole crisis of the currencies, which will be a positive for the U.S. dollar or other world currencies and for gold.
TGR: In the same way people are talking about Greece, people are talking about Portugal and Ireland; people are even talking about England. If England shows any kind of debt issues, will people really flock back to the U.S. dollar or look to alternative currencies as a safe haven?
BA: The practical part of it is that you can move huge amounts of currency in a pretty short period of time, and what typically happens is money will slosh around in different currencies and go from one currency to another as circumstances change. I saw it a while back by virtue of friends of ours in Ireland who were wanting to move money out of Ireland and saying, “Where do we go?” and their first impulse was to go to the U.S. dollar. I said, “Well, I’m not so sure that is your best place to go. Would you consider putting money into gold?” Their immediate response to me was, “What you say might all be true, but you don’t understand how bad the prospects look for the Irish currency.”
TGR: How long can we expect this situation with the euro to last?
BA: It will occur until such a time as the situation in Europe stabilizes, and then we will find a more moderate exchange rate. But there will be—and there has already been—a movement to world currencies, and other potential currencies might emerge as world currencies.
TGR: As far as gold investments go, what sort of vehicles are you most likely to recommend to people?
BA: It really all depends on one’s tolerance for risk when it comes what vehicle you choose or how you gain that exposure to gold. On a recent trip through Europe, as well as New York, for the first time ever I found almost no interest in senior gold stocks. People are saying to me, “If I need that kind of exposure, I will just go to the ETF, thank you very much, and not take on operating risk. If I want to invest in equity, I want something that is going to give me a 20%-30% rate of return; hence I am going to look into the smaller tier of gold stocks where there’s something that’s got more sex appeal, with exposure to the kind of company as well as gold.” That struck me.
TGR: What are the reasons behind it?
BA: I think there are probably two reasons behind it. One has been the evolution of the ETF as a viable instrument and one that factors in people’s thinking; the other is exposure to the gold price without taking on operating or political risks. You may have some element of counter-party risk there, but you certainly don’t have the operating risk aspect. Until recently, the senior gold stocks had not really distinguished themselves because they were not able to show really good increases in bottom-line performance with this rise in gold. They were largely wrestling with operating costs, the growth in cash flow and earnings as a result of better commodity prices. I think the backlash was people saying, “Fine, if I’m going to buy an equity, I want something that’s going to give me good, solid rates of return, and that’s something more than just 10%”
TGR: An April research report from Mackie says you’re bullish on Barrick Gold Corp. (NYSE:ABX;TSX:ABX) and Newmont Mining Corp. (NYSE:NEM), but less so on some of their competitors. What are Barrick and Newmont doing that others are not?
BA: What I had recognized in making that statement is that certainly both Newmont and Barrick would give us good bottom-line performance. In other words, show us good leverage in a gold price environment, give us earnings, give us cash flow. Both Newmont and Barrick did handily outperform street expectations in Q1 based on much better commodity prices.
TGR: What’s your view of Goldcorp Inc. (NYSE:GG;TSX:G) and Kinross Gold Corp. (TSX:K;NYSE:KGC)?
BA: I was only a little bit more moderate on Goldcorp because of the fundamental fact that Goldcorp has a very big mine it is developing, called Peñasquito in Mexico, which really doesn’t hit full stride until the end of 2010. I thought the share price would tend to lag initially, but certainly get better toward the end of the year.
In the case of Kinross, again it was a fundamental issue that I wanted to see, which I have not yet seen. One of the major mines it has developed—the Paracatu mine in Brazil—has some operating issues. It’s been a recovery problem, and sometimes recovery problems can be systemic. I was being a little bit more cautious with Kinross; as with Goldcorp, their major portion of growth is yet to come.
TGR: What are some of the mid-tiers best positioned to capitalize on the stronger gold price like Barrick and Newmont have?
BA: The two we have selected within that group are El Dorado Gold Corp. (TSX:ELD;NYSE:EGO) and Agnico-Eagle Mines Ltd. (TSX:AEM). What I recognize in both of those names is a tremendous growth profile—when I say “tremendous,” I mean quite dramatic growth profiles over the next two years, whereby the companies are effectively transformed from where they are to where they ultimately should end up.
In the case of Agnico, that’s probably going to be the year-end before we see that transformation. In the case of El Dorado, it’s probably going to be more into 2011. But both of these companies have a tremendous growth profile, so they’re going to dramatically increase production. We are not alone in looking at them; they’re probably the two names in the intermediate space that the “Street” loves to love, and so they tend to be expensive. You’re paying up front for growth that’s going to happen later this year or next year. We’ve been a little bit more “nimble,” if you will. We’ve always bought Agnico-Eagle on bad news; we try to get a better value based on whatever startup issue it might have. In the case of El Dorado, we try to do the same. We recognize that both of those companies are exceedingly well positioned for the next 18 months to deliver spectacular growth rates.
TGR: You place gold companies in four groups: senior equities, intermediate equities, junior equities and development equities. Could you explain what differentiates companies in the last three categories?
BA: When we talk about a junior mining company, we’re probably talking something that has a production capacity of less than 500,000 ounces. An intermediate would be 500,000 ounces or more. Typically, the market cap is, in the case of Agnico-Eagle, a $10 billion market cap type company, whereas if you get down into the juniors, the market cap will be more into the $2-$3 billion kind of range. The junior mining company probably has one or maybe two operating assets in its portfolio, whereas the intermediate guys will have more and that provides them with more production base diversity.
TGR: And the risks of each?
BA: The intermediates probably have a lower liquidity risk. And because they have multiple mines in production, they have a bit more portfolio-type flexibility in managing their production base. So a little bit lower risk there as well.
In the case of the juniors, you tend to be leveraged to a particular mine. So you have a higher degree of operating risk associated with the junior, and you may have an element of political risk, depending on where that mine is located. From our perspective, the risk profiles are a little bit higher on the juniors than on the intermediates.
TGR: There was also a “development” category. Describe those companies.
BA: Companies in that tier are not producing. They’re companies either building mines or at the early stage of mine assessment. They’re companies that have advanced beyond exploration but don’t have a mine in production.
TGR: And the risks?
BA: They have incumbent risks associated with them depending on where in the development cycle they are. For companies that are reasonably well advanced as far as having mines under construction—Osisko Mining Corp. (TSX:OSK) is an example—it would typically have a lower-risk profile than a company like Oromin Explorations Ltd. (TSX:OLE;OTCBB:OLEPF) or Sandspring Resources Ltd. (TSX.V:SSP), which really have just a National Instrument 43-101 resource estimate and are conducting pre-feasibility studies of those resource ounces and trying to get to the feasibility stage. So it is a much higher-risk profile.
TGR: What types of risk?
BA: There are lots of different types of risks. You clearly have a funding risk because most of these are unfunded projects. You have a construction risk in the sense that if you have a reserve, then you have to start building the mine. In some cases, we don’t even have a reserve; we have a resource, and we’re not sure how much of that resource is going to convert into reserves, so you have a geological risk. In that tier, you’re going to want a much better return to compensate you for the risks.
TGR: Some companies in the development category have been doing quite well. Tell us about those.
BA: In the development equities, it’s about taking those risks that we talked about and removing them from the equation. A company that was our top pick for this year was called Comaplex Minerals. It’s been taken over by Agnico-Eagle. That’s a classic in what we really are looking for in this group of companies. What Comaplex did was de-risk the project to the extent that there was someone out there, in this case Agnico, who felt that this would be a good fit for its asset base. We got a good valuation as a result.
We’re looking at a couple more that fit into that category, albeit much further behind than a Comaplex, like an Oromin or a Sandspring. We would say Oromin is probably a year or so behind where Comaplex was; we expect there will be some form of take out there as well, but it won’t be until the end of this fiscal year until we’ll be in a position to really see that.
And then with a Sandspring, which is even further behind than Oromin, that’s likely going to be a 2011 event. But this is about expanding the resource size beyond what we currently believe it to be; then taking those resource ounces and de-risking them into reserves; and then about looking at the economic prospect of developing them into an operating mine. That’s where you have your highest risk; but if you get it right, you also get your best returns.
TGR: What are some other development-stage juniors on your radar?
BA: We’ve been deep into Rubicon Minerals Corp. (NYSE.A:RBY; TSX:RMX); we were their first financiers. But let’s be clear, Rubicon has the highest risk profile of probably any company out there. It was pure exploration, and they’re still in exploration at this juncture. Rubicon has found something of very significant size and proportions, and the real question is: what have they found? That’s what the market is debating. They’ve got well over 150 holes drilled into something that is holding together very nicely. We’re clearly, and have been for some time, on record as saying that we think there is something very material to Rubicon. We have put some numbers around it, but we’re ahead of where the company is.
TGR: Any others?
BA: Detour Gold Corp. (TSX:DGC) has the Detour Lake project. It will be a big project to build so there’s a big funding requirement. The market has taken a little bit of a slower response in looking at Detour because of those issues. It’s really a question of how they are going to fund this thing. Are the shareholders going to be diluted, or is it going to be a very large debt position? That’s a major part of that story that needs to be de-risked before you see the next increment. They’ve got an economic assessment of what all those ounces mean, and it’s now time for them to actually fund and build a mine.
TGR: Do you still see share price upside on either Detour or Rubicon or both?
BA: Definitely; probably more so on a Rubicon than on a Detour, but that’s a personal judgment. I think Detour has more significant issues to deal with in the development cycle than its compatriot, which would be Osisko. Osisko and Detour are direct comparables, and there’s a third one, which is called Rainy River Resources Ltd. (TSX.V:RR), which would fit into that category as well. These are the large, low-grade, open-pits in Canada.
TGR: The track record of these projects is somewhat sketchy, no?
BA: That’s absolutely correct. The mining industry takes a very cautious view on these large low-grade pits when they get up to this size in this part of the world. We have not had a successful track record in Canada of running and operating these large low-grade open pits. So there’s a bit of a technical hesitation among the mining companies about getting involved in a takeover bid, but there’s also a very significant entry price, because we’re talking about some big market caps to buy and build.
Sandspring’s Toroparu is much smaller and more modest in an area—Guyana—where there have been a number of these deposits developed over the years. Historically, they’re a little easier to mine, so there’s a better track record there.
TGR: Are you saying Sandspring is a more likely takeover target than Detour?
BA: Our view on Sandspring is more about adding ounces to the resource than it is about an imminent takeout. Detour has done all that work; they’ve shown the economics, and now the market is saying, “Alright, let’s see you build it.”
TGR: Among some of the risks you highlight, you say that share liquidity has impeded some valuations, at least in the short term. To what extent has the merger and acquisition activity overcome the restrained evaluations?
BA: Well, for instance , we can point to the recent purchase of Comaplex by Agnico-Eagle. Comaplex had quite a good market performance over the fiscal year. I know that just prior to the purchase by Agnico-Eagle, the stock was in the $8 range and Agnico offered them $10. There was a 20% premium right there. That reflects a little bit of that valuation you get off of better liquidity and the better values at which senior golds will trade—or an intermediate in this case—relative to a junior. They can offer those kinds of prices and still show accretion to their shareholder base. So that is another way of looking at that element of liquidity: what can it do for you? Now, there’s also the possibility that the senior mining company is prepared to be more aggressive with the purchase price. But I would suggest to you that generally speaking, the valuations on a more liquid stock are better; thus, they are able to offer the junior a premium and still be able to show accretion to their bottom line.
TGR: What about some noteworthy junior golds?
BA: Aurizon Mines Ltd. (TSX:ARZ; NYSE.A:AZK) is a steady-as-she-goes type of company. They’ve done a good job building their mine, which is Casa Berardi. They have reached a steady level of operation and they’re not going to embarrass us. I think the market has started to ask—and we have asked this as well—”Alright, where do we go to from here other than the gold price? We’re a producer of 160,000 ounces. Where’s my sizzle? Where’s my joy? To get off into that intermediate category, I am going to have to double my size; so how is that going to happen?” That’s really been the issue for Aurizon at this point. They know that; they have a development team that’s been out looking at new acquisitions. Aurizon has a property called Joanna that probably is not sufficient at this point to get them to that level, but they are spending. Lately they’ve had a little bit more success drilling there. And they’re drilling Casa Berardi to get additional mineralization. Those are kind of organic things, and the market is looking for something that is a bit more of a step change.
TGR: Are there some other junior companies that are steady producers with some upside?
BA: Alamos Gold Inc. (TSX:AGI) is similar to Aurizon to a certain extent, except it’s a Mexican producer. Alamos fits into that category with a Gammon Gold Inc. (NYSE:GRS; TSX:GAM) as an operation that is in Mexico that is producing gold and silver. It’s an open pit; it had initial start-up problems, but the practical part of is that they got it right, and they’re doing very well on an operating front. They’re producing consistent operating results from quarter to quarter with good operating costs, and now what they’ve done is they’ve gone out and tried to leverage their operating talent into two properties in Turkey.
The catch with Alamos is it’s a big step for a one-mine company going from Mexico to Turkey, and that’s just sheer politics of jurisdiction. The assets look like they’re similar; I have not actually seen them.
Barry Allan joined Mackie Research’s Investment Banking Department in 1998 as a mining specialist, and transferred to the Research Department as a Mining Analyst in 2001. Barry has over 15 years of experience in the mining sector. Prior to joining Research Capital, Barry was a Gold and Precious Metals Mining Analyst with Gordon Capital, BZW, and Prudential Bache. Prior to equity research, Barry was a member of the specialist finance group at CIBC, one of Canada’s largest financiers of mining projects. Barry earned his B.Sc. (Geology) and MBA degrees from Dalhousie University.
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1) Brian Sylvester and Karen Roche of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None
The following companies are sponsors of The Gold Report: Aurizon Mines Ltd., Detour Gold Corp., Sandspring Resources Ltd., Rubicon Minerals Corp., Goldcorp
2) Barry Allan: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family are paid by the following companies: None.
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