Mike Niehuser: Producers’ Upside Potential

Source: The Gold Report 07/21/2010

Fascinated to see gold soar in a period of low inflation, Beacon Rock Research Founder Mike Niehuser won’t be surprised if it crosses the threshold into 2011 at above the $1,500 price point. Whether it levels off or reaches new heights, Mike explains where to seek investment opportunities in this exclusive interview with The Gold Report. According to him, companies with improving near-term production, pipeline projects to expand reserves and promising exploration prospects present better-than-average potential for returns. Because the market is pricing some pessimism into equities these days, he also sees good opportunities in companies with strong potential to increase fundamental value.

The Gold Report: Considering the turns we’ve seen in the relationship between gold and the U.S. dollar, what is your view on gold prices these days?

Mike Niehuser: We are really quite happy with where the prices are now. Our beginning of the year guess for gold in 2010 was a range of $900 to $1,200 per ounce. We saw a greater potential for gold exceeding that range and going to $1,500 than for retreating to below $800. While gold prices have been closer to the high end of our range, this has pretty much been the experience so far this year.

Over the last eight years, precious metal prices moved up beginning in the early fall through spring, due to increased seasonal demand in Asia, then flattened over the summer months. This pattern broke in 2009 as investor demand offset reduced demand by jewelry fabricators. For 2010, gold prices have remained surprisingly strong given the increasing perceptions of a double dip in the economy, low inflation and low interest rates.

It is fascinating to see gold at record highs during a period of record low inflation. It makes one think something else must be supporting current prices. In any event, with renewed seasonal demand coming in August and September and the potential for government monetizing debt or other stealth stimulus programs, $1,500 gold prices at year-end are not out of the question.

TGR: Do higher gold prices translate into opportunities for gold stocks?

MN: Obviously, higher metal prices should bode well for gold stocks, but this is not necessarily so across the board. For a company’s stock to do well we would assume that there must be some combination of improving company-specific fundamentals or interest in the mining sector. On the continuum of investor tradeoff between risk aversion and return requirement, institutionalized concerns over a double dip in the economy has led fear to win out over greed.

Mining and gold exploration stocks are considered to be on the riskier end of the spectrum for all equities. Over the last couple years, even companies with good projects and a track record for meeting guidance are not getting the respect they deserve. There are probably a number of concerns weighing on the minds of investors that will persist through the end of 2010.

TGR: Are you implying that this may be a good time to reduce holdings of mining and metals companies?

MN: Not at all. It is really more a factor of time horizon and expectations for return. We continue to believe that companies with improving fundamentals will outperform companies that do not create value. A lot of pessimism may be priced into the market now, which creates an opportunity for careful stock selection opportunities for investors looking for companies with the potential to increase fundamental value. We are living in historic times, and growing expectation of a double dip in the economy is all too reminiscent of the stagnation in the economy during the 1970s.

TGR: What parallels or factors do you see influencing the economy?

MN: It is starting to look a lot like the Nixon and Ford years. As if the ’60s were not unsettling enough, the Nixon administration brought forward new regulations including the EPA and OSHA, deep-sixed Bretton Woods for a floating exchange rate, enacted wage and price controls, and introduced the earned income tax credit, which was a redistributionist negative income tax.

The current administration has accelerated deficit spending and intervention into private markets. Clearly, deficits can either be reduced by increasing tax revenues or financed with more debt. Fortunately, we are in global markets and for the time being, the Chinese are maintaining an artificially low exchange rate while the U.S. dollar has been strong against the euro. As the exchange rate moves into balance, interest rates in the U.S. should increase and the government may be forced to monetize the debt.

This is why we like gold producers; while the government produces and monetizes debt, diluting intangible assets, gold miners are producing the ingredients of real currency. From a stock point of view, many companies with operating mines are still trading below levels seen just years ago before the mines were built or in operation. These appear to be among the best opportunities to preserve principal with some upside potential.

TGR: Given the uncertain outlook for the economy and investing, what do you look for in gold stocks?

MN: It would appear that the market may become less efficient, not more. Small investors have a bad taste in their mouth and computerized trading by institutions suggests stocks are being influenced by factors that aren’t company-specific. It is not clear what the market will identify in an individual company stock that will lead to a full valuation. If metal prices appreciate rapidly, the market may look for exploration upside. If metal prices are flat and investors more defensive in looking for value, they may want production and cash flow, or improving balance sheet fundamentals. It makes sense to me that good stock selection would look for one or the other, and if possible both. This may include companies that have improving production profiles in the near term, project pipeline to expand production or reserves in the near term, and competitively promising exploration prospects on the horizon. As the market may not currently recognize more than one of these characteristics, when it does it would be logical that those stocks have a better-than-average opportunity for performance.

TGR: Could you tell us about some companies that fit the investment profile for a range of opportunities?

MN: The first is Brigus Gold Corp. (TSX:BRD; NYSE.A:BRD). This is the recent business combination of Apollo Gold and Linear Gold. Apollo brought in the gold-producing Black Fox mine and mill near Timmins, Ontario and Linear brought in cash, which immediately improved Apollo’s capital structure. This appeared to be a good fit as it was a merger of equals, and strength was matched with weakness, immediately resulting in a less risky and more financially flexible company. The stock price has not reflected this perspective, but by optimizing production they should continue to reduce project debt and the gold hedge that will both increase profitability and reduce risk in the near term.

Brigus in the mid-term has good exploration upside at the Black Fox mine. Deep drill results below the identified resource with even better grades may expand the current mine resource. It is not unknown for underground mines along the fault structure in the Timmins area to go several hundred meters deeper. Apollo had also acquired the Grey Fox and Pike River along another fault that has reported very good drill results near surface. As the Black Fox mill is being optimized, there is very good potential with additional exploration success to demonstrate that potential resources in these new areas are reserves increasing the mine life.

Brigus also brought in its Goldfields Projects. I have not visited these, but they are a reserve level of classification, which means they are advanced assets and should be economic. Both exploration at Black Fox and advancement of Goldfields are reasonable mid-term opportunities. Both Apollo and Linear brought reasonably prospective long-term exploration projects into Brigus, particularly Apollo with its Huizopa target near Minefinders Corporation’s (TSX:MFL; NYSE:MFN) Dolores mine in Chihuahua, Mexico.

TGR: Does Minefinders fit your investment thesis?

MN: It does. It is interesting that Minefinders is now profitable and selling at or below where it did earlier, even before there was a road built to the Dolores mine site. Minefinders also has good potential to outperform market expectations this year. Mining in the open pit is moving into the heart of the deposit, encountering higher grades of both gold and silver. Company guidance for the year anticipates higher grades of gold in the second half and silver grades stepping up each quarter. They also appear to be focused on improving the recovery rates of silver, which also should lift production. As Minefinders is unhedged, it should benefit from higher metal prices, and with increasing production, costs per ounce of production should decrease. A combination of these events should provide good opportunity for increasing profitability in 2010.

Minefinders is also studying the addition of a 3,000 ton-per-day flotation mill. This would allow Minefinders to access ore underground below the pit or in the pit wall in parallel high-grade structures. As with Brigus, the ability to process additional ore potentially would allow additional resources to come into reserves, increasing Dolores mine’s economics and mine life. This would also lead to higher and more consistent recoveries of both gold and silver and even higher levels of profitability.

Minefinders also recently reported a prefeasibility study on its La Bolsa gold project on the south side of the U.S.-Mexican border. La Bolsa is anticipated to be a profitable, low-cost heap leach gold operation. The project has a low strip ratio with low risk profile and, like the opportunity of a mill at Dolores, provides a solid mid-term component to the investment profile. The management team at Minefinders are explorationists at heart, and it would appear that with their discovery at La Virginia they may have located a Dolores “look alike.” La Virginia, with Minefinders’ other exploration prospects, provides good long-term upside.

TGR: Any other good fits?

MN: Alexco Resource Corp. (TSX:AXR; NYSE.A:AXU) is not in production yet, but considering the modest size of operations, it has very good potential to be at a full run rate by the end of 2010. Alexco is on schedule for constructing its 408 ton-per-day flotation mill at its Bellekeno mine at its wholly owned Keno Hill Silver District. Alexco has applied for its water license, its critical last step before commencing production. Upon receiving this important permit, the mill will begin production and thus eliminate much of the remaining risk.

In addition to the relatively lower risk of a small operation, Bellekeno will be among the most profitable high-grade silver mines in the world. Historically, the Keno Hill Silver District produced over 200 million ounces of silver at about 60 ounces per ton. The ore contains lead and zinc and should be desirable for smelters. Alexco’s exploration team has consolidated and studied historic data on the district and has had good success with blind targets. The company also has embarked on an aggressive 30,000-meter-drill program in 2010 that may reveal additional blue-sky upside in the near term.

It is interesting that Silver Wheaton Corp. (NYSE:SLW; TSX:SLW) contributed C$50 million for the development of the Bellekeno mine in exchange for purchasing only 25% of the district’s silver stream at $3.90 per ounce. As the identified resource does not provide a significant return on investment for the investment, it must be apparent to them that the Keno Hill Silver District has enough exploration upside to complete the transaction. The current drill program is devised to focus on 5,000 meters of underground drilling at Bellekeno to expand the deposit and mine life, as well 25,000 meters to locate the next mine at Keno Hill. As Alexco is also being paid for environmental cleanup of earlier mining operations, they have other upside over the long term.

TGR: Great. That’s a lot of good information about Brigus, Minefinders and Alexco. Thank you.

MN: All three of these companies appear to be well managed with competent individuals for exploration through production. In addition, all three trade on both the TSX and the NYSE Amex, so they should have exposure on both sides of the border.

Metals and mining Analyst Mike Niehuser is the founder of Beacon Rock Research, LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Named after what Mike describes as the largest monolith in the western hemisphere, Beacon Rock Research is an independent investment research firm committed to help investors “attain an uncommonly better understanding of opportunities and risks, enhancing the possibility of timely and informed investment decisions.” Its work is designed to withstand the “torrential flows of contrary and fickle opinions and beliefs” and go beyond the “cramped conventional wisdom (that) often spoils natural curiosity and optimism, the attributes fundamental to learning, understanding and making the intuitive connections that help us perceive what might be around the next bend.” Previously a vice president and senior equity analyst with the Robins Group, a registered broker dealer, Mike also served as an equity analyst with The RedChip Review, where he initially followed bank stocks but expanded to a diverse industry range. A graduate of Pacific Coast Banking School—where he now serves on the faculty—Mike spent 18 years with U.S. Bank, with expertise in all areas of real estate lending and valuation. A life-long learner, he earned his B.S. in Finance at the University of Oregon. He has written hundreds of research reports and related articles on investing in small cap companies.

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1) The following companies mentioned in the interview are sponsors of The Gold Report: Brigus Gold and Minefinders.
2) Mike Niehuser: I personally and/or my family own shares of the following companies mentioned in this interview: Minefinders and Alexco. I personally and/or my family am paid by the following companies mentioned in this interview: Brigus, Minefinders and Alexco.