Brock Salier Unlocks the Secrets of Gold Miner Valuations

The Gold Report: Brock, your research suggests that the production margins of gold companies are near all-time highs. Why has that not translated to share price appreciation?

Brock Salier: The weak equity markets play a role in the disconnect between gold prices and gold equities, but a lot has to do with maturing gold assets.

A lot of gold mines were funded between 2007 and 2009 and commissioned between 2008 and 2010. Most companies typically mine above their reserve grade for the first one to three years to speed capital and debt repayments. But, if they have not found an expansion and completed a feasibility study, or if they lack a new mine to develop, that grade has to fall. As production falls, cost rises and share prices legitimately fall along with profits.

TGR: Can you go into a bit more detail about that concept, which is known as "high grading?"

BS: If a company plans to mine for 10 years at 2 grams per ton gold (g/t), in the first two years it will often mine at perhaps 2.4 g/t. This lowers costs and increases production, which brings the company's cash flows forward. In addition, tax breaks in the early years often motivate companies to get as much cash as soon as they can.

By the third year, the mine's residual reserve is 1.8 g/t. The same amount of material goes through the plant, but production drops while operating costs stay the same. The company is spending the same to produce less gold; there is less profit.

"The companies with the very high-grade deposits are lucky enough to be able to mine under reserve grade."

At this stage, many companies will have an expansion or a new mine in place. For example, Banro Corporation (BAA:TSX; BAA:NYSE) is mining above reserve at the Twangiza mine in the Democratic Republic of the Congo (DRC). When that grade falls, its second mine, Namoya, should come into production. And while Teranga Gold Corp. (TGZ:TSX; TGZ:ASX) does not have a second mine, it has an expansion, which should allow the company to maintain its production level.

TGR: What is the quickest way for an investor to learn whether a company is in fact high grading at the start of its production cycle?

BS: Investors should always check the last quarterly report to see what the head grade is going into the mine. Quarterly, every company will tell you what grade it is mining and what its reserves are. If the reserve grade is substantially lower than what is being mined, you know that eventually production will fall. The reverse is also true.

Some companies, such as Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE), are mining well under their reserve grade. That is a great position to be in because it means production will rise and cash cost will fall as the mine goes on.

The companies with the very high-grade deposits are lucky enough to be able to mine under reserve grade. In Randgold's case, many of its mines have reserves at 5 g/t and are being mined at 3.5 g/t.

TGR: In addition, when a mine comes into commercial production with 100,000 ounces/year (100 Koz) gold, it does not necessarily mean it will produce 100 Koz/year gold for the life of the mine.

BS: Ideally, the mine will produce 100 Koz/year and after a few years when the grade declines, the company will do an expansion and continue to produce 100 Koz/year. Without an expansion in the plant, production and profits will drop after about three years.

TGR: Is it best for an investor to get in just before commercial production begins and not stay invested too long?

BS: It makes sense to get in before commercial production begins and then take a view on the next project or the expansion. If you think the company's expansion or the second project is legitimate, has been funded, has a feasibility study and perhaps is under construction, it is definitely worthwhile to stay in the company.

"It makes sense to get in before commercial production begins and then take a view on the next project or the expansion."

If you go in before commercial production and later the company's expansion and feasibility studies are not being completed on time or a second mine is not in the pipeline, you do not want to be stuck holding that company as its production goes through the shrinking phase.

TGR: Given all of that, what happens next in this space?

BS: There are three scenarios for mid-cap producers. First, companies like Teranga that have expansion nearing completion or companies like Banro that have a second project fully funded and under-built can simply extend their production. They are in the best position.

The second scenario is companies that may not have that production growth, yet are generating cash. This is where the merger and acquisition (MA) story comes alive. We are seeing a significant increase in nil premium, or paper mergers, and consolidation. Mid-cap producers without growth projects can nonetheless start consolidating to create larger companies and value that will snowball up their production.

The third scenario, unfortunately, is companies without expansion or new projects that are not undertaking some kind of MA activity. They will get left by the wayside.

TGR: Recent deals have included early-stage or midtier producers buying production, and, in some cases, exploration assets from small-cap players. There seems to be a merger of needs scenario right now.

BS: You are right about the merger of needs. In 2011, we saw relatively easy access to debt and equity among the juniors and very high equity valuations. The juniors had a degree of comfort, such that when they were approached by mid-cap producers with maturing assets, the valuations were too high or, alternatively, the juniors did not need to be acquired. They could self develop.

In 2012, the juniors' valuations are significantly lower, due mainly to capital constraints. They can no longer self develop, and MA makes a lot more sense.

TGR: Which smallish producers could see some MA interest?

BS: Cluff Gold Plc (CFG:TSX; CFG:LSE) is a good example of a small producer that could see some attention. It has a small producing asset in Burkina Faso and a substantial, undeveloped project in Sierra Leone. Cluff's producing mine offers immediate, added production and cash flow to a bidder. Its undeveloped project, which is receiving little valuation in the equity market right now, offers upside.

TGR: Would investors or potential acquirers be willing to venture into Sierra Leone?

BS: Sierra Leone and Liberia are two of the newer gold countries. With the rest of West Africa, they are peaceful and stable, with lots of development going on. Historically, political difficulties in Africa result from the removal of long-term incumbents. That has already happened in Sierra Leone and Liberia. Both now have democratically elected leaders who do not have the same stranglehold on the country as their former dictators. The election season in West Africaa traditional tipping point for potential civil unrestis mostly over. Sierra Leone's election will be in Q4/12.

We are very positive and upbeat on the political stability of virtually all of the Central African gold-producing countries.

TGR: Another boon for companies operating in Africa is that the threat of nationalization is remote.

BS: Talk of nationalization or civil unrest in Africa is very common, yet it essentially never happens. When I take into account both nationalization and the environmental permitting process, which is a greater constraint in mature arenas like Europe, Africa ranks extremely high.

I judge geographies by the number of precedents. How many precedents have there been of assets being nationalized or mines that have been unable to obtain licenses? There are essentially no precedents in all the African countries I cover.

TGR: Barrick Gold Corp. (ABX:TSX; ABX:NYSE) is trying to sell its African Barrick Gold Plc (ABG:LSE) stake. One of the interested buyers is the state-owned China National Gold Group Corp. Why is China more interested in African plays than elsewhere?

BS: I would not agree that China's interest lies in African gold per se. In my African coverage universe, there has been little to no precedent of Chinese companies buying gold assets. There is some precedent in South Africa, but those are larger, lower-grade, larger-cost operations.

China's interest in Africa is more in the base metals, such as copper and iron ore, as a supply chain for its industrial economy. I would not expect Chinese investors to add to the MA fever in Africa in gold in the same way that they have in iron ore and copper.

Regarding Barrick Gold, I believe that Barrick is using that approach to start an option process with the expectation that the Chinese parties will end up owning those assets.

TGR: In a recent GMP resource report you wrote, "with equities trading at record lows and capital expense requirements, in most cases, larger than group enterprise value, dilution is critical in assessing the value of pre-producers." How do you determine equity dilution before it happens?

BS: That is a valid question. One must assume that a degree of dilution will happen if these companies self fund. This is much of the rationale behind MA.

If these gold pre-producers were to press the button on development now, they face a degree of equity dilution. The value of an undeveloped mine in the hands of a pre-producer may be at risk of dilution. That risk would not exist if a bidder that had the cash to develop the asset were to acquire the pre-producer. There is a rationale in MA that mid-cap producers with cash generation from existing operations will actually see more value in undeveloped ounces than the juniors.

"Ghana and Mali are much more well explored than the rest of West Africa. Sierra Leone, Liberia and Ivory Coast are far less explored. "

The reverse of this is also trueif the market does recover, then deeply discounted valuations of the juniors would reverse simply because they would have more access to equity. Their share prices would rise. Any potential dilution, as you point out, would be reduced. And, there would be an opportunity for a significant rerating. But that is completely dependent on a wider global market recovery.

TGR: Looking back over the last 10 years, do you have a feel for the average percentage of dilution that happens with each successful financing?

BS: Qualitatively, I would expect a pre-producer to target a maximum of 50% dilution, perhaps a $300 million (M) market cap raising $200M in equity dilution or a $200M market cap raising a mix of debt and equity.

The problem facing many juniors is capital expenditure (capex) bills on the order of $200M to $300M, with market caps below that. They are using the market slowdown to revise their projects with a focus on higher-grade areas and lower capex.

Over that 10-year window, most projects fund on the cyclical upturn. So, yes, dilution would be a high risk for investors now. But in reality, these juniors will not fund until the cycle has turned, so that dilution probably will not happen. The risk here is having to wait a long time if the market does not turn.

TGR: You also wrote that you quantify the value of pre-producers to bidders by "calculating 'undiscounted' return, which is the percentage of reserve value [mineable gold less cash costs, royalties, taxes and minority stakes] over total cost to gold market cap at 25% premium plus capex from a selection of juniors in Africa. This shows even without exploration upside, all juniors offer upside to bidders." Are these pre-producers that are deeply undervalued or does this speak to gold mining and exploration in Africa in general?

BS: The MA metric that you refer to is what we call total cash return. Say it costs $400M to acquire a junior and build the mine. Because the cash cost for a larger producer to buy a pre-producer is at a cyclical low, the undiscounted cash return will be positive in all cases.

But, the percentage upside is key here. When you're looking at acquiring a pre-producer, this is an undiscounted return. What that means is that's the life of mine. You have to build the gold plant. You have to mine that gold over 10 years. So, it's a lengthy investment horizon. If the cash return is something like 25% or 50%, yes, that is a positive return but it's probably not enough of a return for that gold producer to go ahead and buy the pre-producer because the gold producer would still have to build a mine and operate it for 10 years. But, in some cases, the percentage return on a cash basis is substantially higher than that. In our report we note that someone like Cluff Gold, which I mentioned earlier, could provide healthy cash returns.

TGR: But Cluff Gold is not a pre-producer.

BS: True, Cluff Gold does have existing production. However the company has a substantial undeveloped asset at Baomahun, which is what would offer potential upside as it goes into production.

TGR: Can you give us an example of a pre-producer?

BS: Take Aureus Mining Inc. (AUE:TSX; AUE:LSE), a small, higher-grade company. We estimate there is 124% return on the cash that a potential bidder would invest to acquire the company and build the mine. That is a good return although it does come with a risk of the time value of money and execution.

TGR: Are there other pre-producers or producers with similar numbers?

BS: Papillon Resources Inc. (PIR:ASX) has made probably the highest quality, undeveloped gold discovery in Africa held by a junior. Its maiden resource in Mali is more than 3 million ounces (Moz) and over 2 g/t. Papillon ticks off a lot of boxes for investors: it is big, can be open-pit mined, is metallurgically simple and high grade.

TGR: What about companies that will be growing over the next two to three years and could see some takeover interest?

BS: Banro fits that description. It recently completed a $175M bond issue while also finishing the commissioning on its Twangiza Mine. Its Namoya mine is expected to be at nameplate production at the end of 2013. The engineering and feasibility studies are finished, construction is underway and the company has the cash to build.

TGR: You project Banro's production between now and 2015 will be up 450%. Is that too good an opportunity for a potential acquirer to pass up?

BS: The 450% is based on Twangiza's very low production base earlier this year and is a bit exaggerated.

The production growth curve is critical. We see 100% production growth between today's 100120 Koz/year and the tail end of next year when Namoya is commissioned.

TGR: Does Banro have the management team to succeed?

BS: Banro's very strong technical team built up a lot of experience in its first mine build. The general manager, Thinus Vorster, has now moved from Twangiza to Namoya. Banro's principal founder, Arnold Kondrat, has been operating in the DRC for a long time and understands how the country works. Banro has a great combination of political and commercial know-how and technical management on the ground.

TGR: Are there any other companies poised for growth that may not be as well financed?

BS: La Mancha Resources Inc. (LMA:TSX) is the subject of a takeover offer. Its Australian asset generates a lot of cash; its West African asset less so. Its Sudanese copper-gold projects, however, have tremendous growth potential.

TGR: What are some pre-producers with good assets but not enough money to properly develop them?

BS: Volta Resources Inc. (VTR:TSX) and Orezone Gold Corporation (ORE:TSX) both have interesting assets in Burkina Faso, which is a center for the discovery of substantial, albeit low-grade, gold resources.

Volta has 5 Moz at 1.1 g/t. Orezone's resource is similar. To overcome the short-term funding gap, these pre-producers are realigning themselves to decrease capex by building staged development earlier on in the mine life, for example by building lower-cost, heap-leach mines.

Volta has a small, very high-grade discovery close to its existing low-grade resource. Recent drilling has seen hits as high as 10 meters at 13 g/t. Volta can build a smaller, very high-grade starter pit and use the cash to self-fund production from the larger, lower-grade resource.

Orezone can use an early heap leach at a much lower capex than a traditional mine and use the cash generated to develop in stages as production grows.

Riverstone Resources Inc. (RVS:TSX.V) is on a similar growth curve, although not as far developed. It, too, has a low-grade, but very large resource in Burkina Faso.

TGR: Orezone's market cap is $177M and it needs $350M to build a mine. Volta's market cap is $122M, with $610M in capex needed to build. In both cases, if you double the number of shares at the current value, you still are not close.

BS: No doubt whatsoever that it will be hard to fund those projects in their current form at this stage in the cycle. That is why these companies have to come up with alternative options. They have to reduce their capex, look at smaller, staged development and for higher-grade resources. In a capital-constrained market, the capex/market cap ratio is much higher and is a significant challenge.

At the opposite end of the spectrum are the very high-grade exploration stories. An example of that would be Loncor Resources Inc. (LN:TSX.V; LON:NYSE.MKT). It is in the DRC and recently announced 1 Moz at 7.6 g/t. Roxgold Inc. (ROG:TSX.V), in Burkina Faso, came out with a resource of 660 Koz at 11 g/t. That is almost unheard of in Africa.

These projects' lower cash cost and their attraction from an MA standpoint make these high-grade projects attractive.

TGR: Are these high-margin deposits simply the "flavor of the month" or are they here to stay?

BS: For the African space, that is yet to be determined. Africa lacks depth of expertise in underground mining. While the high-grade underground projects certainly offer good investment returns at face value, human resourcing these projects is not necessarily easy.

In the long run I think all gold producers would prefer to have an open pit. But we will be seeing more high-grade underground mines because the near-surface resources are already being exploited.

TGR: Is it true that Africa is underexplored?

BS: You have to look at it country by country. Ghana and Mali are much more well explored than the rest of West Africa. Sierra Leone, Liberia and Ivory Coast are far less explored.

TGR: What three things do you look for before buying into a gold exploration company operating in Africa?

BS: I look first for grade: a high-grade asset, meaning over 2 g/t, open pittable and free milling. By that, I mean no metallurgical issues and ready for treatment in an off-the-shelf plant.

Second, I look at the fiscal regime of the country where the company operates. Fiscal regimes also vary. When you tally up all the taxes, royalties and carried interest in Ghana, it equates to a 48% tax equivalent. Senegal, which has a 7-year tax holiday, is at a 23% tax equivalent.

Finally I would look for cash in the bank or a supportive strategic shareholder.

TGR: Brock, thank you for your time and insights.

Brock Salier joined GMP Securities Europe LLP in 2011 after three years at Ambrian Capital where he was head of the small-cap mining desk, which achieved a #1 Extel ranking, and he was individually ranked at #3 among small/mid-cap mining analysts in the UK for two years running. Prior to this, Salier was a management consultant in London for three years, part of which was spent in the natural resources practice of Accenture. Salier worked as a mining geologist with Great Central Mines in Australia and held exploration geology positions with Placer Dome and Rio Tinto. He holds a PhD (Distinction) and Bachelor of Science (Hons), both in economic geology specializing in gold, from the University of Western Australia.

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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his 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: Banro Corporation, La Mancha Resources Inc., Orezone Gold Corporation, Loncor Resources Inc. and Roxgold Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Brock Salier: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I have seen material operations of the following issuers: African Barrick Gold Plc, Aureus Mining Inc., Banro Corporation, Barrick Gold Corp., Cluff Gold Plc, Orezone Gold Corporation, Loncor Resources Inc. and Volta Resources Inc. I was not paid by Streetwise Reports for participating in this interview.
4) GMP Securities Europe LLP and/or any of its group affiliated companies has, within the previous 12 months, provided paid investment banking services or acted as underwriter to the following issuers: Banro Corporation, Cluff Gold Plc, Aureus Mining Inc. and Orezone Gold Corporation.

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