Junior Producers Riding Exploration Success To Reratings: Raj Ray

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In this interview with The Gold Report we learn that it's not enough for junior gold producers to have strong management teams running thrifty, efficient operations. These companies must be able to extend their mine life, either through exploration or distressed M&A, to reach the coveted market rerating, says National Bank Financial Mining Analyst Raj Ray. He covers a growing list of companies that, with help from depreciating currencies, are up about 75% year-over-year and could see further gains with success via the drill bit. Ray shares those names and others with outsized leverage to a big move in the gold price.

Mine truck

The Gold Report: Have you ever witnessed such a sustained period where the U.S. Federal Reserve and/or the European Central Bank have had so much sway over market direction? Is it sustainable?

Raj Ray: What we are seeing right now is a throwback to the Fed's original goal of preservation of financial stability. Central bankers believe that maintaining financial stability is just as important as managing monetary policy. Only time will tell whether it's sustainable, but it's here to stay for the foreseeable future.

TGR: Are central bank decisions changing how you do things?

RR: As a mining analyst, the objective has always been to focus on companies with efficient operations, good management and capital discipline. In addition, I am looking for exposure to investments that to some extent can hedge the gold price risk as a direct result of central bank decision-making. A lot of miners' favorable currency exposure has buffered the impact of an otherwise muted gold price. It's not about changing what we do. It really is about sticking to the basics and being more diligent about what we do.

TGR: What is your call on gold as the traditional summer doldrums approach?

RR: I expect gold to oscillate around the $1,200/ounce ($1,200/oz) mark, but it will be economic-data dependent. The possibility of the Fed raising short-term rates has kept a lid on gold prices. The market seems to expect a June increase as unlikely. If the Fed decides to maintain rates, you might see a small uptick in the gold price to $1,250/oz.

TGR: Do you, like most other mining analysts, believe that it will be 2016 before the mining sector turns the corner?


RR: I believe it will be commodity-price driven more than anything else. Late last year, National Bank Financial (NBF) Senior Mining Analyst Steve Parsons published a report looking at the impact of project deferrals on production declines. NBF believes that these deferrals have charted a direct course for production declines, which we forecast will commence in 2016 but any resulting impact on the gold price is more likely to play out in 2017. That's because come 2016 the hangover from the Fed's policy decisions on interest rates could be playing out on the gold price and it will be late 2016 before we see gold production supply/demand issues.

TGR: We've seen some recent strength in the gold price. What accounts for that?

RR: It's the expectation that the short-term rise in interest rates might happen later than September. At the last Federal Open Market Committee meeting, the Fed policy removed all calendar-based references in its forward guidance and has taken a more data dependent approach. So a rate increase could happen once positive economic data start coming out, but that doesn't seem likely in the next three months.

TGR: We have seen some recent mergers and acquisitions (M&A) activity, and two companies National Bank Financial follows were involved—AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE) and Alamos Gold Inc. (AGI:TSX). What should investors take away from that deal?

RR: Both Alamos and AuRico are covered by our precious metals analyst, Adam Melnyk. It's a good example of a deal where both parties stand to benefit. For Alamos, it's exposure to AuRico's long-life Young-Davidson gold asset in Ontario, a mining-friendly jurisdiction. For AuRico, it's much needed access to liquidity. There is market appetite for further synergistic M&A, as well as distressed M&A. I wouldn't be surprised to see some consolidation in Canadian mining camps given the operational and corporate synergies that could be realized.

TGR: Though the sector is down year-over-year (YOY), certain names have managed to perform and perform well, especially a handful of companies you cover. What do those juniors have in common?

RR: The companies that have outperformed have strong management teams, efficient operations and a disciplined approach to capital spending, but favorable exposure to a depreciating currency has helped, too. If I build a portfolio of one stock from each of the Canadian junior underground miners, the average return over the last 12 months would have been close to 75% as opposed to -30% for the Market Vectors Junior Gold Miners ETF (GDXJ:NYSE.Arca). These companies must keep doing what they're doing, and with help from a depreciating currency they are in a good position to not only build their balance sheets but also get going on exploration programs, an overall weak point in the last couple of years.

TGR: What are some companies with favorable exposure to a depreciating currency?

RR: OceanaGold Corp. (OGC:TSX; OGC:ASX) is in a strong position to benefit from the continuing weakness in the New Zealand dollar versus the U.S. dollar. OceanaGold has almost 65–70% of its production over the next two years coming out of New Zealand and the company should continue generating free cash flow in this environment.

TGR: Many Bay Street analysts believe currency depreciation has already been factored into share prices. Is there upside left?

RR: Yes, part of that has been factored into the stock price, but I believe there is further upside. Over the last 12–18 months, management of these companies has focused on making operations more efficient and cleaning up balance sheetsand many have been successful. While being on the right side of currency exposure has resulted in the run-up in the stock prices we have seen to date, I don't think those stock prices have factored in growth potential. The focus is now on exploration as select companies are in a better position to expand their exploration programs.

At Lake Shore Gold Corp. (LSG:TSX)Kirkland Lake Gold Inc. (KGI:TSX) and Wesdome Gold Mines Ltd. (WDO:TSX), some of the companies that I cover, exploration programs are back with a bang. Lake Shore Gold, for instance, is undertaking a $30 million exploration program in 2015. There are some significant catalysts over the next six to eight months that could change the whole outlook for these companies.

TGR: Are companies likely to look at nearby M&A activity in addition to exploration?

RR: The talk on the Street is that we might see some kind of merger in the Canadian camps but it's still early days. Some companies have turned the corner but we'll probably have to wait another 12–18 months before they reach a position where they can undertake M&A. Having said that, Lake Shore could be an attractive opportunity to a lot of the larger gold players, especially if the company can add to its otherwise limited mine life. But with the 144 Gap discovery, that is looking promising. Lake Shore expects to release its first resource update in early 2016. That could be an important catalyst to improve its attractiveness to potential acquirers.

TGR: Why is the 144 Gap discovery important?

RR: The current mine life is 3.5 years based on the reserves it has at the Timmins West mine, near Timmins. Initial drill results from 144 Gap point to a sizable resource at significant grades. Lake Shore is already a profitable operation. If it can outline anywhere between 1–2 million ounces at 144 Gap, that changes the entire perspective. The only thing that the company has been lacking is mine life. The 144 Gap discovery could address that concern.

TGR: What is your target on Lake Shore Gold?

RR: I have an Outperform rating and $1.75 target.

TGR: What are some other companies you cover that could see further tailwinds from the Canadian dollar depreciation versus the U.S. dollar?

RR: Kirkland Lake and Wesdome will continue to see tailwinds from the Canadian dollar. Some others are Claude Resources Inc. (CRJ:TSX) and Richmont Mines Inc. (RIC:NYSE.MKT; RIC:TSX), which are covered by Adam Melnyk. The Canadian dollar has recovered some of the losses it sustained earlier in the year, but it's still at a place where these companies can continue to benefit from the weakness. The average all-in sustaining cost for some of these companies is around CA$1,250/oz. The gold price at this point is around CA$1,440–1,450/oz. There's some margin there.

TGR: Since becoming Kirkland Lake CEO, George Ogilvie has made a number of changes, not the least of which was firing about 150 people as part of a move toward a more automated mining system at the Macassa Complex. What are your thoughts on him and what he's done?

RR: Ogilvie has been there just over 12 months and it's been a phenomenal year for Kirkland Lake. His vision of what this mine is capable of has been spot on. Grades have always trumped tonnage at the Macassa mine. There has been significant improvement in mine grades. That's the reason why the company has returned to profitability. The stock price reflects that confidence in Ogilvie and the current management team. The company has delivered on its objective over the last 12 months. Beyond this, the stock price has to move. It has to do more.

TGR: Do you have a target on Kirkland?

RR: I have a $6.50 target and an Outperform rating.

TGR: What is Wesdome doing to extend the mine life of its operations near Timmins?

RR: Over the last 12 months, the company's focus has been drilling newly discovered parallel zones, 300 and 7. These zones have shown significant grades and widths, which could enhance mill throughput. The important thing is that the company made a modest increase to its exploration budget in 2014. That resulted in a 57% increase in reserves. These parallel zones remain open laterally and at depth. The company is just starting to explore these deposits and over the next few months we could see significant reserve expansion at the Eagle River underground mine.

Wesdome has also started producing from the Mishi open pit. That's where the real upside lies in increasing mill throughput. Currently, it is operating only one crew on a week on/week off schedule at Mishi. All it needs to do to increase throughput is to start another crew. There is some significant upside in increasing both reserves and mine life at both the underground and the open-pit mines for Wesdome.

TGR: What's your target on Wesdome?

RR: I have an Outperform rating and a $1.65 target.

TGR: A recent NBF research report noted that "company efforts to maintain strong balance sheets in a weak gold price environment have been prudent, but the unintended consequence, in many cases, has been an adverse effect on production sustainability." Does that mean that high grading has put companies at risk?

RR: When we talk about the consequences, we are really referring to the cuts in exploration and funding for project development, which have resulted in a flat to slightly declining growth pipeline for a lot of these companies over the next three to five years. High grading can be an issue, but as long as a company is mining in such a way that it is not sterilizing the ore body, it can still leave some room to recover the low-grade resource in a higher commodity price environment.

A lot of the Canadian underground miners that I cover are backfilling, which provides the option to recover some of the low-grade resources in a higher commodity price environment. So, yes, it's a mix of companies that have optimized their mine plans and others that have realized the importance of grade over tonnage. When commodity prices were strong, the goal was to have higher tonnage from mines that were not supposed to operate that way. As commodity prices fell, companies reduced tonnage and dilution, and that's meant an uptick in grade and profitability for a lot of the junior underground miners.

TGR: How has NBF adjusted its investment thesis to place a greater emphasis on companies with "production sustainability?"

RR: While we continue to focus on profitable companies with strong balance sheets and favorable dilution and cost exposure, production sustainability remains an important part of our investment thesis. We look for companies with potential to add to reserve and mine life close to current infrastructure but without spending large amounts of capital. SEMAFO Inc. (SMF:TSX; SMF:OMX) is one example where management not only added reserves through the drill bit but also through its M&A strategy via the Orbis Gold Ltd. (OBS:ASX) acquisition. Smaller but value-accretive acquisitions are the way to go forward.

TGR: A few of the companies you cover had 100% or more YOY increases in free cash flow. One was SEMAFO, another was OceanaGold. What are some common elements of those stories?

RR: These companies have strong management, efficient operations and a disciplined approach to capital spending. In addition, both SEMAFO and OceanaGold have been able to replace reserves with value-accretive acquisitions. SEMAFO acquired the Orbis Gold Ltd. (OBS:ASX) mine and OceanaGold recently announced the acquisition of the Waihi deposit in New Zealand from Newmont Mining Corp. (NEM:NYSE). These are smaller acquisitions, but what's important is the value that the companies derive from them.

TGR: Do you think SEMAFO is done with M&A for now?

RR: SEMAFO is likely done with M&A for now. It has some considerable exploration potential close to its current Mana mill. Over the next 12–18 months, the company will also focus on getting Natougou, the project it acquired from Orbis, up and running. What could be a bit of a hangover on the stock over the next six months is the Burkina Faso political situation. The country has returned to normal but there is an election later this year. We will be watching that closely.

TGR: What is your target on SEMAFO?

RR: I have an Outperform rating, $5 target on SEMAFO, and an Outperform rating on OceanaGold with a $3.65 target.

TGR: If gold were to jump to $1,500/oz or perhaps even $2,000/oz, what are some companies under coverage with outsized leverage to the gold price?

RR: Given the gold price environment and high development costs attached to new projects, we have witnessed a complete reluctance on the part of the market to pay for optionality. Although the timing is uncertain, we believe optionality will return. If we get a sustained period of strong commodity prices, exposure to companies like Seabridge Gold Inc. (SEA:TSX; SA:NYSE.MKT) and NOVAGOLD (NG:TSX; NG:NYSE.MKT) could provide leverage to the commodity price. Seabridge's KSM deposit is one of the few large-scale projects in a stable jurisdiction. It already has environmental approval, which makes it attractive to a large number of base metals and gold mining companies. NOVAGOLD has a relatively high-grade, large-scale deposit in Donlin Gold, but is not expected to receive environmental approval until late 2016. Until then, we might not see much movement in the stock unless and until there is a steady and upward movement in gold price.

TGR: NOVAGOLD has significant cash in the bank. It's definitely not going anywhere in the short term.

RR: Its cash is currently around $136 million. That provides NOVAGOLD with protection to that optionality. That's an important point because a lot of junior development companies have large projects but do not necessarily have the cash to continue to operate for two or three years. We don't know when the gold price is going to return, so what this cash does is give NOVAGOLD the flexibility to continue advancing its project over the next two to three years as it waits for the commodity price to go upward.

TGR: Please give us one lead-pipe cinch call before we let you go.

RR: When looking to invest in the mining sector, I think it's important to focus on companies that have the cost structure to maintain profitability and a strong balance sheet in the current muted gold price environment. As such, Lake Shore remains my top pick. With some significant exploration results expected over the next six to eight months, we believe there is further upside to the story.

TGR: Thank you for talking with us today, Raj.

Raj Ray Raj Ray is a metals and mining research associate analyst with National Bank Financial, covering junior mining companies. Prior to joining NBF, Ray worked as an equity research associate with GMP Securities covering diversified and fertilizer sectors. He has also worked in investment banking with Dundee Capital Markets on equity financings and M&A transactions for small- to mid-cap gold and base metal companies. Prior to this Ray was a process engineer at Vedanta Resources Plc for four years. Ray holds a Bachelor in Metallurgical Engineering from India and a Master of Business Administration in finance from the Schulich School of Business. He is also a CFA charterholder.


1) Brian Sylvester conducted this interview for Streetwise Reports LLC, publisher of  more

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