John McClintock: Gold Producers Riding the Risk Trade

Source: Zig Lambo of The Gold Report (8/29/11)

http://www.theaureport.com/pub/na/10717

With the price of gold soaring to over $1,900 an ounce and investors abandoning equities for commodities, John McClintock, equity research analyst at Mackie Research Capital, sees gold mining companies benefitting from this flight from risk. In this exclusive interview with The Gold Report, McClintock identifies several gold mining companies with great upside potential.

Companies Mentioned: Argonaut Gold Inc. - Avion Gold Corp. - Avocet Mining plc - AXMIN Inc. - Chesapeake Gold Corp. - Eldorado Gold Corp. - Gryphon Minerals Ltd. - Nevsun Resources Ltd. - Randgold Resources Ltd. - Yamana Gold Inc.

The Gold Report: With the recent performance of the gold market, what expectations do you have for the next 6-12 months?

John McClintock: I think nothing is really going to change on the equity side until we see the risk trade coming back on to invest in equities. That risk trade is going to be a function of the U.S. housing market rebounding, as investment is a function of wealth, and the resolution of the debt crisis in Europe. We are going to see companies that have shown consistent operating performance continue to outperform the market. Currently, the focus on quality is paramount, and we are likely going to see that continue for at least the next six months.

TGR: The situation is a little different from past markets when people were jumping into mining stocks because the metals were going up and they were buying almost anything in sight.

JM: Right.

TGR: So are people now being a lot more selective?

JM: Yes, in where they are going. People are focused on just the risk trade. If you look at the equities, all the major precious metals in Toronto are down on the year and definitely underperforming the commodity. It is not because the companies are themselves poor. Investment dollars for the equities other than institutions, predominantly retail, are largely going to exchange-traded funds (ETFs). ETFs are competing with the supply of funds for all of equities. People are saying, I don't want to own Treasuries as much anymore.

I've already seen a bit of that. Just go to the commodity, be safe right now and then when we get out of this turbulent time, maybe in six months, you're probably going to see stocks run. Maybe by September we'll have more visibility. Going down the market cap, you're going to probably see people start focusing on the intermediates and the junior producers that show consistent execution.

TGR: So what do you like in that range?

JM: Two stocks that I cover have had very good execution and share prices that are actually outperforming the commodity index and their peer groups. Argonaut Gold Inc. (TSX:AR) is in Mexico and Avion Gold Corp. (TSX:AVR; OTCQX:AVGCF) is in Africa. They share very strong commonality on execution.

TGR: Unlike a lot of juniors, Argonaut came out of the blocks fully loaded with cash. The company did a big IPO and has projects that were producing and ready to produce. Isn't this unusual for a company that went public in the last couple of years?

JM: It is and it isn't. It was a functioning mine, and produced, I believe, 40 or 50 thousand ounces (Koz.) prior under the name Castle Gold Corp., with cash costs in excess of $1,000/ounce (oz.). The new management team came in and executed. Even though it seems that it started with an extra handout because it did the large IPO, the funds were spent in a prudent, focused way. I look for three very simple things: 1) whether the company owns the asset, and this includes permitting risk or any subsequent geopolitical event, which would affect development; 2) merit of the assets-what are the technical/geological characteristics, and how do they affect profitability in different commodity and cost environments; and 3) management, management, management. With both Avion and Argonaut, unlike many stocks that come across my desk, I can check all three boxes. Somewhat proof that my system works is that both Argonaut's and Avion's stock prices are going up in an otherwise very bearish equity market.

TGR: Can you give us a little bit more background on the company?

JM: Absolutely. I call the company Meridian Gold 2.0 affectionately, although it is definitely not Meridian Gold currently. Meridian was acquired by Yamana Gold Inc. (TSX:YRI; NYSE:AUY; LSE:YAU) in 2007 for about $3.8 billion. Brian Kennedy, who was the president and CEO of Meridian at the time, is now chairman of Argonaut Gold. The CFO, Pete Dougherty, is the current CEO of Argonaut, and Edgar Smith, who is the COO of Argonaut, was also the COO of Meridian. They reassembled the team after their non-compete clauses with Yamana expired, and started Argonaut.

The team was very strategic in the asset they picked and asked, What can we do at this point in the market with these gold prices? A lot of assets in Mexico, Chile, Peru and Argentina became available in the crash. In the prior Meridian days, the team ran such assets as El Peñón mine, which is a very high grade gold and silver mine that will go down in mining history as one of the best assets ever. What Argonaut selected as its starting point was the El Castillo mine, which was low grade with small defined resources at that time, and people just saw it as a push along owned by Castle Gold. These guys came in and saw a diamond in the rough. I very much liked Castle Gold, but the company had some difficulties due to undercapitalization.

The Argonaut team saw an asset that had an incredibly good leach-recovery cycle and was able to cut a deal with the prior management of Castle Gold. Argonaut saw an ability to prove up or increase the reserve by 100% through a very strategic drilling program. Its mine development expertise was second to none from putting mines into production in the Meridian days. Given the complexity of a simple heap-leach operation in Mexico, it wasn't really challenging.

Along with developing that mine, Argonaut also kept an eye out for other opportunities. One of the companies in Mexico that was available was Pediment Gold Corp. It had two simple heap-leach projects, which were very similar to El Castillo, called San Antonio and La Colorada. Moreover, Argonaut continues to add value post the acquisition. For example, at San Antonio, the previous resource mine plan was based on a mix of sulphide and oxide ore, and Argonaut took a calculated risk by stepping out certain zones and expanding the oxide resource. So it went from a potential four-to-six-year oxide production to about a 10-year oxide mine life resource.

Another example of Argonaut's management caliber is its development strategy at La Colorada. La Colorada was a historical producer that Eldorado Gold Corp. (TSX:ELD; NYSE:EGO) had closed in 2001 because of low commodity prices. I recently came back from the site. I had always been a little skeptical of the asset, but Argonaut could very well have another 50-70 Koz. producer by 2013. Management was able to see a diamond in the rough and execute. Now the market is rewarding it for good execution.

TGR: Argonaut released earnings recently and, apparently, beat expectations.

JM: Yes, two reasons. On the cash cost side, it came in at $578/oz. We were expecting $580/oz., but General & Administrative and other corporate expenses came in lower than we expected. Q211 earnings were more a sign of management successfully executing on all concurrent things the company is doing. Argonaut has a 57,000 meter (m) drill program at La Colorada that is being financed out of cash flow and it is committing to another 10,000m of drilling at San Antonio, out of cash flow.

TGR: Are you expecting that trend to continue? The gold price jumping up the way it has is probably going to make a lot of companies look better than originally expected.

JM: We don't think it's reasonable to expect Argonaut to beat every quarter, but we view the operating risk associated with the company as low. With regards to the gold price affecting other gold equities, a high tide does raise all boats. However, in the context of current market conditions, execution is paramount, which translates into cash flow and good growth prospects with lower funding risk. Again, Argonaut is one such company.

We estimate by 2013 Argonaut should grow its production to 185 Koz. at cash costs of $541/oz. from 70 Koz. at cash cost of $581/oz. (or 164% production growth and 8% decline in cash costs) through: 1) expanding the mining rate at El Castillo in 2012 from 28 kilotons/day (kt/d) to 36 kt/d at minimal costs (we expect this to add 20 Koz. of average annual production); 2) construction of the San Antonio project in 2013 (Life of Mine (LOM) average production of 84 Koz. at total cash of $493/oz.); and 3) the addition of the La Colorada project (LOM average production of 47 Koz. at total cash costs of $499/oz.), also expected to be completed in 2013. We estimate the total capital cost for all three production expansions to cost $123 million (M). Moreover, this production growth is fully funded by internal cash flow-at $1,500/oz. Argonaut should generate $88.3M; a net cash balance of $22.7M; and the execution of 25.7 million warrants with a strike price of $4.50/share.

TGR: Do you think Argonaut has enough on its plate at this point or is it still out looking for other properties?

JM: I don't think it would be acquiring tomorrow, but a mining company should always be looking for new assets and new opportunities, and should never stand still. If a great opportunity walks in the door, sure. But with two development projects on your plate, you should finish that up or at least get them closer to the finish line before you go out and buy more.

TGR: The other company you like is Avion Gold. You call it a turnaround story.

JM: Prior to Avion getting the Tabakoto asset in Mali, the mine was built by a company called Nevsun Resources Ltd. (TSX:NSU; NYSE.A:NSU), which had some problems understanding the block model on it. Nevsun spent approximately $150 million to build the mine, only to close it 18 months later. Most of the investment community looked at it and said, It's a broken asset. Sell it for scrap. Two very astute people, Andrew Bradfield and Don Dudek from Avion, looked at it and said, It is not the asset. The block model is not so bad, it is just misinterpreted. They went in there and merely focused on the structural geology of the deposit, and reinterpreted it from, I believe, a solely north-south trending deposit to one with east-west cross-structures. Sure enough, the grade came in line with the drilling, and the asset was able to restart. But not everything in Avion went perfectly for the first year-it started in 2009. It missed on two quarters but since then, it has had, I believe, five quarters of stable execution.

Very much like Argonaut, Avion was able to not only focus on production, but also to grow its resources at Tabakoto from 0.9 Moz. in 2008 to 2.2 Moz. in 2011. It also, like Argonaut, was able to do two very astute, very cheap acquisitions-the Kofi Project from AXMIN Inc. (TSX.V:AXM) and then the Houndé Project in Burkina Faso from Avocet Mining plc (LSE:AVM). Avion picked up the Houndé asset, I believe, for $10M in an all-stock deal, and the Kofi project for $0.5M in cash and 4.5M Avion shares. Here's another team that said, What can we add value to? and be very strategic. The similarities between the Avion management team's view of things and execution and Argonaut's are just striking.

TGR: What are the prospects on these other two properties-the Kofi and the Houndé?

JM: The Houndé Project right now has a current inferred resource of about 0.6 Moz. at about 2.87 grams/ton (g/t). That current resource is based off 800m of strike. Avion has drilled it on strike to about 3.7 km with very consistent intersections between 6, 10 and 15m, all within +1.8 g/t. One striking comparable that I like to use is Gryphon Minerals Ltd.'s (ASX:GRY) Banfora project. The company trades at about a $400M-$500M market cap. It has an approximately 2 Moz. resource at 2.1 g/t. We look at Houndé and it has the same mineralization footprint. Avion hasn't closed yet but completed a $50M deal to raise funds to drill out that project. Right now it has a visibility on 2.2-2.5 Moz., and it's just a function of drilling now to see where it gets it. The updated resource due at the end of the year will probably only come out with 1.5-1.7 Moz. That's only a function of time and drilling, not a function of the deposit or the potential there. Again, Houndé is a deposit that I'm quite excited about.

The second project Avion bought was from AXMIN just recently. It's in the Loulo trend. Loulo is a mine run by Randgold Resources Ltd. (NASDAQ:GOLD), and it is definitely the marquee asset in Randgold's portfolio. Currently, the Kofi Project has another 0.6 Moz. resource at 2.47 g/t broken up in nine zones. It's quite interesting because four of these nine mineralized zones are located within an approximately 5 km wide structural corridor. This structural trend, which intersects the Kofi property, is associated with a conductivity feature that extends for 19 km on the Kofi property, and hosts at least 17 Moz. of gold on the Randgold property. Although, Kofi is much earlier stage than Houndé in terms of where it could go, we don't believe the market has really caught on to the potential there. The Avion market price is really just factoring in the production from Tabakoto and the ongoing expansion, and the next stage in Houndé's resource growth. You can't really see what is going to be there yet, but there is the potential that Kofi could someday be better than Houndé. Only the drill bit will tell, but I'm excited.

TGR: A question some investors might have is about political stability in countries like Mali and Burkina Faso.

JM: Absolutely. In 2003 and 2004, West Africa had a big wave of transformation to attract mining investment by changing tax codes and giving exoneration periods for taxes to keep companies there. Now, the prices of commodities, particularly fuel, have caused a dramatic increase in domestic prices, which has had a destabilizing effect on the broader economies. People who don't make a lot of money don't have a large propensity to spend. There has been civil unrest, much of it focused at government. People want subsidies for agriculture and fuel. In Burkina Faso, we have seen riots and things get out of hand a little bit. Do we think there's going to be a full civil war or change in government in Burkina? No. But we do think there is an upward pressure on royalty rates and taxes on mining companies that will have to be factored into the valuations.

Right now, depending on which West African country you are in, there are exoneration periods for taxes for 4, 6, 8, even up to 15 years. Tax rates are generally lower, about 20-30%, and although the governments do get carried interests of 10-20%, the mining companies don't pay out dividends to the government until all capital is paid back. So the governments really don't get much of the immediate cash flow from the company. We do believe that the revenues and profits, particularly with the very successful companies, will have to be redistributed to some degree to keep political stability and also to ensure a long-term mining industry there. So investors should be aware that royalty rates will change. A lot of it has already been factored into the stocks, we believe.

TGR: Do you have any closing thoughts you'd like to leave with us as far as the gold market in general and expectations for juniors and mid-tier mining stocks?

JM: In the general macro scheme, I think gold will be the thing. The U.S. will have to deflate its dollar and rely heavily on exports. Inflation in the U.S. will not be put away for at least 5-10 years. In the early 1990s, it took the Canadian government about 10 years to get out of it and cut its deficit. Europe will have to print money to get itself out of its current situation. Who knows about the debt and real estate situations in China and other emerging markets worldwide? So in the longer term, I'm very bullish on gold and commodities, in particular, hard assets. It has been an investment trend that is likely to continue, particularly in the precious metals. Industrial commodities like copper can be expected to come off with an economic slowdown. People seeking safety and wealth preservation will cause gold to continue to be strong for the near and mid-term, without a doubt.

TGR: Hopefully that will filter down to the equities?

JM: For sure. It's just a function of the risk trade coming back on. The U.S. will not hit 4% gross domestic product any time soon. We need the housing market to bottom, and people to get back into the equity market and begin to make investments. When people have taken 30-50% haircuts on their biggest asset, they can't afford to lose a lot of money in the stock market anymore. So people are very risk averse right now and it is about wealth preservation more than wealth generation. With the long-term commodity price the way it is, people will come back to the market eventually, but it's not going to be tomorrow or next month. We are going to see a volatile market here, but six months from now, I'm optimistic the gold stocks will catch up.

TGR: It looks like we are still in the fear stage. So we need fear to turn into greed.

JM: I'm sure you've heard that one before.

TGR: So your final thoughts?

JM: I'd say just stay focused on quality and on management teams that have executed like Argonaut and Avion. If investors want to focus on the development companies, we would suggest again to focus on quality strategic assets for senior and intermediate companies. Such a company would be Chesapeake Gold Corp. (TSX.V:CKG). Although it is a development company, it is catalyst-rich, reasonably funded, has excellent management and its Metates flagship asset is very strategic for either senior or intermediate companies. Metates is a gold deposit in Mexico that has 28 Moz. gold. We estimate it can produce 1 Moz. of gold at sub-$475/oz. cash costs at a 20-year mine life. It is assets like those that have strategic importance for major companies that people should focus on.

TGR: That's another one our readers can take a look at. We greatly appreciate your insights and a couple of good stories that look like they have some solid potential. Thank you very much for joining us today.

John McClintock is an equity research analyst at Mackie Research Capital, specializing in mining and metals. Prior to joining the firm in 2008, John was with Bank of Montreal Capital Markets where he worked in investment banking. John began his investment industry career in 2005. He holds a Bachelor of economics and commerce from the University of Toronto.

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DISCLOSURE:
1) Zig Lambo 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: Argonaut Gold Inc., Avion Gold Corp.
3) John McClintock: I personally 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: Argonaut Gold Inc., Avion Gold Corp., Chesapeake Gold Corp.

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