Matthew Zylstra: Value in Small-Cap Gold Producers
Source: George Mack of The Gold Report 03/09/2011
Northern Securities Analyst Matthew Zylstra seeks out junior precious metals stocks with value in the ground and growth potential that are not yet obvious to the markets. He also looks for companies that have unrecognized base metal potential that can significantly reduce the cash costs of precious metals production. In this exclusive interview with The Gold Report, Matt shares some names and discusses catalysts that could move portfolio values significantly upward.
The Gold Report: What lies ahead for gold prices?
Matthew Zylstra: We don't officially put out a gold price forecast, but I believe that the bullish environment, basically a perfect environment, will persist because of continued geopolitical friction, inflation and currency debasement concerns. I expect the spring and summer to be relatively choppy, but conservatively I believe the price of gold will rise above $1,500/oz. by the end of 2011.
TGR: Is this fear of catastrophe, fear of inflation, a hedge against a weak U.S. dollar?
MZ: I think it's a number of factors. On the demand side China is emerging as a large producer, but it is also a consumer of gold. It's trailing India, but demand is exploding and China looks poised to become the largest consumer nation. I also think developments like the Sprott Physical Gold Trust (NYSE.A:PHYS; TSX:PHY.U), which holds physical gold, are positive, as opposed to something like the exchange-traded funds such as iShares Silver Trust (ETF) (NYSE:SLV) or SPDR Gold Trust (ETF) (NYSE:GLD), which hold a lot of paper certificates. So, from the demand side, things look very positive.
Driving this demand I believe is a growing mistrust of fiat currencies, which are subject to the whims of politicians, the threat of monetization and the possibility of a sovereign debt crisis. I think it's the worth of a dollar that should be on trial, versus the value of gold. If you cut the value of a currency in half, you know everything gets adjusted in price. Right now in North America, people are generally content in trusting paper money in its various forms, but I think this could change, especially with rapid increases in things like food and energy prices-these are hard to ignore.
TGR: When might that change occur?
MZ: I don't expect it would be something immediate or sudden-but I think it is happening now. As investors become more concerned with monetization and rising inflation, and as yields on debt securities remain at record lows, I simply expect people will become more concerned with the erosion of purchasing power and will move away from paper assets to tangible assets as a store of value.
TGR: We have had a fairly peaceful revolution in Egypt and now one not so peaceful revolution in Libya. There's turmoil in Tunisia, and it looks like a domino effect in northern Africa. Now we're thinking of the Middle East, particularly Saudi Arabia, Kuwait and Jordan. With all that's been going on, we have seen gold move up only about 5% since the beginning of February. That's not a spike. Is that because gold is fully valued at this point, and that might be why it did not react to this unrest?
MZ: Market reaction to political events is not always immediate or what we may expect. There are a number of factors to consider that influence the gold price. People in countries with high political risk may decide to slowly move their investments to gold because it is perceived to be a safe investment, but it takes some time for people to decide what, in fact, a safe asset is. For example, is the U.S. dollar a safe asset? Are bonds a safe asset? I think people perceive fiat money as safe currently, but as they see their purchasing power erode while holding these safe assets, some will change their view and put it into a tangible asset like gold or silver.
TGR: Could it be a bullish signal that people have not had the knee-jerk reflex to buy gold in reaction to the unrest in the Middle East and northern Africa?
MZ: Yes. If all investors felt that political unrest automatically leads to higher gold values, then gold would likely be much higher already and hence there would be less opportunity for appreciation. I feel there is considerable long-term upside to the gold price, and part of that upside is because of healthy skepticism about gold and silver as safe haven currencies. This skepticism provides opportunity for bullish investors-it's sort of a contrarian idea. What I mean is that if everyone was invested in an asset, there wouldn't be any upside left.
TGR: Do you have a forecast for silver?
MZ: Silver has really surprised me. I don't have a price target, but I think the same factors that are influencing gold are factors for the move in silver. In the silver market there is also a lot of talk of a very large short position on the COMEX, so short covering could be a big factor. I have also read a lot about the difficulties in obtaining physical silver.
TGR: Do silver producers have more upside than gold producers?
MZ: Yes, I believe that silver producers do have more upside. With the current spot price of silver in the $33-$36/oz. range-which we have not seen since the 1980s-and with typical silver cash costs for producers in the range of $5-$10/oz., margins will be significantly higher for silver producers even if silver prices stay where they are, and certainly if they go higher. I also don't think the recent and very significant rise in silver has been factored into silver equities prices. But I don't focus so much on the silver producers. I do look at some of the silver exploration companies, and that's primarily due to valuation.
TGR: What about the valuation of silver exploration companies?
MZ: Silver exploration companies trade at much cheaper valuations based on ounces in the ground, about one-fifth on average. I have looked into them, and there are a few that I like-Oremex Resources Inc. (TSX.V:ORM), Cream Minerals Ltd. (TSX.V:CMA), Apogee Minerals Ltd. (TSX:V:APE) and emerging producer Avino Silver & Gold Mines Ltd. (TSX.V:ASM,OTCBB:ASGMF). I just think that on an enterprise value to resource in the ground valuation, they are significantly cheaper than the producers, but of course there are number of factors that must be looked at, including management, characteristics of the deposit and infrastructure.
TGR: If commodity prices remain the same, can producers increase margins enough to satisfy investors?
MZ: Certainly. Gold and silver producers could increase margins in two areas. They could reduce cash costs by increasing the number of ounces they produce so that they are able to spread fixed costs over a greater amount of production. They could also improve efficiencies, for example, by increasing recoveries.
TGR: Do you think of these producers you're following as value stories or growth stories?
MZ: Currently, I think they're a bit of both. They are value stories because investors haven't really factored in the current prices of the commodities. In my models to value companies I'm using a $1,000/oz. long-term gold price to be conservative. And for silver I'm using something under $20/oz., which is considerably lower than the spot price. I think investors are doing the same thing. They have seen a move up in the price of gold and silver over the last few years, and they're still basing their valuations on much lower gold and silver prices. For that reason, they look like value propositions. Furthermore, when you buy gold or silver equities you are buying resources that will end up as future production for a fraction of the current spot value-currently this is around $130/oz. of gold resource for a junior gold producer, for example.
These companies also look like growth stories. The junior producers typically have not spent a lot of money to explore their properties, and so a lot of them have considerable exploration upside that they just haven't been able to focus on. Also, when these companies start making money, you will see a lot more M&A activity as smaller producers combine to reach that mid-cap status and begin to achieve a higher valuation on the basis of being larger and more stable companies. These companies also typically have a lot of room to grow production organically. So, I see it as both value and growth.
TGR: What are some examples in the gold sector?
MZ: Here at Northern Securities, we focus on a lot of small-cap explorers and producers. Some examples where we've been involved in recent financings include NioGold Mining Corp. (TSX.V:NOX; OTC:NOXGF.pk), Armistice Resources Corp. (TSX:AZ) and currently we are working on the financing for a company called Golden Band Resources (TSX.V:GBN) in Saskatchewan. A couple others that include base metals and precious metals are Canadian Zinc Corporation (TSX:CZN) and Buchans Minerals Corp. (TSX.V:BMC).
TGR: You mentioned you have a couple under coverage. What companies do you like?
MZ: Barkerville Gold Mines Ltd. (TSX.V:BGM) is a stock that I cover that is a small gold producer. I went on a site visit in September of last year, and I really liked the property and operations. I think that the company could produce around 40,000 ounces (40 Koz.) this year and rising to around 85 Koz. in 2013. I currently I have a $1.50 price target, but have it rated as a Hold since it has just about reached my price target and I need to see some things fall into place. It's a bit of a show-me story right now. I am waiting to hear news on permitting, or increasing production before making any changes to my rating.
The catalyst I expect over the next couple of months is permitting of the Bonanza Ledge property, which is a high-grade gold zone. It's a very soft ore, and I think the company would be able to process it at a higher rate, and it is actually looking to move a second mill close to that deposit. I want to see better visibility on profits or production, but I think its resource could be expanded greatly, and it has a lot of potential.
TGR: Would good news from Bonanza Ledge have a meaningful effect on stock price?
MZ: Certainly-it's what I am waiting to hear news about, and I expect it would have a significant positive impact on the stock price.
TGR: At that point, would you consider revising your target price upward?
MZ: Yes, I would. I would have to go back to my models and make some adjustments.
TGR: You were also talking about NioGold Mining, weren't you?
MZ: NioGold is one that we are not currently formally covering, but I am very positive on the area where the company's properties are situated in the Malartic and Val-d'Or gold camps, which have produced about 45 Moz. in a number of past-producing mines. I think seven are currently operating. It's in Quebec, Canada, and it's arguably one of the better areas to mine, thanks to generous tax credits and a government which is very supportive of mining. The company is in a joint venture with Aurizon Mines Ltd. (TSX:ARZ; NYSE.A:AZK), which has an option on a portion of Niogold's property. To earn that portion they have to spend $20M on a drill program.
TGR: Why is it trading at such a low valuation-only $24-$30/oz. in the ground?
MZ: I don't believe small gold exploration companies in this camp get very much appreciation by the market, but it's a very interesting project right next to the Osisko Mining Corp. (TSX:OSK) Canadian Malartic property, which is going to be in production in Q2 of this year. Osisko has roughly a $5.5B market cap, and I am surprised that NioGold's share price doesn't get more traction based on that.
TGR: It sounds like a takeover candidate with its low ounce-in-the-ground valuation and market cap.
MZ: Well, certainly, it could be a takeover candidate by a company like Osisko, or maybe Aurizon, with whom they have the agreement for drilling.
TGR: What about another company that you are watching?
MZ: I really like Orvana Minerals Corp. (TSX:ORV), which has projects in Spain, Bolivia and Michigan. They all appear robust-high grades and strong economics. I visited Orvana's Spanish operations last fall and I was impressed with what I saw. This company appears to reasonably valued on its gold production alone, while it should have significant copper production and also a small amount of silver. I have rated the company a Spec Buy, and I have a 12-month $5.70 price target on the stock.
TGR: That represents better than 50% upside from here. What is the catalyst that would move it?
MZ: Well, the first of the company's projects has everything in place to be in production within a month. This is its Don Mario Upper Mineralized Zone-a gold, copper and silver deposit in Bolivia. A second project, El Valle/Boinas-Carles mines (EVBC), should be in production in the spring of this year. I think those two projects represent significant catalysts. When the company starts producing from those projects, I expect it will generate a lot more attention. The company also has a large copper resource in Michigan, where I feel the market has not yet recognized the value of this project. I know we're talking about gold, but you're basically buying the gold asset for slightly below what I think are the market averages, and you're getting the copper asset thrown in for free.
A company that looks similar to Orvana that I don't cover is OceanaGold Corp. (TSX:OGC; ASX:OGC). I wanted to mention that one too because it looks very interesting based on valuation. It's a very similar story to Orvana in that it's a gold producer with a large copper project. The market seems to be giving no value to its Didipio gold and copper project in the Philippines. It trades at a valuation that looks attractive based on the gold alone, and the copper asset doesn't seem to get any value in the market.
TGR: Is this a case of investors just not focusing on projects that are more than a year away?
MZ: I think that has something to do with it. If you are near-term producer and everything is in place, the market gives you close to a full valuation relative to producing companies. When production is further out, you get less value-you have less visibility on that project and projects are especially discounted when there are questions regarding permitting or financing. In the case of Orvana or OceanaGold however, when you have a gold producer that also produces considerable amounts of other metals, it makes the story a little bit more convoluted, and it's sometimes difficult to figure out the value.
TGR: Matt, I have enjoyed talking with you very much.
MZ: Thank you very much, George.
Analyst Matthew Zylstra joined Northern Securities in 2010 after having worked at Sprott Resource Corp. (TSX:SCP) and investment counsel firm Foyston, Gordon and Payne Inc., a unit of Affiliated Managers Group Inc. (NYSE:AMG). He is focused primarily on junior precious metals producers, and he also follows some base metals miners. Matthew has worked in the finance sector since 1999.
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1) George Mack 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: Apogee, Aurizon and Barkerville.
3) Matthew Zylstra: I personally and/or my family own shares of the following companies mentioned in this interview: Avino Silver and Gold, Ormex and OceanaGold. I personally and/or my family am paid by the following companies mentioned in this interview: None, though Northern has done banking business for those mentioned in the financing section.
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