Gold Mining: The Haves and Have Nots

Is this the valuation bottom...?

THE MINING world has been divided into haves and have-nots. There are gold companies that have managed their balance sheets wisely and there are those that have burned through cash and are left begging for financing. It's a great time for those flush companies that don't need handouts to take advantage of the resulting valuation differential, says Paolo Lostritto, the director of research and mining and metals analyst at National Bank Financial.

In this interview with The Gold Report, Lostritto talks about a subtle shift he has seen in the market that may signal a bull run similar to that of the late 1970s and early 1980s. 

The Gold Report: National Bank Financial began taking a defensive approach to gold equities in April by focusing on companies with strong balance sheets, which could fund their own growth and not have to go to the equity markets to survive. How do you validate that defensive thesis? 

Paolo Lostritto: We were right to have a defensive approach, but we probably weren't defensive enough. Multiples contracted much more aggressively than even we expected. There was a raft of project delays, cancellations, and capital and operating cost increases that have decimated the space so much that less than half of the gold mining industry is actually making money based on our all-in-cost estimate from third quarter data. 

TGR: Should investors expect some takeover deals throughout 2013? 

Paolo Lostritto: The market's been bifurcated into haves and have-nots. Executives are signaling that a number of junior companies are reaching out for a lifeline. It is an opportunity for companies that have cash and cash flow to dictate terms, take significant positions through private placements or purchase companies outright. There are a lot of opportunities for companies to pull the trigger on good assets. The question everyone is trying to answer is: Is this the valuation bottom?

TGR: You said you perhaps needed to take an even more defensive approach to equities. Does that apply now? Should investors take an extreme defensive approach at this point? 

Paolo Lostritto: While things are fairly depressing in the gold mining space, we're starting to see early signs of lower deflation risk and the potential for improved velocity. We're not out of the woods yet, but there are early signs. Importantly, Basel III liquidity and capital ratios, which were expected to be enforced by the end of 2012, have now been deferred four years. This alleviates pressure off Tier 1 banks that had been hoarding cash in order to meet those capital and liquidity ratios. Now that they have more time, they are likely to loosen up the purse strings and deploy some of that capital. Mining and junior exploration equities are some of the riskiest asset classes out there and will likely be the last to benefit from that flow of funds. We're not there yet, but we're cautiously optimistic.

TGR: Tell us about the price to net asset value and price to cash-flow compression. What does it mean to the average investor?

Paolo Lostritto: Price to cash-flow multiples were basically flat across the industry, excluding royalty companies, at around 10–12x for cash flow. Price to cash-flow multiples have compressed over the course of 2012. Some senior gold producers are trading as low as 5–6x forward cash flow, while some junior single-asset companies are trading as low as 2.5–3x cash flow. 

For multiples to go back to historic levels, an element of greed has to come back into the marketplace and that will only happen if we get some margin improvement. If we're right about the flow of funds and the velocity of money, there should be an eventual benefit to the gold price and margin expansion in late 2013. 

TGR: You suggest going into "harvest mode" as a response to this multiple compression. As a result, you favor royalty companies and producers with dividends and share buyback potential. 

Paolo Lostritto: Companies that are in harvest mode have already developed their assets and have less capital requirements relative to the rest of the industry. Royalty companies are positioned well in the current market environment. The junior market has been absolutely decimated. There hasn't been a better market for royalty companies to talk to junior developers and work out royalty deals to bolster their existing pipeline of royalty assets. 

TGR: Do you expect more royalty companies to come into the mix?

Paolo Lostritto: There's definitely an attraction to the royalty model. There is a lot less risk, yet the shares still give you exposure to exploration upside. 

Yes, there are a number of groups out there trying to create new royalty companies, but the hardest part is to attract a premium valuation. In order to attract a premium valuation, the royalty company has to have a portfolio of royalties. It's very difficult to gain enough critical mass to attract that premium valuation and truly be in a situation where one plus one equals three. Groups are trying, but it's not easy.

TGR: Will larger royalty companies buy up some of the smaller royalty companies? 

Paolo Lostritto: I would imagine that they have reviewed their competitor's portfolios. However, a company just finished spending $1 billion on the Cobre Panama project with very little short-term impact on its share price. We believe the asset will eventually start to improve the share price as it gets closer to generating cash flow. It's very difficult to move the needle for larger royalty companies and as such they try and focus on longer-life assets or assets they believe have exploration upside.

TGR: Do any juniors fit your defensive thesis?

Paolo Lostritto: That's the thing—there are not many juniors that fit the defensive thesis. There are a number of single-asset production companies that are interesting. 

TGR: What's the one message you want to get across when you're out there giving presentations to various institutions? 

Paolo Lostritto: I want to highlight that we see the early signs of money flow but that we are not out of the woods yet. It is about the velocity of money. The initial reaction would be for the market to start to price in higher interest rates; however, we would only start to worry about the gold trade if the outlook for real interest rates was positive. 

Everybody has had a very difficult 2012. No one wants to jump in with both feet because that would be imprudent. But if we're right, and the velocity of money picks up, then we could be in for an interesting three-year period whereby foreign exchange (FX) reserves increase. The velocity of money could take the existing FX reserves from $10 trillion (T) to even $15T just by way of circulation and drive the gold price higher. 

TGR: How long could that be sustained? 

Paolo Lostritto: In the 1970s, after we went off the gold standard, the gold price increased from US$35/oz to US$200/oz. Then we went through a notable recession in 1973, which led to a deflationary scare until 1975—similar to the one we went through in 2012—which caused the gold price at the time to correct from US$200/oz to US$100/oz. It was only when the velocity of money started to pick up that the concerns regarding deflation shifted toward concerns about inflation. Central Bank interest rates started to rise, but inflation rose at the same rate or faster. It was a controlled burn in terms of devaluing the currency. That's a better scenario for central banks than being behind the curve and pushing on the string. Once that started in 1976, we went from US$100/oz to as high as US$800/oz. Even if we used gold's average price of ~US$400/oz during the 1980s, it is a pretty impressive fourfold move. 

Who knows what's going to happen, but the data's starting to suggest that this is bubbling to the forefront. There are still a lot of challenges to deal with—the US debt ceiling and European sovereign debt issues are still a concern—but I encourage people to take a second look at the space as there could be some opportunities. 

TGR: Thanks for sharing your thoughts with us, Paolo. 

Paolo Lostritto: Certainly. You're welcome.

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