Cost creep is eroding margins...
PAULO LOSTRITTO, Gold Mining equity research analyst with National Bank Financial, attributes development companies' current struggles to both the recent trend for capital and operating cost increases and to the European sovereign debt crisis.
In this interview with The Gold Report, Paulo Lostritto explains that there are opportunities as long as investors look for companies with free-cash-flow growth and solid balance sheets.
The Gold Report: Paolo, a lot has changed since we talked in January 2011. Specifically, National Bank Financial purchased your former employer, Wellington West Mining. More generally, the once-rebounding world of precious metals equities is now decidedly bearish. What is your take on precious metals equities?
Paolo Lostritto: We are seeing two things. One is ongoing cost creep and eroding margins. The second is a dampening of valuations as the market tries to assess the resurgence of sovereign debt risk and the potential of an unorganized breakup in Europe, as signaled by bond yields.
TGR: How have those factors changed your thesis for gold equities?
Paolo Lostritto: This situation is ultimately a positive for gold as there are only two ways out. One, you can try to devalue your currency, which a lot of countries are trying to do and should lead to an inflationary recession. The second is having the multiple layers of debt collapse onto itself, leading to a deflationary recession.
The gold market is struggling to figure out which scenario will play out. Gold Bullion protects you in both scenarios. In an inflationary recession the metal outperforms. In a deflationary recession, gold equities would eventually do better.
TGR: Perhaps, but that was not the case for gold equities in the fall of 2008 and early 2009.
Paolo Lostritto: In 2008, the market was pricing in the risk of a depression. As a result, gold behaved as the last source of liquidity. Yes, gold came off a bit, but it worked as the go-to source of liquidity, the insurance policy that worked.
Equities also behaved the way they were supposed to—the multiples contracted initially. But on the back of reduced costs, margins expanded and project internal rates of return improved. Once the initial depression scare passed, the precious metal equities outperformed.
TGR: What are you looking for in gold equities?
Paolo Lostritto: We are looking for companies that can fund their growth organically on their own, companies with strong balance sheets that do not have to go to the equity markets to survive.
Development companies are struggling right now because the equity markets are not open to funding exploration or development.
TGR: You and your team use a number of metrics to compare apples to apples among precious metals companies. Please tell our readers about a couple of your favorite metrics and how you calculate them.
Paolo Lostritto: We are big believers in both net asset valuation and price-to-cash-flow growth valuation.
Over the last 12 months, we believe the market has applied a higher discount rate to future cash flows that have been trimmed to account for higher costs.
We are seeing a transition from a historic premium applied to precious metal companies to one with a more traditional valuation methodology. Precious metal companies are being modeled similar to base metal companies. We no longer see the premium we used to see in gold companies, in part due to cannibalization from exchange-traded funds. Many gold companies are trading at 12–15% discount rates using the forward curve.
Using the price-to-cash flow metric, these stocks typically trade anywhere from 10 to 12 times cash flow. Right now, some of them are trading as low as three to five times cash flow 2013 estimates.
TGR: So there are bargains to be had?
Paolo Lostritto: Right now, our view is that investors should take a conservative stance. Focus on companies that have cash, cash-flow growth and solid balance sheets. The old saying is that the markets can stay irrational a lot longer than you can stay solvent. You want to have a defensive portfolio in this market, until we get a clear signal that deflation risk has been reduced. The recent Long-Term Refinancing Operations (LTRO) program from Europe only managed to give us two months of reprieve before the second LTRO program at the end of February disappointed relative to the sovereign debt risk.
TGR: Let's talk a bit about Burkina Faso, a small country located between Ghana and Mali. It is home to about 30% of the Birimian greenstone belts of West Africa. What are the main characteristics of gold deposits native to these greenstone belts?
Paolo Lostritto: We are in the early stages of defining what Burkina Faso has to offer in terms of exploration.
TGR: Why would companies look for gold deposits in the greenstone belts of West Africa instead of Ontario or Québec, for example?
Paolo Lostritto: The influx of money into West Africa was fueled by the large deposit discoveries and a favorable tax environment.
However, labor costs, royalties and taxes in West Africa have been increasing. The recent increase in royalties and taxes has caused some deviation in this flow of funds.
TGR: Did the recent coup in Mali cause you to rerate any of the companies you cover?
Paolo Lostritto: We are watching that situation very closely in light of the ties to al-Qaeda in parts of Northern Mali. If this trend continues, it could have implications for surrounding countries and how we value them.
TGR: Does jurisdiction risk outweigh the exploration potential in West Africa?
Paolo Lostritto: We believe there are still elephants to be found in that part of the world. But the discount rate that one uses to value these assets will have to change from country to country, and jurisdiction to jurisdiction, relative to the associated risk.
For example, we use a higher discount for a company in Bolivia versus a development story in West Africa, versus a development story in Ontario.
TGR: Have you already beefed up your discount rates for companies operating in Burkina Faso, Ghana or Mali?
Paolo Lostritto: We have not. In our current view, projects in Burkina are politically safe. We are keeping a close eye on Mali. If things start to spread to surrounding countries, we may have to reassess the discount rate we apply.
TGR: Despite the pullback in some of the exploration plays in West Africa, do you see more value in companies operating there than a couple of months ago?
Paolo Lostritto: I would say there is a lot more value here in North America when you adjust for the risk profile. A number of these stocks have been hit in tandem when it comes to development stories.
TGR: What three things should our readers know before taking a position in a West African gold play?
Paolo Lostritto: First, there are still elephants to be found there. Second, focus on names that have good infrastructure. Those companies will be better insulated against the cost inflation we're seeing in West Africa. Third, grade is king. Better grades also provide insulation against cost inflation.
TGR: What constitutes good grade there?
Paolo Lostritto: It is a function of the dimension and characteristics of the deposit, the metallurgy and the strip ratio. For example, a project with soft rock characteristics and low strip ratio can process lower grade material than one with harder rock characteristics and a high strip ratio.
TGR: Thanks for your time.
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