Kerry Smith: Putting Together a Portfolio During Trying Times
Source: The Gold Report  10/03/2008

A veteran analyst, Kerry Smith of Haywood Securities covers a broad range of companies in the mining sector, from juniors to mid-tiers to majors, from explorers and developers to producers, from base to noble metals. In this exclusive interview with The Gold Report, he covers a lot of territory, discussing the outlook for gold, the next stage of sector consolidation and the rough political terrain in some of the world’s most resource-abundant geographies.

The Gold Report: How should investors play this market, and what's your outlook for commodities, gold in particular?

Kerry Smith: Big picture, I would expect the U.S. dollar to trend lower over time. That should be positive for gold and to a lesser extent the commodities. Short term, there’s so much uncertainty and scrambling to get liquidity and cash, with hedge funds blowing up, that it tends to confuse the picture. To me, the bigger picture hasn’t changed. I am neither a currency guy nor an economist, but that’s my view of the world, so I’d say commodities and gold are good places to be.

For commodities in general, the muted supply response from producers in the last five years adds a bit more credibility to this view. We haven’t seen much new production come on, whether it’s copper, nickel or zinc mines.

While demand has softened in Europe and the U.S., demand is still growing in emerging economies such as Brazil, India and China. Demand for metals generally is still growing, so metal prices should be relatively well-supported.

The bigger issue is what commodity demand will be on a go-forward basis. For the first time in six years, China recently cut Central Bank rates by a quarter point. I think China is less worried about inflation and more worried about growth, and cutting rates suggests that they don’t want their economy to slow too much. As you know, China is the biggest consumer of copper, nickel and all the rest of it, and I think will consume more and more metal every year. That should make up for any demand destruction in Europe or North America.

So I like the base metals. The demand side of the equation is good, despite these occasional hiccups during which people get fixated on slowdowns and financial crises in North America and Europe. If you talk to the companies, they don’t really see any slowdown on the demand side; they still see strong sales from their customers.

TGR: Any base metals in particular that you like?

KS: Among the base metals, I prefer copper because the market is still in a slight deficit. Zinc has a bit of a problem; surplus is likely to continue through 2009 and prices probably won’t rebound much. We’d need more mine closures to get the zinc market back to a more balanced position. On the other hand, the Brunswick mine—the world’s fourth largest zinc mine—will be mined out in 2010. The surplus isn’t likely to exceed the 200,000 tons of metal the Brunswick shutdown will take off the market, so if we continue to see reasonable growth in demand, maybe in 12 months’ time we will get to the point where zinc prices start to pick up.

In addition to copper, I’d prefer to be involved in iron ore, coal or some of the agricultural commodities. The market for coal looks good.

TGR: Do you have any preference regarding investing in explorers-versus-producers in this environment?

KS: In this market, the producers are quite cheap. With the producers’ cash building up on their balance sheets and their stock prices depressed, you may see some share buybacks. Another thing I think they will do in a market like this is use cash and cash flow to add projects into the mix in their pipelines.

Most of the easy acquisitions in the base metals and the golds probably have been done, particularly for the large caps. The next wave of consolidation probably will be the mid-caps. But at the same time, I think you will see the large caps with cash also buying assets. The CEOs of these companies don't worry about the metal price tomorrow or care what the copper price does next week, but they want to add to their pipelines because they’re planning for the next 30 to 40 years. What they care about is having a pipeline of projects to maintain their production profile and grow over time. In the current market I think most companies would rather acquire development-stage projects, given the reasonable prices today in the market, and then get those projects into production over the next five to 10 years.

Gold, of course, has potential to go a lot higher, given that people will gravitate to gold as a safe haven as the dollar keeps trending lower. Gold is a good hedge against currencies, and I don’t think Europe’s economy is in much better shape than North America’s. It’s China and the emerging countries that are now driving the global economy.

The big-cap gold producers look pretty cheap and are not trading at expensive multiples, so I wouldn’t be afraid of buying a Goldcorp (NYSE:GG, TSX:G), a Barrick (ABX), a Kinross (K.TO) or an Agnico-Eagle (TSX:AEM). Those stocks would be the first places I think everybody puts their money, and then over time it will filter down to the next tier, which in my portfolio includes Eldorado Gold (ELD.TO, AMEX:EGO) and Red Back Mining (TSX:RBI).

The big caps and mid-tiers are cheap enough that I don’t think you have to go to the development-stage companies right now, but that is where you’ll make the most money as the cycle continues. Thus, I think you’d like to have a mixture of producing companies that are relatively cheap on a cash-flow or earnings-multiple basis—Barrick, Agnico, Goldcorp or Kinross, and then Eldorado and Red Back in the mid-tier.

I’d think you’d also want to own some of the development-stage companies because ultimately the bigger producers will acquire them. It is not easy for producers to go out and find a 5 million ounce deposit, but there are three or four development-stage companies with deposits of this size now and valuations are relatively modest, making them attractive potential acquisitions. So you have companies such as Detour Gold (TSX:DGC), with 12-plus million ounce gold resource in Ontario, CGA Mining (TSX:CGA, ASX:CGX), Mineral Deposits (TSX:MDM, ASX:MDL), Bear Creek Mining (TSX.V:BCM), which has a big South American silver deposit, Apollo Gold (AMEX:AGT, TSX:APG), which is coming into production, Andina Minerals (TSX.V:ADM), with 7-plus million ounce gold resource in Chile, or Osisko Mining (TSX:OSK) with a deposit of 7 to 8 million ounces in Quebec. If you are in a pretty stable first-world country, those companies are going to get picked off at some point because it becomes cheaper to buy ounces than explore.

TGR: Can you talk a bit about Red Back Mining Inc. (TSX:RBI), one of the mid-tiers?

KS: I have 250,000 ounces of production for Red Back this year, going to about 350,000 ounces next year and north of 400,000 ounces by 2011. They have two mines in production in West Africa, one in Ghana and the other in Mauritania. The company is generating cash. This is the kind of company that will continue to grow, has production and a pretty good management team. They’re in reasonably decent parts of the world, and they’re probably looking at some acquisition opportunities out there as well.

CGA Mining Ltd.(TSX:CGA, ASX:CGX) is also a good example; it has a mine being built in the Philippines, fully funded, that will be in production by year-end, with a couple hundred thousand ounces of annual production. CGA’s market cap is about $160 million, and they have a 5 million ounce resource. It’s quite a large deposit and at some point an asset like that could get sold to the Chinese, who are definitely in the market to buy production.

Any company looking to grow can find opportunities out there. What you need is a turn in sentiment in the market, because right now the market is only focused on liquidity through selling, irregardless of the fundamentals.

There are opportunities for near-term producers to cheaply acquire development-stage projects such as the ones I named—Detour Gold, Osisko, CGA and Bear Creek Mining. Moto Goldmines Ltd.(TSX:MGL) is another good example. It has about a $165 million market cap and a nice gold deposit of about 8 million ounces. It’s in the Congo, and there are too many political issues; so it’s not the best place to be today. But at some point, something will happen there.

With big caps cheap and mid-caps cheaper, that’s where you’d want to start today, in terms of building a position. But some of these development-stage names are going to get acquired, and when they are taken out, it will be at prices a lot higher than today’s.

TGR: You mentioned Crystallex International Corp.(KRY) and the permitting issue in Venezuela.

KS: Yes. It’s 16 million ounces of reserves and +25 million ounces of total resources—so it’s big and it would be a long-life mine. It’s simple mining and metallurgy, and it’s at sea level, not at 4,000 meters in the Andes. It’s got good infrastructure; a lot of the things you’d like to see in a project. It has incredibly cheap power because the government subsidizes power. Power off the grid in Venezuela, all from hydro, runs two or three cents per kilowatt-hour. You can buy diesel fuel and gas in Venezuela for five cents a liter. So it’s going to have low cash costs. The problem is it’s in Venezuela. The situation has gone on for so long. I think if the government really wanted to nationalize the project, they’ve had plenty of opportunity and would have done it long ago. My simple view is that the government doesn’t want to nationalize it, and will figure out a way to move this project along. So at some point, it will get permits and go into development by somebody.

TGR: Could you talk a bit about Anvil Mining (TSX:AVM)?

KS: Anvil’s run by an Aussie who’s done a really good job over the last 10 years building this company up. His problem is that Anvil’s in the Congo. It’s getting exceedingly more difficult over time to find and permit deposits there, whether gold or base metals. It’s also tough to finance them and get them up and running. Ultimately, we’ll need more copper deposits, which is what Anvil’s involved in.

Companies aren’t really finding any new copper deposits in Chile or North America, so a lot of the big new projects will come out of places such as Africa. If you’re a producer and want to be in the copper business for the next 100 years—I don’t think it’s a question of whether you’d ever go to the Congo. I think it’s a question of when, because nowhere else on the planet has such very high-grade ore deposits.

The problem in the Congo is political risk and high infrastructure costs, so security, transportation and supply line logistics and everything else is very expensive. A 1% copper deposit in Chile is probably just as good as a 2.5% deposit in the Congo, because you need that higher grade to offset all these incremental costs you incur to mine there. But the Congo has great geology and lots of big deposits, so we’ll see deposits mined there over the years.

Anvil’s CEO, Bill Turner, recognized this opportunity early, established himself there and built up a relationship with the government. As a result, Anvil has three projects today, all in production. He started modestly, but he’s reached the point where Anvil’s going to produce about 80 million pounds of copper this year. When it comes on-stream, the next project they’re building will move them to 150 million pounds by 2010. So Anvil has a nice growth profile and works in a geologically very prospective part of the world.

In a place like the Congo, I think the companies that survive over time will be those with critical mass and cash flow already. They will need to be connected politically, and they need to know how to operate there. While some of the exploration companies in the Congo today have interesting projects, they don’t have cash flow and markets are tough, so a lot of them will not be able to raise additional capital to move their projects ahead. They’re not going to be able to raise money under very favorable terms, so some consolidation is likely in the Congo.

Companies such as Anvil can be a part of that consolidation because they have cash flow and critical mass. They’re established there and know how to operate. A development stage company, in contrast, might have a great project with nice resources, but still has to figure out how to finance and build it, and how to get it into production. That’s tough anywhere, but it’s more difficult in the Congo.

TGR: Could you comment on Linear Gold Corp. (TSX:LRR)?

KS: Linear is an exploration company and in this cycle, few new greenfields or grassroots discoveries have been made. We had Éléonore (Virginia Mines (TSX:VGQ); Fruta Del Norte (Aurelian Resources (TSX:ARU), Penasquito (with Western Silver, which became Glamis, which became Goldcorp), Gold Eagle (which has just been bought by Goldcorp) and Ixhuatán (Linear’s discovery in Mexico).

Out of all those deposits, the only company that hasn’t been acquired yet is Linear, but Linear did a deal on that discovery with Kinross Gold Corp. (K.TO). It’s not a big discovery—only a couple million ounces—but it was one of the few new discoveries. So Linear is sitting there with about 28 million shares outstanding and about $25 million in cash and it’s basically trading at cash. They still have a residual interest in Ixhuatán. The deal is set up for Kinross to spend $15 million in exploration by next October to earn 70% in the project and pay Linear $100 million in cash.

Kinross is continuing to drill, but we won’t really know their intentions until this time next year. Linear may wind up owning it all because I don’t think Kinross would exercise their back-in option if they don’t find 3.5 million or more ounces there. And if they don’t find anything else, Linear will get it back with Kinross’s extra $15 million of exploration invested.

Ixhuatán isn’t the 4 million to 5 million ounces everybody thought when the stock went to $12, but 1.7 or 1.8 million ounces. That’s still a mineable deposit, and certainly at $1,000 gold, you can make pretty good money. It would interest a mid-tier gold producer, who for $100 million could build a mine that produces 100,000 to 150,000 ounces a year for eight to ten years. So they could generate some nice cash flow from it and bump up production.

But as I say, Linear has a lot of cash and has now gone to Brazil looking to make another discovery. As an exploration company, it’s pretty cheap—pretty much trading at cash, and there’s residual value for the Ixhuatán project. Either Linear will own a 100% of Ixhuatán or they will have a 30% free carry, and they’re spending exploration dollars in Brazil, one of the better geological areas of the world for gold endowment. It’s a good place to be looking for gold, and they’ve got the cash to do it. They don’t need to finance. But management is going to be careful with cash in a market like this—not aggressive.

So I’d say Linear is one of the better exploration plays, given where it’s trading at and what’s in its portfolio. If you buy this one, you can buy it at cash and stick it away. Linear is a cheap exploration play, and there could be significantly more value if they were to get a $100 million of cash from Kinross on a back-in—that’s almost $3.50 a share in cash incrementally.

TGR: How about First Quantum Minerals Ltd. (TSX:FM)?

KS: First Quantum is another copper stock that seems ridiculously cheap. It’s trading at about three times cash flow, which seems pretty low. And First Quantum has a good growth profile, with a number of projects in the pipeline. It holds a 65% interest in the Kolwezi copper-cobalt tailings project under development in the Congo. It’s a very simple project and will generate a great return. First Quantum also bought Scandinavian Minerals with its big Kevitsa nickel-copper-PGE project in Finland. That’s probably the next project they will bring on stream, probably three or four years out. They also own 20% of Equinox, another copper producer in Zambia. They don’t have to buy anything. In Q2, First Quantum generated $300 million in cash flow, up from $270 million in Q1. That’s $1 billion of cash flow for the year, and their current market cap is about $3 billion.

Freeport-McMoRan (NYSE:FCX) also seems ridiculously cheap to me. If I were to buy copper stock today, I wouldn’t necessarily buy Anvil or First Quantum. I would just buy Freeport.

TGR: What fundamentals would make Freeport more appealing than First Quantum or Anvil?

KS: Freeport has big mines and two big operating centers; one in the southwestern U.S. with the old Phelps-Dodge assets, and also Grasberg (Papua province, Indonesia), the world’s biggest copper and gold mine. There’s a higher level of political risk with Indonesia, but the stock was recently trading at $60; about 3.5 times cash flow. I have First Quantum trading at 3.3 and Anvil at 3.0 times cash flow.
But Freeport is not trading at an expensive multiple; so that’s probably my starting point.

It’s the same with the golds, such as Agnico or Kinross or Barrick or Goldcorp—all those stocks look pretty cheap to me. That’s where you could start, and then on top of that you’d want to own some development-stage companies or near producers such as an Anvil—which is trading at a pretty modest valuation, and it’s not a big-cap company—or a Detour Gold, an Andean, an Osisko or CGA Mining or Bear Creek. All those names seem pretty cheap to me. You just have to buy them and be patient.

TGR: With prices so beaten down, is this the time for a long-term investor to be loading up?

KS: Yes, I would agree with that. If I had a longer-term horizon, more than a couple of years, I would want to own maybe a couple of the big-cap golds—Goldcorp or Kinross, for instance—and a couple of mid-tiers such as Eldorado and Red Back, and three or four of the emerging producers/development-stage companies—CGA, Detour, Osisko, Bear Creek. Because if somebody comes along and buys Detour, I can guarantee they won’t get it for $10 a share. It will be double, $20. I don’t know when that will happen, but it’s going to happen with a company like this, assuming the gold price does not collapse.

The big-cap golds cannot find enough ounces to replace their production. They’ve never done it historically, and I wouldn’t expect them to do it on a go-forward basis. Certainly a lot of these companies grow by acquisition—Barrick, Goldcorp, Eldorado.

And if you look at the value—Gold Eagle, with a $1.2 billion market cap and not even one resource ounce in the ground, got taken out at a pretty big price. Or even Aurelian, with a current market cap of $750 million. It’s a great discovery—no question. It’s in Ecuador, which isn’t as bad as people think. Another interesting one is B2Gold (TSX.V-BTO), which has a really nice exploration portfolio in Colombia and a really good VP of Exploration. At some point a discovery will come out of that.

Detour, with a market cap is $400 million, is easily worth a valuation similar to Aurelian’s, $750 million. So if you own something like a Detour with a 12 million ounce gold deposit in Canada that’s in feasibility; that deposit could be in production within three years. That’s worth looking at if you’re in the gold business. A number of companies would like to own a project like that it. It’s not a question of if it happens, but when.

I don’t know how long these things will take, but if you’re patient, I think that’s where the opportunities are.

Analyst Kerry Smith has consistently ranked among the top 15 for precious metals and diamonds research, and earned top analyst ranking for junior mining companies in the Brendan Wood International Survey in 1997. In 2001, he brought his 20-plus years of experience in the industry to Haywood Securities, joining the firm’s Toronto office as a senior mining analyst. Kerry focuses primarily on companies with production in the precious metals, base metals and diamond sectors. Kerry holds a bachelor's degree in mining engineering from the University of Alberta and a master's degree in business administration from the University of Western Ontario.

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