We may be headed into a new year, but Chris Thompson, mining analyst with Raymond James, expects more of the same in the precious metals prices: volatility. In this Mining Report interview, he advises investors to play that volatility. He details why — despite its higher royalty tax — Mexico remains a silver powerhouse, and which companies will feel the royalty pinch most.
Thompson is an analyst who specializes in the mid-cap precious metals sector. He was trained in South Africa and has over 20 years of industry experience working as a geologist for major through to junior mining/exploration companies, in addition to a stint working as a mineral economist for the South African State. He has a bachelor’s degree from the University of the Witwatersrand, a graduate degree in engineering, a masters in mineral economics and a PGeo designation. Thompson received the 2011 Starmine No. 1 Stock Picker award for the Canadian Metals and Mining Sector.
Interview by Brian Sylvester of The Mining Report
The Mining Report: Your research reports make it clear that mine operating costs are creeping up. For investors, which should be the bigger concern, lower commodity prices or climbing operating costs?
Chris Thompson: Both are a concern, but right now operating margins are an investor’s biggest concern. For producers, volatility in the metal prices has led to rapidly changing operating margins. Companies are demonstrating their ability to reduce costs, but how far they need to reduce these costs will be determined by the commodity price.
TMR: Do you have a threshold for operating margins; a minimum that you want to see?
CT: It depends on the metal price forecast, but we’re happiest with a 50%+ operating margin on the company’s total cash cost.
TMR: What are your gold and silver price forecasts for 2014?
CT: We have silver at $25/ounce ($25/oz). Historically, that is not unrealistic, although it is a significant premium to today’s ~$20/oz price. Our gold forecast is $1,400/oz.
TMR: Do you calculate the correlation of equities to the daily spot price?
CT: We calculate correlation coefficients for equity valuations and market valuations relative to metal prices. At the moment, pure play precious metal producers, especially the silvers, correlate very well in many respects with the silver price.
TMR: Some miners publish cost-per-ton numbers; others don’t. How does the average investor calculate cost-per-ton for silver?
CT: That’s a metric I use a lot because from an operating perspective, it’s one of the most relevant metrics in the metals space. It’s a metric with a lot of components, including mining costs, processing costs and general and administrative costs — all calculated on a per-ton mill basis. Adding those components together gives you a cost-per-ton milled, which is a pure reflection of mine site operating costs per ton.
TMR: What would be a favorable cost-per-ton in today’s market environment for a silver mine and a gold mine?
CT: You need to recognize that the operating cost on a per-ton basis is only one part of the story. We need to look at the metal value or the metal that’s encased in rock and the company’s capacity to beneficiate that metal.
To answer that question, you have to look at grade, as well as metallurgical recoveries. On a cost-per-ton basis, a mine may be a very high cost producer, but it may also be very profitable based on high grade and good metallurgical recoveries.
TMR: Which three or four silver producers in your coverage universe do you expect to outperform your benchmark index?
CT: Out of the 10 silver producers we cover, four have the potential to outperform their peers: Tahoe Resources Inc. (THO:TSX; TAHO:NYSE), Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE), First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE) and Mandalay Resources Corp. (MND:TSX).
TMR: Tahoe’s 2014 guidance predicts production between 18–20 million ounces (18-20 Moz). Is that a realistic target?
CT: The underlying preliminary economic assessment calls for a lower production, but in discussions with the company, we understand that there’s potential for better-than-anticipated grade in the near term. That alone underpins the operation’s capacity to deliver 20 Moz silver annually.
TMR: You recently increased your target price on Mandalay. Why?
CT: After seeing the company’s Q3/13 financial results, and more specifically, the performance of its Costerfield mine in Australia, we realized that we were being a little conservative with our 2014 cash-flow projections, so we lightened the cost somewhat at Costerfield. That was the catalyst for the higher target price.
TMR: You visited Mandalay’s Cerro Bayo mine. What were your impressions?
“Companies are demonstrating the ability to reduce costs, but how far they need to reduce these costs will be determined by the commodity price.”
CT: I visited Cerro Bayo about three years ago, when production had just re-started. The company was still improving its understanding of the mine and its exploration potential.
I saw a lot of potential for both production growth and exploration. The company’s main focus at Cerro Bayo is to fill a mill, which is currently rated at 1,600 tons per day (1,600 tpd). Next year, the guidance is for 1,400 tpd. Based on exploration upside, qualified by mine life, Mandalay sees medium- to longer-term potential to fully fill the mill and maximize production at Cerro Bayo.
TMR: Looking at Fortuna, its costs at Caylloma are trending lower. How rare is that?
CT: I like Fortuna and I like management’s approach to trimming costs, especially at its high-cost Caylloma mine.
How common is that in the industry? I believe there’s a lot of potential for many companies to trim costs and we’re beginning to see that happen. We’ve seen it from Pan American and Mandalay and other similar companies. Cost-trimming is a necessity given the current metal price environment.
TMR: It’s also a necessity given the new royalty coming into play in Mexico: a 7.5% flat tax on EBITDA (earnings before interest, tax, depreciation and amortization deductions). How is that affecting Mexican silver producers and how are you factoring it into your calculations?
CT: The net effect is marginal for marginal producers operating marginal mines. Unfortunately, for operators that enjoy healthy operating margins, it has a much more significant effect on their ability to generate cash flow. It’s very much a leveler.
Furthermore, it is a deterrent on investment in Mexico. Companies have to, and are, thinking twice about exploring for, building and operating mines in Mexico.
TMR: Nonetheless, you have buy ratings on just about every company that you cover there. For example, you have a strong buy rating and a $5.50 target price on Fortuna.
CT: Our buy ratings are based on our metal price forecast for 2014, and many are driven by multiples to cash flow. Remember, our 2014 silver price forecast is $25/oz, a full 25% higher than spot. This is reflected in high target prices relative to current market prices. Our target prices are more a reflection on valuations should silver prices strengthen to ~$25 oz . Having said that, one company, Santacruz Silver Mining Ltd. (SCZ:TSX.V; 1SZ:FSE) offers production growth, as well as a stellar property portfolio. Our buy rating for Santacruz reflects the potential offered by this portfolio, which is longer term and not directly linked to current cash flow.
TMR: Your most recent report on First Majestic says to expect growth, but that it will be tapered. Can you tell our readers more about that?
CT: We had two reasons. Number one, First Majestic’s key growth asset is its Del Toro mine, where it has slowed its ramp-up plan. The company will scale back on processing concentrates in favor of processing oxide material. This a more cost-effective way of increasing production, but it meant we had to bring our production forecast down. The revised ramp-up may be more economical, but it comes with a slightly lower production growth plan in the near term from Del Toro.
Number two, all of First Majestic’s mines are in Mexico and the company enjoys one of the higher operating margins relative to its peers. Consequently, our 2014 cash flow estimate for the company was disproportionately affected, relative to peers, by the higher Mexican royalty. According to our calculations, its valuation has been hit hardest among Mexican silver-focused producers.
TMR: Should investors expect more volatility in precious metals prices in early 2014?
“The little stories that can deliver on all fronts are the stories that investors should gravitate to, regardless of the metal price.”
CT: Absolutely. The one thing we can expect in 2014 is pretty much what we had this year. We’ll be in a very volatile space for quite some time.
My advice to investors is stay with quality; stay with good management teams that have good asset bases in geopolitically secure regions. Stay with companies that can demonstrate what I call “realistic executable organic growth plans.”
TMR: In other words, projects already in the pipeline that should be relatively easy to finance and bring into production with high recovery rates and controllable costs.
CT: Absolutely. That is the most risk-averse focus a company can offer investors right now. In an environment where money is tight, there’s little chance of projects being financed, but if they carry palatable capital costs, are attractive and the company has the right skill set to advance the assets to production, that’s what the company needs to do. And it’s what investors need to look for.
TMR: That makes sense for midcap or small companies. For the slightly larger players, is there enough confidence in precious metal prices for them to enter a fresh round of mergers and acquisition (M&A) activity?
CT: Broadly speaking, there’s very little confidence for M&A at the moment. However, within management groups that have in-house expertise to deliver on value, there is a much better appetite for M&A.
B2Gold Corp. (BTG:NYSE; BTO:TSX; B2G:NSX) continues to demonstrate this. It has made an acquisition a year for the last three years.
TMR: Before we move onto gold, do you have another silver name for our readers?
CT: Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) has the healthiest balance sheet in the sector at the moment. Its Q3/13 financial results surprised a lot of people. The company is one of the higher cost operators in the sector, but it has really managed to deliver on cost reductions at its South American mines.
The growth opportunity for Pan American lies squarely with La Colorada, where the company wants to expand production.
Coeur Mining Inc. (CDM:TSX; CDE:NYSE) should be looked at together with Pan American. Both are high-cost, senior producers. Each produces more than 20 Moz silver per year. Both have a history of disappointing investors. Judging by recent quarterly performance, both seem to be turning the corner. Both need another quarter or two of positive performance before investors or the investment community begins to give both companies the credibility that they may arguably deserve. If the price moves significantly to the upside, these two companies, being the most leveraged stories in the silver space, should generate significant cash flow growth.
TMR: Aside from B2Gold, what other gold equities do you cover and have buy ratings on?
CT: We also cover Sulliden Gold Corp. (SUE:TSX; SDDDF:OTCQX; SUE:BVL), which offers an interesting opportunity for a potential acquirer. It has a very doable, scalable project in Peru that can be developed relatively cheaply. Peru, however, has a rather checkered past in terms of geopolitical risk. Sulliden’s project is in a geopolitically secure location. It could be an interesting acquisition target for a company looking for low-cost gold ounces.
TMR: How much capital expense (capex) would it cost an acquirer to develop Sulliden?
CT: We have a capital cost of about $150 million ($150M). The company is well financed. The $150M is what we think it would cost to fund a heap leach at 10K tpd production. Over time, we model increased production at an ore crush rate up to 30k tpd. With that kind of processing rate, you’re looking at production starting at 100 Koz/year, increasing to 250 Koz/year by 2017.
TMR: Nonetheless, a recent financing proved to be quite dilutive to the share float. Is that an issue for a potential acquirer?
CT: Not really. The equity financing was the right approach. Sulliden shored up its working capital base, and by the same token, lightened up on its need for a significant financing. We assume there will be a debt financing next year to complete funding requirements for Shahuindo.
TMR: Let’s switch back to B2Gold. Where will its growth come from?
CT: B2Gold has three operation centers: It has the Libertad and Limon mines in Nicaragua, Masabate in the Philippines and Otjikoto in Namibia.
In Nicaragua, we see limited growth from exploitation of a new zone — the Jabali deposit — at the Libertad Mine. This is a satellite deposit within trucking distance of the mill.
Otjikoto is the most important from a near-term production growth and cash-flow growth perspective. The mine is a little less than midway through a two-year construction period that started early this year. We have it commencing production in early 2015 at a rate of ~140 Koz per year.
Having said that, you have also got to watch Masbate, where the company continues to refine and improve on operating efficiencies. In time, we expect to see growth coming from Masbate. But for now, it’s all about optimizing the operation at the current production rate.
In short, we see growth across the board, but primarily from Namibia in the near term, and potentially from Masbate later.
TMR: How would you compare B2Gold’s management group with its peers in the gold space?
CT: I think B2 Gold offers a number of strengths as far as management is concerned. The management are very good operators. They proved to be good mine builders and explorers at Libertad and Limon. The Jabali deposit was a grassroots exploration discovery.
The exploration news coming out of Otjikoto’s new Wolfshag deposit is very interesting in itself. It presents production growth potential over and above what we’re modeling right now for Otjikoto.
As far as M&A goes, B2Gold has a very good team. They can tell the good from the bad. They know what to look for. If conditions are good and the price is right, the team can execute. In total, it’s a well-rounded management group.
TMR: And one with a solid following among major institutional investors. What’s one thing investors in the precious metals space can look forward to in 2014?
CT: More volatility, I’m afraid, if that’s something to look forward to.
You need to play the volatility. This is the time for people to buy stock in solid, high-quality names when the silver metal price is $19–$20/oz. If the silver price strengthens to ~$25/oz, which we think it might, it will be time to lighten the load or offload names.
Often, the little stories that can deliver on all fronts are the stories that investors should gravitate to, regardless of the metal price. You have to play the volatility and acquire positions in good, solid companies when metal prices are low. At these metals prices, there’s more upside potential than downside risk.
TMR: Chris, thank you for your time and your insights.
COMPANIES MENTIONED: B2GOLD CORP. : COEUR MINING INC. : FIRST MAJESTIC SILVER CORP. : FORTUNA SILVER MINES INC. : MANDALAY RESOURCES CORP. : PAN AMERICAN SILVER CORP. : SANTACRUZ SILVER MINING LTD. : SULLIDEN GOLD CORP. : TAHOE RESOURCES INC.