After months of turmoil that has lasted longer than investors could have imagined, the mining world has been divided into haves and have-nots. There are gold companies that managed their balance sheets wisely and there are those that 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. Does Alamos Gold Inc.'s (AGI:TSX) $780 million (M) takeover offer for Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.MKT) 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.
On the surface, it looks as if Alamos is trying to take advantage of a multiple differential. Aurizon is spending more capital to ramp up production in 2014. The market correctly priced it in a lower multiple as it was deploying that capital. In the meantime, Alamos was enjoying a much higher multiple. I believe Alamos' intention is to create a new midtier producer with more than 330,000 ounces (oz)/year (330 Koz/year) and total cash costs of about US$335/oz.
TGR: In November, you noted some "underwhelming" M&A multiples. The Alamos deal is $4.65/share for each share of Aurizon, or $0.35/share above your 12-month target price for Aurizon. Do you consider the offer underwhelming or did it surprise you?
PL: The offer surprised a lot of people. It's a strategic shift for Alamos to go from heap-leach mining in Mexico to underground mining in Canada. We actually bumped our target to recognize that the company is in play and that different valuation metrics apply. It's no longer about fundamental value; it's about the takeout valuation. There's probably a sweetened offer to make the bid friendly in order to retain some key people. There are still several iterations to go through between the fairness opinion and the data room being opened.
TGR: Should investors expect similar deals throughout 2013?
PL: 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 like Alamos 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?
PL: 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?
PL: 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.