You scan the menu and notice that the prime rib and the hamburger are the same price. What do you order? The precious metals market isn't so different, according to "Mexico Mike" Kachanovsky, consultant to hedge funds and mining companies and contributor to SmartInvestment.ca. The market has pulverized the price of top-notch mining stocks to the same level as the struggling names. So, which would you buy? In this interview with The Gold Report, Kachanovsky reveals how to find the prime rib of the gold market.
The Gold Report: Mexico is a mining jurisdiction where mining investors have made a lot of money, especially over the last decade. Mexico recently passed a 7.5% royalty on earnings before interest, depreciation and amortization (EBIDA) for mining companies operating there. Are the salad days over for miners in that jurisdiction?
Mike Kachanovksy: There are still a lot of unknowns on how this new royalty is going to affect mining companies in general and how it's going to be applied within the country.
The majority of the producers I talk to don't feel it is going to be that disruptive because it's a royalty on earnings, not a gross smelter royalty. The way it is structured, companies that aren't making a lot of money right now won't be paying a lot of extra taxes. There are also going to be deductions that companies can put in play that would lower their overall tax spike from the new royalty.
For the companies that are already in production and that have been established in Mexico, it's really not going to doom their operations. However, it is discouraging retail investors from participating and buying up Mexico-related stocks. There's uncertainty and fear in the market until people start to understand it's not going to devastate the bottom lines of miners.
TGR: Could the tax be lowered?
MK: I don't think the Mexican government will change the actual total amount, but it will probably allow more leeway and flexibility on what counts as earnings and what deductions will be allowed against that royalty. One thing to keep in mind: Part of the rationale for bringing this new law into place was that it would force companies to pay a certain amount of money back. It would go to the immediate local domestic or regional government. That money could be used to pay for schools or road construction or a lot of the things that the mining companies are doing now voluntarily.
Perhaps some of these companies that already have scholarship programs and are building playgrounds and schools for their local communities will be able to deduct that money they're spending already in goodwill. My feeling is that there will be enough pressure behind the scenes that the structure of this royalty will be less restrictive than how it stands right now.
TGR: Do you think companies are going to avoid Mexico as a result of this royalty?
MK: I've heard some saber rattling from certain companies that say they are going to restrict investment within Mexico and start looking at other jurisdictions. I think it's a lot of political brinkmanship. The arguments for continuing to operate in Mexico are still more positive than negative. Even with this new royalty, Mexico is still one of the most favorable and lowest-cost mining jurisdictions in the world.
TGR: Timmins Gold Corp. (TMM:TSX; TGD:NYSE.MKT) and Torex Gold Resources Inc. (TXG:TSX), which both operate in Mexico, were among a handful of junior mining companies that recently completed bought-deal financings. Does this signal a warmer financing environment for junior mining companies—especially those operating in Mexico?
MK: I consult for a number of funds that are saying now is the time to start investing in these junior mining stocks. The stocks are so beaten down that a firm can put $2 million ($2M) down on a financing and end up owning a third of the company. I believe that we're going to see bought-deal financings and more appetite for private placements that will allow companies to get funded and move forward.
However, there are still companies that have extremely attractive projects that are not able to get financing just yet. The market is still too weak for them to attract funding. I think we're still at the much earlier stage. At some point we're going to see a lot of money flowing into the sector. Right now, the lowest-hanging fruit is being picked. We're still a long way from a healthy speculative market.
TGR: SNL Metals Economics Group, which is based in Halifax, Nova Scotia, estimated that the total worldwide budget for non-ferrous metals exploration dropped about 30% to $15.2 billion ($15.2B) in 2013 from $21.5B in 2012. Yet Mexico remained a top-five destination for exploration spending. What keeps the drills turning in Mexico?
MK: Mexico is still relatively underexplored and it has a treasure trove of prospective geology. There's always going to be that discovery potential that makes the risk/reward balance in favor of continuing on with exploration. Even in an environment where metals prices have come down, the chance of finding a brand-new high-grade deposit in Mexico that could be economic to develop will have companies spending money.
The cost of exploration in Mexico is still much lower than many other places in the world. Exploration spending has dropped now that a lot of junior mining companies have access to high-quality consulting firms and drilling contractors. A company can get a lot more meters of drilling done today for less than it would have cost two years ago.
TGR: Mexico is known more for its silver than gold. Which are you more excited about right now?
MK: I'm a silver bull, but investors need to have leverage to both. We're at the latter stage of a very long and severe correction for both metals. As things roll over into a more bullish posture, silver tends to outperform gold on the upside. If I were going to be putting new money into a metal today, I would probably put a little bit more weight toward silver.
TGR: Mining magnate Rob McEwen, who's well known in mining circles, told Mineweb.com that consolidation will pick up this year. He added that his namesake company, McEwen Mining Inc. (MUX:TSX; MUX:NYSE), is likely to grow through mergers and acquisitions (M&A). Do you see an uptick in M&A coming?
MK: Absolutely. The urgency and likelihood that it's going to pick up this year is just that much higher because there's less exploration spending and existing mines are being depleted. If these companies want to stay in business they're going to need to either find more minerals or buy them. The severity of this correction means there are a lot of very attractive projects available that have lost half or even 90% of their market value. It's cheaper to buy late-stage defined deposits than it is to look for them and drill them.
TGR: What are some companies producing silver and gold in Mexico that finished the year strong and are poised for further gains this year?
MK: Investors have to look for the companies that survived the downturn intact with prospects for growth. I'd select a company like Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.MKT), where production is increasing 19% on a silver equivalent basis year-over-year and guidance for 2014 is for a further 10% increase in total metals output. Great Panther has $24M in cash on the books with no long-term debt. It has a very strong financial position and the market cap is a fraction of where it was a couple of years ago when there was a lot more risk in the story.
TGR: Do you think that Great Panther is likely to attract an acquirer?
MK: A lot of companies have been saying they want to do acquisitions and are looking at possible targets for mergers. The problem is that a lot of the acquisitions won't be acquired at current market value. Companies are going to have to pay a premium to get them. All of a sudden it doesn't look as if a project is an accretive acquisition any more. Sure, assets are cheap, but some of these companies that are in a position to do a deal are gun shy because by the time they pay a premium to take over something, it looks expensive in hindsight. We're going to need to see a rebound in the price of the metals and locking in the cheap market caps of some of these acquisition targets. We may be just on the cusp of that. It's too early to say.
TGR: Great Panther exceeded its 2013 production guidance. Are you willing to go out on a limb and say it might beat its guidance for 2014?
MK: It will at least be in the ballpark. Great Panther's president has done a very good job of underpromising and overachieving. Companies that have missed expectations get severely punished in the market. Just this week, Alamos Gold Inc. (AGI:TSX), which is a very successful midtier producer in Mexico, missed expectations and issued lower guidance for 2014. The stock is down by more than 30% in one week on numbers that are not that bad. It makes more sense to be very conservative with guidance and then go out and surprise the market.
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