With generous enough cash flows to fund expansion and fuel organic growth without going to the market for capital expenditures, the companies that Mike Starogiannis follows should be in a position to drive stock valuations up. According to Mike, Wolverton Securities' Mining Research Analyst, as long as they enhance their production profiles, they are in good shape—unless the price of gold drops considerably. But in this exclusive interview with The Gold Report, he tells us that his sights are set on gold averaging in the neighborhood of $900 to $1,000 per ounce over the next year or two, and any spikes in either direction would be temporary phenomena.
The Gold Report: Gold is a big topic of conversation today and, of course, the big thing everyone is discussing is how high it will go. What is your perspective?
Mike Starogiannis: I think that gold is positioned to go higher from here strictly based on the current fiscal policy of the United States in terms of printing cash to fund a lot of new infrastructure projects and economic stimulus packages. Eventually, in the mid-term, that money will trickle through the economy and inflate the U.S. dollar. Because gold has always been a historical hedge against U.S. dollar inflation, just fundamentally based on that we could see upward movements.
TGR: If most developed countries are similarly expanding money supply, wouldn't you expect to see inflation around the world? What happens to gold if all the currencies are inflating?
MS: The U.S. economy out-leverages most other economies, and the economies that really count are probably China and the U.S. China is seeing its own economic slowdown right now and China holds U.S. dollars. Another impetus for gold to move upward is too many U.S. dollars coming through the economy.
TGR: Most of what we read suggests that China is getting rid of U.S. dollars by buying base metals from around the world. Will that help offset the inflation that the U.S. economy faces?
MS: I don't see that the Chinese buying base metals with U.S. bucks will impact significantly the U.S. dollar inflation, no.
TGR: So looking at the U.S. as core economy driving the price, how high will gold go?
MS: My crystal ball is no better than anybody else's. If you look at the trading pattern for gold historically through economically turbulent times, it can easily spike upwards by 50% of what it's currently trading at, but it'll spike right back down almost as fast. I believe fundamentally that any spike will be a temporary phenomenon. My target for gold pricing mid-term is right about where it is now.
TGR: What do you mean by 'mid-term'?
MS: We could see gold spike well through $1,000 on a 12- to 24-month horizon, but I think it'll be in the $900 to $1,000 band for that period on average.
TGR: If gold stays in the $900 to $1,000 band, what hope do you have that stock value of any junior or producing company that you follow will appreciate?
MS: Appreciation will not come if gold stays in this band, based on fundamental valuation and current production profiles. Where appreciation will come from is these companies' leveraging their fairly generous cash flows. These cash flows, basically, are accumulating in cash accounts until these companies come up with good generative projects to invest in—and there are projects out there. I believe the next leg up for some of these juniors will come with spending their cash wisely and investing in good new projects. In other words, it won't necessarily come from fundamental share appreciation based on current production. Many of them are fairly valued at this point.
TGR: What is the likelihood of their projects proving to have sizeable gold assays?
MS: Take a company like Alamos Gold Inc. (TSX:AGI), for example, which is currently trading around the $10 mark. They're generating ample cash flow and have their cash costs under control. They seem to have their heap leach operations at Mulatos in Mexico in steady state. So by all accounts they're doing quite well.
At $10, one might argue that they're fairly valued, but they also are building ample cash reserves at the moment. It's quite a war chest they've built up and they're talking about spending at least a small part of that money to build a new mill that will be operational in 2011 to enhance their production profile. It's that kind of investment that we believe will be the next leg up for many of these companies.
TGR: The $10 should already cover the gold in the ground, so it's the mill that will create an increase in the value of Alamos stock?
MS: The mill will create incremental cash flows. Many of these companies are valued on cash flows and so the incremental cash flow should create the next leg up.
TGR: When should that mill be operational?
MS: The company recently said they expect it to be operational in the last quarter of 2011 and that should create an extra 30,000 to 40,000 ounces of production annually. Currently, the reserve life for the milling portion of their mine is quite short—about two years. But between now and 2011 I give them very good odds for creating more reserves to go through the mill, more high grade.
TGR: Is that because the project they're currently in hasn't been fully drilled out yet?
MS: They've got quite an extensive property package surrounding the Mulatos mine and have had some very good exploration success in various targets, including a target called Puerto del Aire, which is just adjacent to their existing pit, as well as some other recent extensions to their Escondida high-grade zone.
TGR: What's the probability that an Alamos Gold might be taken out by a major? And if so, is that good news for Alamos and its investors?
MS: You can argue that any company that makes itself attractive enough is a takeout candidate. Deal risk is relatively high in all of these cases. For me to say there are good odds probably would be erroneous. For all these junior gold companies, not just Alamos, there are many variables, including entrenched management, changes in valuation over the period of time that the deal is expected to close, commodity price volatility, etcetera that can lead to deals not happening. What you have to count on is the company will progress and build organically.
TGR: Can you give us a quick overview of what Capital Gold Corp. (TSX:CGC) is looking forward to in terms of properties?
MS: Capital's main property is El Chanate in Sonora, Mexico. They have a small open pit there, currently producing at a run rate of approximately 50,000 ounces per year. I believe they're going to hit that production target this year, and next year they'll be doing between 55,000 and 60,000 ounces. They're producing at fairly low cash costs and they're cash flow positive. That's another one of these companies that would make a great acquisition for a company such as Minefinders Corporation (NYSE.A:MFN) (TSX:MFL) or Alamos or Gammon Gold Inc. (NYSE:GRS) as a bolt-on operation.
TGR: Given that they're cash flow positive and they're currently mining, it sounds as if they can sustain for quite a while as an independent company.
MS: This is correct. There's no gun to their head to carry a transaction to fruition. It's just a good exit strategy at this point for realizing shareholder value. Alternatively, if a transaction is not in the cards, they can reinvest their cash flow in some new projects.
TGR: Do they have a good exploration team?
MS: Their onsite exploration team (for generating ounces on their current property) is pretty good, and their Vice President, Scott Hazlitt, is a great geologist and is quite well-versed in Mexican properties and capable of finding new projects for them, yes.
TGR: You're positive about Capital and about Alamos. Capital is currently mining with some good positive cash flow. Alamos won't have its mill running for a couple of years. How do you compare investment opportunities between companies getting ready for production and companies already producing?
MS: Just to clarify, Alamos is already in production, with their open pit producing at a rate of about 150,000 ounces per year, and they are generating very generous cash flows per quarter at these gold prices. The recently announced Alamos mill is incremental to their current production.
TGR: Are pretty much all the companies you're following already in production?
MS: Yes. The only exception is Nayarit Gold Inc. (TSX.V:NYG), a junior gold/silver exploration company with principal projects in the Nayarit state in Mexico, which is on the Pacific side. They've had some very good successes in the past year in drilling off their property and we look forward to them growing their resource and establishing a formal 43-101 resource by year-end.
TGR: What caused you to look at Nayarit as a junior explorer compared to the hundreds of others out there?
MS: Their exploration success to date. They've been able to drill off a zone that has the potential to host 500,000 gold equivalent ounces in one small area of their fairly extensive property. Given the success in this small pocket of mineralization, they have good indications that it's a well-mineralized property and they're likely going to prove up more ounces over the course of the next year.
TGR: Has Nayarit's management team done this before?
MS: Yes. Actually, the president and CEO, Colin Sutherland, was part of the Gammon team that brought the Ocampo assets into production. He's well versed both in running public companies and in building value for shareholders and their Vice President of Exploration, Hall Stewart, has had spectacular successes in proving up the Ocampo and Palmarejo projects.
TGR: Who else do you cover?
MS: The only other producer we're currently covering is Castle Gold Corporation (TSX.V:CSG), which is very analogous to Capital Gold. Their producing asset is the El Castillo open pit and heap leach operation, which is in Durango, Mexico. They're currently producing at a run rate of about 35,000 ounces per year and we're estimating that next year they can probably do 40,000 ounces. They have some good upside on their property in terms of near mine exploration. They recently released some interesting drill results from the periphery of their existing pit, which indicate that there is good room to expand the size of their pit going forward.
TGR: In light of what you said earlier, that bringing the new ancillary mill online is likely to increase Alamos share price, what will move Castle's stock up?
MS: I think what's going to move the Castle price going forward is hitting their production milestones. They've said they can produce in excess of 50,000 ounces a year. We figure by the end of 2010 they may be able to hit that milestone. That will be one catalyst for moving the share price. The other will be positive cash flow. Until fairly recently they were in a neutral cash flow position. This quarter they should be in a positive cash flow position and be able to fund capital projects organically and not have to come back to the markets. And again, near mine exploration results such as those recently released will show good upside to grow the overall mineable resource that's on the property.
TGR: Could the projects they're starting to drill potentially exceed 50,000 ounces a year?
MS: At this particular property, I believe so—if they're really aggressive in drilling off the areas around the pits and also making some key changes to the operation in terms of fleet sizing, mining scheduling, and size of the crushing and screening plants. They would also require heap leach pad expansions. But, yes, all these things are doable. Should they prove up enough ounces to merit expanding the operation, they could hit in excess of 60,000 or 70,000 ounces of production. Bear in mind that it probably would not be until two to three years down the road.
TGR: Some of those operational investments seem capital-intensive. Would their cash flow be large enough to fund these capital expansion needs organically?
MS: I think organically in the next 12 to 24 months they could probably fund the capital expansions necessary to get them to the 50,000-ounce-per-year range. After that, it would depend on prevailing commodity prices. If you assume a $950 gold price 12 to 24 months out, when they're at the point that they can grow to 70,000 ounces of production, they may have to come back to the market, but presumably at better valuations.
TGR: Do any of these companies that we're talking about—Alamos, Nayarit, Castle and Capital—risk financial instability should the price of gold go down to $800 or $850?
MS: Currently all the producers are unhedged. They may carry some short-term hedges inter-month, which are not required to be reported; but in general they don't carry hedge positions. So, yes, all unhedged gold mining companies, whether it's Castle, Capital, Barrick Gold Corporation (NYSE:ABX) or what-have-you, are largely exposed to the downside in gold price.
TGR: Will that cause any of the companies we just spoke about to become cash flow negative?
MS: Yes. Most of these companies at $500 gold would probably have trouble remaining going concerns. But that applies to just about everybody. Most senior companies are now boasting cash costs anywhere in the range from $400 to $500 per ounce.
TGR: Given U.S. fiscal policies, isn't seeing it down even to the $700s improbable for the next 5 to 10 years?
MS: Yes. There's always room for short-term stimuli to push commodity prices downward if someone were to flood the market with physical gold for whatever reason; if, for example, one of the central banks decided to sell gold, en-mass, into the market. But in the short term, for the next year or two, I believe that we're in a good solid trading band between $900 and $1,000 per ounce.
TGR: You recently looked at Queenston Mining Inc. (TSX:QMI) properties. What were some of your impressions?
MS: I really liked what I saw. It was my first time to the Kirkland Lake mining camp in Ontario. We toured the surface works on their properties there. I was very impressed with some of the recent exploration results they've generated out of their property packages. In particular, one of the properties I like most is what they're calling the South Claims Joint Venture. It's a joint venture with a company called Kirkland Lake Gold Inc. (TSX:KGI) . They've produced some fairly spectacular drill results, bonanza grades over pretty wide intercepts. The really exciting part of that for me on the technical side is that, historically, the companies that have mined in this camp have mined in vertically dipping shear hosted gold mineralization. Fairly recently, within the last two to three years, companies such as Kirkland Lake Gold and Queenston Mining have discovered horizontal or shallow dipping structures within the camp, at depth, that host equally high grade and broad intercepts of gold. So they're basically giving new life to this camp.
TGR: Is there a cost differential between mining vertically and horizontally?
MS: There may be differences in costs, but it's really hard to say until mining has begun. It's kind of a backward-looking exercise, so you probably would have to get a year of mining at commercial rates under your belt before you can really assess whether there are any dramatic differences. From a technical standpoint, mining in vertical structures is sometimes easier and therefore may be cheaper. You can use gravity to your advantage to load and move ore around versus mining in horizontal structures, where you generally have to scoop ore and truck it over to where you're hoisting or ramping it.
Another difference may be in how you support underground openings; in terms of requiring more support, such as rock bolts and screening, which can add to the operating cost per ounce when developing new ore. But it's pretty early days to assess whether mining horizontally vs. vertically in this particular case is going to be dramatically different.
TGR: So the big news here is the fact that there's more life to this property on finding the horizontal structures, not so much that they are horizontal rather than vertical.
MS: Correct. For me, the real news with the South Claims Joint Venture is that they're no longer limited to looking at vertical structures. They've discovered that gold carries in these shallow dipping structures and that these structures may repeat. They've found one particular structure that spans two vertical structures. The question now is whether there will be some repetition of these horizontal structures throughout the 40-kilometer length of this mining trend.
TGR: Is Queenston currently producing?
MS: It is not producing; Queenston is strictly an exploration company at this time. And the soonest we can envision them organically becoming a producer is probably at least two to three years out. However, it's our opinion that Queenston is not really aiming to be a producer. Their strengths lie in exploration and any exit strategy for them would be to build the assets, to grow ounces, to put more confidence around those ounces in terms of doing scoping studies and feasibility studies and either sell those assets or be taken out entirely by a more senior company.
TGR: So given that business model, this horizontal discovery is really big.
MS: Yes, and Queenston has seen a good run up in their share price commensurate with these discoveries, but we believe there's lots more room to grow for these guys.
DISCLOSURE - Mike Starogiannis:
I personally and/or my family do not own equity in any companies mentioned in this interview. In addition, I personally and/or my family am not paid by any companies mentioned in this interview.
Some of the travel expenses associated with researching these companies were paid for the by the companies mentioned in this interview.
Mike Starogiannis is Mining Research Analyst at Wolverton Securities, a privately owned family business that has participated in the Western Canadian investment community since 1910. The oldest member of the Toronto Stock Exchange Group, Wolverton is associated with every major stock exchange group in North America through either membership or trading agreements. The company's longevity and financial stability, combined with the quality and expertise of its employees, are key factors that further Wolverton's position as a valued resource and a recognized leader in Western Canada. Before joining Wolverton last year, Mike was Metals and Mining Analyst at Fraser Mackenzie.
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