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Marshall Berol and Kevin Puil: Takeover Talk
Source: Brian Sylvester of The Gold Report (11/5/10)
Encompass Funds Portfolio Manager Marshall Berol and Analyst Kevin Puil spend a lot of time examining junior mining companies for investment opportunities and they're pretty good at it. The Encompass Fund was up 139% in 2009 and it's up another 21% so far this year. In this exclusive interview with The Gold Report, we talk to Marshall and Kevin about how they choose junior gold stocks and whether or not the growing number of takeovers is influencing their decisions.
Marshall Berol: We don't think the rise in the gold price is solely responsible. There are a number of factors that are involved in the increasing mergers and acquisitions (M&A) activity. Companies that are doing the acquiring like Kinross or Goldcorp need to increase their reserves and increase production, and acquiring a junior can contribute to that.
A company such as Argonaut, which is a small producer, merging with a company like Pediment, which has attractive resources, will result in a stronger company with better recognition in the market and greater ability to finance growth. Effectively, one and one will equal three.
Another aspect is that larger companies are seeing tremendous increases in the cash flow that they are getting from producing gold at cash costs of $450 to $500 an ounce and selling it for $1,200 or even $1,300. They are often using that cash flow for merger and acquisition activity.
The rise in the price of gold or silver or some of the other commodities contributes to M&A activity, but there are other reasons too.
Kevin Puil: I think one of those reasons might be that a lot of the senior producers have a shortage of internal growth projects. They need to look outside to add ounces to their production pipeline. And they're looking obviously toward the juniors for that.
TGR: But is there a pattern here?
KP: A lot of the seniors look for the low hanging fruit: companies with resources and low cash costs that are close to infrastructure and that will complement their existing operations. Location plays a big factor in this.
MB: Certainly location is a factor as Kevin said, but the M&A activity is not just in gold. You're seeing some M&A activity in connection with silver. It's not directly merger and acquisition activity that's going on in the silver space. But increasingly we're seeing for example Silver Wheaton Corp. (NYSE:SLW; TSX:SLW) financing new or expanding silver projects by advancing money to the junior company and having a agreement to purchase the company's silver production over a number of years or maybe even the life of the mine. That's not directly M&A activity but you're seeing that. There is some lesser amount of that going on in the gold space with the gold royalty companies such as Gold Wheaton Corp. (TSX.V:GLW), Royal Gold Inc. (NASDAQ:RGLD; TSX:RGL) or Franco-Nevada Corp. (TSX:FNV).
TGR: We've been looking at the mice in this cat and mouse game, but let's look at the cats for a moment. You've got companies like Goldcorp and Kinross but Argonaut is certainly far different from either of those. Argonaut is basically one operation and it's looking for synergies with Pediment Gold. Is this a trend?
KP: I think the seniors aren't looking for the sub-million ounce deposits or the sub-100,000 ounce-per-year producers. Seniors are looking for 3-to-4-million-ounce deposits or producers producing several hundred thousand ounces a year. I could see a lot of these junior producers and advanced exploration companies merging to make themselves more attractive to senior producers.
TGR: Effectively a two-tier takeover process.
MB: Yes, that could be or the case where two juniors are merging as a merger of equals or near equals to grow the ounces they have in the ground or grow production or consolidate facilities that are near each other. We're likely to see more of that activity. For example, in Mexico there are a good number of junior silver mining or silver prospecting companies that are reasonably close to each other. You'll see consolidation and merger activity there, such as is the case with Argonaut and Pediment.
TGR: Or with Timmins Gold Corp. (TSX.V:TMM) and Gammon Gold Inc. (NYSE:GRS; TSX:GAM) making plays for Capital Gold Corp. (TSX:CGC; NYSE.A:CGC; Fkft:CGU). That's another example of what you're talking about. We've seen a range of premiums with takeover bids this year. There were substantial premiums paid for Red Back and Andean, and a much smaller premium on Pediment. Could you comment on the prices being paid for these companies?
MB: There are two kinds of premiums. One is a premium based on the number of ounces that the company has reported under 43-101 procedures, and dividing that by the acquisition price to determine how much per ounce is being paid for the gold in the ground. That leads to a far wider range of valuations than is the case with stock market prices. Part of that is because the acquirer will often have their own idea of how much gold is really in the ground even though it hasn't all been assessed under 43-101 standards. The second aspect is the premium based on the stock market prices of the respective companies. Kevin will give you some of the numbers on both.
KP: As Marshall said there's quite a wide range of valuations per measured ounce in the ground. For instance, our model has Goldcorp taking out Andean at roughly $1,100 per measured and indicated ounce in the ground. Other deals we've seen have been a lot lower. For example, Gammon Gold's current bid for Capital Gold is roughly $142 per ounce in the ground.
I think that shows that Goldcorp is paying for the potential of a mineralized system that could prove to hold many more millions of ounces than have been found to date. I think there are 3 million ounces of gold and 60 million ounces of silver at Andean's Cerro Negro gold and silver project in Argentina. Based on Goldcorp's takeover bid, I think they would need to prove up a few more million ounces of gold to make Andean a worthwhile purchase.
But four or five years ago Goldcorp bought Virginia Mines. I don't think they had a 43-101 resource estimate at the time, but Virginia had outlined about 3 million ounces of gold. Since the takeover Goldcorp has defined over 9 million ounces of gold. It sort of works out roughly to $50 an ounce.
Goldcorp obviously saw something they liked and didn't wait for a defined resource and bought it. I think gold was $500 per ounce at the time.
My point is that while you've seen some lofty prices being paid, they're not just paying for the defined resource today but the many millions of ounces they see in the future.
MB: Generally speaking, it would appear that what's being paid for known ounces in the ground would be from $50 up to $200 an ounce. That's looking at a full range of 43-101 ounces reserves as well as resources in the measured and indicated and inferred categories. Sometimes you'll see an ounce per dollar value that's only based on measured and indicated ounces. But if you add in the inferred ounces you certainly get a different number. When people are looking at valuations it's important to see exactly what they are being based on if they're trying to compare one company's acquisition with another company's acquisition.
We've been talking about the valuations per ounce of gold in the ground. Stock market price valuations on acquisitions or mergers are running from a 35% premium being offered to a 50% or 60% premium. Sometimes it's a stock-per-stock deal. Depending on how the market reacts to the transaction, the premium may increase or decrease from what it was at the time of the announcement.
TGR: In most cases it's cheaper for these companies to go out and buy another company than it would be to find and develop a deposit on their own.
MB: We would certainly agree with that. It's also a factor that the intermediate and major commodity companies, particularly if you're looking at gold and silver or copper, do not have the exploration capacity that the juniors have. They have a different structure. They tend to have committees deciding which projects to explore, which ones to advance. A smaller junior company is more flexible and makes those decisions more quickly. Often junior companies are only constrained by the capital that they have or can raise. It usually pays for a senior company to acquire the junior that has a good project and possibly have the people come along who are familiar with that project.
TGR: Marshall, you manage the Encompass Fund. That fund was up 137% in 2009, which is impressive. But your fund is heavily weighted toward junior resource companies. With the growing number of acquisitions, are you now buying junior resource companies with an eye toward these companies being taken over?
MB: Malcolm Gissen and I co-manage the fund, along with the able assistance of Kevin Puil and our other analyst, Craig Valdes. We do not buy companies based on our belief that they're going to be acquired because that's very dicey as to whether or not it will happen and at what point.
We're primarily focused on companies that we think are solid companies in terms of management, projects, project location, capital structure and the ability to finance progress. Having said that, some management is clearer than others. Some believe the best way to increase shareholder value is to have the project or the company taken over or merged with a larger company. But most managers say that they will continue to develop the projects, and certainly if an offer comes along they will consider it in light of overall shareholder value.
Unless a merger has already been announced we tend not to play the arbitrage that might be available in merger activities. We look at the prospects for a company to advance far enough that it's going to be attractive to another company, but it's not a major factor. We're looking at the underlying fundamentals of the company that we're investing in.
TGR: Two of the larger investment positions in the Encompass Fund are Avion Gold Corp. (TSX.V:AVR; OTCQX:AVGCF) and Exeter Resource Corp. (NYSE.A:XRA; TSX:XRC; Fkft:EXB). Do you expect these two companies to be taken over, or are these companies that just provide good value?
MB: They probably represent both aspects of what we were just talking about. I'll start with Exeter. Exeter Resource has the Caspiche project, a very large gold and copper deposit in the Andean Mountains of Chile. Malcolm Gissen, my co-manager, and I have visited the property. It's a very large project that has a 30, 40 million ounces of gold equivalent defined in a 43-101 resource report but several billion dollars in capital is necessary to turn that project into a mine. South of Caspiche, Kinross Gold and Barrick Gold Corporation (NYSE:ABX; TSX:ABX) own the Cerro Casale gold-copper project. And to the north Kinross has another existing mine. When we initially invested in Exeter several years ago, we felt they had some attractive projects and believed in the management. At the time, Exeter had projects in Chile and in Argentina. Earlier this year they spun off the Argentinean projects into Extorre Gold Mines Ltd. (TSX:XG; Fkft:E1R; OTCQX:EXGMF). Extorre is now moving toward production in southern Argentina.
Exeter management has said that it's likely that the Caspiche project in Chile will either be sold or the company will be sold, or Caspiche will be joint-ventured because it's likely beyond the capacity of Exeter to develop it as a mine. Some other larger company is likely to do that. That's probably a good example of a company that is not likely to be the one that brings the project into production.
Avion on the other hand is operating in West Africa. It has brought a couple of mines into production and has done some acquisitions. Kevin can give you some additional comments on Avion.
KP: Avion is one of those smaller junior producers that we talked about earlier that is reasonably priced and could attract some suitors. Avion has good cash flow. It's in a great neighborhood, and there is the potential to discover millions more ounces there.
TGR: Where are its mines located?
MB: Avion's operating mines are in Mali, West Africa and they are advancing projects that are in Burkina Faso, also in West Africa. They have just acquired some other projects in Burkina Faso.
TGR: Is there any jurisdiction risk there? Mali is relatively stable but Burkina Faso is a bit more on the edge.
KP: We've obviously done work on the political risk in Burkina Faso and are quite comfortable with that mine's jurisdiction.
TGR: If you were gambling men—and I want to emphasize that very few successful fund managers like yourselves would ever be characterized as gamblers—are there three or four precious metals juniors companies that you would be willing to wager would be acquired in the next couple of years?
MB: Well, the answer is yes but we're not riverboat gamblers in any fashion. There is certainly an aspect of uncertainty involved in any kind of investing. We like to feel that between fundamental and technical factors we greatly reduce the "gambling" element. We meet with the management of most of the companies in which we invest. And we meet with them on an ongoing basis to get updates or participate in the conference calls or meet with them at conferences. We feel that's important. We know some fund managers don't view meeting with management as being useful but that's not our view. Having said that, we would anticipate that a company like Exeter would not be an independent company in a few years. But whether that's 12 months or 24 months or 36 months is really hard to say.
Another company that's likely to be acquired is Seabridge Gold Inc. (TSX:SEA;NYSE.A:SA), which the Encompass Fund owns and has owned since the fund started business four years ago. Seabridge Gold has two very large projects, one in British Columbia and another in Canada's Northwest Territories. Both will likely require a major producer to develop those projects into mines. Having said that, Seabridge keeps advancing the projects, keeps exploring, drilling and working toward permitting. Seabridge management has stated that the company or its projects will likely be acquired by a major. But again, it's really hard to say when an acquisition is going to take place even if you believe that it's a possibility or if management has said that's a possibility.
KP: That being said, we've also we've identified a few grassroots exploration companies that could become the subject of takeover bids. One of our holdings is Corex Gold Corp. (TSX.V:CGE), which we think has the potential for a multi-million ounce deposit in northern Mexico. They are probably a year away from having a defined resource, but as we talked about earlier, location can be very important. Corex has property next to both Gammon Gold's Ocampo gold-silver mine and Alamos Gold's Mulatos mine in Mexico. We think that in a year or two when Corex defines their resource, it could be attractive to a company such as Gammon.
TGR: Let's move away from gold and into another hot commodity, rare earth elements (REEs). We talked before about the performance of the Encompass Fund. One aspect of that performance is its positions in junior companies holding and developing rare earth elements deposits and the share price appreciation of those companies. The REEs sector is much smaller than that of gold. Do you see some consolidation happening in that sector?
MB: That's harder to get a handle on at this point. We're basically value-oriented investors, and we try to identify business trends that will result in attractive stock market investments down the road. In doing so we identified the rare earth elements. Not many companies were involved in REEs at the time. We made an investment in Avalon Rare Metals Inc. (TSX:AVL; OTCQX:AVARF) which, as you mentioned, has worked out extremely well.
The number of companies involved in the REEs sector is maybe a couple of handfuls. How is that going to play out regarding consolidation or merger activity? We think it's likely to happen down the road because that's the nature of most industries as they mature. Some companies are more interested in growing through acquisitions, whereas others for a variety of reasons feel that being bought out or merged is the way to increase shareholder value. Consolidation will probably happen but it's difficult to see it happening in the near term.
A reliable supply of REEs has become more and more necessary due to their use in wind turbines, solar panels and hybrid electric automobiles. The marketplace has taken to heart the value of rare earth elements in the ground, particularly if they're outside of China. China currently produces 95% or 97% of the world's REEs. China periodically has said they may reduce REEs exports. That has brought to light the value of having rare earth element deposits outside of China. There are various companies such as Avalon that are advancing those projects.
TGR: That leads me to my next question. Even if we don't see near-term consolidation in the REEs sector, what are some names that offer good value in the REEs space?
MB: That's a harder one to answer. Over the past month or two, REEs juniors have had a collective rise in their share price because of the increased awareness of the ability of companies outside of China to potentially produce REEs, and the fact that there aren't many companies involved. The share price of companies such as Molycorp Inc. (NYSE:MCP), which has an REEs deposit in California and did an IPO earlier this year, and has gone up 2.5 times since its IPO. So to say there's good value is more difficult now than in the past. Having said that, there's likely to be some backing off of the pricing. It bears watching and deciding when there's decent enough stock market pricing to invest in an REEs company.
Another company that the fund has owned since it went public is Dacha Capital Inc. (TSX.V:DAC; OTCQX:DCHAF). Dacha has a business plan of acquiring rare earth elements in China, exporting them under license to warehouses outside of China, and then ultimately selling them to users at a good profit. We think it's a very interesting business plan. We think it's an attractive way to play the REEs sector without the risk of mining or prospecting.
TGR: But China has largely declared a moratorium on REEs exports. How is that affecting Dacha's business?
MB: Well, whether there's a moratorium or not seems to depend on which news release you read on which day. There may be a moratorium. But today China is saying there is no moratorium and they will again be exporting some rare earth elements. Having said that, it's a two-edged sword for Dacha to the extent that it's more difficult for them to acquire REEs. On the other hand, the REEs that are warehoused outside of China become more valuable to companies producing automobiles or windmills or solar panels or cell phones, all of which use rare earth elements.
TGR: Do you have some parting thoughts on M&A activity in the mining business?
KP: I think that as the price of bullion increases, you're definitely going to see some more acquisitions among the non-producing, ounces-in-the-ground companies. The money is going to follow the ounces in the ground. Stay tuned for a flurry of activity.
MB: There's no indication that the intermediate sized or major gold and silver companies will decrease their desire to acquire companies or projects that give them the ability to grow. Larger companies grow by expanding the projects that are already producing or by acquiring new projects and neighboring projects that they can consolidate into their business to improve the economics. That's going to continue as the price of the metal continues to increase. It often comes down to a smaller company getting an offer that they can't refuse.
Marshall Berol has been engaged since 1982 as an investment manager in San Francisco, CA. Since 2000, he has been the chief investment officer of Malcolm H. Gissen & Associates, Inc. In addition, for more than 20 years, Mr. Berol has owned his own investment firm, BL/SH Financial. Mr. Berol's investment management experience has focused primarily on investments in publicly traded companies. Mr. Berol did his undergraduate work at the University of California (Berkeley) and received a JD degree from the University of San Francisco School of Law.
Kevin Puil has more than 15 years' experience in the investment management business and currently serves as portfolio manager at Malcolm Gissen & Associates and as an analyst at the Encompass Fund in San Francisco. Mr. Puil spent the majority of his career working in Canada before relocating to California. He studied economics at both the University of Victoria and the University of British Columbia and holds the designation of Chartered Financial Analyst.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Avalon, Avion, Capital, Dacha, Exeter, Extorre, Franco-Nevada, Goldcorp, Pediment, Royal and Timmins.
3) Marshall Berol or Kevin Puil: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family is paid by the following companies mentioned in this interview: None.