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Look for Gold Juniors with Theme-Changing Catalysts: Annie Zhang

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Annie Zhang Annie Zhang, an analyst with Toronto-based investment bank Octagon Capital, is expecting some good stories to come out of Argentina and Canada this year. In this exclusive interview with The Gold Report, she targets several exploration and near-term producing companies with burgeoning results on the horizon.

The Gold Report: The bottom fell out of the junior precious metals sector in late 2011. Why should investors believe that this sector is going to perform better this year?

Annie Zhang: In 2011, gold was up by about 10%, while gold equities underperformed as investors became more risk averse. Junior exploration companies were beaten down pretty badly. We continue to hold a bullish view on gold, but we think 2012 is going to be a volatile year.

Good stories with theme-changing catalysts will outperform in 2012, however. For example, Mega Precious Metals Inc. (MGP:TSX.V) is coming out with a resource update for the Monument Bay project in Manitoba. This resource update will outline for the first time the open-pit resource potential, which will significantly derisk the project and potentially improve the economics.

Premier Gold Mines Ltd. (PG:TSX) will come out with its preliminary economic assessment (PEA) on the Hardrock deposit, which is part of its Trans-Canada project in Northwestern Ontario. The PEA will provide more visibility for the project. Premier will also start exploration drilling sometime this year on the underground high-speed drift system passing through its joint-venture property with Goldcorp Inc. (G:TSX; GG:NYSE) in Red Lake.

TGR: You have a "speculative buy" on Mega Precious Metals and lowered your price target to $2.95 from $3.30. However, Mega has several promising projects, including Monument Bay and the North Madsen gold project in Northern Ontario's Red Lake camp.

AZ: We recently lowered the price to $2.95 due to the dilution. Juniors are facing financing risk under the current market conditions, especially companies with aggressive drill programs into 2012.

Mega has five projects in its portfolio. Three of them, including Monument Bay, North Madsen and Headway, are currently being actively drilled. The Satterly deposit, which is southwest of Gold Canyon Resources Inc.'s (GCU:TSX.V) Springpole deposit, was just optioned in May and Mega is currently doing the fieldwork there, preparing for preliminary drilling to test some early projects this year. It also has the Blue Caribou high-grade copper deposit in Nunavut, which has been on hold for a couple of years while Mega waits for infrastructure to be developed in the region.

Mega's management has been focused on Monument Bay and North Madsen, anticipating that they have the best potential to grow gold ounces. They have been delivering results. Through drilling conducted in 2011, North Madsen's gold resources in Measured, Indicated and Inferred categories increased to 1.3 million ounces (Moz) from fewer than 36,000 ounces (oz) in 2010. At Monument Bay, gold increased to 1.8 Moz, up from 1.2 Moz in 2009.

Going into 2012, Monument Bay and North Madsen will continue to be a focus. Drilling at North Madsen will be targeting growing ounces in order to prove the project will be economical as a standalone project. At Monument Bay, drilling will focus on growing ounces and derisking the project. Drilling at Satterly will depend on the funding availability. Whether drilling will continue at Headway will depend on the outcome of the current deep-hole drilling program.

TGR: You've assigned a $20 million (M) value to Headway, Blue Caribou and Satterly. It has done some drilling on those, but I thought that was a little high. Can you tell me why I'm wrong?

AZ: First of all, Mega's market cap, before it obtained 100% of Monument Bay through the $10M acquisition of Rolling Rock, was about $25M. Back then, it only had about 36 thousand ounces (Koz) in North Madsen, Blue Caribou was already on hold and it had 17% of Rolling Rock. That $25M market cap was mostly based on the Headway project because Headway was a very exciting project for Mega. It was located literally in the shadow of Goldcorp's headframe, about 600m southwest of Goldcorp's high-grade zone, 1 kilometer (km) south of the Campbell gold mine. If it hits something at Headway, the potential for stock price appreciation is huge.

TGR: What are you expecting from the Monument Bay resource update?

AZ: Since summer 2011, drilling has been focused on delineating an open-pittable resource at Monument Bay. That's what the upcoming resource update will be focused on. The current resource estimate is about 1.8 Moz at average grade between 5–6 grams per ton (g/t) and is only for underground potential mineralization. Our target is between 2.3–2.5 Moz.

TGR: What are you expecting from the revised resource estimate for North Madsen?

AZ: That resource update is not coming out until the second half of this year. Management plans to do a little bit more drilling in order to demonstrate another significant resource increase. The next stage is to grow the ounces from the current 1.3 Moz to at least 1.8 Moz.

TGR: Is management at Mega considering spinning off North Madsen into a separate company?

AZ: Not at this stage. It would be an option down the road. When I said standalone, I was referring to its initial strategy for North Madsen. Management believed that Goldcorp would build a super pit in Red Lake. Mega's early strategy was targeting to find enough ounces to feed the mill. Now Goldcorp is planning to do underground bulk mining in Red Lake. Mega has to prove North Madsen's economics. North Madsen is a low-grade bulk tonnage deposit, not the typical type of deposit in Red Lake, which was one of the reasons that it didn't attract a lot of attention on the Street.

TGR: But it's starting to now.

AZ: Because of the size. Drilling in 2010–2011 increased the resources significantly from 36 Koz to 1.3 Moz. Mega has to change investors' perceptions and prove the project could be economic.

TGR: Premier Gold Mines has a share of the Rayhill-Bonanza joint venture in Red Lake. It owns the PQ North project not far away in the Musselwhite district, but Premier recently received some positive news from both its Saddle gold project near Elko, Nevada, and the Key Lake project near Geraldton, Ontario. That's a lot of projects for a junior. Is Premier spreading itself too thin?

AZ: It's a fair question. We are watching that very closely. In 2011, upon the completion of the GoldStone Resources Ltd. (GRC:TSX) acquisition, Premier was actively drilling on nine projects, totaling 170,000m. It recently announced establishment of a royalty company. There is a lot going on there, but keeping in mind that Premier is not the operator on all projects, and not all projects were being drilled all year round, the main focus was and will continue to be the Trans-Canada project. In addition, in the last six months, Premier has strengthened its management team by adding Paul Huet as the chief operating officer, Brian Morris as its vice president of exploration and Abraham Drost as the head of its royalty company. They, particularly Paul and Brian, brought substantial expertise in mining operations, which clearly demonstrated Premier's commitment to advancing its project and ensured the company is not spread too thin.

Is Premier going to sell some of its projects? The company has long been perceived as a takeover target, primarily due to the Rayhill-Bonanza joint venture with Goldcorp in Red Lake. Premier's current market cap of roughly $650M is very different from the Premier of a year ago. It has added more assets, such as Satterly and Key Lake, and the projects are bigger and more advanced, such as the Trans-Canada project. So it is more than just a takeover candidate.

That being said, the takeover premium is always imbedded in its stock price, which is clearly demonstrated in our valuation. Its present net asset value (NAV) per share on a pure comparison basis is roughly $6.20, but the potential takeover valuation could be between $11–12.

TGR: Premier's chief executive, Ewan Downie, is a bit of a rock star in the mining space. He has done this before. He turned Wolfden Resources into almost $1 billion when it sold its base metals project in the Arctic to Australian company Zinifex Canada Inc. in May 2007. Does that give you faith that he can do it again?

AZ: Absolutely. He has been very successful. Downie is trying to prove that he can move the company forward. He's not just waiting around for someone to take it over.

TGR: What's your target on Premier?

AZ: It's $10.80, based on the ratio 20:80 on NAV/share and the takeover potential.

TGR: Heading south, you're very bullish on the Santa Cruz district in Argentina. The country is a safe jurisdiction, but it also recently introduced a number of taxes and royalties to mining claims. Does that make you a little less bullish on Argentina?

AZ: One of the recent developments in Argentina is the repatriation of its currency. When it came out, the market did overreact because there wasn't any clarity on what it means and how it would be implemented. It was out of the blue. Later that week, there was more information available about what it meant. It doesn't mean that money cannot leave Argentina. It gives the government means to increase the currency liquidity. Money has to be converted into the local currency before it gets transferred out. It would affect the producers more than exploration companies. In fact, some companies came out saying it would affect their costs by about 1%, which is not that significant.

TGR: You're very bullish on Hunt Mining Corp. (HMX:TSX.V), which is a pure exploration play in Santa Cruz trading around $0.25. It's unusual for a brokerage to cover a company that small that's not anywhere close to production. What do you see in that name?

AZ: We like Santa Cruz due to the favorable regional geology for epithermal gold and silver deposits and the attention the region has received from majors recently. We picked three juniors to cover, including Hunt Mining. Hunt is one of the largest land package owners in the region with more than 286,000 hectares, which provides it with a massive hunting ground for gold mineralization, which is why Eldorado Gold Corp. (ELD:TSX; EGO:NYSE) was interested in reviewing and evaluating Hunt's project.

To put this in perspective, Fomicruz S.E., which is the Argentina government-owned corporation in Santa Cruz, owns about 500,000 hectares and Mirasol Resources Ltd. (MRZ:TSX.V) owns about 315,000 hectares. Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE) owns about 187,000 hectares. We could not put a value on the land in our report, but keep in mind it probably would cost more than what Hunt's current market cap is to assemble its entire land package today.

Also, Hunt's project, La Josefina, was awarded to Hunt through public bidding. To earn a 40-year contract with Fomicruz to jointly operate the project, Hunt Mining has to complete a positive feasibility study by the end of 2013, commence project construction in 2014 and start production in 2015. This is a very clearly set timetable, which should establish it as a relevant, potential near-term producer in the region. At this point, we have no reason to suspect that the company is not going to stick to the timeline.

TGR: There could be a potential joint venture with Eldorado. Why is that likely to happen?

AZ: Eldorado previously bid for Andean Resources Ltd. (AND:TSX; AND:ASX) when it was looking for growth potential in a pipeline, so it is clear that that Eldorado likes Argentina. Reasons to justify the likelihood of that happening will be Hunt's huge land package holdings and low market capitalization. If I have to pick the likelihood between a joint venture and a takeover, I would say takeover, because of Hunt's share structure; Tim Hunt, the chairman of Hunt Mining, owns over 40% interest in the company. Whether it's going to be Hunt or not is a separate question.

TGR: Staying in Argentina, what other companies are you bullish on?

AZ: Argentex Mining Corp. (ATX:TSX.V; AGXM:OTCBB) is another junior that has been busy. Its Pinguino silver-gold project is located about 35km northwest of AngloGold Ashanti Ltd.'s (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) Cerro Vanguardia mine in Argentina's Patagonia region. It hosts two types of deposits: a silver-gold deposit and a polymetallic deposit containing silver, gold, indium, lead and zinc.

The current resource estimate, completed in 2009, shows the project contains an Indicated resource of 14.8 Moz silver equivalent (Ag eq) and an additional Inferred resource of 15 Moz Ag eq. About 60% of this is in silver. The 2009 resource estimate was targeting the polymetallic deposit, which now seems to have challenging economics. About 20% of that resource estimate is contained in the oxidized silver-gold deposit, which has been its focus for drilling since late 2009. Since then, a total of 26,000m of drilling has been conducted. Based on the drill results released to date, we are anticipating 31–45 Moz silver, up from the current 8 Moz.

TGR: That's a huge increase.

AZ: Yes, it is. It is also a wide range of anticipation because we are not clear how many veins will be included in the geometry of the oxidized silver-gold deposit. Management's target, which came out at the beginning of the 2011 drill program, is about 14 Moz. We expect the upcoming resource update to beat management's expectations. We assumed 16 veins would be included in the resource calculation. Only the top 50 meters (m) from the surface is oxidized, so our expectation is relatively conservative.

TGR: Once the resource estimate and a PEA are complete, will Argentex become a prime takeover target?

AZ: We don't recommend stories based on takeover speculation. We try to identify relatively undervalued, good stories. The current PEA, completed in early 2011, was based on the 8 Moz oxidized silver-gold deposit delineated by drilling up to 2009 —relatively small and low grade. It only served the purpose of demonstrating the positive economics of the project. If the upcoming resource update is in line with what we are expecting, the study would seek to optimize the project, specifically whether the operating scales would be enlarged and the mining sequence would be changed.

The silver production outlined in the study was very volatile, because it's very small and didn't have a lot of veins to mine from. If it does have about 16 veins in the upcoming PEA, it could sequence the operation very differently and increase the production in order to be a very meaningful silver producer in the region.

TGR: If the resource estimate climbs to about 30 Moz, as you suggested, do you think it's reasonable to think that the internal rate of return (IRR) could double?

AZ: Not necessary. The currently PEA arrived at an IRR of 44% assuming capital expenditures (capex) of $20M, total silver recovered of 6 Moz through approximately an 8.5-year mine life at 5% discount rate. We modeled the production scenario assuming annual silver production of 2.5 Moz for 11 years at capex of $100M. So it is a dramatically different production profile. Applying 12% discount rate, the IRR is less than 20%. Keep in mind, this is a very preliminary number, as the sequencing is uncertain without knowing the ore in each vein, and we are expecting at least three considerably big high-grade veins.

Based on our analysis, we believe that the market is not giving any valuation on its polymetallic deposit. The stock is trading at about $0.21/oz silver in the ground compared to about $1/oz for its peers. If we strip out the polymetallic deposit and only base it on the current oxidize deposit, then it would come close to what its peers are trading at. It appears to us that the current stock price doesn't illustrate any polymetallic deposit at all. Therefore, any increase in its oxidized silver-gold deposit should directly result in price appreciation.

TGR: What is your current target price on that?

AZ: It's $0.90.

TGR: Any other companies in the Santa Cruz province of Argentina you would like to mention?

AZ: Mariana Resources Ltd. (MRY:TSX; MARL:AIM) just started trading on the Toronto Stock Exchange in June and has not yet become a very liquid stock in North America. However, it is well positioned to capitalize its potential on several opportunities.

Mariana has succeeded in keeping up with multiple projects through joint ventures with majors on Los Amigos in Santa Cruz and two iron oxidized copper-gold projects in Chile. The drilling is conducted by majors on those projects.

Mariana has focused its drilling activities on its Las Calandrias and the Sierra Blanca projects. Mariana discovered Las Calandrias in late 2009 and delivered an initial resource estimate in March, with only about 0.5 Moz gold equivalent at about 1 g/t gold, low grade with 80% in gold. Although relatively small, its delivery timeline was very impressive. It just completed a fourth drill program and will commence the fifth sometime this quarter. Sierra Blanca is located about 50km northwest of AngloGold's Cerro Vanguardia mine and adjacent to Argentex's Pinguino deposit.

In November, AngloGold made a 20% strategic investment in Mariana. The upcoming resource update from Pinguino will also draw some attention to Mariana's Sierra Blanca project. Mariana is currently working on a 5,000m drill program on Sierra Blanca. However, our valuation is only based on Las Calandrias.

TGR: Are there any other companies that you'd like to discuss?

AZ: This year is going to be the end of North American Palladium Ltd.'s (PDL:TSX; PAL:NYSE) transition as it approaches completion of Phase 1 expansion at its Lac des Iles mine in Thunder Bay, Ontario. Starting 2013, it is going to mine from the Offset Zone through a shaft as opposed to mining from the Roby Zone, which will significantly increase its palladium production and lower the cash costs.

We have recently lowered the target price to $3.10 from $4.60, in light of the news on its 2012 production guidance and the closing of the Sleeping Giant mine. The execution risks and the uncertainties at the transition stage are still overhanging the story. But the stock appears to be oversold for the last couple of days. The current price of below $2.40 is a good entry point, if investors are willing to look beyond 2012.

TGR: Do you have any parting thoughts for us on the sector?

AZ: Realizing the uncertainties and the volatilities that we're facing, this is not a market in which pigs will fly. Investors should stay with good stories with long-term growth potential and companies that have projects with potential good economics, located in safe jurisdictions and led by good management teams.

TGR: Thanks for your time.

Annie Zhang has been an analyst at Toronto-based investment bank Octagon Capital covering precious metals since October 2010; she joined Octagon in March 2007 as a research associate. Zhang holds a bachelors in accounting from Zhongnan University of Finance and Economics in China and a Master of Business Administration from Concordia University's John Molson School of Business and has been a CFA charter holder since 2006.

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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: Mega Precious Metals Inc., Premier Gold Mines Ltd., Goldcorp Inc., Gold Canyon Resources Inc., Extorre Gold Mines Ltd. Streetwise Reports does not accept stock in exchange for services.
3) Annie Zhang: I personally or Octagon Capital own shares of the following companies mentioned in this interview: Mega Precious Metals Inc. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise for participating in this story.

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