Five Must-Haves for Junior Mining Companies: Aleksandra Bukacheva

Aleksandra Bukacheva Valuation disconnects among producers, rising gold price and juniors facing funding crunches are among the factors fueling a spate of M&A activity. In her first exclusive Gold Report interview, Aleksandra (Sasha) Bukacheva, a mining research analyst with Fraser Mackenzie in Toronto, shares her list of likely targets and suitors in the zinc, copper and precious metals spaces.

The Gold Report: Sasha, what are four or five must-haves for investing in junior mining companies in today’s market?

Sasha Bukacheva: To start, I prefer metal producers to developers and explorers, especially in this market.

In terms of specific criteria, number one is quality of the asset base. To me, that means mines with the higher grades and healthy volumes to sustain operations for at least 10 years. Second, I want companies that have manageable growth. A company should be able to deliver growth at a reasonable price and not overspend on a new mine with lower return on capital. Third, I like companies that are unique in some way: in their commodity exposure, exceptionally high grade or mine concentration in a friendly jurisdiction. My fourth criterion is a good management team; the assets are only as good as the people who run them. Fifth is low political risk; everything else being equal, a company with a project in Nevada is more appealing than the one in Ecuador. It’s rare that you can find a company that fits all of these parameters, but it’s a good frame of reference.

TGR: You cover several companies operating in Argentina. Do you consider Argentina to have low jurisdiction risk?

SB: No, I do not, but Argentina has world-class projects that you might not be able to source elsewhere. By world-class, I mean copper assets that are among the world’s largest in the north and exceptionally high-grade precious metals deposits in the south, in the Santa Cruz Province.

“Argentina has world-class projects that you might not be able to source elsewhere.”

Argentina has a fairly long history of mining. There have been years when the mining industry has done well and there are years, like 2012, when the government’s policies and decisions have challenged the mining industry. Ultimately, my view is that regimes and policies change, but the quality of the asset base does not. I am willing to hold a company that has a good asset and accept higher political risk as a trade-off.

TGR: Did the European Central Bank’s (ECB) move to buy government bonds on the open market change your outlook on the companies you cover?

SB: Absolutely. Everyone has been sitting on the sidelines waiting to see what will happen in Europe and China. The ECB’s move was very encouraging. It demonstrates political will to inject stability and is an indication of a more concerted effort in Europe. Any additional stimulus in Europe or China would likely be encouraging for growth, which would be good for commodity prices, which in turn would be good for the mining equities.

TGR: Do you think it could raise the target prices of some of your companies?

SB: Most of my companies still have a way to go to reach my target prices. I am comfortable with my target prices because they are based on certain long-term price assumptions that forecast a slightly more stable world than the one we live in today. I have not changed my commodity prices either. I may revise my price deck in a few months if necessary.

TGR: In addition to the good news from the ECB, we may see more quantitative easing from the Federal Reserve. There also is a new round of merger and acquisition (M&A) activity in the small-cap junior precious metal space. Inmet Mining Corp. (IMN:TSX) has a takeout offer out for Petaquilla Minerals Ltd. (PTQ:TSX; PTQMF:OTCBB; P7Z:FSE). Endeavour Mining Corp. (EDR:TSX; EXK:NYSE; EJD:FSE) has an off-share offer for Avion Gold Corp. China’s Western Mining Group has a bid out for Inter-Citic Minerals Inc. (ICI:TSX; ICMTF:OTCQX). Does this signal the start of serious M&A activity?

SB: It looks that way. It makes perfect sense because there has been a valuation disconnect between certain producers trading at higher cash-flow multiples and others trading at lower cash-flow multiples.

A lot of producers see higher gold prices as an opportunity to pull the trigger on an acquisition. But the rationales can vary a lot. Endeavour fits the scenario of an existing producer seeking to augment its production base. But Inmet is probably just trying to clean up the area around its proposed Cobre Panama mine.

TGR: Is there a pattern or theme among these takeover offers?

SB: In addition to the disconnect in valuation among producers, there is an even greater disconnect between companies with cash flow and those without. Juniors without a source of internally generated funds depend on the market for new equity, and investors are rather skeptical about their ability to source that.

TGR: Are the boards and the management teams of these junior companies now more amenable to takeovers, given the market?

SB: A lot of the juniors feel they are up against the wall and do not have a lot of choice. They have to either take an offer or discontinue their existence as a going concern. Given that choice, management will probably pick an offer that allows them to preserve some sort of value.

TGR: How many of the companies that you cover would you consider takeover targets?

SB: The first and perhaps most likely would be Trevali Mining Corp. (TV:TSX; TREVF:OTCQX). It is the only emerging junior zinc producer listed on the Toronto Stock Exchange. Trevali is commissioning a new mine in Peru in the next couple of months. It also has a portfolio of polymetallic deposits in New Brunswick, Canada, where it started mining earlier this year and it initially toll milled some of that ore at Xstrata Plc’s (XTA:LSE) Brunswick facility. Recently, Trevali made a deal to purchase its own plant for its New Brunswick operation and expects to be producing zinc there in 12 months.

“To me there is more value in intermediates than in majors.”

We as a firm are bullish on zinc. We believe that there is likely to be a zinc supply shortage in the next three years, which could be a tailwind for the price of zinc. History shows that every single junior zinc company that’s made it into production, like Farallon Mining and Breakwater Resources, has been taken out within a few years of operation.

Foran Mining Corp. (FOM:TSX.V) is another zinc junior that I follow. Foran has a sizeable volcanogenic massive sulfide (VMS) deposit called McIlvenna Bay located 60 kilometers (km) west of HudBay Minerals Inc.’s (HBM:TSX; HBM:NYSE) operation in the Flin Flon Belt, Manitoba, on the Saskatchewan side. It is the only sizeable undeveloped zinc project in Canada as far as I am aware that has good access and power close to site. Most of the development capital would be spent in the plant and costs directly related to site and underground development of the ore body.

TGR: Foran is run by Patrick Soares who helped sell Brett Resources to Osisko Mining Corp. (OSK:TSX).

SB: Patrick is very disciplined and focused on adding value. He would not take on a project he did not think could go through to production on its own, although it may not be his intention to build and operate it. He understands the importance of proving the economics and scalability of a project to attract third parties.

TGR: In your coverage of Foran you switched from an enterprise value divided by resource valuation (EV/Pound) method to a straight net asset value (NAV) calculation. Why?

SB: Another analyst here at Fraser Mackenzie originally initiated coverage on Foran and valued it on the EV per pound basis because at that time we lacked sufficient information related to metallurgy and potential operating parameters. It would have been difficult to conceptualize McIlvenna Bay as a standalone operation.

When I transferred coverage on Foran, it had just completed initial metallurgical work, which provided a benchmark for estimating recoveries for different metals. I further benchmarked several operations with deposits of similar magnitude to see what throughput might be appropriate for a resource of that size and what the operating and capital costs could be like. Thus, I could conceptualize McIlvenna Bay as a standalone operation and estimate annual cash flows.

“You have to know your companies and understand why you are buying a specific stock.”

To me, a discounted cash flow model is better at capturing value for Foran; it allows me to include assumptions related to capital and operating costs. EV/Pound is largely irrelevant because, in a perfect world, where everything is fairly valued, EV/Pound would simply represent the difference between the commodity price and what it costs to extract the ounce in terms of operating and capital costs such that the more ‘expensive’ companies on an EV/Pound reflect an asset base that is cheaper to develop and mine.

TGR: What is the next catalyst for Foran?

SB: We expect the resource update from its 12,000-meter drill program by the end of the year. That resource update will form a basis for an engineering study for McIlvenna Bay and shed more light onto the potential economics of the operation.

TGR: Any other takeover targets in your universe?

SB: Imperial Metals Corp. (III:TSX), which has a target of $15/share and is trading at $11/share. It is a copper company that operates two mines in British Columbia and has an excellent growth project in there. I consider it a takeover target because of its attractive asset base. It may or may not be up for sale; Imperial has a 30% shareholder whose preference would likely be to build and operate a third mine.

TGR: You assign $974 million (M) in value to that project.

SB: Yes, Red Chris is a big project. The current market cap is in the ~$850M range.

TGR: You have a Strong Buy rating on Imperial. What is next for the company?

SB: Imperial’s next catalyst is to secure the financing for Red Chris to make sure that it can maintain construction timelines. The company has its mine permit, it has ordered some of the long-lead items and moved a lot of mobile equipment from its Mount Polley Mine to Red Chris to facilitate the initial stages of construction.

The management of Imperial is very disciplined, which is great for cost control. But the company still needs $300M, which will most likely come in the form of a debt financing.

TGR: Are there any logistical problems with Red Chris?

SB: Imperial will have to do some road upgrades and bring in a power line extension. BC Hydro is building out the initial 340km transmission line to Bob Quinn Lake substation, scheduled for completion in 2014, and Imperial will put in an extension to Red Chris. That is probably the biggest construction risk.

TGR: You recently launched coverage on Lundin Mining Corp. (LUN:TSX). Tell us about that one.

SB: Lundin hardly needs an introduction. It is a diversified base metals producer with about 65–70% weight in copper. It does not have a big-scale development project in the pipeline but it does have $300M in cash that could be spent on acquiring an asset that would add value to the company’s portfolio. Lundin is probably looking at producing or near-production copper mines for growth. But if the zinc price rallies and stays over a buck, I think Lundin may want to bolt-on a zinc project.

TGR: Lundin’s market cap approaches $3 billion. Why did you take that step up the ladder?

SB: We have been encouraging clients to go into bigger caps because of the increased liquidity. Juniors can provide higher returns, but if you need to sell for any reason, whether it is related to your view on stock fundamentals or not, it is a lot harder to move some of those smaller names compared to something like Lundin. And, as I said, I favor producers in this market environment and they generally have higher market caps.

TGR: Is this move into midtier miners something more brokerage houses are going to do, given the liquidity issues in the small-cap space?

SB: Every brokerage house makes its own decisions. At Fraser Mackenzie we have a lot of freedom to pick the names that we like. If I wanted to cover Barrick Gold Corp. (ABX:TSX; ABX:NYSE), I would have full support here.

However, to me there is more value in intermediates than in majors. For example, an expansion at a great copper-cobalt project like Tenke Fengurume in the Democratic Republic of the Congo where Lundin has 24%, does a lot more for Lundin stock, than it does for Freeport McMoRan Copper & Gold Inc. (FCX:NYSE), which operates the project.

I think intermediates right now are a better place to be because they’re better cashed up. Their operating track record is a little bit more stable than that of the juniors. They have a better asset base and are better positioned to weather the storm than some of the juniors. Certain intermediates that have better assets or nice growth profiles are more accretive to shareholders because it moves the needle for them. Incremental production of 100 million pounds for Lundin could be 50% of its principal copper production, whereas 100 million pounds means almost nothing for someone like Freeport.

TGR: Can you tell us about another story you cover, perhaps with a smaller market cap?

SB: McEwen Mining Inc. (MUX:NYSE; MUX:TSX) made a nice recovery after being punished when Argentina’s President Christina Fernandez de Kirchner introduced capital controls and import restrictions that made it difficult for producers to get cash out of the country and for developers to bring equipment in. McEwen traded down to $2/share at the end of May and is now back over $4/share.

McEwen has 49% interest in a solid gold-silver mine in southern Argentina and will start gold production at its El Gallo mine in Mexico in a month or two.

Phase One at El Gallo will produce 30,000–40,000 ounces gold annually. When Phase Two, silver mining, starts in 2015, it will add 5 million ounces (Moz) of silver per year. The consolidated silver production profile for McEwen between its interest in an Argentinian mine and Mexico silver will be 8 Moz. So far, everything is on schedule.

TGR: But, is there not some uncertainty related to the challenges of repatriating the capital from its San Jose gold silver mine in Argentina?

SB: Certainly, the repatriation of capital from Argentina is a challenge. The bottleneck there is Argentina’s banking system. In Argentina, once a company exports its dore or concentrate, it must bring the revenue back to Argentina within 90 days from the day of the sale. At that point, it is converted into local currency. If a company wants to pay its vendors, repay debt or pay dividends, it must receive a central bank approval for a wire transfer to get the money out of the country.

McEwen got some money from Argentina in January. After releasing its Q2/12 results, management indicated higher confidence about getting money out of Argentina. Its Q3/12 report will show if the company can get repatriate cash flow from San Jose.

TGR: Can you share one more story?

SB: Talking about takeover targets, Minera IRL Ltd. (IRL:TSX; MIRL:LSE; MIRL:BVL), presents an interesting opportunity.

The team running Minera IRL worked for Newcrest Mining Ltd. (NCM:ASX), Newmont Mining Corp. (NEM:NYSE) and a number of other major mining companies. Minera started out with a small-scale operation in Peru called Corihuarmi, producing 30,000 gold ounces a year. The company has a growth project in Argentina called Don Nicolas not too far from Cerro Moro, which was Extorre Gold Mines Ltd.’s (XG:TSX; XG:NYSE.A; E1R:FSE) flagship asset before Extorre was bought by Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE). Conceivably, if Yamana were looking to consolidate that high-grade district, it could consider a transaction with Don Nicolas/Minera IRL.

On Sept. 5, Minera IRL announced the discovery of a new gold-silver zone at the Don Nicolas project. The project is fairly advanced: Minera IRL completed a feasibility study, applied for permits, and anticipates permitting by year-end. It will be building a small plant and the mine should be operating by 2014. The company expects production of 50,000 ounces of gold annually at cash costs between $730–750/oz. This new discovery could add a couple of years to the initial four-year mine life. Minera IRL will be mining there for more than 10 years.

Minera IRL also has a big development project in Peru, Ollachea, which has been engineered to produce 100,000 gold ounces annually starting in 2015 with the modest capital expenditure of $170-200M. We expect a feasibility study soon for Ollachea.

Minera IRL has a market cap of $90M, and both Don Nicolas and Ollachea could be worth close or more than that as a standalone. That asset base makes the company very attractive.

TGR: Any advice for retail investors in this market?

SB: The best advice is to not be complacent. You have to know your companies and understand why you are buying a specific stock. You need to know the catalysts, and most important, you have to understand the risks and not be afraid to sell if you have to.

Investors ought to look at their portfolios and steer clear of anything that might not hold up for 12 months if that company cannot raise money.

If you ask me, this is the time to buy. This is not the time to sell. But be very discriminating in the companies you want to get behind.

TGR: Sasha, thank you for your time and your insights.

Aleksandra (Sasha) Bukacheva is a mining research analyst with Fraser Mackenzie, covering precious and base metals producers and development-stage companies. Previously, Bukacheva was a part of the Mining Equity Research team at Haywood Securities in Vancouver. Prior to that, she was vice president of finance and administration for a TSX.V-listed junior mining company and worked at Brendan Wood International as head of the energy sector. Bukacheva is a CFA Charterholder and holds a Master of Science degree from the London School of Economics and Political Science.

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