NEW YORK ( TheStreet ) -- High gold prices have triggered a wave of mergers and acquisitions in the gold mining sector, and there are four ways one could profit from this consolidation wave:
  • Short the buyers and potential buyers;
  • Buy the buyout targets;
  • Buy the large miners that already have made big purchases;
  • Buy the mid-tier miners who focus more on organic growth rather than buyouts

First off, M&A for gold miners is here to stay as long as gold prices stay high. The stronger the gold demand, the more gold a company must produce, the more gold it has to find to replenish supply.

According to the World Gold Council gold demand trend report, mine supply grew 3% in the third quarter compared to a year ago while gold demand rose 12%. Although the difference between supply and demand was largely made up for by an increasing recycled gold supply, as prices sustain high four-digit levels the pressure is on to find new deposits.

Gold Stocks to Buy as M&A Heats Up

Using rough math, if a producer wants to increase its annual production by 1.5 million ounces a year, the miner must find twice as many ounces of resource. CEO of Novagold ( NG) Rick Van Nieuwenhuyse says "typically resources to reserves is about 60% and you get about 90% recovery."

Finding a new mine and bringing it into production can take upwards of 10 years during which time the company must contend with geopolitical and environmental risks, which could slow the project down. Some companies get lucky like Endeavour Silver ( EXK) which took its Lucera mine from discovery to production in four months, a pretty rare scenario.

Another option is partnering. A senior miner can partner with a junior on a new project to help shoulder some of the financial burden while reaping the benefits of someone else's work. Paolo Lostritto, mining analyst at Wellington West Capital Markets, thinks that this strategy, however, is just a fallback.

Juniors might enter into a partnership expecting the richer company to jump-start the project into production, but since the senior typically has a longer production time line (maybe it won't need more gold deposits for 10 years) sometimes an asset just sits there. "A buyout is more beneficial for a junior," argues Lostritto.

This leaves takeovers, a trend that heated up this year as gold prices skyrocketed. Agnico-Eagle ( AEM) bought Comaplex for a 34% premium; Goldcorp ( GG) snagged Andean Resources for $3.4 billion, a 35% premium; and Kinross Gold ( KGC) bought Red Back for $7.1 billion, a 21% premium.

Mergers are also made easier through the help of royalty companies like Franco Nevada, Royal Gold ( RGLD) and Silver Wheaton ( SLW). The buyer can sell forward some of the gold or silver from the new deposit to help finance the deal instead of just issuing shares or tapping the debt market.

Playing the takeover trend is risky, so in addition to doing your homework on a stock, know your options.

Short the Buyers

One possible option is betting against the big gold companies that will have to shell out cash to make a big acquisition. This means finding the producers that are depleting their reserves quickly and haven't made a recent purchase.

The definition of a large-cap miner can vary greatly among analysts but it's safe to assume that a senior can be regarded as any miner that produces 1 million ounces plus of gold a year.

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Barrick Gold ( ABX) is the biggest gold miner in the world with a market cap of more than $53 billion. In the third quarter, the company produced 2.06 million ounces of gold and raised its full year production estimates to 7.65 million to 7.85 million ounces.

The company hopes to increase annual production to 9 million ounces within five years, which it will reportedly be able to do as soon as two of its projects come on stream. Puebla Viejo in the Dominican Republic is expected to give Barrick 625,000 to 675,000 ounces for the first full five years of production and should come on stream in the fourth quarter of 2011.

Its Pascua-Lama project, bordering Chile and Argentina, will round out production giving Barrick 750,000 to 800,000 ounces of gold for the first five years starting in the first quarter of 2013.

With mines getting ready to produce soon and two more large development projects in the works at Cerro Casale and Donlin Creek, Barrick, it seems, is unlikely to make a big purchase.

Brian Hicks, co-manager of the U.S. Global Investors Global Resources Fund, says "based on what I'm hearing I don't think there is a major acquisition on the horizon for Barrick." Hicks likes the stock and is convinced the company will continue to "build its war chest" to generate cash. "There may be some small acquisitions but I think they're content to maybe increase a dividend."

Investors seem inclined to agree -- short interest on Barrick is only 10% and Barrick recently announced a fourth-quarter dividend of 12 cents a share.

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Newmont Mining ( NEM) is the third-largest gold miner in the world, behind Goldcorp, with a market cap of $30.75 billion but it might find itself in a different situation.

Due to lower grades at two of its mines and mill maintenance at a newer mine, the company only produced 1.4 million ounces of gold in the third quarter. Newmont also was forced to revise its 2010 outlook for gold production from 5.3 to 5.5 million ounces to 5.3 to 5.4 million ounces.

Short interest on the stock is 30% despite the fact that shares have rallied more than 27% year to date. The fact that investors are betting against Newmont could signal worries the company could run into production issues or have to dilute shares to make an acquisition.

Pratik Sharma, managing director at Atyant Capital, advises clients to stay clear of shorting gold stocks no matter how tempting the thesis. "This is a market that is tough to short because you have every central bank in the world" pumping liquidity into the system. Sharma also points out that gold projects that weren't economically viable when gold was trading at $900 an ounce have suddenly become profitable with gold trading above $1,400.

High prices also have expanded options for big miners who might choose partnering rather than a buyout to replenish resources. Barrick currently partners 50/50 with Novagold at Donlin Creek, which has 34 million ounces of gold reserves, half of which is Barrick's for $2 billion.

Buy Miners That Already Have Made Big Purchases

The theory here is that the gold producers that have already ponied up the cash to buy a smaller producer won't need to make any other big acquisitions. These companies already have diluted their shares and should be able to provide more future value.

Kinross Gold and Goldcorp are the companies most recently fitting this bill.

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Kinross is a $20.1 billion company and in the third quarter produced 575,065 ounces of gold. Its recent acquisition of Red Back turned out 11,000 ounces and the mines have reserves of 5.1 million ounces.

In 2010, Kinross spent time and money reshuffling assets. The company bought the Dvoinoye deposit and Vodorazdelnaya property from the Russian government and acquired B2Gold's rights to an interest in the Kupol East and West area near the Kupol mine site. Kinross also sold all of its Harry Winston ( HWD) shares.

Kinross expects to produce 2.3 million to 2.35 million ounces of gold this year and it seems as if Kinross' reshuffling is over for the short term. Hicks likes Kinross saying that "many of the senior names with gold at these levels will start to generate free cash flow and are trading at multiples that are quite compressed."

Shares of Kinross have definitely struggled this year and are down 1.45% despite gold's 25% rally.

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Goldcorp is a $34.66 billion company that is in a growth spurt right now. In addition to its acquisition of Andean Resources, the company is advancing five projects that are in various stages of development from drilling to construction to permitting.

CEO Chuck Jeannes said the company will grow "50% over the next five years to 3.7 million ounces." Jeannes said Goldcorp didn't need the Andean acquisition but that it made it a "better company." Andean's main asset, Cerro Negro, has indicated resources of 2.54 million ounces of gold and 23.56 million ounces of silver and should be in production by late 2012.

In the third quarter, Goldcorp's Peñasquito mine reached commercial production of 17,300 ounces and should reach its full potential of 130,000 tons per a day in early 2011. Goldcorp produced a total of 596,200 ounces of gold in the last quarter and reiterated its 2010 production guidance of 2.55 million ounces.

The company also announced a dividend increase of 100% to 36 cents a share, which could signal a commitment to returning capital to shareholders rather than diluting shares with another acquisition.

Shares are up 15% year to date, far lagging the Market Vectors Gold Miners ( GDX) ETF, which has popped 31%.

Buy the Buyout Targets

A popular way to play the consolidation trend is to find those small companies that are good explorers and developers, that have big assets in geopolitically safe areas and that are in need of cash. But the speculation game is like looking for a needle in a haystack.

There are more than 2,000 listed mining companies in the world and Adam Graf, director of emerging miners for Dahlman Rose & Co., says that maybe 100 have market caps of over $500 million and the rest are all junior players.

Among the 1,900 juniors, the miners fall into a couple of categories, he says.

"There are juniors that have fairly large projects, mid-sized projects which they maybe can do themselves or maybe they prefer to get taken out. Then there are the juniors that have very large projects, sometimes large low-grade projects, that, at current gold prices, are very attractive or should be very attractive to the majors and I think those guys are pretty clearly looking to get taken out."

Another reason why buying the takeouts is so risky is that there are only a limited number of majors that can afford big purchases and those that have already bought a junior producer might not buy anymore.

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Take NovaGold, for example, a name that has been floated among some analysts as being the next big takeout target. Its market cap is over $3 billion, it won't enter into production until 2015 at the earliest, and it has two of the largest gold and copper deposits in the world. NovaGold is a junior with a mid-sized market cap and senior deposits, which could make for a very difficult valuation for a buyer.

"It's certainly a valid strategy to develop an asset especially if that asset is the biggest and the best and you feel like you're at the top of the heap and you're going to get taken out," says Graf. " But the danger is that you're the guy that's out in the cold after the flurry is over."

Nevertheless a large portion of analysts are placing bets on explorers and emerging gold miners but not as takeout targets but because that's where they see value.

Scott Redler, chief strategic officer at T3Live.com, says NovaGold is one of the most undervalued gold miners he sees in the gold space and that a takeover bid would just be the icing on the cake.

"It could get taken out but it can't be your only thesis. You can't just be playing the stock for a takeover ... It needs to have a strong fundamental story and a strong technical picture."

Sharma is picking smaller gold companies with market caps between $300 million and $500 million saying they represent the best value, " large gold companies is where a lot of retail money goes and if you're an institution you can only invest in the big gold companies."

Sharma argues that gold stocks have rallied but not every company has seen the upside, "the rising tide has only poured into the big caps not into the mid tiers and the juniors."

Lostritto built his business plan on finding these small companies with both the assets and people to build "the next generation" of gold companies. He looks for growth and multiple to cash flow and favors management who are experienced explorers, who have had a history of building assets from the ground up and who can get a project noticed.

"The market will migrate to the high quality names and if you can identify them earlier then there is more alpha. Those high quality names will also attract a potential buyer and acquirers."

Buy the Mid-Tiers

Another alternative is to stay out of the M&A battle altogether and focus on companies that make small purchases and/or focus on organic growth.

Mid-tier gold miners can range from those who produce 150,000 to a million ounces of gold a year, but the definition can vary. Some typical names are Agnico-Eagle and Randgold ( GOLD).

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Agnico-Eagle produced 285,178 ounces of gold in the third quarter with full year guidance at 1million ounces. About three years ago, Agnico was a one mine company and it now has six operating mines and doesn't seem to be done growing.

For the time being, COO and President Ebe Scherkus said that Agnico will focus on expanding current projects and then will be on the "lookout for other opportunities out in the industry."

Agnico already made a big acquisition this year buying Comaplex Minerals for a 34% premium. The new project will add 3.29 million ounces of measured and indicated gold resources, but a feasibility study should add more details by the end of 2011.

"We do have quite a bit of organic growth," says Scherkus. "We have a very aggressive exploration strategy. We have 37 drills working across all of our properties ... but also we look at certain situations. We will never proceed with a massive merger or acquisition where we have to bet the farm."

Agnico's goal is to produce 2 million ounce of gold a year and the company hasn't ruled out the possibility of being a takeover candidate itself. Scherkus told me at the Denver Gold Forum earlier this year that "if someone decides they would like to own Agnico and are willing to pay us for it and pay the shareholders for it, there's very little to do. But in the meantime we want to continue with our strategy of growing this company."

Angico-Eagle is one of Hicks favorite gold stock picks. "It's unique in that it is a large cap name and it does have organic growth so we think from that standpoint it looks attractive." Shares are up 51% year to date, providing two times leverage to the gold price.

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Randgold Resources has an $8.51 billion market cap and is a go-it-alone producer in West Africa, a very coveted gold mining area. The company is well known for finding, exploring, developing and producing its own projects and produced 101,468 ounces in the third quarter and is expecting to produce 455,000 for the full year.

On Friday, however, the stock received a downgrade from hold to reduce from Oriel Securities which cited concerns that the company will miss its full year production target. Oriel blames rising tensions in the Ivory Coast which could disrupt production at its mines in the area.

CEO Mark Bristow wants to grow the company to be a 1-2 million ounce gold producer which he hopes it will be by 2014. On Nov. 8, the company poured its first gold bar at its new Tongon mine in the Côte d'Ivoire, which will have a throughput rate of 300,000 tons of gold a month once it is ramped up to full production. Aside from its three producing mines, there are two other projects under way.

Shares are up 13% year to date but have recently stalled out. Hicks likes the stock but sees better value elsewhere -- "it started to outperform earlier in this up cycle and it has consolidated somewhat." The stock is trading at an estimated forward price-to-earnings multiple of 23.22 which is slightly higher than the industry average.

There are many ways to buy gold and play the gold consolidation trend. Most analysts recommend that 10% of your portfolio be in gold, with gold stocks making up a smaller and riskier portion of that allocation.


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-- (symbol) by Alix Steel in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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