Keep the Faith, Says Michael Fowler: Juniors and Midtiers Poised for M&A-Fueled Breakout Once Gold Recovers

Source: Brian Sylvester of The Gold Report (8/25/14)

Michael Fowler, senior mining analyst with Toronto-based Loewen, Ondaatje & McCutcheon, predicts when gold breaks out, mining M&A will take off. He expects the major producers to lead the next rush of M&A. The majors want development-stage companies with high-grade, near-term production assets and Fowler suggests some targets in this interview with The Gold Report.

The Gold Report: A report titled "M&A and Capital Raising in Mining and Metals, 1H 2014" from Ernest and Young (EY) says that mining and metals deal values in H1/2014 are "down 69% year-on-year, to $16.7 billion ($16.7B), from $53.8B, with deal volumes down 34% over the same period." Why aren't more mergers and acquisitions (M&A) happening in the precious metals space?

Michael Fowler: The first reason is that there are some big egos in the mining sector and some mining companies would prefer to go it alone or at least be in charge. But if both companies want to be in charge, someone is going to lose out. Ego is a big factor.

Job entrenchment is a second reason. CEOs, for example, want to keep their jobs versus being kicked to the curb.

Third is asset quality. Miners looking at other companies believe that their own assets are of superior quality and those of targeted companies are poor. Generally, asset quality is not high.

Number four is transaction costs. It costs a lot of money to make a transaction, especially for small companies with limited cash.

TGR: Obviously, there were more transactions last year and the quality of assets couldn't have changed a lot since. How do you define poor quality?

MF: We define that by the return to the prospective acquirer. As companies look at some of these assets, they see decreasing mining grade or reserve grade. That means cash margins will be less than what they would have been, say, 10 years ago. Grade plays a large role in determining the economics of putting a deposit into production and making a profit. I should note, too, that recently I have seen too many overly optimistic feasibility studies and scoping studies or what they now call preliminary economic assessments (PEA). Generally, asset quality isn't that high.

TGR: Overly optimistic feasibility studies and PEAs. Are you suggesting that recoveries won't be as high as expected? That capital numbers are generally too low? Mine life will be shorter? All of the above?

MF: All of the above and more, particularly in the case of PEAs. The stated returns in some of these reports are far too optimistic.

TGR: EY estimates that mining-focused private equity funds may have as much as $10B ready to deploy in the mining sector. What is private equity seeking?

MF: Most of the private equity firms want big assets. They are not interested in small exploration plays or tiny companies. They want assets that are in production or near production, perhaps offloaded by majors looking to trim debt; other targets could be companies with big development projects with juicy returns. Pretium Resources Inc. (PVG:TSX; PVG:NYSE) is one example. In April, Boston-based Liberty Metals & Mining Holdings bought roughly 5.78 million (5.78M) Pretium common shares at CA$6.92 apiece and received a seat on the board. Private equity wants to be involved in the decision-making.

TGR: Typically, how large are these private equity deals?

MF: Private equity generally wants to have a big chunk of a company, typically 10-20%, maybe more in some cases. It's about having a say in what these companies do.

TGR: Why not outright takeovers?

MF: A huge amount of private equity has not been deployed into the resource business. I don't think private equity is particularly comfortable with it. Most private equity managers don't have the expertise to actually run a mine. They generally prefer a big stake, but not actually run the company.

TGR: Are institutional bidders going to start bidding up these stocks or does the market rise owing to greater M&A speculation and activity? Which comes first?

MF: The institutions are going to be more actively involved in the space but they want to see more cost cutting, better earnings and cash flow, and generally good fundamentals in the gold sector. Institutions shunned the sector because there was tremendous cost inflation. Now it's going the other way. If the gold price goes up, M&A activity will gain steam.

TGR: If M&A gains steam, who would be the likely aggressors? Is it the large-cap producers? The midtiers? Small cash-flowing juniors?

MF: The majors are still in the game for good quality assets. We saw that with Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) and Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) taking over Osisko Mining. There are other assets out there with reasonable quality and some of the majors may well pick them up.

TGR: As you said, Osisko and Yamana just did a deal. Kinross Gold Corp. (K:TSX; KGC:NYSE) has taken some write-downs, as have Barrick and Newmont. With the exception of Goldcorp Inc. (G:TSX; GG:NYSE), the list of majors doesn't extend much beyond those names. It is generally understood that the major producers are focused on fixing internal problems, many of which were caused by aggressive M&A.

MF: It's a good point but at the end of the day these companies have to face the reality that their reserves are depleting because they have not invested a lot in exploration. When we're talking about a $10B company, companies trading for, say, $200-300M are still doable for a major. The activity level won't be nearly the same as what it was in the past, but I can foresee an increase in that kind of transaction.

TGR: What else do you foresee in M&A?

MF: I also see an increase in juniors merging, despite what I said about egos. At the moment small producers don't receive much interest in the stock market so they will probably be forced to merge to reach a bigger critical mass. An example of that would be Primero Mining Corp. (PPP:NYSE; P:TSX)merging with Brigus.

TGR: Is it more cost effective to buy gold production than build it?

MF: No. If you look at where the producers are trading, there's not much to gain by taking over a producer based on the cost versus the return.

It does make sense, though, for majors to take over companies with development projects. Those are trading at much lower multiples than producing companies. There's an accretion factor to the bigger company in those transactions. An example would be Torex Gold Resources Inc. (TXG:TSX). That company is not in production but it's fully financed and its El Limon-Guajes gold-silver project is high grade. Torex is in the sights of some majors.