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Commentary: Gold sector fragmentation hurts investors

The first gold pour from Agnico Eagle Mines’ Meliadine mine in Nunavut. (Image courtesy of Agnico Eagle Mines)

Of all the mining sectors, gold is possibly the most fragmented, and the gold industry and its investors would realize considerable benefits from consolidation. Brokerage Pollitt & Co. estimates that 50% of global iron ore and copper production comes from four and 10 companies, respectively, while 25 companies account for just 45% of total gold production. Technical talent seems to be spread thin, too. An internal Resource Capital Fund study earlier this year reported that 107 mining projects that went from feasibility study through to construction were 38% over budget, on average, which indicates poor planning and engineering that could have been alleviated with more talent, and experienced engineers and planners.

The greatest potential for synergy and value creation rests among the large number of single-asset companies. Historically, such companies were merger and/or acquisition (M&A) targets for larger producers. However, producers have become reluctant to pursue M&A because:

The greatest potential for synergy and value creation rests among the large number of single-asset companies. Historically, such companies were merger and/or acquisition (M&A) targets for larger producers. However, producers have become reluctant to pursue M&A because:

  • Investors have soured on M&A as many companies overpaid for acquisitions in the past
  • It is difficult to know all of the risks contained in a target company
  • The strategic focus of most producers has shifted from growth through acquisitions to organic opportunities
  • Many majors are looking to sell non-core assets
  • Deals done at a premium bring arbitrageurs that substantially drive down the share price of the acquirer
  • Much of the share register winds up with arbitrageurs, which churns in the market for months
  • Valuations are low across the sector

The lack of M&A has resulted in an abundance of single-asset companies. An investment manager may now have a gold portfolio, for example, of 20 single-asset developers and five single-asset producers. These are the companies that are providing many new mine developments across the sector. When investing in a development company, shareholders expect to benefit when the company either gets acquired at a premium or when it takes its project to production. In this M&A environment, developers must plan on becoming mine builders and operators. Once a developer becomes a producer, we expect it to have its next project in view in order to grow into a mid-tier, multi-mine company.

An efficient way of unlocking the latent value of one-property companies is through a merger of equals. The benefits of creating larger multi-property companies include:

  • Deeper technical talent that is fungible across operations
  • Geopolitical risk that is spread across jurisdictions
  • Procurement scale that enables better pricing for materials and equipment
  • Reduced general and administrative costs
  • Cheaper access to capital
  • Ability to attract larger institutional investors
  • More opportunities to create value

Consolidation of single-asset companies to form larger multi-mine companies can unlock these benefits, and the shift in valuation has great potential. For example, let’s create a hypothetical “Mergco” with three companies that are currently single-asset: Detour Gold, Pretium Resources and Sabina Gold & Silver. According to their September 2019 corporate presentations, Detour and Pretium combined produce roughly 1.1 million oz. gold per year from their two mines, while Sabina has a shovel-ready project that could produce over 200,000 oz. per year. All are large projects in Canada with long mine lives. Mergco would have a combined $5.2-billion market capitalization, and, using RBC Capital Markets valuations, trade at a weighted average price/net asset value (P/NAV) of 0.83X.

Contrast this with Kirkland Lake Gold, which, according to its September 2019 company reports, also has roughly 1 million oz. of production, mainly from two mines in the safe jurisdictions of Canada and Australia. Kirkland has several exploration and development projects that may bring future growth. It has a $9.4-billion market capitalization and trades at a P/NAV of 1.92X. With good management and the advantages of larger scale, Mergco could achieve a valuation that should be closer to Kirkland’s. In a merger of equals, Mergco’s share price would have to increase 131% to match Kirkland’s P/NAV valuation. Achieving a re-rating of just half of this would still be a windfall to Mergco’s shareholders. In addition, a merger without premiums would reduce arbitrageur positioning — potentially freeing the stock to trade higher.

There are many combinations of single-asset companies around the world that would benefit from such consolidation, so why have we not seen such combinations?

  • Management adherence to the old M&A model, hoping to sell the company at a premium
  • Lack of vision amongst managements, boards and shareholders to achieve such an M&A outcome
  • Entrenched management protecting their jobs
  • Boards with no desire to maximize value for shareholders

It is time for single-asset gold companies and their shareholders to reconsider the M&A landscape and adapt new strategies that will build the mid-tiers and majors of the future.

— Joe Foster is a New York-based portfolio manager and gold strategist with VanEck.

(This article first appeared in the November 11-24, 2019 edition of The Northern Miner).