Not digging it: Gold explorers stymied as producers hoard cash
By Paul Whitfield    Updated 05:01 PM, Feb-01-2013 ET   

Gold exploration companies have spent much of the past year doing a reasonable impersonation of pyrite, the little-valued mineral better known as fool's gold.

While the price of gold has remained near historic highs, valuations of the companies that find new reserves have slumped. The problem?  Gold producers have seemingly turned their back on the exploration sector, robbing prospectors of their traditional route to a payday.

Yet hope, the lifeblood of companies involved in the high-risk world of exploration, springs eternal. Recent transactions suggest that exploration companies are changing tactics, looking to mergers that pool cash and assets in order to make the transition from exploration to production. At the same time, exploration companies' CEOs and gold analysts claim to see signs of the bottom of the market and are, tentatively, predicting a rebound.

"I think we will see more M&A going forward but not necessarily as rational business decisions but out of desperation," said Ken Cunningham, CEO of Nevada-based exploration company Miranda Gold Corp. "Financing is not available and there are a lot of illiquid juniors that have the cash to keep the lights on but not to continue operations."

The cruel twist for explorers is that while they struggle to lure bidders, M&A amongst mid- and large-sized gold producers has proven a bright spot in an otherwise subdued year for mining sector M&A. About 26% of all mining M&A by value came from the gold sector in the first six months of 2012, excluding the mega-acquisition of Xstrata plc by Glencore International plc, according to PricewaterhouseCoopers LLP. Gold sector deals accounted for about 29% of all mining M&A transactions, ahead of copper and iron ore.

However, the deals have focused on companies with producing assets, as larger buyers, including a new wave of Chinese investors, seek projects that will immediately benefit from high gold prices. At the same time many producers are unwilling to risk investing in new greenfield projects for fear of ballooning costs.

They have good reason to be nervous. Competition from other mining sectors for raw materials required to make mills and for skilled mine workers has led to huge budget overruns at some of the world's highest-profile projects. "It has been a perfect storm for new developments," said Newstrike Capital Inc.'s Richard Whittall, CEO of the Vancouver, British Columbia-based owner of exploration properties in Mexico. "The projects were bought when the BRIC [Brazil, Russia, India and China] countries were raging and [demand for raw materials] put huge pressure on mine inputs and labor, which led to enormous cost overruns."

Few examples illustrate the sector's problems as well as Kinross Gold Corp.'s $7.1 billion takeover of Red Back Mining Inc. The acquisition of Red Back's early-stage gold developments in Ghana and Mauritania was sealed in September 2010. By mid-2012 the takeover had contributed to a roughly 50% fall in Kinross' share price, $2.49 billion in write-downs and cost Kinross CEO Tye Burt his job.

"The Kinross deal for Red Back has become the poster child for the problems that company boards and management are afraid of exposing themselves to," said Ralph Aldis, who manages about $650 million of assets across two precious metal funds for San Antonio-based U.S. Global Investors Inc.

Kinross is one of at least five gold companies that have jettisoned their CEO this year. In June, Aaron Regent, then head of the world's No. 1 gold producer, Barrick Gold Corp., paid the price for a massive increase in development costs at the company's Pascua-Lama gold and silver mine, which straddles the border of Argentina and Chile. In November, Barrick increased its budget for the mine's development to $8.5 billion, almost 3 times the initial $3 billion estimate in 2009.

The effects of cost blowouts and angry shareholders at the top of the gold sector have trickled down to the bottom. There were only four "producers acquiring developers" transactions in 2012, as of an early December note by analysts at Canadian broker Haywood Securities Inc.

Exploration companies initially responded to the M&A drought by biding their time. However, as it continued into late 2012, a handful attempted to strike out to become producers.

"It is safe to say that the usual 'food chain' in mining is beginning to become a bit altered," noted Haywood Securities' Timothy O'Neil. "The best-in-class explorers and developers are no longer under the immediate M&A microscope of the intermediate and junior space and thus are being forced to finance themselves through their development program and in many instances initiate planning for funding their path to full production."

The immediate problem with making the leap from explorer to producer is finding the cash, however. Debt remains unavailable, or prohibitively expensive, for most exploration companies. Selling shares is often unpalatable because investors, chastened by recent poor returns, are demanding steep discounts.

Some gold prospectors are therefore pursuing a new type of deal, seeking mergers within their own sector to pool cash reserves and cut costs. In early December Australia's PMI Gold Corp. and Canada's Keegan Resources Inc. announced plans to merge and create a new Ghana-focused company with a market capitalization of about C$700 million ($695.7 million). Keegan has $210 million of cash on its books while PMI has about $130 million, enough to fund PMI's Obotan gold project through to operation within about two years, said Keegan president and CEO Peter Breese.

"I have the project, you have the cash" deals could become a feature of the exploration sector in the coming months, according to Haywood Securities.

The decline in exploration company capitalizations means there is no shortage of potential targets whose cash piles could attract companies with strong projects.

"A lot of explorers have market capitalizations below their cash levels," said U.S. Global Investors' Aldis. "When you get to these valuations you do have to think that the market looks cheap."

Of the top 20 companies on the Toronto exchange whose market values are less than their cash, 12 are gold exploration companies or companies that invest in gold explorers, according to Haywood Securities.

However, for each cash-rich explorer there are many more exploration companies that had planned to raise funds to finance further test drilling or were counting on a takeover by a small or midsized producer. For these companies time is running out and that could also spur deals.

"I have been offered desperation deals from junior explorers," said Miranda Gold's Cunningham.

Desperation is likely to be mixed with frustration. A tripling in the price of gold in the past five years has delivered huge cash flows to many producers.

"The irony is that many in the industry have never been in better shape from a balance sheet point of view," said Newstrike's Whittall. "It is staggering how much cash is on the balance sheets and so little debt but they [gold producers] have stubbed their toes and they are being extraordinarily cautious."

With pressure on costs easing, in particular as demand for commodities from China has weakened, midsized and small gold producers may yet return to M&A because of attractive valuations and the need to replenish reserves.

There was evidence of that on Jan. 11, when Canada's Alamos Gold Inc. made a C$780 million move on Aurizon Mines Ltd., a Quebec-focused gold company that owns one mine, one gold development and six exploration sites.

The bid "was made at a time when Aurizon's shares were trading at [the] lowest levels since December 2008," hostile target Aurizon complained. Perhaps tellingly, holders of 16% of Aurizon's shares negotiated to sell their stakes before the offer became public.

However, a decline in Alamos' own price suggests that shareholders remain wary of managements' ability to extract value from gold sector deals. Many boards are under pressure to defer capital expenditure, and to hand cash back to shareholders instead.

"Many of these companies have portrayed themselves as growth opportunities," Whittall said. "Now they have found themselves in a period where high yield is in demand because of low interest rates and they are playing that game by returning cash to shareholders through dividends."

The outlook for M&A will also depend on a factor largely beyond the control of anyone in the gold sector, namely the gold price itself. Gold traded Jan. 29 at $1,662.34 an ounce, compared with a record high of $1,920 in 2011. As of December the price had risen for the 12th consecutive year.

"I don't see the price going higher, and more likely going lower," Cunningham said.

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