Excerpted from GoldEditor.com Newsletter
12 April 2004
Kenneth J. Gerbino & Co. is a money management firm based in Beverly Hills, California and has been investing in precious metal mining stocks for 30 years. Their managed accounts in precious metals investments were up over 100% in 2003. Additionally, the Gerbino Gold Group LLC. is a private fund investing in precious metal stocks.
Some will remember Ken as the Founder and Chairman of the American Economic Council, the lobbying group established in 1979 and credited for the passage of the Gold Coin Act of 1984, which brought the American Gold Eagle Coin into being.
Ken shared his views on the mining market in general with us, along with some of his top picks in the sector. His exhaustive research methodology, developed over the last 30 years, allowed us to peek at how he values one of his favorite holdings - Northern Orion Resources (NTO-AMEX, NNO-TSX). His industry experience and his detailed number crunching gave us a fresh new look at the company.
GE: 2003 was a very good year for the mining sector, what's your outlook for 2004?
KG: Most commodities with gold and silver and the base metals will go up in price in 2004. Long term global monetary increases are now affecting commodity prices coupled with strong demand, led by very robust demand from Asia. I think gold will trade between $375 and $450 this year, which would be bullish for the mining companies especially those that have a good growth profile. After 2004 gold will trade higher.
A major upswing commodity price pendulum is starting that could last for a decade. Past bull markets in metals were always cyclical and short term. China and India have changed all this. We are witnessing the beginning of a multi-decade demand driven bull market in resources….and at the same time we are at the tail-end of 10 years of one of the greatest money printing binges the world has ever seen by almost all countries, especially the U.S.
These two mega-trends are now coinciding and the result will be higher prices for natural resources. I would be very happy with a gold price of $400 for the next 10 years, as there are always opportunities in the mining sector. But the fundamentals favor a higher price.
GE: How will this play out in regards to gold?
KG: This is an historic change in mankind's progress. People are just starting to grasp this. China is now the number one consumer in the world of copper, steel, platinum, zinc, and iron. They produce more steel than Japan and the United States combined. There are more cell phone users in China than in the U.S. Over 200 million users now. I was just in Beijing. China is booming. I saw 3 cops in 7 days in a city of 18 million people. Communism is a joke. The army, unions, in fact almost every organization owns businesses and has investment pools. Capitalism is everywhere.
The U.S. and Europe consume 11 grams of gold per capita annually…about a third of an ounce...and most of that is jewelry. When China catches up on a per capita basis it will be equal to 5 times the global mine production of gold annually! Even a 10 % demand increase over annual mine supply is huge in terms of the gold market…this will be 50 times that…and these numbers are mostly just for jewelry. This is what is coming. The Chinese currency was wiped out in the late 40's…so they know the value of gold as a currency also. The investment demand from China coupled with jewelry demand will change the gold equation for decades to come. Now lets be very logical here. The mining companies have to replace 84 million ounces of production from reserves each year. That's the equivalent of finding 17, five million ounce deposits a year. This is impossible. I've seen maybe one five million oz discovery in the last two years. So from a longer-term supply viewpoint a squeeze is developing as well.
GE: Interesting. Tell us what specific criteria you use to evaluate mining stocks?
KG: If it's a developing story I always look at the grade (richness) of the deposits and try to get a handle on the dimensions of the mineralization before anything else. If it's a producer, I'm looking at two distinct parts to the equation…the usual suspects…net asset values, net present values, cash flow, mining costs per oz, but I am also looking at the most important projects in their pipeline that have yet to come on stream. Here is where the value proposition can change.
We do our own in-house version of a stripped down scoping study (preliminary engineering report) on properties. We pencil out 30 or so factors that we believe are crucial to the project's viability. Years ago we use to have 80 factors extrapolated out 15 years for all these companies and it was overwhelming and too complex. I have now narrowed it down to the nuts and bolts. This allows us a rough but very important advanced look ahead of Wall Street by sometimes 12 months on the value of a deposit or discovery. It allows us a jump on analysts that are waiting for resource calculations and engineering reports from management. After 30 years of analyzing mining stocks and making every mistake in the book, I feel this is the best method.
The grade of the resource to me is the key variable that must be there. Managements can look pretty good with higher-grade deposits whether open pit or underground. Grade allows you to make up for a lot of problems that usually occur in most mining operations. Of course, good people are essential …a good mining operation usually means the management are good problem solvers. Ideally, we like companies already with production and with very large precious and base metal resource projects (for gold a 3 million oz minimum resource potential) in development. Here is where you get value and growth.
GE: You are known for not speculating on grass roots exploration plays... why?
KG: Grassroots (early) exploration plays are probably the highest risk investments around and should be avoided. Years ago the ratio was something like only one out every three thousand exploration companies ever produced an ounce of gold or silver. Advanced exploration and development plays with at least some defined resource are sometimes okay for high-risk takers, but one has to be very careful here. The advanced projects at least have enough drill results and preliminary engineering questions somewhat answered to allow you to make an intelligent decision. I also tend to discount early stage chip samples, float samples, anomalies, or channel sampling from outcrops or trenching…all important data but still in the very high speculative realm…probably 10,000 failed properties all had some good showings on surface…it's just not enough. Until you have multiple drill results and the direction of those holes and some handle on the lithology (rock formation) and other geological data you really are still in a crapshoot.
There are so many solid values today with plenty of upside why even look at grassroots exploration plays. Northern Orion (NNO-TSX, NTO-AMEX) for instance has a market cap. of US$320 million and a minimum resource of 10 million oz of gold and 18 billion lbs. of copper at their Agua Rica property. That means the stock sells for $32.00 per oz of gold and the copper is free, or just 1.8 cents per pound for the copper and the 10 million ounces of gold are free. They also own 12.5% of the Alumbrera copper/gold mine (the second largest gold mine in South America) which should throw off $50-60 million cash flow this year and $35-70 million or so in cash flow annually for 6-8 more years, depending on metal prices. So, this year you pay 5-6x cash flow for the stock, and totally separate from that you also own one of the largest and richest copper-gold deposits in the world…Agua Rica…where $50 million has already been spent on the property.
The grade is well above average and I might add that from the drill logs I inspected on my visits to their offices starting back in 1995, I believe the deposit is a lot larger and richer than management can claim because of all the new regulations. This deposit easily is in the top 5 best copper-gold deposits in the world when considering size and grade. You have Grasberg, Antamina, Pascua-Valadero, OK-Tedi and then Agua Rica.
These are some back of the envelope calculations, that show why a Major should buy out NNO. Giant base metal producer, Noranda, will spend $850 million putting their El Morro property in Chile into production. Agua Rica is 25% larger, has 28% higher grade and cash costs per pound will be 15¢ versus 52¢ for El Morro. Agua Rica would cost only $300-$400 million in capital expense.
Also, their El Pachon property in Argentina, will cost Noranda $950 million in capital expense and produce copper at 58¢ per pound and produce 500 million pounds per year versus Agua Rica which will produce 845 million pounds equivalent per year. At $1.00 copper, Agua Rica will cash flow before tax $591 million a year. That means a buy-out for $1.5 billion plus the $300 million capex is paid off in 3 years. At $1.25 copper, make that two years. Fully diluted, NNO has 163 million shares outstanding so that would be $9.20 per share buy-out for just Agua Rica. Throw in $76 million cash from fully diluted in-the-money options and warrants and discount their future cash flow from Alumbrera of maybe $250-$300 million, and you could add another $1.60 to the $9.20. That leaves you a $10.80 U.S. target as a real price tag, considerably higher than the current $2.68 U.S. stock price.
In 2003, Noranda had an $.80 realized copper price and total corporate cash flow of $1.23 per share. A buy out of Northern Orion for $1.5 billion, or 75 million shares of Noranda (@$20 a share) would be immensely accretive to Noranda shareholders. At $1.00 copper Noranda would gain an additional after tax cash flow of $1.20 per share. Even at $.80 copper (copper is now at $1.30), Noranda would gain an additional after tax cash flow of $.90 per share.
Bottom Line: Noranda issues 25% more shares and increases its cash flow by 73% at $0.80 copper. Their shareholders would have to love it. Northern Orion is a buy-out candidate that will allow the new owner to build a mining dynasty for the next 40-50 years. We own this stock and believe it will have considerable upside.
GE: Long term, where do you see the price of gold and silver?
KG: Gold will do what everything else has done in this world…go up in price...and for the same reasons; Printed money. Paper and credit created out of thin air. Investment demand for gold will have three phases. It looks to be a long bull market. The first phase is happening now, the US dollar weakness. Gold correlates to the dollar 56% of the time in opposite directions. The weak dollar reflects two fundamentals regarding the U.S.: a debt ridden economy and a paper money dependent nation...two fundamental economic tidal waves that will not go away any time soon.
After this phase will be global inflation…that will propel gold up most likely in terms of all currencies. The third phase will be based on fear of a banking and credit collapse and this could cause the largest move up. When people fear that their monetary assets could actually desinigrate by default or bankruptcy they will turn to gold for insurance.
Even a small percentage of the global investment or savings community doing this would be very bullish for gold. Homestake Mining going from $40 in 1926 to $544 in 1935 was because of fear of debt defaults and banking collapses not inflation.
GE: Do you see any changes with the Central Banks position on gold as a reserve asset?
KG: It's hard to believe that these guys think they can print wealth…and also think that interfering with a free market in interest rates, and currency values is a viable economic option. Sooner or later this will all fail. Some country will break ranks eventually and revert to sound money and hence validate gold as the only reserve asset. It will probably take another generation to finally expose the many flaws of paper money and central bank policies.
I am hoping the Chinese and Indians take the lead here in the next decade. The non-monetary establishment is still being hoodwinked by the financial and banking establishment. The recent Argentina crisis was promoted to everyone as a debt crisis when in actual fact it was a currency crisis…a printing press crisis. None of the major newspapers in our country called it like it really was. They either didn't understand it or didn't want to rock the boat.
Someone needs to get an editorial board meeting with the NY Times and get them to understand just two things: printing paper money is bogus, and a gold standard is a lot simpler and easier than people think. It's like a ruler—a standard of measurement—12 inches to the foot..every day, every year.it never changes. The gold standard is also simple, it's a standard of value for a medium of exchange—money—and the standard shouldn't change either. If the NY Times "gets it", then the world changes.
GE: Will interest rates going up be negative for gold?
KG: Interest rates are very low and gold in my opinion is undervalued, so both can go up from here together for sometime. In the late 70's I remember rates going up dramatically and gold exploding upwards also. Gold holders who own 5% or 10% of their assets in gold as an asset class for diversification or insurance will not sell gold because they can get 8% in a money market. ...They may sell conventional stocks and bonds to get that 8% return but the typical gold holder globally would most likely add to his/her position over time regardless of interest rates. Don't forget most gold above ground is on women's bodies or in jewelry cases, interest rate insensitive.
As far as central banks go—yes, they have been selling off their gold reserves but they have more or less kept their selling to about 300-500 tonnes per year for decades. European central banks just signed a deal limiting sales to 500 tonnes a year for 5 years. This was seen as a non-event in the market. Getting back to interest rates… remember that interest rates will go up when inflation goes up because interest rates must keep up with inflation or the banks would become illiquid. So as rates go up due to inflation so will gold, as it is an inflation hedge.
GE: Where do you stand on the Inflation-Deflation debate?
KG: There has never been an economy or country ever that has had a multi-year deflation with a paper money system. End of argument. Paper money increases always brings on inflation—always. Japan in the early 90's had stock and real estate prices collapse—that is not a deflation that's investment sectors collapsing—totally different animal. Inflation is a decrease in the purchasing power of the currency not your net worth. The whole deflation argument was started, as it always has been throughout history, by those institutions that want to print more money to bail out various big and powerful institutions that are failing. To justify inflating, they scare people about deflation…a slick strategy that still hoodwinks the non-financial establishment. Printing money depreciates the currency and redistributes wealth from the lower and middle class earners of a society to the big, the bad and the ugly. Anyone interested in reading more about this can go to my website at www.kengerbino.com and read my commentaries.
GE: Tell us about some other mining companies you like and why?
KG: I like Newmont (NEM - NYSE). They are the big dog on the block and should be part of everyone's portfolio. The institutions will all own this one. Newmont controls over 60 million acres of land on four continents in some of the best mineral belts in the world. They have 90 million oz of gold in reserves and another 56 million oz in the resource category. They will produce over 7 million oz in 2004 at a cost of $225 per oz. They own 51% of the greatest gold mine in the world, Yanacocha, producing by itself over 3 million oz annually at a cost of $125 per oz The company has 260 active geologists and $1.2 billion in the bank. Every time gold goes up $1 the stock should move up 1% just based on it's typical cash flow multiple.
Wheaton River (WHT- AMEX, WRM-TSX) is an exceptional story. Sixth largest Canadian gold mining company. They will double their gold production in the next 3 years without having to issue any new shares or borrow any funds. That is extraordinary. They have expanding production, low production costs of $100 per oz when you factor in base metal credits, solid cash flow, and an interesting business model. They are like Starbucks — getting bigger by opening new stores — only Wheaton does it by buying good medium size mines or very advanced properties that are ready for production. The mines they make more efficient. They have the right people who can raise lots of money and buy and manage these medium size mines. The big companies are too slow and the little companies don't have the cash…. so Wheaton has a great niche.
I believe they can go from 550,000 oz of gold production in 2004 to 2.5 million oz in the next 5 years which makes them a great growth story, one that will do well even if gold just stays in the $375-400 range. They also have very nice copper and silver exposure. In the coming super-bull market in copper led by Asia, this will be very accretive to earnings. By the end of 2007 with copper even as low as 80 cents (it's now at $1.30) they will be producing over one million oz of gold for less than $75 per ounce because of the copper credits. We own plenty. Fidelity owns 13% of the company, a good name to have on the shareholder list.
GE: Thanks for your time Ken and good luck.
Kenneth J. Gerbino
Kenneth J. Gerbino
9595 Wilshire Boulevard
Beverly Hills, CA 90212
Phone: (310) 550-6304
Fax: (310) 550-0814
Kenneth J. Gerbino & Company
9595 Wilshire Boulevard, Suite 303
Beverly Hills, California 90212
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