Commentary: Gold sector fragmentation hurts investors

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).