Marketdepth

The Crowded Room

The most crowded investor meeting I ever attended was held in a very large hotel ballroom in Boston.  As the event began, the lights dimmed, and the hundreds of analysts and bankers in attendance were treated to a colourful laser show with blaring rock music.  Finally, from behind a curtain, a triumphant executive team emerged to a round of applause.  The CEO’s name was John Roth.  His company – Nortel Networks.  The date stamped in my passport was November 21, 2000, mere weeks after now-worthless Nortel’s quoted value had reached its $366 billion apex.

  

That experience introduced me to one of the investing world’s most dangerous situations, the crowded room.  I’ve seen a few crowded rooms since then:  one that feted a bearish fund manager as he toured this country promoting an equity fund loaded with over 90% cash (right before a massive commodities and equities rally); and another whose guest of honour touted global base metal demand just as copper and zinc prices began to melt down.  And let us not forget the rooms that filled for “peak oil.”

  

Figure 1:  The Plaza: Host to 2010’s Crowded Room?

 
  

  

I do not blame the shining lights of finance for burning a few moths along the way.   Each crowded room phenomenon started years before with a plausible, often excellent idea.  And early followers who got into a trade in advance of “standing room only” signs and fire code contraventions generally made out quite well.   But the thinking investor should always be on guard against the perils of a well-loaded bandwagon.

  

 The Crowded Room of 2010

  

Surveying the investing scene of 2010, there appear to be as least as many “crowded rooms” today as there were ten years ago.   I will ignore for the moment the mere swarms surrounding Canadian bank equities and long-dated corporate bonds in favour of addressing the greatest crowded room of them all – a veritable Lollapalooza – that supports the obscene valuation of United States government bonds.  From this great insanity, all the little bubbles draw their courage.

  

The US bond market’s crowded room moment may be coming soon.  My guess at its precise physical location would be New York City’s Plaza Hotel, which hosts the upcoming Bank Credit Analyst conference.  Topping the bill at that meeting is a much heralded “debate” between two institutionally-approved hot hands, Gluskin Sheff’s David Rosenberg and Oppenheimer’s Brian Belski.  Rosenberg is a leading cheerleader for long-dated US Treasuries who has insisted recently that the United States will never default.  As a consequence, “Rosie” is convinced that the currently tiny yields on US Treasuries are juicy given the coming deflation.  His “opponent” in this event, Brian Belski is expecting the gold “bubble” to burst any day and projects an increasingly strong US dollar and a continuing economic rebound. 

 

Who am I, a humble analyst from a small Canadian city where business lunches generally involve ketchup, to question such financial luminaries?  And yet, it does appear to me that the supporters of US dollars and low-interest US dollar bonds neglect certain key questions.

 

If it is generally true that people and companies with heavy debtloads pay higher interest rates than people with less debt, why does the United States pay a lower interest rate with debt/GDP at 100% and deficits/GDP of 10% than in any other year in the past forty, when US debts were far lower?

 

What is the effect of “open market” operations whereby the US Federal Reserve and the Bank of China buy US bonds in the market with freshly created cash?  What would American interest rates be without such activity?

 

How is it that money supply (M2), as measured by the US Federal Reserve can grow at a rate of 7 to 8% per year for the past decade and yet ten year US bonds can yield 2.7%?  And if US interest rates actually paid investors fair compensation for money supply dilution (yields of 10%, say), how could America possibly service its massive debt?

  

Now I recognize that these are not the type of questions that earn one invitations to address a crowded room circa 2010.  Perhaps we should check in again ten years from now.

 

Pan American Silver Corp - Waiting for Christmas

As the days get shorter here in northern latitudes, we note that the market optimism of the spring has faded.  The uber-bear of this moment, David Rosenberg, beats a drum for long bonds as the best way (save being short) to survive a continuing depression.  Technical analysts warn of a Hindenburg omen, presaging a stock market crash.

 

However, at this juncture, I find myself in the unusual position of being a relative bull.  Save for a few noteworthy trouble spots (such as certain banks originating real estate loans in the world’s remaining overheated housing markets) the stock market looks to me more poised for a melt-up rather than melt-down.  Three percent long-bond rates should simply not co-exist with 10x earnings multiples on Dow components like Microsoft (NASDAQ: MSFT) and Chevron (NYSE: CVX).  And while end-demand is soft in the developed world, credit expansion may be making up the difference in emerging markets, at least for now.

 

But given the uncertainty, I am partial to companies that can thrive in either a weak or strong economic outcome.  As an example of this class, I offer Pan American Silver Corp (TSX: PAA; NASDAQ: PAAS)  which faces either growing industrial demand for its production in a strengthening global economy or a growing fear-trade demand for silver should we descend again into crisis.  Having flatlined for the past two years against a 40% gain in silver, Pan American is overdue for an upward re-rating.

 

Silver vs. Gold

 

Before addressing the specifics of Pan American, it is worth revisiting the case for silver as the value play in the precious metals universe.  I believe there is still great potential for silver because the price ratio between the two metals (currently about 65:1 in favour of gold) has rarely been as lopsided.  Back in the days of gold and silver money, the value ratio between silver and gold coins was typically about 15:1.  Through the 1970’s gold was typically about 30:1 to silver and touched 15:1 at the peak of the precious metals cycle in 1980.  Even if gold stayed flat through the next round of quantitative easing, a re-rating of silver to its past 60 year average ratio would imply silver in the range of $25 per ounce.

Figure 1: Silver’s Re-Rating Potential

 

 

Catalysts for re-rating of silver vs. gold?  I can think of a few.  One might be a supply shock.  Keep in mind that over 70% of silver production is by-product production from mines whose major focus is base metals or gold.  A weaker market in base metals, for instance, might reduce silver output to a degree even in the face of higher prices. 

 

Another catalyst might be simply be price outperformance of the pearly metal and the resultant effect on speculative activity.  Note that the i-Shares Gold exchange-traded fund (NYSE: GLD) has $48 billion in assets, while its sister silver fund (NYSE: SLV) has only $5 billion in assets.  A price momentum shift in favour of silver that drove even a modest amount of gold-to-silver bullion switching could have enormous effect on the much smaller silver bullion market.  I am aware that the foregoing reasoning is entirely circular.  Having witnessed a few of these fund flow valuation changes, however, all I can say is welcome to the capital markets.

 

Digging into Pan American

 

For the uninitiated, Pan American Silver is a 16 year old company which has seven significant silver mines distributed through the Americas.  Its top mine, the Mexican Alamo Dorado property produced over 5 million ounces of silver in 2009.  Total production in 2009 was 23 million ounces and its resource base, on a broadly defined basis, is over 900 million ounces.  The company has significant production of other associated metals including gold, lead, zinc and copper, which combined amounted to nearly 40% of revenues in the trailing 12 months.

 

Relative to its peers, Pan American stands out for having a clean balance sheet, with no debt and net working capital of over $300 million.  Conservative perhaps, but useful in consideration of the major capital development projects on the company’s plate, most notably the very large Navidad project in Argentina.

 

Management appears sensible, with a focus on long-term economics and value creation.  In highlighting his priorities, Chief Financial Officer Rob Doyle emphasizes return on invested capital over production growth for its own sake.  And despite being surrounded by bullish prognostications on future silver prices (such as my own) his $14 per ounce base case silver price projection demonstrates a relentless commitment to sobriety.

 

Upside surprise for Pan American might be delivered by a couple of different sources.  The first driver is the potential rebound in the prices of base metals.  Chilled by deflation fears, lead and zinc have been beaten back to trough valuation levels and now trade near 20 year lows in relation to silver.  A rebound in these prices to the levels experienced in the middle of the last decade could boost Pan American’s profitability enormously.  It is worth noting than in 2006, base metals accounted for 40% of company revenues compared to 22% this year.

 

Figure 2:  Lead Prices Could Provide a Catalyst

 

 

 

The second driver relates to the potential amendment of the current mining law in Argentina’s Chubut province, where Pan American’s 600 million ounce Navidad project is located.  The project requires open pit mining, which is currently banned in  Chubut.  In view of this, the market is currently ascribing very little value, if any, to Navidad.  If and when the law is amended, Pan American’s silver output could rise significantly.

 

 Risks and Valuation

 

No investment is without risk and a company whose entire operating portfolio is comprised of Latin American mineral deposits is hardly immune from such consideration.  Clearly political risks, taxation and expropriation are potential outcomes in certain countries.  A futher big picture risk would be a general, but not life-threatening deflation that drives silver prices down without threatening the existence of fiat money.

 

More specific to Pan American’s operations, diminishing ore grades, a gentle erosion at the moment, but always a cause of concern could weaken results going forward.  Cost inflation (running at 20% in Mexico and Peru, comprised of approximately 10% currency and 10% operating costs) is also a headwind that offsets much of the benefit of higher silver prices.  However, relative to a silver price rise of 33% over the same period, the cost inflation has only moderated, not eliminated, the leverage to operating earnings that a miner like Pan American has to silver price gains.

 

As for valuation.  I think the best way to value a mining company is to value its mines on a full-extraction discounted cash flow basis, without reference to current period earnings.  However this approach is complex, and requires a lot of detailed mine-level information.

 

Figure 3: Pan-American Silver Stock Price

 

 

 

A reasonable way for an outsider to derive a price target for Pan American Silver might be to think in terms of two relative valuation ratios which can fluctuate in our favour.  Since 2008 PAA has declined 40% relative to the price of silver, a gap which could easily close.  The price of silver itself, were it just to revert to its historical average value ratio against gold of 48:1 would increase 35%.  Applying those two mean-reversions alone could boost Pan American Silver to $44 per share, an increase of about 75% from today’s level.  Layering on an improvement in base metal pricing or perhaps a “Christmas present” in the form of a Navidad mine permit could send Pan American well beyond $50 per share.

 

Overall, Pan American Silver strikes me as a good risk/return opportunity with potential to double over the next three years.  Relative to the other miners I have reviewed of late (Silver Wheaton and Goldcorp) Pan American appears somewhat cheaper and therefore is my preferred pick in this relatively attractive sector.

 

Goldcorp Inc: Some Thoughts on Valuation

With gold prices again testing record highs in the neighbourhood of $1200 per troy ounce, I thought it would be interesting to think through the valuation of our local $30 billion gorilla, Goldcorp Inc. (TSX:G, NYSE:GG).

 

Goldcorp background

 

Active since 1994, Goldcorp has acquired assets of several entities such as Whetaon River Minerals, Placer Dome (Canadian assets), and Glamis Gold, through mine purchases and mergers.  The company’s cash cow, Ontario’s Red Lake mine, is a very large, low cost operation which still accounts for about a quarter of total gold production and an even greater proportion of profitability.

 

 

Figure 1:  High Grade Ore from Goldcorp’s Red Lake Mine

 

  

Goldcorp has ten active mines in total, with key production located in Canada, Mexico and elsewhere in the Americas.  The company also has seven significant mine development projects underway, with at least one project slated to enter production in 2011.  Two other properties, the San Dimas mine in Mexico and the Escobal silver deposit in Guatemala, were recently divested for total gains in excess of $500 million.

 

Earnings and Cash Flow

 

With the rise in gold prices, Goldcorp’s profitability has expanded considerably. Average realized gold prices in H1 2010 were $1,160 per ounce, up from $978 last year.  Excluding the gain on the sale of San Dimas, year-to-date net income is $367 million, putting Goldcorp on track for an annual profit of about $730 million or about $1.00 per share.  Free cash flow (after maintenance capital expenditures) may be slightly higher, possibly in the neighbourhood of $ 1.0 billion or $1.30 per share.

 

Recent profit performance has been impressive.  Year-over-year gains in operating profitability are 59% through June 30 on production growth of just 3%.  As the table indicates, Goldcorp’s earnings are demonstrating the positive gearing to the metal price that attracts the most determined gold bugs.

 

 

Figure 2: Goldcorp Financial Highlights 2008-2010 YTD

(US$ millions)	2008	2009	2010 Estimated
Revenue	$2,420	$2,724	$3,100
Operating Cash Flow	933	1,180	1,400
Net Income (adjusted)	397	588	730
Adjusted eps	$0.56	$0.80	$1.00
Gold produced (oz)	2,324,000	2,421,000	2,500,000
Gold price per oz	$868	$978	$1,200

Source: Goldcorp filings.  Note: Operating cash flow is before changes in working capital.

 

 

Valuation

 

To call a spade a shovel, this is an expensive stock.  At the current share price of around $40, Goldcorp is trading near 40x estimated earnings for 2010.  In terms of free cash flow yield, cash returns to total capitalization are in the neighbourhood of 3%.  On an EV/EBITDA basis Goldcorp is trading around 18x.  Producers of other commodities trade at less than half these levels.

 

If gold itself were trading at fire sale prices relative to other commodities, then maybe the high multiples would be easier to digest.  But gold is not obviously underpriced relative to other commodities.  Relative to base metals, or to silver, gold is much closer to the top end of its historic range than the bottom.  And wheat, you ask?  An ounce of gold would buy 30 bushels of wheat in 1974, now it buys almost 200.

 

Although expensive, Goldcorp stock should still be somewhat higher three years from now, or five years from now.  The company’s development projects will augment production.  Goldcorp reserves should also expand as higher precious metal prices transform plain old rock into mineable ore without so much as a drill being lifted. And there is just too much inflation baked into our ponzi-like financial system for gold prices to fall measurably, in my view.

 

But why settle for “somewhat higher” when you can target “much higher.”  Low interest rates and quantitative easing are moving each of the basic materials of life higher in turn.  Gold and Goldcorp have lead the market for the past 22 months.  But valuations appear to dictate that the baton should be passed to other commodities for a while.  Let us hold on Goldcorp for now in favour of grain handlers and oil producers until values catch up.