Precious metals have a long way to go

BMO Capital Markets' Andrew Kaip Says Get Ready for the Consolidation Wave

Andrew Kaip, managing director of mining equity research at BMO Capital Markets, says the stark reality is that the precious metals sector is only part way through a down cycle and that structural issues will result in a fresh phase of consolidation. He adds that the small to intermediate producers will lead the consolidation charge. In this interview with The Gold Report, Kaip suggests some suitors and prime acquisition candidates.

The Gold Report: In late November, BMO Chief Economist Doug Porter warned that interest rates could move higher sooner rather than later in 2015. What's your 2015 outlook for gold given that information?

Andrew Kaip: Our 2015 outlook for gold is that it will trade, broadly speaking, where it is today. Our assumption for next year is $1,190 per ounce. Do we look to Doug Porter's view on interest rates rising and that potential? We do. If the market perceives inflation is becoming a concern, we see that as constructive for the gold price.

TGR: You have extensive experience covering junior gold companies. In your time as an analyst did anything prepare you for this cycle investors are witnessing?

AK: When we look at what has changed over the last couple of years, I think that in general BMO Research understood that the direction was changing. Several years ago we began putting out reports cautioning investors that metal prices had downside risk and we were concerned with structural issues in the sector that continue to play out. And while we certainly understood the direction, I don't think any of us fully understood the magnitude of the shift.

TGR: Do you now have a better understanding of where we're headed?

AK: Metal prices have lost roughly one-third of their value compared to where they were in a peak price environment—even more for silver. If we step back and think about a cycle and how a sector moves from bull to bust, I would say we're really part way through the consolidation that takes place when a sector is out of favor and has to deal with structural issues. That's difficult to hear, but I see the gold space moving through a down cycle. We had a good run from 2010 through 2012, but we're now in a consolidation phase, with the risk of lower precious metals prices.

TGR: There have been casualties along the way. What are you telling your team?

AK: We've always been realistic. Our focus over the last two years has been to steer clients toward mining companies that have strong management teams managing quality assets and building them into stronger businesses.

TGR: You suggested earlier that there are structural problems in the precious metals space, especially among the smaller companies. Could you give us some examples that help illustrate your point?

AK: There are a number of issues that we have focused on. The first is that the operating cost structure for a number of companies is not structured for today's metal price environment. We are looking closely at smaller companies and some larger companies to see how they're responding to lower metal prices. They started by cutting discretionary spending, but now companies are looking more closely at sustaining capital in an attempt to reduce their overall cost structure and maintain profitability. But if you take too much sustaining capital out of the business, how is that going to impact the business in two or three years?

TGR: One hot topic on cutting costs is executive compensation. Has it become unrealistic?

AK: In the context of this current market there needs to be a healthy discussion as to what is appropriate compensation for executive teams. In some instances, levels of compensation are significant relative to a company's production. One thing that our clients are telling us is that they would prefer to see the old business model where executive teams had significant ownership of the companies that they were running. They benefited from their success through share price appreciation. Investors want management aligned with their interests.

TGR: Is there a tangible way investors can determine what is reasonable and what's excessive?

AK: If a management team has significant share ownership—an amount at least comparable to their base salaries—then investors should begin to feel comfortable that those individuals are trying to create wealth and make decisions that will benefit all shareholders.

TGR: What is your view on high grading?

AK: The reality of lower metals prices, particularly in the precious metals space, is that companies have to move toward higher grade to maintain profitability. But that comes at the expense of reserve life. We saw that at the beginning of 2014, but our expectation is that we will see further declines in reserves when reserves are restated at the beginning of 2015. For some companies, that's going to precipitate a decline in reserve life to the point where it could become motivation for consolidation. Some of these companies will have to look to acquire smaller companies with new projects in order to maintain their production profile. In fact, some of these companies are going to have to look at consolidation if they are going to continue operating.

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