Why Gold Mining Companies Habitually Destroy Capital (w/ James Rasteh)
JAMES RASTEH: I'm James Rasteh from Coast Capital Management in New York. We are fund that takes a private equity approach to investing in public companies. And what that means is we look for and invest in companies that have important positions in fundamentally profitable industries, but that have very low valuations on depressed earnings. We then work with the very best managers and experts on that company, and sometimes on the industry that we're investing in, to put together a turnaround plan and a value creation plan for the company that we invest in. We make long term investments. And we create consensus around our plans among our fellow investors. I started looking at the sector from a personal perspective. I was interested in having some exposure to a financial instrument that would protect me from a likely bought of inflation at some point down the road. We're quite agnostic on the price of gold and not a gold bug at all. But I've been struck by the prevalence of bad management and onerous cost structures imposed upon the gold mining companies that we look at. We've been fascinated with the gold mining sector in that, basically, that the mid-cap miners, if you will, seem to trade at an extraordinarily large discount to their larger cap peers. And that's on earnings that are depressed because of a long history, and a protracted and continued history of capital misallocation toward exploration projects, overly generous management compensation structures, very large and unnecessary and overly compensated board members and board structures as well. So when we look at the sector, it seems to us as though there's been a breakdown in discipline in how many companies in the sector are managed. And we think that there is room for an actively engaged investor to come in and invest in companies that most benefit from a rationalization of their cost structure, a sale of non-core assets, or perhaps a sale of the overall company. Very difficult for a bottom up fund manager like myself to formulate a conclusive view on the macro trends affecting the sort of ebbs and flows into specific industries. But, certainly very cognizant of the fact that a lot of historical investors in gold seem to have allocated capital to cryptocurrencies and to Bitcoin over the past few years. That's really been the preferred instrument for a lot of investors to bet against potential inflation or an erosion of the value of Fiat currencies. These gold mining companies happen to be, in large part, headquartered in Canada. And a lot of capital that would have historically flown toward gold mining companies seems to have flown into sectors that have garnered much greater interest in Canada. Cannabis companies, believe it or not, being a case in point. And, in general, I would say that the management teams in the gold mining sector have given investors every reason not to invest in their companies. Right? Management teams in this sector have an extraordinary track record of destroying capital. And that capital is being destroyed basically through terrible investments in exploration projects, but also really destructive M&A over the past few years. So by way of example, the whole sector right now has about $225 billion in market value. And most of the companies in the sector are publicly quoted. So for about $225 billion, you could buy every single gold mine in the world just about. Right? But the top 20 players in the sector alone have destroyed $157 billion worth of capital just only over the past 10 years. This extraordinary mismanagement track record is the biggest reason I can think of why investors have shunned this sector and why they will likely continue to shun the sector unless important changes are made. And we're investing in the sector to affect and to bring about change. Investors have allocated to the sector with on average pretty terrible results historically. Right? Since 2006, I think the price of gold has almost double, right? And the average company has lost 50% of its equity value. So investors would have been right to avoid the sector. And that's what's gotten us to a point where valuations are near all-time lows. The price to cash flow that this sector is trading at, particularly among the mid-level miners that we look at, valuations are currently at 30% on a price to cash flow basis of what they have been on average over the past 20 years. Why now, you ask? Here are two reasons. One is in 2020, starting in 2020, almost every major gold miner in the world will have entered a period of declining reserves and productions. Right? And so you think, all right, well, maybe they can offset this declining reserve and production through new discoveries. Well, here's fact number two. We're not finding new gold. OK? Last year, we spent three times as much CapEx looking for new gold reserves around the world as we had spent in '95, three times as much. We found only 5% of the gold that we found in 1995. And the quality of the gold that we found was 50% measured in grams per ton of what it was in '95. So the majors are running out of gold. They're not discovering any new gold. The only way for them to replace those reserves is through consolidation. And by the way, there is an extraordinarily powerful economic rationale for consolidation. In fact, there are many. But here's one of the most powerful. As a major gold miner, you are trading at twice the multiples on price to net asset value, price to cash flow, whatever metric you want to look at. On average, you trade at a 100% premium to the smaller players in the space. And so, financially speaking, it certainly makes all the sense in the world to consolidate the sector. And then when you think about the fact the smaller miners have lower margins because they're encumbered with onerous and unnecessary cost structures, all of which at the GNA level can be done away with upon consolidation, you look at an extraordinarily powerful rationale for consolidation. And we think that consolidation has to happen and has to begin to happen before 2020 lest the majors in this space continue to decrease in size. There are many companies in the sector that spend over, almost, and in some cases over 100% of EBIT on GNA. Right? And they trade at half the multiples of the major players in this sector. Right? You remove GNA and many of these companies, you'd double profits. If you look at the number of gold mining companies in any given market cap range, say, maybe $1 to $5 billion, the gold mining sector has three times as many companies than any given market cap range as producers of other metals in the world, some of which have bigger end markets in terms of yearly sales. Right? And so this is a sector that, it seems to us, particularly in the mid-cap range of this space should have a third of the companies that it currently does. So you're looking at many, many dozens of transactions that need to happen. Just over the past 10 years, the top 20 companies in the sector have destroyed $157 billion worth of capital. Over the same frame, they've made almost $130 billion worth of cash. Now we're looking at pretty stratospheric numbers. And the way that that capital has been destroyed is by investing in new and Greenfield projects that have yielded very little and, in fact, have yielded zero return on capital. OK? And then, here's another big problem with the sector, which I think is maybe the root problem, is that the management teams in the sector have very low ownerships of the companies that they lead. Right? Average insider ownership rate-- management, and top managers, founders, what have you-- is about 0.4%. That's a fifth of the next lowest insider owned industry that we're aware of, which happens to be in the natural resources space as well. So these management teams really aren't incentivized based on share price performance. But their yearly cash bonuses-- which tend to be very generous-- are calculated based on how large the reserves of the companies are, and how large the production is, and how large the production profile is. So what happens is when the price of gold goes up, the share price of the company might go up, the cash flow certainly go up, the bankers throw a lot of capital at these companies. They use their share price and their cash flow and that capital that's newly available to them to buy the biggest gold mine that they've been looking at buying and that they'd be interested in buying and adding to their collection of assets. And for maybe a year, they make a much higher compensation. But when the price of gold then goes down, their cash flows dry out, their share prices decline. And now they have leverage to contend with. And they could potentially face liquidity problems, right? And so they sell the very asset that they had bought often for pennies on the dollar. And you rinse and repeat this process over a cycle, you end up with an industry that-- even though fundamentally, very profitable at the operational level-- will, through an extraordinarily nonjudicious allocation of capital and business development, destroy the kinds of capital that this industry has destroyed over time. We take a long-term perspective to investing in this sector. And our investment time horizon will be anywhere from two to five years. If you're looking to invest in a company with a view to improve the management and the performance of the company, you have to really give it time to work. And very often-- and this is the bane of my existence-- things go against you before they start to go in your favor. Right? So I think it's really primordially important to give the average company that we're looking at at least two years to work out. We are not operators. And ultimately, when you buy into a company, you're buying into an operation. And how that operation performs will determine how well you do as an investor. So we work with the very best operators and the very best managers in the sectors that we invest in to vet the quality of the assets that we're buying into. In the case of gold mining companies-- which happens, obviously, to be an area of interest for us-- we use the greatest management teams in the sector and the greatest geologists that these managers have a long history of working with to vet the quality of the operations that we're buying into. Certainly the safety of jurisdiction ends up being a primordially concern. But then we will also have a very specific and well-defined perspective on what could and should be done differently with the company to create value for investors. What are the non-core assets that this company has been plunking good capital into that will, for the company itself, earn zero return on that capital over time? And, therefore, what are the assets that should be sold? Should the company itself be sold? Who are the likely buyers? Why? How? What is the rationale? How do we go about putting all of that into place? We find that the sector experts that we work with help us develop an incomparably richer perspective on the companies that we invest in than we could ourselves alone by just only studying the financial data available to investors. I think that investors in the sector on average are pretty keen for change. I think investors understand that consolidation needs to happen. I think investors understand that capital needs to be spent a lot more judiciously. I think investors understand that there is a lack of sophistication in the financial decisions that have been made and that continue to be made by the companies in the sector. So our work is to aggregate the thoughts of the most competent leaders in the sector and the greatest, I would say, experts on the very companies that we're investing in, put together a detailed value creation plan for the company at hand, and create consensus among our fellow investors around our plan. And to the extent that we invest in great companies that are badly managed and have very low valuations on depressed earnings, usually we find that our fellow investors share our frustration and share our desire to see productive change and will be very interested in engaging with us in pushing for some of these changes. The compensation that these CEOs work toward and work for has very little to do with the share price performance and with value creation and return on capital. And it has a lot more to do with the growth and the reserves and the assets that the company has and the production rates that the company has. And so over time, there's been a tendency to focus on acquiring assets when the markets are buoyant. The gold price is going up. The cash flows are strong. The share prices are strong. Acquire assets. Market then reverses. Gold price goes down. Their share prices go down. The cash flows go down. They sell the very assets that had bought for pennies on the dollar. And this process has, as mentioned, destroyed a lot of value. And we've, over the past three years that we've studied this sector, put together an advisory board that gathers well over six of the leading CEOs in the space. These are individuals who have a clear and exemplary track record of creating value for the investors and their companies. They're wonderful world class advisors. They have wonderful geologists that they've surrounded themselves with. They have a very developed understanding of what are the most attractive assets to buy into and how to trade around attractive assets whose performance has been masked by subpar management, be it financially or operationally, and most often both. So we work with our advisors in putting together turnaround plans for the companies that most need them. We're very excited about the process of bringing about change to these companies, particularly in light of the extraordinary amount of capital that these companies have destroyed and probably, left to their own devices, will continue to destroy. I'm not at all advocating that investors invest in gold mining stocks period. I'm not a gold bug. We have no view on the price of gold. But we have a very large number of gold mining companies where there's room for extraordinary returns to be generated for investors specifically. And we aren't quite yet at a point where those changes are beginning to occur. And unfortunately, there aren't enough companies that are going from bad to better or changing their practice. The sector basically has sort of three buckets in which you can place a company. Right? There are the majors. There are the juniors and maybe venture stage companies. And in the middle, there's mid-cap players, from my perspective, that actually have cash flow, attractive operations in many instances. But the middle of the market is where the greatest opportunities are. There's like a company for everyone. If you like growth companies with world class management teams and maybe above par valuation, there are companies like Randgold which is a wonderful, very well-managed company in the sector, probably the most competent management team. And we greatly admire them. If you like companies with very sustainable and attractive cash flow profiles, there's a lot of coal mining royalty companies that we certainly think very well of. The folks at Osisko and have spent a fair bit of time getting to know them and their operations and their perspective of the world. And we're very intrigued and impressed with what they've done. In that SSR in Canada is really in a way Canada's answer to Randgold. Great management team, wonderful assets, neatly managed, focused on operations, much more importantly from my perspective an extraordinarily pragmatic and value focused M&A strategy. But we really get much more excited about the wonderful assets that are fundamentally very productive and cash flow generative, but whose output and whose cash flow and whose value is being masked by consistent destruction of capital and consistent mismanagement financially and operationally. And in that category we think Detour certainly is one that investors should look at. And it's a company that I think investors should absolutely put up for sale lest they see and they continue to allow the credit and extraordinarily incompetent management and board continue to destroy value for investors. But we think of the fact that the management team of that company in a recent and very feeble attempt to try to defray investors' demands and not comply with investors' demands that the company appointed a brand new slate of board directors with a view to put the company up for sale. They've proposed three new board members who-- by the way, look reasonably competent and have great backgrounds, and who should have been appointed all along, and who would have probably not allowed the current CEO's quote unquote CEO's antics to continue. They would have probably put an end to status quo quite a long time ago. And so we think that Detour is a very interesting case of a company that clearly should be sold. We think that Torex in Mexico, which has a very attractive and productive mind, but has recently dealt with some labor issues that I think have been resolved very satisfactorily. But the share price doesn't reflect that yet. I think that that's a very, very neat company and certainly every timely one to look into as well. There are companies like Yamana Gold, again, assets across the Americas, but really mostly in Latin America. A number of assets that don't necessarily jurisdictionally belong together. The only company in this sector whose chairman also happens to be the CEO and has quite unchecked powers over the company saddled with an unnecessarily onerous cost structure, and a board that's rubber stamped management's decisions consistently. And management's decisions have been not always very productive from investors' perspective. If you look at the company, they're starting to really pay lip service to the idea of change and to the separation of powers and there being checks and balances on the chairman and CEO. And the company is talking a lot more about a focus on cash flow and return on capital, which is quite extraordinary for them. I'm not sure that has led to changes in operational practice quite as much as it could and should. But there is evidence of burgeoning change, which we think over time will be quite valuable and, frankly, productive. We think that the process needs to be accelerated, not only in the case of Yamana, but for many companies across the sector. If you look at mining companies in Australia, incomparably better managed, focus on operations, focus on cash flow generation. And any company in Australia in the same market cap range will trade and add premium to their Canadian counterpart. Right? And the premium based on price to reserves, to EBITDA, price to net asset value, price to book value, price to cash flows. Australian companies trade at a meaningful premium, because they're just operationally focused, focused on operations not M&A. They do a much better job. And their cash flow profiles are much more attractive. And we think with that kind of discipline, focus on operating performance, would do the Canadians a world of good. I expect that a lot of the Australians should and, therefore, are looking at acquiring their way into Canada and bring some of that discipline across the Pacific Ocean. That's a very important question, particularly when you think, again, about the fact that over the past 10 years, we've seen almost doubling in the price of gold and the average companies lost 50% of its market value. Right? So these are companies that destroy capital on that share price declines, even in an environment when the price of gold goes up. Right? And the environment that we've seen over the past few months where gold prices declined from well over $1,300 to now less than $1,200 an ounce. Very difficult for a lot of these companies. The sector is fundamentally very profitable operationally, right? The average company has $950 in all in sustaining costs to produce an ounce of gold. Gold is still being sold for just about $1,200 an ounce, $1,180 or whatever it happens to be today. So these companies are earning a pretty good profit on an EBIT basis for every ounce of gold produced. You then have to look at-- I think that the answer to your question really depends on the company. It depends on the amount of leverage at the company at hand. It depends on their own sustaining costs. It depends on their CapEx needs. But our view would be that a lower gold price, while presenting a lot of these companies with difficult if not unfathomable challenges, I think over time to the extent that it pushes for consolidation might serve the industry very well. If I think about the fact that the major gold miners would trade at twice the multiples of the medium and smaller cap players in the sector are entering into an ad infinitum period of declining reserves and production. And if I think about the fact that there's no new gold being discovered. OK? We had a theory of peak gold in '07, '06, '07, '09-- I apologize peak oil in '06, '07, '08. Nobody's talking about peak gold. But in terms of discovery, I think that the argument in favor of peak gold right now is much more important than the argument was back then in favor of the concept of peak oil. So majors have twice the valuations, are running out of reserves. And they need to, presumably, maintain, if not increase their production to continue to warrant the multiples that they trade at. They cannot do that through discovery, which is what they've done historically. The only path available to them, the only path saving them from literal extinction, is consolidation. The reason why I think now's the time to look at consolidation is because we're a year and three months away from a period in which the majors see declining production. This is a sector that has an uncanny ability to fail to do the right thing at the right time. And that's why I think investors need to engage. That's why I think the sector needs active investors and active investments. And that's why I think the advisory board that we've put together and the process that we've put in place should help us create a lot of value from companies that are currently hiding it through operational or financial malpractice.