July 23, 2012 / 3:59 PM / in 5 years

Analysis: Nuggets of value seen in Canada's mid-tier gold miners

TORONTO (Reuters) - While the world’s top gold miners struggle to contain soaring capital costs at multibillion-dollar mega-projects, their mid-tier counterparts are quietly building output through smaller mines at a fraction of the cost.

That means shares of Canada’s Yamana Gold Inc (YRI.TO), Alamos Gold Inc (AGI.TO) and other mid-tier firms are outperforming the Toronto Stock Exchange’s S&P/TSX Global Gold index, which has fallen more than 24 percent this year as gold prices stagnate and costs rise.

“Investors want to see gold companies stop building projects that don’t make sense,” said Darren Lekkerkerker of Pyramis Global Advisors, a Fidelity Investments company. “They do want to see growth, but they want to see it delivered and they want to see it deliver value.”

The portfolio manager, who co-manages the Fidelity Global Natural Resources fund, is bullish on gold. He said mid-tier miners with low cash costs and affordable, near-term development projects offer good value in the current market.

Take Yamana, which started production at its Mercedes mine in Mexico ahead of schedule late last year. The operation cost about $200 million to build and is expected to produce 120,000-150,000 ounces a year.

Toronto-based Yamana plans to start up two more mines this year, with a third going into production in 2013, adding up to about 400,000 ounces of new output between 2011 and 2014 at a total capital cost below $1 billion.

That compares with the $5 billion Barrick Gold Corp (ABX.TO), the world’s biggest gold miner, is spending on the 800,000-850,000 ounce Pascua Lama gold mine on the border of Argentina and Chile, or the $4 billion that Barrick competitor Goldcorp Inc (G.TO) will have to spend to bring its El Morro copper-gold project in Chile into production.

With second-quarter results out later this week, investors will watch for cost increases from top miners and for signs that mega-mine developments may be delayed.

RISE OF THE MEGA MINE

The price of gold has more than quintupled in the last decade, from about $300 an ounce in 2002 to just under $1,600 an ounce, a stratospheric rise that has pushed gold miners to seek growth at any cost.

But after centuries of exploitation, large gold deposits are rare. To sustain growth, the world’s top miners are building huge multibillion-dollar mines in remote regions of the globe.

Building a mine where there is no infrastructure is not cheap, and labor and material costs have risen along with metal prices. Even the slightest delay can wreak havoc on a mine’s development budget.

The bigger the project, the more likely are the problems, whether technical, political or community-related, said Morningstar mining analyst Joung Park.

“‘Mega project’ has a nice ring to it, but I think in today’s environment, where capital expenditure inflation is a big concern, smaller to medium-scale projects that have attractive economics are probable perceived more favorably by investors,” he said. “There’s definitely better growth potential with the mid-tiers.”

SLOW AND STEADY

Thinking small has worked well for Yamana. The stock, which rose 20 percent in 2011, is down just 7.5 percent this year, while top producers Barrick, Newmont Mining Corp NEM.N and Goldcorp have all lost more than 26 percent.

Yamana’s stock has actually outperformed the price of gold over the past 19 months, rising 14 percent since January 2011, while gold is up 10 percent.

Spot gold, which hit a high above $1,900 an ounce last fall, is expected to climb back up to around $1,800 an ounce later this year, as investors turn their backs on paper currencies.

That has analysts and fund managers eyeing Eldorado Gold Corp (ELD.TO), a Vancouver-based miner that has projects in Brazil, Turkey, Greece, Romania and China.

With low cash costs at its existing mines, Eldorado gets high returns from every ounce it produces and can reinvest that money into new developments, Park said.

The company plans to spend about $2 billion on development over the next five years to more than double its output to 1.7 million ounces in 2016.

Eldorado shares are down 29 percent so far this year, on permitting delays at the its Eastern Dragon project in China and worries that the company will lower its 2012 production outlook when it reports second-quarter results this week.

With uncertainty weighing on its stock, it could be an ideal time to take a stake in Eldorado, said Raymond James analyst Brad Humphrey in a note to clients on Monday, noting the share price could dip further once results are published.

“Although (Eldorado) is higher on the political risk spectrum and is exposed to above average development risk, we believe at current levels investors are more than compensated for this risk,” he said. “Eldorado continues to offer investors an industry-leading cost structure, solid growth profile, and strong management team at historically depressed levels.”

Another top pick is Alamos Gold, which produces about 200,000 ounces a year from its low-cost mine in Mexico and is developing two projects in Turkey. Its stock has fallen about 17 percent this year.

With the world’s top miners struggling to rein in costs, many investors want companies to return cash flows to investors instead of building new projects.

While dividends and buybacks are good, Joe Overdevest, who co-manages the Fidelity resource fund with Lekkerkerker, said companies need to be careful to balance the money handed over to investors with the money invested in replacing mined ounces.

“Unlike other business, mining and gold have a natural decline rate to them,” he said. “You have to have a smart management team that you trust will do the right thing to find new growth somewhere, otherwise you will have a depleting asset.”

Reporting by Julie Gordon; Editing by Frank McGurty and Janet Guttsman

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