Newsletter Value Investor Insight carried an interview July 28th with D3 Family Funds manager David Nierenberg (pictured left), whose $500 million fund focuses on small and microcap stocks and has generated an average net return of 16.8% per year since its launch in 1996, versus a 9.3% for the Russell 2000, according to Value Investor Insight. Here's the segment of the interview in which Mr Nierenberg discusses his position in Yamana Gold (AUY), which was trading at $9.70 at the time of the interview (chart here):
You’re clearly not afraid of cyclical industries. Tell us about Yamana Gold (AUY).
CD: This is a gold-mining company headquartered in Toronto, but with all of its operations in Latin America, primarily Brazil, which is a good country for mining businesses. Today they only produce gold, but their largest mine, which comes on line in the fourth quarter of this year, will also produce copper.
Last year, Yamana produced a little over 100,000 ounces of gold. In 2007, through increasing production from existing mines, acquisitions of operating mines and in-house, fully financed development projects, they should produce at least 625,000 ounces. A couple years later, that should reach one million ounces.
Is now the time to be sextupling down?
CD: Commodity cycles are different from cycles in industries like semiconductors. To bring mining capacity on line can take 10 years, so it takes time for supply to catch up with demand. As a result, commodity cycles typically run for as many as 20 years. With gold on an upward trajectory for only four or five years, we think we’re early in the cycle. In addition, there has been a substantial increase in investor demand for commodities to use as hedges against geopolitical unrest, a trend we don’t see slowing anytime soon.
Yamana’s operating management consists of long-time Brazilian industry veterans, who know the country, the culture, the politics and the labor force. They’ve been very strong operators, showing the ability to increase production efficiently and quickly from acquired mines and also to build their own new mines, which is another skill entirely.
DN: In the mining business, as a broad generalization, there are some companies driven by operators and some driven by financiers. Yamana’s CEO, Peter Marrone, has surrounded himself with a great operating team, while as a former miningindustry attorney and investment banker he also knows how to talk to the Street and keep the company well funded. His background is perfect for the role.
The stock, recently at $9.70, is up five-fold in the past two years. Why do you think there’s more room to run?
CD: The company is marginally profitable right now, but as production ramps up we expect a significant increase in free cash flow, to a normalized level of around $1 per share by 2008. So the stock trades at only about 10x that normalized number. One reason is that the market seems to be taking a wait-and-see approach to the huge Chapada mine that is planned to start production later this year. A lot of things can go wrong in bringing a mine on line, so people want to wait until it is producing before the skepticism recedes and the assets get valued more appropriately.
Another issue is that Yamana continues to be valued as a junior gold producer, which typically trade at a discount to the 15x cash flow that intermediate gold producers – producing around 400,000 ounces per year – tend to trade. As production takes off, we expect that valuation gap to narrow and Yamana to justify a 15x multiple on the $1 in free cash flow we expect them to earn. As production grows further to the one million ounces we expect, you’re likely to see a share price north of $20.
What are the biggest risks?
DN: There’s obvious execution risk for a company increasing its production so fast. You’ve also got the volatility of what the Canadian dollar does against the U.S. dollar, what the Brazilian real does against the Canadian and U.S. dollars, and what happens to the value of gold and copper.
But with a long enough time horizon and a strong stomach for the volatility, we’re happy to accept all those short-term risks to partner with the management team at Yamana.