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ATON - Russian Gold miners - Jun 28, 2012, Introduction.

RUSSIAN GOLD MINERS

Gleam at $1,650/oz and Fade Away at $1,400/oz

In this report, we revisit our investment case for Polyus Gold, Polymetal, Petropavlovsk, Highland Gold Mining and High River Gold. We also add Nord Gold to our coverage. The call we made in RUSSIAN GOLD MINERS: Short Gold, Long Gold Miners (released 5 Oct 2011) proved correct until the beginning of Feb 2012: by that time, most of the names under coverage had shown a solid performance: Petropavlovsk (39%), Polymetal (27%), Highland Gold (20%) and Polyus Gold (4%) all gained on a gold price rise of 5%. The picture started to look ugly in mid-March when investors, spooked by the outcome of the Duma and presidential elections, started to dump Russian equities, including gold miners.

(To view the full document, please click on the link below:

http://reports.aiidatapro.com/brokers/AtonEN/28062012_RUSSIAN_GOLD_MINERS.pdf)

Gold miners should remain under pressure. The XAU Index/Gold ratio has now broken 10, exceeding its previous historical high of 9.0 (recorded in Oct 2008 when the last economic crisis hit), and far above 4.5, the ratio's average since 1984. A seemingly unstoppable wave of negative news from Europe is putting pressure on all risky assets, including gold mining stocks. Risk reduction driven by softening gold prices may push gold mining equities down even further, in our view.

Super-growth seen in 2008-11 at an end; long-term trend yet to be revealed. Recent gold price movements may suggest that investors have lost their passion for the yellow metal. While we doubt that gold has lost its appeal to investors, we think the explosive price growth of 2008-11 was unjustified and further softening can be expected. How far gold may fall is dependent on the world financial system's liquidity situation. We believe that money printing is the primary gold price driver: over the past 10 years, gold demand has increased by only 30%, while the gold price has increased by 5x. We think that another round of quantitative easing could bring the current gold price correction to a

halt.

Higher WACC estimates are justified. Our previous WACC assumptions ranged from 9.6% for Polymetal to 10% for High River Gold. This was lower than the 11.2-11.4% we employed for steel companies, reflecting the defensive nature of gold mining stocks. Nowadays, given the risk to the gold price, gold miners no longer provide protection on the downside. Furthermore, we believe a higher WACC assumption is stipulated by the heightened risk perception of the Russian market. Our new WACC estimates range from 11.2% for Petropavlovsk to 12.5% for Highland Gold.

Based on our mid-term gold price estimate of $1,650/oz, all of our companies are rated BUYs with the exception of Polymetal and Polyus Gold (HOLD). However, all of the shares would become HOLDs at $1,400/oz (our long-term price estimate), which is only 15% below the current price. Given our gold price assumption and increased WACCs, we view Polymetal and Polyus Gold as fairly valued. Both companies now have LSE premium listings and we see no further catalysts for their stocks. Petropavlovsk, Highland Gold, High River Gold and Nord Gold trade at significant discounts to peers, which in some cases are justified, in our view. We expect this status quo to be maintained for quite a while as see no catalysts that would allow the undervalued companies to catch up. We also see downside risks for the price of gold, which could put further pressure on gold miner equities.

Investment Summary

Our Cybuy gold miners, short gold' call was short lived. The call we made in our last report RUSSIAN GOLD MINERS: Short Gold, Long Gold Miners (released 5 Oct 2011) proved to be correct until the beginning of Feb 2012: by that time, the shares of the gold names under our coverage had demonstrated a solid performance: Petropavlovsk (39%), Polymetal (27%), Highland Gold Mining (20%) and Polyus Gold (4%) all gained on the back of a gold price rise of 5%. (High River Gold was the only exception, declining 3%).

Unfortunately, the picture started to look ugly in mid-March when investors, spooked by the outcome of the Duma and presidential elections, started to dump Russian equities, including gold miners. Later on, negative news from Europe took its toll. We believe that gold mining companies will continue to be undervalued vs the gold price for at least the near term. After breaking 10 (its absolute historical high), the XAU Index/Gold ratio is now slightly below that level. The picture resembles what we saw in Oct 2011, when gold miners started to outperform. However, that event was short lived and a sharp reversal has now followed. We are afraid this may happen again with the catalyst coming from Europe in the form of debt problems in Spain, Italy or Greece.

Gold's super-growth trend of 2008-11 is over, but long-term trend intact

It seems that investors have either lost the passion for the yellow metal they displayed in 2008-11 or they are now reassessing the risks and challenges of the world economy before plunging into another gold super-rally.

The direction of gold price movements will largely depend on the resolution of the European crisis and further stimulus measures taken by the world's central banks. Many investors expect another round of quantitative easing (QE) by the US Fed aimed at keeping the nation's economy out of recession. If implemented, this could help to boost commodity prices, including gold. However, we believe this would be short lived as the experience of previous QE demonstrates that fundamental problems have not been resolved. Unemployment is still high, external debt is rising and consumer sentiment remains sour. But the main problems are still coming from Europe. A eurozone collapse is the worst-case scenario and it cannot be ruled out. The debt situation with Greece, Spain and Italy is aggravated by worsening economic conditions in Germany and France, the pillars of the euro economy. Investors are reducing exposure not only to risky equities, but also to gold, the universal safe haven. It looks like cash, namely the US dollar, is the optimal asset nowadays.

We use forward price curves for 2012-15 price assumptions with long-term prices taken from analyst consensus provided by Bloomberg: $1,400/oz for gold, $22.5/oz for silver and $7,083/t for copper.

We raise our WACC to account for higher equity risk. Our previous WACC assumptions for the companies ranged from 9.6% for Polymetal to 10% for High River Gold. This was lower than the 11.2-11.4% we use for steel companies to account for the defensive nature of gold mining stocks. Nowadays, when there is downside risk for the gold price, gold miners do not provide protection on the downside, in our view. Furthermore, a higher WACC assumption is stipulated by the heightened risk perception towards the Russian market. Therefore our new WACC assumptions range from 11.2% for Petropavlovsk to 12.5% for Highland Gold.

We maintain our BUY rating on Petropavlovsk, Highland Gold, and High River Gold and assign a BUY to Nord Gold. We maintain our HOLD ratings on Polyus Gold International and Polymetal. We prefer not to indicate a top pick as we see further downside risk for the gold price, which could send gold mining sector stocks further down.

Nord Gold: good assets and ambitious plans, but a positive track record is needed. We add Nord Gold to our coverage with a BUY rating and a price target of $6.8/share. Nord Gold is a relatively new company established by the spinoff of the gold mining segment of Severstal. Nord Gold represents a set of gold mining businesses in Russia, West Africa and Kazakhstan which were accumulated through a series of successful M&A activities. In 2011 Nord Gold produced 755koz of gold which implied 28% YoY growth. This year the company expects to produce 800- 850koz of gold and reach the 1mnoz level in 2013. This would imply a CAGR of almost 20% in 2010-13. This is solid production growth in our view, on par with Polymetal and higher than the 11% growth for Polyus Gold and 17% for Petropavlovsk (based on our estimates). We think a good production growth track record is what investors expect from the company. The company's substantial reserve base of relatively highquality ore should help it to match investors' expectations, in our view.

Highland Gold (HGM): no mid-term growth. We do not expect a strong operating performance from the company in the coming years as Highland Gold will not have any growth projects until 2016 when the Taseevskoye deposit is set to be

commissioned. Until then we expect production to level off at 215-230koz per year. We think this may explain why Barrick Gold decided to sell its stake in the company, as it does not represent a mid-term growth story. On 26 Apr (source: Interfax), Barrick announced that it had sold its entire 20% stake in HGM to several portfolio investors, including JP Morgan and Prosperity, for 120 pence per share ($1.94/share or 9% below the previous day's closing price) . Nevertheless, Highland Gold remains one of the most undervalued gold miners, in our view, with a strong balance sheet and a relatively good reserve base. HGM remains the lowest cash-cost producer among the companies under our coverage with average cash costs of $594/oz in 2011 vs the industry average of $659/oz.

We have lowered our target price for Highland Gold from $3.3/share to $2.1 due to our higher WACC assumption and reduced price expectation for gold in 2012-15. Nevertheless, we maintain our BUY rating.

Petropavlovsk remains an underdog in terms of share price performance despite improved reporting. Since we published RUSSIAN GOLD MINERS: Short Gold, Buy Gold Miners (5 Oct 2011), the company's shares have lost 36% due to the sell-off on the Russian market, although there was a period of strong performance (5 Oct 2011 to 2 Feb 2012) where the shares gained 40% driven by strong reporting for 2011. Despite the evident improvement in management's reporting practices the company remains an underdog in terms of share price performance, suggesting that investors'

attitudes could remain negative for a while longer.

Nevertheless, under our new gold price assumption and increased WACC, Petropavlovsk remains significantly undervalued vs its peers. The company recently raised its start-of-year production guidance for 2012 from 680koz to 700koz following a series of improvements at its production sites, including the successful commissioning of the fourth production line at Pioneer and the second line at Albyn, both of which took place ahead of schedule. Nevertheless, we have reduced our 2012-13 production expectations by roughly 4% (our earlier estimates were too optimistic). Given our lower gold price forecast and increased WACC, we have cut our TP for Petropavlovsk to $8.7 from $14.8, although our rating remains a BUY.

High River Gold (HRG): TP trimmed to $1.47/share (from $1.60); BUY rating unchanged. Importantly, due to the difficult layout of ore bodies at two of HRG's mines in Buryatia (Zun-Holba and Irokinda), it is very difficult for the company to determine reliable gold reserve estimates. For this reason, the company's practice has been to determine if it has sufficient mining volumes (reserves) for two-to-three years and then simply process them. Originally, we highlighted the risk that HRG's Buryatia reserves were becoming depleted (we estimated a mine life of two-to-three years), but our expectation that production would end in 2013-14 now appears incorrect. HRG geologists now believe the mines could last for 30 years (in the bestcase scenario). To err on the conservative side, management has stated that it expects production in Buryatia to continue for the next 15 years. We therefore adjusted our production profile to account for a stable contribution from Buryatia until 2020.

HRG's shares have been relatively defensive lately, shedding only 4% since our last sector update, while the average decline for the six companies under coverage has reached 22%. This relative outperformance can be explained by the shares' low liquidity and the fact that most of the free float is consolidated by a group of investors that see HRG as undervalued and are ready to exchange their shares for Nord Gold's stock if the latter makes a good exchange offer. The company's revised near-term production estimates, our lower gold price assumption and higher WACC yield a target price of $1.47/share (down from $1.6), while our BUY rating remains unchanged.

Polymetal: with an LSE primary listing in hand, no short-term drivers remain. We reduce our target price for Polymetal to $14.7 (vs $17.7 previousl) primarily due to our higher WACC assumption. Our HOLD rating remains unchanged. Polymetal is the best mining company in Russia in terms of asset quality, corporate governance and management ability. Its recent LSE primary listing has exposed the company to a broader international investor base. At the same time, most of Polymetal's drivers have materialised and investor expectations are high. Any hint of underperformance could be taken negatively by investors, particularly in a highly volatile market.

Polyus Gold International: long road to LSE primary listing. Polyus Gold's road to an LSE listing has been a long one, extending through the purchase of KazakhGold and a series of intricate corporate actions. KazakhGold's assets are still within the group, although Polyus has signed a conditional agreement with the Assaubayev family's AltynGroup to sell its mining assets in Kazakhstan and Kyrgyzstan for $385mn (source: Interfax, 9 June). The agreement has a number of conditions attached which, based on earlier experience, carry a high risk of not being met. This suggests to us that Polyus will hold onto its Kazakh assets for some time. On 19 June, the company's shares started to trade under an LSE primary listing. We view this as a non-event for the company, given the muted reaction of investors. We have slightly reduced our production expectations for 2012 and 2013. Once again, our lower gold price forecast and elevated WACC assumptions have led us to reduce our price target, this time to $2.9/share ($3.5/share previously), with our HOLD rating unchanged.

Valuation Approach and Results

We value Russian gold companies by employing an NAV calculation along with a multiples-based approach comprising EV/S, EV/EBITDA, P/E and P/BV coefficients based on 2011E Bloomberg estimates. We assigned an 80% weight to our P/NAV valuation with the remaining 20% allocated to a multiples-based approach.

NAV Approach

The NAV calculation is a common approach and in our opinion the optimal way to value gold mining companies. A company's NAV is calculated by summing up the discounted cash flows (DCF) produced from each mine. This valuation method takes into account the cash flows over a mine's entire life and hence the size of its reserves/resources along with metallurgical recoveries and the initial and sustained capital required to build and operate the mine.

At the same time, NAV is by no means perfect. One of its drawbacks is the determination of an appropriate discount rate. Theoretically, a lower discount rate should be used for gold mines than for base metal companies. One reason is because according to the Capital Asset Pricing Model (CAPM), which calculates the discount rate, a negative beta should be used (the gold price has a negative correlation to the market). This effectively gives a discount rate for gold mining companies less than the risk-free rate, which logically should not be the case, as the gold mining business is a risky one. Below we provide our assumptions for the companies' NAV valuations:

- We use Bloomberg forward price curves for our price assumptions on gold, silver and copper for 2012-15 while our long-term assumptions have been left mostly unchanged: $1,400/oz for gold, $22.5/oz for silver and $7,083/tonne for copper

- We increased equity premiums to reflect a high-risk market environment, so the WACC assumption for the companies increased to 11.2-12.5% from the previous range of 9.2-9.5%

- We valued the companies at a P/NAV of 1x except for Polyus Gold International and Polymetal, which we valued at a P/NAV of 1.3x due to the sheer size of their reserves and asset quality

We provide the results of our NAV calculation for each company below.

Below we provide the results of our P/NAV and relative valuation approaches, which we applied in a proportion of 80% and 20%, respectively.

Gold Price Driven by Money Printing

Gold price looks too high to attract buyers. While the recent correction in the gold price has removed some overbuying, the latest demand statistics suggest that the metal is still too expensive for buyers, including retail investors, central banks and even speculators who buy gold through ETFs. Over the last two quarters demand for gold has shrunk from 1,226 tonnes in 3Q11 to 1,098 tonnes in 1Q12.

We believe the gold price has little if anything to do with demand: it is rather a function of money in the world system. We see no other explanation for the phenomenon seen over the last 10 years, when the gold price has grown by more

than 5x, while demand has increased only 30% (for most of this period eAE 2002-09 Co demand has remained stable at around 3,500 tonnes). We estimate that during this time, demand has been balanced by supply with roughly one-third of requirements satisfied by recycled gold, which means that less new gold was needed from miners.

Commodity prices have been driven primarily by the abundant liquidity that resulted from monetary easing by central banks globally. A relative comparison of the gold price with other precious metals like silver and platinum suggests that on average, gold has not been the sole object of investor passion. Cravings for silver and platinum have been followed by periods of gold frenzy, but on average since 1987 (as far back as our records extend) all three metals have remained at the same relative levels.

$1,200-$1,300/oz is a fair price for gold right now. We believe that the fair price of gold should currently be $1,200-$1,300/oz, as determined by a cash cost of production of $1,000/oz (for higher-end producers) and a reasonable profitability ratio of 20-30%. Given global inflation rates and the depletion of high-grade gold reserves, we estimate the long-term gold price at around $1,400/oz, a figure we employ in our valuations. As noted, we believe the gold price is primarily driven by the quantity of money in the world financial system, so any further stimulus measures, if implemented, would likely serve to keep the gold price at an artificially elevated level.

*****

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Publication:Russian Banks and Brokers Reports
Date:Jun 29, 2012
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