Published January 14, 2013

Yellow Metal’s Blue Chips Are Greener Than You Think

Dear Reader,

Many readers have expressed concerns about press reports on how rising costs are eating miners' lunches. Sentiment is so bearish, some companies have delivered great news to the market in recent months only to see share prices fall anyway.

This is great news for contrarians, who – made of stronger stuff – are happy to buy when the faint of heart flee the field. But what is the reality of gold mining today? Is the business really as bad as so many investors seem to think?

Your metals mining team has had a look at the numbers and reports its findings below. Quick version: we're still buyers.


Louis James
Senior Metals Investment Strategist
Casey Research

Rock & Stock Stats
One Month Ago
One Year Ago
Gold 1,678.00 1,709.60 1,639.60
Silver 30.92 32.96 29.89
Copper 3.71 3.68 3.55
Oil 94.27 85.79 101.09
Gold Producers (GDX) 45.40 46.28 54.31
Gold Junior Stocks (GDXJ) 20.20 21.25 26.60
Silver Stocks (SIL) 22.41 22.96 22.55
TSX (Toronto Stock Exchange) 12,602.18 12,282.36 12,260.94
TSX Venture 1,240.25 1,183.93 1,531.12

Yellow Metal's Blue Chips Are Greener Than You Think

By Alena Mikhan, Casey Metals Team Researcher, and Andrey Dashkov, Research Analyst

Disenchanted with gold's lackadaisical performance over the last year, some investors are losing interest in the equities that are supposed to provide leverage to the metal's price movements. The press has added fuel to the fire by increasingly attacking gold-mining CEOs for rising production costs and weak stock prices. This has driven some investors to pursue ETFs or other vehicles as a replacement for gold stocks, while others have simply thrown their hands up and left the precious-metals space. Is this overreaction or rational decision-making?

In this article, we set out to objectively evaluate how gold-mining majors have been performing operationally in the current commodity bull market that started roughly at the beginning of 2002. We compare them against the S&P 500 – the mainstream "blue chip" index – to see if gold miners deserve the beating they've received. We also look at what may lie ahead for one of our favorite subsectors of the gold universe.

Size Matters

The market capitalization of the major producers has grown at an impressive rate since 2002, as the following chart shows. What may be surprising to some investors is how well it has tracked the gold price – and how strongly it has outperformed the S&P.

(Click on image to enlarge)

The total market capitalization of our select group of companies has grown, for the most part, in proportion to the gold price since 2002: 358.3% and 453.9% respectively as of December 31, 2012. It's interesting that growth of the majors slowed in 2011, but was actually outperforming gold itself until then. Even so, it left the S&P 500 far behind, which expanded by only 51.3%.

The majors we use for our data in this article include the following companies: AngloGold Ashanti, Barrick Gold, Eldorado Gold, Gold Fields, Goldcorp, Kinross Gold, Newcrest Mining, Newmont Mining, Randgold Resources and Yamana Gold. These are the top ten largest gold producers that existed throughout the time period we examined.

The majors grew both organically, via increased production from existing operations, and from mergers and acquisitions.

So why have share prices languished recently? Growth in market cap did not necessarily translate into share price gains on a one-to-one basis because producers diluted their capital structures at the same time; more market capitalization, but also a lot more stock. In spite of this and other factors, stocks of the largest gold majors have advanced an average of 331.1% through the same period – less than 358.3%, but not that much less.

Another issue that has bothered investors has been that the majors have not been very good at generating cash for shareholders…

Free Cash Flow: The Mystical Beast

Although shares of mining majors have delivered outstanding gains for those who bought early into the current cycle – Eldorado Gold, for example, appreciated from C$0.91 to C$12.80 as of December 31, 2012, a whopping 1,306.6% gain – share price is just the tip of the iceberg when it comes to performance analysis. One of the metrics that provides insight into a company's inner workings, as discussed by Gold Field's CEO Nick Holland in his excellent Melbourne Mining Club address, is free cash flow (FCF).

Free cash flow is basically what is left after a company deducts capital expenditures (which are necessary to maintain growth) from its operating cash flow. It is the cash available for distribution to the company's shareholders. This parameter is often used as a performance metric along with net income (which we'll look at in a moment). Some analysts consider these two measures as the ultimate health barometers for producing companies.

We compiled the next chart to see how free cash flow margin (FCFM) – measured by how much free cash flow is generated per dollar of revenue – has changed since 2002. As you can see, the changes in FCFM of the largest gold producers have been very volatile and don't paint the most optimistic picture at present. The data indicate that we are now in one of the toughest periods for generating free cash flow – even worse than 2008, which is saying something.

(Click on image to enlarge)

The S&P 500 looks much more stable in this regard, though there's been almost no growth.

Negative free cash flow is not bad in and of itself. It could be a sign that a company is making large investments – constructing a mine, for example – that may pay off in the long term. Gold mining requires significant capital inflows to maintain existing operations and to develop or purchase new assets to make up for reserve depletion – every day a miner operates, its asset base shrinks. In contrast, when Apple launches a new product or even just updates the current line, it doesn't necessarily have to build a separate plant and new infrastructure for it. A certain amount of initial investment would certainly be needed to conduct proper R&D and design and then tune the production process to meet the needs of the new technology, but this is hardly comparable to the start-up expenses and regulatory hurdles gold majors run into when developing a project like, say, Barrick's Pascua-Lama.

Another performance metric relevant to shareholders is dividends. While FCF shows how much cash can potentially be allocated to dividends, dividend yield measures the actual payout. As a reminder, dividend yield is the ratio of a company's dividend per share to its share price.

As the next chart shows, dividend yields of the gold majors have not been that bad at all. Since 2010, they have grown at an impressive rate and are on track to close the gap with S&P 500 companies, though the median dividend yield of that group has remained higher during the whole commodity cycle that started in 2002 – definitely a gripe for some mining investors.

(Click on image to enlarge)

Net Income Growth Rates: Breathtaking

To deliver for investors who seek not only stock-price appreciation but also a share of the company's income, gold miners need to manage their bottom lines more effectively, including a focus on delivering strong yields. So let's have a look at the most traditional performance parameter: net income.

In terms of normalized net income (NNI is post-tax income less unusual items), the industry's largest gold miners have made tremendous progress. Their combined NNI has skyrocketed since the current commodity cycle began.

(Click on image to enlarge)

The current weakness in the gold price has kept a lid on net incomes, but the growth rate remains far above those delivered by the S&P 500 companies.

The real eye-opening data point, however, is revealed when one examines margins. Although net income growth is impressive, margins tell a more complete story, especially now when mining companies face stubbornly rising costs. Measured by normalized net income margin (NNI/total revenues), the average gold major became more profitable than the average S&P 500 company by the end of 2006, and has remained so ever since.

(Click on image to enlarge)

This is clearly a positive trend, and will likely continue given investor demands.

New Demands Are Driving Big Shifts

The most favorable time period for the gold price was between September 2007 and September 2011, where it nearly tripled – from around $680 an ounce to an all-time high of $1,920. The majors used that momentum to boost their production and buy up other assets – "growth at any cost" was the motto. Once the gold price leveled off, however, weakness in share prices set in hard, causing some investors to question if it was worth owning them at all. This brought into the spotlight issues that had been overlooked before, and now CEOs are now talking about cutting costs, focusing on profit margins, and becoming more investor-oriented. Among the companies that have announced cost-cutting plans or reviews of their capital projects are Barrick Gold (ABX), Kinross Gold (KGC), and Goldcorp (GG).

This is a good thing. Producers have had their hand slapped and hopefully will restore investor confidence in the sector.

Will It Make a Difference?

First, our research shows that gold companies overall are performing better than believed. They definitely have challenges to respond to, but the situation is not nearly as catastrophic as some in the media portray it.

Second, management teams are obviously not to blame for everything bad that has happened. The sector has had difficulties not only because of errors in strategic planning – humans do make mistakes – but also from factors CEOs can't control, including cost inflation, political risk, labor unrest, and tax increases. On the latter point, the definition of the word "windfall" seems to be rather loosely defined by politicians, and more often than not the media tend to equate it with "unfair." Unfortunately, a bull market creates not only opportunities to earn higher margins but also a risk that the local government might step in and take a bigger bite.

The bottom line for us is that gold miners are again becoming an ideal contrarian investment opportunity: companies continue generating income, in many cases are working on correcting their strategic errors, have stronger operational performance than generally believed, and yet their share prices remain depressed. Gold-mining majors have hurdles to overcome – who doesn't? – but their assets remain in place, as do their financial resources and experience... as does the global economic uncertainty that supports a continuing rise in the gold price.

Without ignoring the hurdles, we think the current anti-mining sentiment is to a large degree not grounded in sound fundamentals. Gold miners remain one of the most attractive equity investments you can make at this time. Of course, not all management teams will make the necessary adjustments, nor will all be successful. So, as Doug Casey has cautioned many times, it's important to be picky about which stocks you own. Find out which of them our own senior analyst fore the majors, Jeff Clark, thinks are the absolute best deals in this undervalued industry.

Gold and Silver HEADLINES

Mining Industry Achieves Average Annual Shareholder Returns of 18% Between 2001 and 2011 (Mining Weekly)

According to a report released by business strategy advisor The Boston Consulting Group, the global mining industry achieved an average total shareholder return (TSR) of 18% annually between 2001 and 2011. Rising commodity prices accounted for nearly 14%, while the remaining 4% was the result of a combination of production gains, margin expansion and contributions from cash flow.

"Even more remarkable was the decade-long yearly average TSR of the industry's top ten performers – a stunning 39%," the company said. Top-tier gold miner Randgold Resources is among these top-ten value creators.

The report examined 34 leading mining companies and calculated TSR as a product of multiple factors, including the combination of revenue growth and change in margins as an indicator of a company's improvement in fundamental value.

This echoes our analysis in the article above: the underlying performance of gold majors is better than believed.

Surging Chinese Gold Trades Buoy Shanghai Gold Exchange (Mineweb)

The Shanghai Gold Exchange (SGE) reported record trading volumes in its physical 99.99% gold contract. In the first four working days of the current year, a total of over 1.3 million ounces of gold were sold, up 8.3% from the same period last year. This increase is most likely inspired by Chinese New Year festivities that will take place in early February, a very favorable time for physical gold and gold ornaments and jewelry sales. Lower gold prices further stimulated buying ahead of the festival.

Infographic on Equity Financing for the Mining Sector (Visual Capitalist)

A new infographic from Visual Capitalist shows how private placements work. Check it out.

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