What analysts have been warning about for over a year now is finally here: when commodity prices fall below producers’ costs, operations will scale back and mines will close.
If that weren’t bad enough for holders of mining shares, producers are also planning to erase billions of dollars from their books in writedowns.
Yet when this slow motion train wreck finally comes to a stop, you might be surprised at what you find as you go rummaging through the debris. Once the writedowns are complete, we just may find some great buying opportunities.
Newcrest Pulls Out Its Eraser
Newcrest Mining Ltd. (ASX: NCM) will soon be making history – even if it is for all the wrong reasons – with its upcoming writedown of $5.5 billion, the largest one-time charge in gold mining ever.
$3.3 billion of that writedown will erase the goodwill overpayment it made when buying the Lihir, Papua New Guinea mine from Lihir Gold in 2010. As an added consequence of slumping gold prices, the workforce at Lihir will be scaled back by 150 workers, some 5 to 7%, in an effort to reduce costs.
Newcrest shares have already lost some 29% of their value since the company earlier this month announced the writedowns affecting properties in Papua New Guinea, West Africa, and Australia. With its market value falling $3.5 billion to $6.7 billion in just three weeks, the entire company is now worth less than the $9 billion it paid for the Lihir mine itself.
More Writedowns Ahead
This is one of the problems plaguing the gold sector in particular – ridiculously high costs incurred during an M&A frenzy totalling some $195 billion spanning a decade. The price paid for new mines and their reserves didn’t matter much when the gold price was steadily rising.
But with the price steadily falling, well, now it’s a different story. Including Newcrest’s writedown noted above, “gold companies will have written down assets by about $17 billion in the past 16 months,” Bloomberg data shows.
“What was encouraged as a capital allocation decision in early 2012 is now seen as a bad decision,” assesses Michael Elliott, mining sector leader for Ernst & Young LLP, in a Bloomberg interview. “It’s a very unforgiving change in the sentiment of the market.”
With gold currently some 33% off its 2011 high, the writedowns may have only just begun.
“We would expect that there would be several, if not many companies, who would also in the next reporting period be coming [out with] a list of impairments,” Elliott expects. “It’s just a question of timing, and who had the largest exposures.”
So who could be next? Any producer currently valuing its reserves using a gold price that is higher than today’s spot price. And that’s a lot.
Both Barrick Gold (NYSE: ABX) and Gold Fields (NYSE: GFI) value their properties using a gold price of $1,500 – some 17% higher than today’s spot price. Newmont Mining (NYSE: NEM) uses $1,400, which is 9.3% too high. Goldcorp (NYSE: GG) uses $1,350, or 5.5% too rich.
Oddly enough, Newcrest itself, despite the writedown noted above, uses one of the lowest prices in the industry at $1,250 for most of its reserves, which is below today’s spot gold price of about $1,280. However, it uses $1,400 for other properties in Indonesia and Papua New Guinea. Similarly, Barrick and Goldcorp each use more than one price for different operations, though you probably have to be a mining exec to understand why.
Harmony Gold Mining Co. (NYSE: HMY), which is partnered with Newcrest in the Papua New Guinea operation, announced it will write down its share of losses by the end of July.
Meanwhile, Kinross Gold (NYSE: KGC) has also announced a writedown of $720 million for Q2 on an Ecuador mine due to agreement complications with the local government.
Further writedowns are expected from a number of mine sales to be let go at below cost prices. Alacer Gold (TSX: ASR) will be selling two Australian mines citing high production costs, while Barrick is making arrangements to sell three of its mines, also in Australia.
“Everyone is going through this process in the gold mining industry at the moment,” Alacer Gold CEO, David Quinlivan, explained to Bloomberg. “Everyone is looking at how they [can] optimize their portfolio in terms of maximizing value.”
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Maximizing Our Own Portfolios
In this steady parade of writedowns – which usually ripple through the mining industry toward the end of each year or when markets take a turn for the worse – investors might be well advised to pull back and let the stocks fall first before picking them up again.
But once the tumbling stops, these miners will be leaner, trimmer, and fitter. Costs will have been reduced, and only their most profitable mines will be in operation. What is more, their properties will be valued using a much lower gold price than before, leaving room for upside gains should the price of gold rise.
Even so, some investors might not want to wait for the writedowns for fear they might miss a rebound. Though some believe gold prices can still fall further to $1,200 or even $1,000 before the present correction ends, others feel that a base is being built now near the $1,300 mark.
What is more, the majority of the large producers are still making globs of cash, even in the frayed state they are presently in.
“Miners are making money,” Rachel Benepe, manager of the $2.4 billion First Eagle Gold Fund, stressed to CNBC. To Benepe, the pressure on gold stocks is unfounded. “The negative bias has taken over and investors are ignoring the fundamentals,” she summarizes.
That cash flow stands only to improve from their tax-saving writedowns and trimming of operations. As Dan Denbow, manager of the $1.1 billion USAA Precious Metals and Minerals Fund, points out to CNBC, “Costs have abated. That should lead to better earnings and better returns.”
When selecting a miner stock, therefore, cash flow should be a leading criterion. Without a steady stream of incoming profit, even the most abundant reserves in the world are nothing more than good-looking rocks in the ground.
Not only does steady cash flow ensure steady production, it also ensures a steady dividend. “Owning the gold miners is like owning gold with a yield,” Benepe adds, “because the miners can provide a dividend.”
Goldcorp, with its yield currently at 2.54%, is well liked by analysts for just that reason. Denbow holds it as his fund’s top holding as of the end of May, noting it “has large capacity to generate free cash flow going forward and the ability to increase the dividend.”
Freeport-McMoRan Copper and Gold (NYSE: FCX) is another cash generator with a current yield of 4.6%. The miner reported net incomes of $3.1 billion in 2012, $4.5 billion in 2011, and $4.3 billion in 2010, enabling it to go on a recent buying spree.
Other notable dividend yields in the space include Barrick at 4.83%, Newmont at 4.82%, Kinross at 3.29%, Gold Fields at 3.19%, and Newcrest at 2.58%.
It may take a while longer before gold rises again and the U.S. dollar weakens under the weight of another 2 or 3 years of continued low interest rates. But if you picked the right miners – the ones with the better cash flows – you will likely be enjoying some attractive dividends while you wait.
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