Too Big to Fail? A Review of Major Gold Producers
April 13, 2017
Could the constant need to demonstrate production growth to the market lead to the disappearance of some major gold producers? To answer this question, we researched nine representative companies. Fundamentally, most are in dire need of quality projects but lack the necessary grassroots exploration programs to find them.
Major gold producers, at their best, provide the market with the following attributes:
Portfolio diversification with multiple assets in various jurisdictions
Enhanced liquidity for institutional investors
Ability to generate economies of scale at regional or district levels
Financial capacity to fund large projects
Human resources with the technical ability to deliver various types of projects
At their worst, they are characterized by these:
Inability to show meaningful production growth
Weak returns on capital employed
Hubristic M&A transactions
Bureaucracy and inertia
A lightning-rod for NGOs and governments
I (Joe) spent most of my industry-related career working for large mining companies, including a couple of gold producers. At the end of my tenure, I began to question the rationale behind the existence of gold mining powerhouses in the face of the insatiable need to replace reserves at ever-higher rates. Could the constant need to demonstrate production growth to the market be the meteorite impact that would vanquish these "dinosaurs"?
To answer this question, we researched nine companies that provide a cross section of the major producers. We evaluated their share price performance, financials, and valuation to see how they impact the junior miners in the current market environment. We also tried to divine their near- and long-term sustainability based on 2016 production results, the quality of reserve bases, and exploration commitments. Fundamentally, most are in dire need of quality projects but lack the grassroots exploration programs to find them.
Most of these companies are based in North America and include Barrick Gold (ABX.T, ABX.NYSE), Newmont Mining (NEM.NYSE), Goldcorp (G.T, GG.NYSE), Agnico Eagle (AEM.T, AEM.NYSE), Kinross Gold (K.T, KGC.NYSE), Yamana Gold (YRI.T, AUY.NYSE), Eldorado Gold (ELD.T, EGO.NYSE), and IAMGOLD (IMG.T, IAG.NYSE). The only outlier is Australian-based Newcrest Mining (NCM.ASX, NCMGY.OTC).
[To keep things level, we measured their performance in U.S. dollars and used their U.S. stock tickers.]
The collective market capitalization of this group is US$85-90 billion, and together they hold over 360 million ounces of gold reserves. In 2016, they recorded over US$30 billion in revenue from the production of ~22 million ounces of gold or ~20% of global production. In Table 1, we provide a summary of our review.
The companies’ valuations and performances are covered by market capitalization, 2016 production, all-in sustaining cost (AISC), and share price performance versus the GDX benchmark in 2016, as well as free cash flow (FCF) yield and enterprise value per ounce of reserves (EV per oz).
We also dissect their reserve bases according to volume, grade, life, jurisdiction, and exposure to gold while reviewing their commitment to exploration. A company’s reserve base provides an indication of what it lacks, like low geopolitical risk gold assets, for example. Its exploration commitment or lack thereof gives us an idea of whether it will need to invest in junior explorers or prospect generators to add to its project pipeline.
Is bigger better now?
It appears investors find large dinosaurs appealing.
The benchmark for large producers (GDX) was up ~50% in 2016, outperforming the gold price by 5-6x during that period. Interestingly, the majority of the larger market capitalization companies (>US$10 billion) beat the GDX benchmark by ~15% on average, specifically the largest ones like ABX and NEM, (Fig. 1). The underperformance by GG (down 34%) weighed the average down.
Those with market capitalization lower than US$10 billion had a higher average outperformance (23%) thanks to IAG’s stellar run (+119%). However, not including IAG, they underperformed the benchmark by 9%. IAG’s anomaly was no doubt linked to the leveraged nature of its asset base—its 2016 AISC was US$1,057 per ounce, 20% above the average for the group.
How much is that dinosaur in the window?
Free cash flow (FCF) is a good way of measuring how much value a company generates through its asset base. The metric, which is derived from the company’s cash flow statement, is the amount of cash left over from its operations after accounting for investing activities.
Consistent, positive free cash flow generation provides a company the flexibility to pay dividends, buy back shares, service its debt obligations and/or build up its treasury to re-invest in its asset base or acquire others.
On the other hand, consecutive years of negative FCF would eventually drain a company’s working capital forcing it to raise funds through divestments, debt or equity. In addition, the inability to generate positive free cash flow may lead to a downgrade of the company’s debt, which would lead to higher interest payments due to the increased risk taken on by the debt holders.
Free cash flow yield is a method of measuring whether a company is relatively cheap or expensive. As an investor would typically want to pay the least for the most amount of free cash flow, a higher free cash flow yield is always more desirable.
Free cash flow yield = Free cash flow per share/Share price
[Free cash flow per share is derived from the company’s cash flow statement and normalized by the number of shares outstanding.]
Many of the major producers divested assets over the past year, which generated positive cash flow. These transactions fall in investing activities but are one-off events that are not sustainable so, in our opinion, a better measure would be to only consider the capital expenditures (growth + sustaining). Therefore, we also calculated the 2016 free cash flow yield of each company by netting out only the capital expenditure portion of the investing activity.
Take EGO for example. The company had a big swing from a negative free cash flow yield (when we only include the capital expenditures) to a large positive one once we incorporated the divestiture of its Chinese assets. The assets were sold in April and November 2016 to Chinese state-owned companies for gross proceeds of US$900 million. A similar trend of divestiture-related positive investing activity can be observed for NEM, ABX, AUY and IAG, (Fig. 2).
The average free cash flow yield is 4% if we only include capital expenditures (Fig. 2). Five companies exceeded the average including three large market capitalization companies (NEM, ABX, and NCMGY). KGC is volatile as other investing activities have dropped its FCF yield into the negative territory. Larger market cap companies that fell short include AEM and GG. Both appear to be relatively expensive.
All reserves are not created equal
We also focussed on enterprise value (EV) per ounce of reserve to measure how the market values the gold reserves of the selected companies. Most companies updated their reserves to the end of 2016 except GG and Australian-based NCMGY, whose reserves are to June 2016.
[Enterprise value is calculated by taking the market capitalization (share price*shares outstanding) and netting out the company’s cash and cash equivalent positions (we used working capital as it accounts for <1-year debt obligations) while adding long-term debt (>1-year).]
The average EV per ounce of reserve was US$225, with four (AEM, GG, ABX, and NEM) of the nine companies (all with market capitalizations over US$10 billion) exceeding it, (Fig. 3). Again, this suggests that the market is willing to pay a premium for ounces held by these larger companies. The exception is NCMGY, whose asset profile is focused on the Asia-Pacific region and its primary listing is in Australia.
We note that AEM, ABX, and NEM have an above average proportion of their gold reserves in Canada, U.S., and Australia. That is not the case for Goldcorp, which has less than a third of its gold reserves in these safer jurisdictions.
In the case of AEM, its reserve grade (2.13 g/t Au) is about 2x the average of the group hence the premium generated by its reserves (>US$500 per ounce), (Fig. 3 and 4). On average, gold grades improved for the group by 1% from 2015 to 2016, with the largest positive impact from NEM (+13% to 1.20 g/t Au), due in part to the divestiture of some of its lower grade assets.
Are year-on-year reserve declines becoming palatable to market?
Large economic gold deposits—those that fit the current criteria of double-digit returns at a gold price of US$1,200 per ounce or less and being targeted by majors—are very rare. Additionally, these projects tend to have many technical, execution, and financing risks due to the multi-billion-dollar upfront capital expenditures required and their high environmental impacts. They also take longer to permit, if ever.
As for smaller gold deposits, even though they have a higher probability of generating decent returns due in part to their smaller footprints and lower upfront capital requirements, they do not move the "growth needle" for large producers.
The decline of reserves for our group of selected major gold producers is not only due to the inability to add enough new ore but also to divestments of non-core assets. On average, reserves declined by 4%, (Fig. 5), with the largest decline (down 20-25%) attributed to EGO, predominantly related to the divestment of its Chinese operations.
Given the companies’ 2016 performance, it appears that investors are no longer overly concerned about a declining reserve profile if this leads to a higher quality core of assets with a better probability of generating returns in the current gold price environment.
Exploration is key to sustainable evolution
Barrick Gold is an excellent example of the potential evolutionary path of these endangered species. The company uses reserve prices of US$1,000 to 2020 and US$1,200 after that to ensure it can generate free cash flow in a volatile gold market.
It is focussed on five core assets (Goldstrike, Cortez, Pueblo Viejo, Lagunas Nortes, and Veladero) that are forecast to yield about 70% of its 2017 production at an AISC of US$650 to US$710 per ounce, 10% below the midpoint of its 2017 guidance for all its production.
We believe that the lack of quality assets (or those that work at US$1,000/oz Au) underpins the company’s forecast of an over 10% decline in its production profile from 2016 to 2019, (Fig. 6).
We have previously stated that the addition of quality assets depends on exploration. The group of major producers under consideration has spent on average about 3% of its revenue (~US$900 million) on exploration in 2016, (Fig. 7). We emphasize that much of the activity is linked to near-mine or brownfield, not grassroots, exploration.
Those with very low rates of exploration expenditure tend to have reserve lives of 15-20 years, making them less desperate (for example, NCMGY and AUY have significant porphyry copper-gold assets). But these assets tend to be low grade.
Survival of the fittest
A review of the performance of major gold producers in 2016 provided us a good snapshot of the state of companies that produced about ~20% of global gold production over that period. The points to consider include:
Share price returns indicate that gold producers with larger market capitalizations (>US$10 billion) can still outperform their benchmarks (ABX, +65%; NEM, +37%), meaning they are still alive and kicking.
Free cash flow yields from 2016 suggest that companies like NCMGY, NEM, and ABX are still good value (NCMGY, 6%; NEM, 7%; ABX, 9%) as they exceeded the average of their peer group (4%).
The EV per ounce valuations indicate that not all ounces are created equal. The market seemingly has no problem paying a significant premium (>US$500/oz vs. average US$255/oz) for AEM’s low-geopolitical-risk (65% in Canada and U.S.) high-grade (2x the average of its peer group) gold reserve base.
In the near term, investors also appear to be okay with the depleting reserve profiles of major producers—the selected group averaged a 4% year-on-year decline in 2016.
Overall, the 2016 results are not bad, especially for some large producers, but we think they may be unsustainable over the long term as companies will need to adapt constantly to a volatile gold price environment to survive. Not unlike the dinosaurs, it is not easy for these corporations to change course quickly.
An evolutionary path that leads them to a smaller core of assets that generate double-digit returns at current or lower gold prices should work, at least in theory. Divestment of non-core assets has proven easier than populating a high-quality project pipeline with new discoveries. We believe that companies without a significant global grassroots exploration program will need to invest in prospect generators and grassroot explorers to achieve this goal.
Our investment thesis is based on this assumption and informs our acquisition of companies with technically competent management teams and capital market experience exploring on district-scale land packages for high-grade deposits devoid of fatal flaws in mining friendly jurisdictions.