[miningmx.com] – I am a gold and precious metals analyst and portfolio manager. It’s what I do. I run a gold and precious metals fund. I have been doing this since 1994. It’s my life and my livelihood. Three things from this:
1. I feel half qualified to make some observations (okay, it’s a rant) about this industry.
2. I have a vested interest in the industry doing well, but selfishly I get really “excited’ when I see my livelihood threatened by serial mismanagement of the industry.
3. I get really sad when our industry does not learn from its mistakes.
As part of my value-add, for the other analysts out there I thought I’d make your lives easier by putting together a report template for Gold Company results and announcements:
• [insert company name] reported results today. Earnings fell by xx% and were below expectations by xx%.
• Production guidance was downgraded for 2013 by xx%.
• Capex and operating cost guidance for 2013 was increased by xx% and xx% respectively.
• [insert company name here] impaired it last major investment by $xx bn..as a result..
• The CEO and COO have been replaced.
• [insert company name here] is raising $xx bn for working capital and new investments.
• The recent recalculation of reserves has resulted in a xx% decrease in reserves and a xx% decrease in expected plant recoveries.
• NAV and target price decreased by xx% and xx% respectively.
• BUY.
This should save all analysts and fund managers like me a bit of time. Gauging from the last several quarterly reporting seasons, the template should work for 95% of Gold Companies. The BUY rating is a stab at the sell side, but more on that later.
I despair. I’m at wits end. I need a drink. Just when you think surely, it can’t get any worse, …after management replacements, recapitalisations, guidance downgrades, more guidance downgrades, more guidance downgrades on the old ones, strategic reviews, asset sales, exorcisms, ..it does get worse.
In my role I am constantly confronted with the reason why gold equities have underperformed the gold price. Obvious question, but I find myself shuffling nervously as I try and find something good to say. My answer has always been..It’s a bad business; gold’s not hard to find, costs follow price, management are for the most part delusional about what’s possible and what’s likely, the market implied cost of equity makes corporates think that its free money.
The only other business as bad as the gold business in resources, in my mind, is paper and pulp . overcompeted, overgeared, over capacity, falling market size, falling real prices etc….
The Gold Business has a lot to answer for as it has not faced many of these issues.
The Gold Price has compounded at near 15% since the low in 1999. It has increased +540% over the period. Since FTSE Global Gold Mines Index has increased a modest 190% (8% p.a.), and this is in round numbers at about twice the volatility of Gold. Almost unbelievable statistics, but not news to many.
So what’s wrong with the gold business?
As a first off in defence of some of the disappointment, the gold industry faces the following structural headwinds:
• Large high quality discoveries have been few and far between in the last 20 years.
• Existing “base load’ operations have become much more difficult as they have matured.
• Good skills have been increasing difficult and more expensive to come by as the resources industry emerged from 20 years in the doldrums.
• Sovereign risks, operating conditions and costs associated with these have deteriorated/changed significantly, by way of higher taxes and royalties, increased risks of nationalisation, local ownership/participation and operational disruption (to name a few).
• High input cost inflation, opex and capex.
These issues, amongst others, have made the mining business more difficult and expensive to operate. In some areas it has made operating efficiently near impossible, like South Africa, but this has been more the exception than the rule.
Gold ETFs
When the World Gold Council (WGC) proudly trotted out its gold ETF in the mid-2000’s as a means to drive gold demand few imagined just the impact these products would have.
Nine years later this ETF and many more like it have facilitated, encouraged and resulted in an enormous and highly efficient way to invest in physical gold. Something that was previously not easily possible.
Today gold and gold ETFs are almost synonymously interchangeable in the minds of investors, and widely owned both institutionally and by private investors alike.
Personally I think they are great. They have greatly helped re-legitimise gold in its rightful and important place as an institutional investment and asset class, something that has always existed pre and post the 1990’s.
Ironically, the WGC ETF was a producer initiative and few thought that gold ETF’s would have the impact on the gold equity business that they have. Gold ETF’s appear to have largely “cannibalised’ gold equity investments taking their status from the “go-to’ Gold Investment to a very peripheral investment in the minds of most gold investors.
The reason, for me is quite simple, Gold companies demonstrated a hopeless inability to turn a higher gold price into commensurately higher profits per share.
In addition, because they are more volatile (risky) investors went to physical gold in preference. In my mind, the switch away from gold equities did not need to happen and could have sustained a happy symbiotic co-existence if Gold companies made more money along the way.
So where has all the money gone?
Growth obsession
In the gold business this is not just an obsession, but a sickness. Until very recently there was not even a question about what to do with retained earnings and free cash flow that Gold Companies occasionally make.
They use it to try and find the next mine or to buy the next mine or fund the operating losses of mines not making money. Management seems to have forgotten that for equity investors there is more than one way to make returns on their investment. In the hands of investors, returns increase when the share price goes up, and if they received returns of capital. Imagine that!
And for those companies that do pay dividends, I’d suggest the point of departure when faced with the question (and it is a question) of what to do with retained earnings, should be “why should we not pay it all back to investors’ as opposed to “how little should we pay them to keep them happy’.
Tax issues/consequences aside, chances are that if you ask them for money at a later stage for an attractive business proposition they are likely to give it back to you. To this point Bloomberg shows that an aggregation of the largest North American listed Gold and Silver companies in the Philadelphia Gold and Silver Index forecasts that based on consensus numbers to have Free cash flow in 2013 and 2014 of -$6.7bn and -$1.7bn on comparable EBITDA of $28 and $33bn!
To be sure that means despite making operating margins (in accounting terms) of around $30bn p.a., the industry is still not making any money on a net basis…this after 13 years of 15% p.a. increases in the Gold price.
They are also not producing any more gold than they were. No wonder the gold shares are being ignored.
The other issue with respect to the growth “problem’ relates to the incessant need to get bigger (by any metric) that occupies most in the gold sector. It would appear to be a complete insult not to be seen to be designing for continual and significant growth in size as opposed to a focus on quality, profit and yield.
Almost without exception, gold companies will spend a significant, if not dominant portion of any presentation on growth. Herein lies the rub. Gold Fields Ltd. calculated back to 2005 that if the world’s top 10 producers grew their production at the rates they all communicated in 2005, their combined production should be 60% higher than it actually is today!
Two problems here…no doubt significant financial resources have been consumed chasing this growth, but again, all of these estimates were delusional, disingenuous in my view. Mining isn’t straight forward but it’s not a lottery either. This goes to my point on guidance later, how many times have they grown production collectively by 60% more than their own forecasts? I guess we all know the answer. This industry will never be believed until they start doing what they say.
The acquisition and impairment game – Now you see it now you don’t.
Not to single companies out, because there are many more examples, but Barrick Gold reported results for 2012 on 14 Feb 2013 (yes on Valentines Day). Most analysts comments were along the lines of “Result OK, guidance lower’…and as an aside, “they wrote down $3.8bn of their Equinox/Lumwana investment’.
Wow! That’s >10% of the size of their company.
Newmont recently impaired/wrote down $1.6bn for its Hope Bay acquisition, 7% of their company. Kinross incurred a $3.1bn write down on its Tasiast/Redback investment which amounts to 33% of the company’s current size.
Companies are obliged under accounting terms to write down assets if they are impaired, but in layman’s terms this means that any return on capital or return on equity calculation that the company or analyst calculates post a write down is wrong(!). It’s over-inflated.
Why? Because $8.5bn collective write down described above wasn’t monopoly money, shareholders actually paid for those acquisitions! This makes a complete mockery of all the returns management proliferates as “industry leading’ and “disciplined risk adjusted returns’ as one of the above told us at the Denver Gold Conference in September. Add all the impairments made back over the past 10 years and re-do the numbers! Different picture.
In 2009, Barrick issued 12.4% new shares to raise $4bn to buy back its hedge book. They applauded themselves at the time as the gold price continue to rise, but no one was held to account for putting in place such a ridiculous amount of hedging in the first place! Who paid for this? Shareholders.
Almost all of the large gold companies did similar things around this time at great expense, but again it was just a footnote to proceedings instead of being highlighted as a serious issue.
Expectations management and guidance – Welcome to Cloud Cuckooland
This for me is 50% of the problem. The gold industry is absolutely shocking at managing expectations almost without exception despite the fact that failure to do so always ends in tears.
Everyone knows that if you promise your kid a bike for Christmas on 25 December and you don’t get him one, he’s going to cry his eyes out and ask some serious questions about your integrity. So, don’t do it.
Expectation management is so key in this game. Some of my rules of thumb in this regard for corporate management:
1. Guidance must be attainable, not 2% of the time, at least 50%…..driving with the review mirror is a healthy sanity check. Chances are if you only produced 80k oz last year you are unlikely to produce 110k oz this year! There is a good correlation between companies that “have high multiples’ and those that regularly deliver on guidance.
2. Conversely, if you have to stretch guidance to a make something meet a hurdle rate/sound acceptable/sound attractive, you probably should not be doing it in the first place. The planets only align very seldom, that’s why everyone runs outside to see an eclipse; it’s a rare event.
Mining the market vs running a mining company – Welcome to the Cocktail circuit
The CEO of a +$1bn gold company with serious operational issues recently told me, he goes to see his operations about once a quarter, but he goes to more than four conferences around the world every quarter to talk to analysts, investors and prospective investors.
Surely the process of making money/running a business with which you are entrusted by shareholders is more important than telling people about it. The cart is in front of the horse somehow.
To me, for too long, gold company executives, have made a living out of spending all of their time marketing and telling people what their share prices should be as opposed to making good returns, providing people with the information, and letting the market figure it out. History shows, that those that companies that make good returns get the share price they deserve. It’s causal!
Obviously shareholder communication is very important, but get the balance right.
Capital Structure/Cost of Capital – Free Money
For me there are several issues in this topic that need addressing and they are complex and subjective, but appear to mostly be the result of one unique phenomena that has long characterised gold companies known as the “Gold Premium’. More on that later. But first some comments.
The simple rules of value creation, return on capital and or economic value added (EVA) are:
• Be sure that your investments make more money than they cost(!)
• Be sure that the return your investments make is greater than the cost of the capital used to make the returns.
• If you make only your invested capital back, you lost money, because you could have got more in the bank.
• If you make your invested capital back plus enough to cover the cost of the capital, you have made or lost no value. On a risk adjusted basis, the same as having your money in the bank.
• If you made back your invested capital plus more than the cost of the capital used in the investment then (and only then) have you added any value..on a per share basis for public companies.
Apologies, this sounds very basic. But the actual understanding and application of these principles is very hard to find in the gold sector.
One of the major issues I find is that very few corporates spend time understanding or know what their marginal cost of capital is. Given the very high use of and dependence on equity capital it would seem that most executives in the gold sector think is very low or even zero.
Back to the issue on the “Gold Premium’.
This issue relates to the fact that using flat or declining long-term real gold prices as valuation assumptions for Gold Companies, they historically traded at very low implied discount rates (5% real or lower).
The reason it’s problematic in my mind, is that it has actually led management and analysts in many cases to believe that their cost of equity is basically close to zero. Here’s an example of how this becomes dangerous:
Recently a prominent North American Silver and gold royalty company announced the acquisition of a gold two separate gold streams from Vale for a combined value of around $2,03bn, of which $1.9bn is cash.
I calculated that using a $1,700/oz spot gold price increasing by around 2% p.a. (the slope of the Gold forward curve) over +25 years, that my best case production scenario was an IRR of around 7,5%.
The deal was around 16% of the current size of the company and would extend the company’s debt position significantly, so a very material transaction. Using pretty standard methods I calculated the company’s cost of capital at 7-9%, so a marginal transaction from a theoretical “value accretive/value destructive’ perspective.
Stressing the gold price and production within normal bounds easily took my IRR to 5.4%. Management was incensed by the notion that this looked to be a marginal deal. “it was a competitive process’ I was told (i.e. there were other bidders), “these are world class assets’.
Asked what they thought their cost of capital was, I was told “way below 5%, all analysts use these numbers’. Enough said.
Save to say the share price went no where, which seemed to confirm that the deal was neither hugely accretive nor dilutive, but I found the discussion very instructive.
I am afraid that I battle to take seriously anyone running a public mining company that thinks their cost of equity or cost of capital is 5% or less let alone uses this as a return hurdle rate for a mining project.
Even though mining royalty deals are much lower risk than mining project returns, I would think that unless a project on paper had a return of 10% or more over the cost of capital using conservative commodity price inputs, it should not be contemplated.
Why? Because implementation costs most always increase, so times significantly and there are almost always hidden and unbudgeted costs that eventuate. Also, metal prices go down sometimes (really), so having a large safety margin isn’t a luxury but a requirement.
Alcoholics Anonymous – “Hi, my name’s GoldCo..’
In terms of the realisation that investors will only reward companies that actually add value on a per share basis, amongst Gold company executives, I find broadly three groups:
• Those still drinking the pub (at a mining conference) – these are the ones who pursue growth “at any cost’, have little if any regard or understanding of their cost of capital, hurdle rates and returns to shareholders.
They firmly believe that their company share prices will appreciate if they grow the size of the business irrespective of the returns it generates. For me, they are the problem that pervades the industry and are firmly in the denial phase.
You can identify them by the ones that take gross exception to any suggestion that they don’t pay enough attention to return. Or cannot compute the math to support their claims of value add. They’ll say things like “the combination of our companies takes our market cap to $xxbn and get us a re-rating’.
• There are those that realise they have a problem, are going to the group meetings and find relief from talking about their problems. There are several senior Gold companies entering this camp.
A gold company CEO recently remarked during his presentation at the Denver Gold Conference in September 2013 that the industry’s new found obsession with maximising value to shareholders and paying dividends was “like a newfound religion’…’a Jerry Maguire moment’.
Although several of them are talking the talk, unfortunately not many of them are walking the walk just yet, including the aforementioned CEO’s company. Actually, he’s just taken a new job down the road.
• There are a couple (literally) that get it. They are either totally reformed or have always been tee-totallers. There are very few in this camp and even they are prone to the occasional drink.
These companies are generally characterised by slow steady growth, very lean capital structures with moderate use of debt, very low levels of increase in shares in issue over time and more importantly strong share price performances.
Normally when you try to reach between reporting periods them they are at their operations and may be irritated by your interruption. They have different priorities that revolve around running their businesses.
A quote from Randgold Resources’ Mark Bristow, which is our minds one of the better examples to follow in the sector is:
“It’s not about the size of your production, but about the value you create’. Sounds obvious, but that approach is almost absent from the gold sector.
The Jerry Maguire moment
A gold company I follow recently completed a strategic review following the appointment of a new CEO and CFO in the last year (this narrows it down to about 10 of the top 15 gold companies globally).
They have also had a large merger/acquisition in the last two years (this narrows it down to about 50% of the top 30 gold companies globally) and have had problematic operations in the past two years (this narrows it down to about 90% of the top 30 gold companies globally). Following the strategic review they proudly pronounced that from now on the company would be run along the following lines:
• Focus on value, by
• Maximizing free cash flow
• Maximizing portfolio value
• Returning value to shareholders
• Minimizing project risk
!!!!
Amazing. I asked “does this imply these were not the principles on which the company was previously run?’. I applaud them for this value set, and honestly believe they will do a better job than the previous management, but honestly this could have come from a 101 finance text book. Any public business should without question be run along these lines. But, unfortunately in many cases the answer to my question is “yes’.
Accounting – lunatics, asylums and all that
10 years ago I was invited onto an advisory panel for the International Accounting Standards Board led by a well known audit firm to “aid’ in their mission to broadly try and accomplish three things in the basic materials accounting practises:
1. Converge reporting standards of Oil and Gas and Mining companies globally,
2. Converge reporting standards of US and non-US companies in the basic materials sector,
But more fundamentally,
3. Propose a move towards full fair value accounting, which for mining businesses would mean a full mark-to-market of reserves and resources at least annually.
To this day I cannot for the life of me understand how this will improve investors understanding of the value of financial position of a company, especially private investors. As far as I know this still has not been “enacted’ but further highlighted to me that, they way resource companies are representing finances and financial performances to investors, was being taken an additional step away from reality.
Fortunately it was creating all sorts of additional work for audit firms that mining companies would be obliged to comply with and pay for…..
A step back from here is until about 1999 most South African mining companies reported according to an “antiquated’ and “thoroughly out-dated’ (note sarcastic tone) accounting system that was essentially based on the principles of cash flow accounting.
This required companies to report and expense most all cash flow items in any given period that they occurred. Fortunately the tax system was broadly aligned with this form of accounting. The downside to this is that….uuuuum, it was really cheap and easy to audit(?!).
The upside was that, it was easy to understand, and more importantly plain to see whether your mining investment was in fact making any money or not, what its actual cost of production was and a direct correlation between Profit After Tax (PAT) and whether the company was actually making any money.
I over simplify, but more importantly appropriation accounting (as it was known) was not based on the principle of accrual accounting or the assumption of the said business being a going concern.
A mine is not a going concern, it has a defined mineral inventory (at any one time) and it will be depleted in time. In my mind, a mining company is not a going concern either, but an aggregation of “depleting’ assets. We seem to have forgotten that somewhere along the way.
My point of the above rant of “how to win friends and influence people in the accounting profession’ is two-fold:
1. With modern accounting standards it’s often hard to decipher whether a company is in fact making any money let alone figure out where it is making an acceptable return on capital. In my mind, this has definitely also confused corporate executives along the way and changed the way they run their businesses.
2. For some reason this whole notion of treating depleting assets as going concerns has somehow compelled mining company management to re-invest most all of the money they may make in the hope of finding the next deposit or buying another asset..the pursuit of growth. This in combination with a couple of other unique circumstances in the gold business has, in my mind, made for a vicious cocktail of value destruction. More on that later.
The Sell-side – Between a rock and a hard place.
Having been a sell side analyst for nine years I understand the dynamic for sell-side analysts. It’s not an easy job trying to manage the conflict that exists in investment banks between research and the advisory side of the business.
For those unfamiliar with this it means the investment research and recommendations given by broking analysts are almost always compromised with a positive bias, why?
Firstly because gold companies feed analysts with delusional guidance, but more importantly because if you said anything about a company you research that was anything but neutral to positive, the chances of your company participating in the next capital raising or advisory fee is effectively zero.
More to the point, you could lose your job as happened to a very good analyst and friend of mine in the space last year.
This effectively ends up enforcing the delusional guidance that companies supply, because rather than say anything negative about company guidance, valuation or stock price forecast, they say nothing.
Fortunately most professional investors understand this dynamic well, but it still skews the outcome negatively. This dynamic will not change until or if sell-side research as a business is separated from Investment banking in the same way consulting and audit firms were forced to do more than a decade ago.
The way forward – NCE/Total (total) costs, a touch of reality
There are several things that need to happen, and I fear it will take time and have many more casualties along the way, but much to his credit, Nick Holland and the Gold Fields team along with the help of some able bodied analysts at JP Morgan have started somewhat of a revolution in the gold industry.
A sort of support group if you like. Much like my friend, Martin Murenbeeld, who in the late 90’s was considered the lunatic fringe because of his gold price views (most of which have proven correct for the right reasons), Nick has espoused the need for, and designed a new gold production cost reporting format.
Scoffed at by other senior gold miners initially, the methodology tries to take account of all of the cash costs associated with extraction.sound familiar?….much like the appropriate accounting of old.
Nick’s point is that by “misleading investors and governments’ that operating costs (according to accounting standards) are much lower than the holistic cost of extraction several things have happened:
• Investors have rightly asked, if your costs are $800/oz, where’s the other $850/oz gone? You should be making a lot more money.
• And governments the world over have used this as a reason to increase taxes and royalties.
Gold Fields uses this internally as a means to benchmark operations and target returns on a total cost basis. I see many of the other senior companies are starting to do similar things, which is, in my mind, a step in the right direction.
This sector is in real trouble and unfortunately I don’t see the panic yet. In the absence of another 13 years of 15% p.a. gold price increase, the sector risks being relegated (back) to obscurity. The gold sector needs a big re-think. Investors are battling to take the sector seriously in the positive gold price environment, let alone any other scenario.
The gold sector needs a breed of company executives who can put the horse back in front of the cart.
We need a breed of management who are realistic about what their assets can deliver.
We need a breed of management that will not pay over the odds for assets and use disciplined and sufficiently onerous return hurdles for any new business consideration.
I know you don’t want me to say it but the oracle of Omaha teaches us something here. Focus on the business and only the business. Focus on real value creation in the old traditional sense. Let the results speak for themselves ….. that’s the best form of marketing.
Brenton Saunders is a director of Taurus Funds Management
