Barrick Gold: A Hedge Against the Dollar and Inflation

Summary:

Barrick Gold (ABX) is trading at a premium relative to other miners at a P/E of 50, the reasons of which will be discussed in detail.

Despite my contradiction in holding low valuation investments, ABX is suitable as strictly a portfolio hedge against the weakening USD and expectations for inflation for 2009. My target price for ABX will be based on a target price for gold at somewhere between $1000 - $1200. This target price is based almost entirely on market valuation, not fundamentals.

The market valuation for gold will be determined by the anticipation/fear/prediction for global inflation in the weeks and months ahead. ABX therefore offers an attractive HEDGE for portfolios not insulated by these drastic price movements.

See disclosure at the end of the article.

Fundamental Analysis:

ABX has absolutely no cash flow issues, a problem encountered by other metal producers like TCK in Q4/08 and Q1/09. Barrick raised $750M US recently and has a low debt/equity.

The company is unique relative to other gold producers in that the market continues to prices ABX as if it has a large hedged position. This investment will therefore appeal to investors who want incomplete exposure to gold.

Gold producer valuation is measured differently than ETFs that track the price of gold. For example, a key measure for gold producers is the “cash cost”. This is the cash cost required to extract an ounce of gold. Gold producers also have a bi-product of other metals such as copper. Price fluctuation of copper is very volatile, and will add a "kick" to ABX shares relative to gold ETFs.

History:

When gold prices rose over the past few years, this hurt the company because the company did not benefit from rising prices. To rectify this, ABX wound down its hedging position. In fact, 4.1 million ounces of its contracts were converted to floating contracts. 5.4M ounces remain hedged. 133M ounces are unhedged reserves. In its Q1/09 conference call, ABX noted that it has the largest unhedged position by 48M ounce.

2009 Outlook:

Here is the latest outlook for ABX as provided by management in Q1/09 for the year:

• 7.2 million to 7.9 million ounces production
• Net cash cost of $360-$385 per ounce.

The latter figure is impressive, as illustrated by its various operations:

• Goldstrike – 400,000 oz @ total cash costs of $435 per ounce
• South American unit - 400,000 @ 291 per ounce

There are of course risks that need to be monitored as its other mines do not perform at the same level of low cash cost:

• Australian Pacific - 490,000 ounces @ 610 per ounce

Still, these projects total 2M ounces and have been in operation at a low cost per ounce for the previous 5 years.

Output for this year will be greater than last year. Since management provided only a one year guidance, I shall do the same. After all, I am unlikely to know more than the executives running the company.

Forecast:

ABX revenue and earnings are directly correlated to the price of gold (and to demand).

Since inflation/deflation is currently very difficult to predict at this time, I have no choice but to speculate market conditions over the next 10-year period. In effect, ABX belongs in a portfolio as a hedge against inflation.

10-Year Outlook:

Management provided an example on its conference call. If 7.5M ounces were sold over a 10-year period @ $1500/oz, this will result in $45 billion in revenue. Applying a profit margin of 9.60%, earnings would be $432M/year over the next 10 years. It is not the revenue that is the key for my forecasts. Rather, Barrick has sufficient gold reserves to continue operations for the next 10 years. For example, the Veladero project is a positive resource for the company, and continued success in its mining exploration will be viewed favorably by the market.

Recent Earnings Results:

Q1/2009 earnings were lower because of lower realized prices and higher cash costs. This is a concern for the short-term, but markets are ignoring this because the stock continues to trade on market volatility instead of at more reasonable company valuation. This is therefore a risk for those buying ABX on company fundamentals alone. Investors who are not holding gold stocks to hedge a portfolio are better served buying Goldcorp (GG).

Financial Sheet Analysis:

• Cash position: $2.1 billion
• Cash Position bye end of year: $1.4 billion
• Debt / total book = 0.27: 1
• PEG = 0.88
• P/E = 51
• Forward P/E = 20.77

Comments on balance sheet: With ample cash, ABX will be able to continue operations and explore new gold mine opportunities. While the trailing P/E is high, the company is expected to produce gold at a consistent level.

Analysis of Gold as Hedge Against Inflation or Deflation?

Management noted the following:

Gold has performed well in both high inflation and deflationary environments. In fact, between 1929 and 1938 in the Great Depression, gold was one of the few assets that actually held its store of value.

Foreign exchange reserves in central banks exceed $7 trillion, a $5 trillion increase since the start of the decade alone. And two-thirds of that is in US dollars and the largest proportion of that is held by only 16 countries and OPEC.

My Comments:

I would disagree that gold would hold its store of value in a deflationary environment. The US dollar will likely maintain its value relative to all other currencies. Gold trades INVERSE to the USD. Therefore, gold stocks are suitable as a hedge against a weak USD and against inflation.

Am I on the camp that the world will face inflation or deflation? I believe that either scenarios will play out, but market fluctuations will be significant. As a result, portfolios must have some exposure to both gold and silver (SLV, SLW). Value investors ought to consider silver and oil as hedge plays as they are better value than gold.

Conclusions:

Buy ABX as a hedge against the US dollar. Anticipate the possibility that gold bugs will dominate the market some time this year as the macroeconomic fundamentals dictate weakness in the US dollar. Do not get too happy should gold prices reach $1000-$1200. Unless inflation is an established certainty and the economy grows uncontrollably, take profits in ABX and other gold ETFs.

With gold at $960, a $1200 price represents a 25% return. Since the ratio of gold price to gold producer stock price is not 1:1, I assign a 4% - 25% range of return on ABX or $47.50.

Risks to target price: US dollar strength, lower gold price, gold production issues, deflation.

Disclosure: I have a long position on a portfolio on KaChing, a virtual community with over 350,000 registered users .Note also that my portfolio is being followed by over 300 users.

Comments

[Thomas J. G...:]

I dont' know why but gold mining stocks haven't done nearly as well as gold. gold mining stocks went down with everthing else in the big financial panic of q42008. gold mining stocks make a lot of sense to me. You get a productive companny making a product that is in demand and that seems better than just holding gold in a vault. but hard facts are gold mining stocks dropped 30-40% since sep 2008 whereas gold held around $900/oz. I think James Grant thinks gold stocks not keeping up with gold is irrational too and that someday we will be rewarded.

May 26 01:33 PM

[Market Sniper:]

Two points to make. Firstly, ABX, in the true sense of the word, is NOT a gold miner. They take over smaller operators, juniors and explorers with good prospects by making available capital (unavailable to smaller enities) secured by forward delievery contracts. ABX then takes advantage of periodic adverse market conditions to force their "partner" against the wall and then take them over for pennies on the dollar. Their takeover of Sutton Resources is one of the better examples of this. No doubt, ABX is a very well managed and capitalized company but I have a suspicion that they are operating under the DeBeers model. They realize that, eventually, gold will again be money and they wish to control as much of it as possible probably as THE dominate force in worldwide gold production. Secondly, why hedge the dollar, which is merely paper, with another paper investment which is stock? Buy ABX for the return, if you wish, NOT as a hedge. You hedge your downside risk in the dollar with ownership, under your direct control, of gold itself.

May 26 08:18 PM

[Mad Hedge F...:]

This is a great company. “There is room for bulls and bears, but pigs get slaughtered,” said Peter Munk, the legendary founder and CEO of Barrick Gold, the world’s largest gold producer. This is his admonition to worshipers of the barbaric relic hoping for a quick super spike to $2,000 or $5,000 an ounce. Since 2003 gold has tripled from $300 to $1,000, outperforming every asset class in every currency, and he has no problem with it backing and filling here in a long term uptrend. The fundamentals look great, as the world is running out of the yellow metal. The industry used to be run by demand from the Indian wedding season. The current economic stress has made the country a net exporter of gold for the first time. Global jewelry demand is at a 20 year low. With the help of satellites, the world is pretty well mapped out, so there will be no more surprise Californias or Klondikes found. The only untapped reserves are in the Andes at 13,000 feet, or in countries too dangerous to visit. The cost of extraction has also doubled in ten years to $400/ounce, driven by labor, fuel, trucks, and environmental mitigation. Gold will only go down when the US government turns off its printing presses. With record stimulus packages in place, there is a fat chance of that happening in this lifetime. Ultimately, the price of gold is a barometer of fear, which will not be in short supply in the new era we are facing.

May 26 08:47 PM

[Eldo:]

It would be good to know the terms of the hedge--that is, at what price are they obligated to deliver the 5.4 million ozs hedged? Also, I would not be comfortable that 5.4 million tells the whole story without a careful reading of the footnotes to the financials with special attention to the terms of any bank financing. Didn't Antal Fekete make the point a couple years back that ABX acted more like a hedge fund rather than a hedger ago. Also wasn't ABX a defendant in the Blanchard gold price fixing suit settled a few years back? Yeah, here it is: www.hartford-hwp.com/a... Barrick, yeah, gotta love 'em . . . or not.

May 26 11:15 PM

[CoinMiner:]

Chris, Nice analysis.

One thing I have noticed is that ABX managed, since the Lac Minerals days, have made very shrewd moves based upon company reserves and properties. One thing they have had more difficulty with is accurately 'guessing' the future price of gold.

i.e. their hedge book history. They are now in the position of 'winding down' losing bets when they could have benefitted from this recent upsdie in price of gold.

Hence, another play is to focus on the obvious ABX targets, based upon previous takeover history and patterns, before actual takeover announcement.

This tack has also worked for me regarding potential KGC takeovers.

Both KGC and ABX have manged their takeover targets remarkably well. In part the mining sector has an easier time of merging mining operations than other sectors/industries.

May 27 02:11 PM

[DmytrenkoArtem:]

I think we can find more attractive companies from this sector. For expample BVN, HMY, GFI. They have better P/E and other classical coefficients.

Jun 02 08:42 AM