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By Ivan Y.

Several weeks ago at the World Resource Investment Conference, Brent Cook, a respected geologist and newsletter writer, suggested that a major gold mining company could go bankrupt. (video)

Honestly, these guys are in big trouble. We're going to see some major companies go under, or at least start shutting down mines."

He gave no details, but he must have had some specific companies in mind while he was saying that. Most people who follow the mining sector probably assume that there will be some junior resource companies that will go bust as a result of what has happened to gold and gold stocks this year, but could a major producer like Barrick or Newmont really go bust as well? In this article, I will look at a couple of financial metrics to see which of the major producers are the likeliest candidates for bankruptcy. For the record, I do not actually believe a major producer will go bust soon like Brent Cook suggested, so this is simply an exercise to see which companies he may have been hinting at. The two metrics I will look at are the Z-score and the Debt/Equity ratio, and the companies I will consider are the six largest gold producers in 2012: Barrick (NYSE:ABX), Newmont Mining (NYSE:NEM), AngloGold Ashanti (NYSE:AU), Kinross (NYSE:KGC), Goldcorp (NYSE:GG), and Yamana (NYSE:AUY).

Z-score

You may be wondering what the Z-score is. The Z-score is a formula developed by Robert Altman that is used to predict how likely a company will go bankrupt in the next two years. The formula is derived from five financial metrics:

  • Working capital / Total assets
  • Retained earnings / Total assets
  • EBIT (Earnings before interest and taxes) / Total assets
  • Market capitalization / Total liabilities
  • Sales / Total assets

Here is the original formula that shows the weighting for each metric:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

A high Z-score indicates financial strength. A low score indicates financial distress. For our six gold producers, instead of calculating the Z-score for each company, what I did instead was look at the Z-score expressed as a percentage that represents how likely it is for the company to go bankrupt in the next two years. The data is provided by Macroaxis, and here it is ordered from least likely to go bankrupt to most likely:

  • AUY 12.5%
  • GG 15.6%
  • ABX 21.6%
  • KGC 39.4%
  • NEM 43.4%
  • AU 47.0%

So based on its Z-score, AU has a 47% chance of going broke in the next two years. To put these numbers in perspective when compared with other industries, Apple (NASDAQ:AAPL) and Exxon (NYSE:XOM) have a 1% chance of going broke based on their Z-score and Boeing (NYSE:BA) has a 12% chance.

Debt/Equity ratio

The debt/equity ratio measures how much debt is needed to finance a company's assets. Based on the data from Yahoo Finance for the most recent quarter, here is the debt/equity ratio for these companies ordered from best to worst.

  • GG .11
  • AUY .12
  • KGC .22
  • NEM .37
  • ABX .59
  • AU .63

AU had the worst ratio and was ranked last again, but in terms of total debt, ABX has by far the highest amount. The balance sheet for ABX shows a total debt of $14.8 billion. For AU, they have a net debt of $2.32 billion, but according to the company that number is expected to increase until later this year. Currently, S&P rates the debt of both AU and ABX as investment grade, but noted the following:

"In fact, some of these companies are taking on unprecedented levels of debt to fund large, risky investments or acquisitions to increase-or even merely sustain-gold output."

Conclusion

It appears from the data above that AU is the most likely to experience financial distress. In both financial metrics that were considered, it ranked last. ABX, NEM, and KGC also fared poorly. All three companies ranked between 3rd and 5th according to both the Z-score and the debt/equity ratio.

At the top of both lists are AUY and GG. Both appear to be the safer choices for mining investors. Relatively speaking, they had a low debt/equity and a low chance of bankruptcy based on their Z-score. I do not believe that there are any safe stocks in the mining sector, but if you are considering buying a large gold producer, then these two should be given a higher consideration.

I hope that this exercise has been somewhat enlightening. I believe that the Z-score as interpreted by Macroaxis is overstating the chance of bankruptcy or financial distress for these gold producers. Seriously, do you really believe that NEM has a 43% chance of going bust in the next 2 years? I don't. Therefore, I am a little skeptical about the accuracy of the Z-score, but nevertheless I think it is useful if you use it as a metric to compare companies in the same industry to see which ones are in a better financial position relative to their peers. If the gold price remains depressed the next two years, there's a possibility that a large producer could go bust, but I would say that is unlikely because there are actions that can be taken to strengthen the balance sheet. First, a company can eliminate its dividend. For example, ABX could save $800 million a year if they eliminated their dividend and KGC could save more than $360 million a year if they did the same thing. Second, all exploration expenses can be cut. It's not a law that a producer needs to replace the ounces that it takes out of the ground. Finally, if necessary, a company could always raise money by selling shares and diluting the existing shareholders.

Source: Will A Major Gold Miner Go Broke?

Additional disclosure: This article is for information only and is not a recommendation to buy, sell, or hold any stock.