We believe that the gold industry is ripe for consolidation. The safest plays may not be in the commodity itself but in mining companies like Newmont Mining Corp. (NEM) that have strong fundamentals and a great dividend.
Why not just invest in the commodity?
Ben Bernanke admits he doesn't understand the price of gold in this CNBC article. We believe this is largely due to speculation in the market for gold. Commodity pricing is determined by the market. Gold, and other precious metals, have four major sources of demand: technology, central banks, jewelry, and investors.
- Technology - Tech companies have a functional demand for gold. Most gadgets used today (smart phones, tablets, etc) have various amounts of precious metals in them.
- Jewelry - Jewelry is another source of practical demand. Humans for a long time have, and for a long time will, wear gold around their necks, in their ears, and on their teeth!
- Central Banks - The US central bank holds the largest amount of gold than any other country at 8,133 tonnes. Reserves are held as a tangible asset to support confidence in the banking system.
- Investors - Investors in the form of ETFs and speculative traders buy and sell the commodity directly and indirectly through derivatives to make a profit.
The World Gold Council recently published Q2's Demand and Supply Statistics, detailing supplier and demand sources. Year over year technology is up 1%, jewelry is up 40%, central bank demand is down -57% and investor demand down a whopping -402%.
The end of 2013's second quarter also experienced some of the lowest gold prices seen in years. Using the World Gold Council's data, we can determine that the huge drop in the price of gold was due to a lack of demand from investors and central banks.
Gold mining is a pretty simple business model. Brave individuals go to dangerous places in the world, pull the metal out of the earth, then sell it at gold spot prices. Many of us may be familiar with these types of operations found on television shows like Bearing Sea Gold, Jungle Gold, and Gold Rush. Reality TV or not, if you have seen the shows, it can be quite costly to pull gold out of the ground. Gold mining takes huge amounts of capital to supply the operation with the technology, equipment, and resources it needs to become productive. Business solvency is dependent upon the cost per ounce mined staying below the market price per ounce.
The business of mining and selling gold is economically cyclical. Existing capitalized mining operations fare well as the price of the commodity rises from an increase in demand (tech, investors, jewelry, and central banks). As prices rise, spread increases due to the semi-fixed cost of the mining operation. It is during this time that gold mining businesses make a killing. These profits attract new mining operations (competitors, think about the guys from the show Gold Rush) and ultimately increase the supply of gold. Once the market has had its fill of supply, demand begins to falter and the price drops. As the price of gold drops, spreads shrink and make many gold mining operations insolvent (bye-bye Gold Rush). These insolvent businesses go out of business, leaving only the strongest mining operations in the marketplace. Supply drops, eventually meeting demand because more and more operations go out of business. The cycle then starts over.
The cost of gold
The cost of gold isn't the spot price found on Bloomberg. It takes money and resources to get gold out of the ground and to market. That cost is around $1200-1300 and ounce. The all-in cost of gold can be found by examining a few domestic mining companies' 10-Qs: McEwen Mining INc (MUX), Allied Nevada Gold Corp (ANV), and Newmont Mining Corp. We found the all-in cost of gold was on average $1261 for the 6 months ending in June 2013. The all-in costs include direct and indirect costs attributable per ounce.
What we just experienced
This last gold run up was not the normal business cycle and, in fact, it was a bubble. This bubble is strongly evidenced by the data the World Gold Council released showing a huge drop in investor/central bank demand. Professor Robert Shiller of Yale explains bubbles through the use of an analogy involving feedback (in his book Irrational Exuberance). Feedback from a microphone and a speaker is produced when the sound produced by the speaker is picked up by the microphone it is attached to. This sound is 'fed back' to and from the speaker and the microphone, producing a very loud sound. Such can be said about the speculation of gold pricing in the recent bubble. Prices rose, so people bought and demanded more gold. Things got louder so more people bought more. And so on.
Putting it all together
An intelligent investor can deduce that we are likely at the end of the business cycle for the gold industry and it could be a great time to invest evidenced by the following:
1) Speculative demand is low (investor, central banks). The feedback loop has silenced leaving a clear view of what the commodity is actually worth in real demand.
2) Functional demand is healthy (jewelry, technology).
3) The average cost of gold is roughly equal to its spot price. This suggests that many mining operations are insolvent and will shut down their operations, thus consolidating the industry.
4) Post-bubbles are the best time to invest.
Investing in a stock, instead of the commodity directly, can produce steady dividends and provide fundamental measures. Newmont Mining Corp has been publicly traded since the mid-80s and has a long history of operational strength. It currently pays over a 3% dividend, trading at 1.15x to net tangible book value and has a strong outlook for the future.
A look at NEM's financials
Newmont wrote down over $2 billion in impairments due to the drop in gold prices during the second quarter. This impairment took about a 10% bite from the company's Property, Plant and Mine Development asset on the balance sheet, causing a downshift in the company's overall book value. The 10-Q breaks down the impairment by showing new assumptions for variables in a discount cash flow (DCF) analysis of mine development. The big assumption change used in the DCF analysis was a decrease in the assumption of gold prices to $1400 an ounce. Therefore, the balance sheet's asset values for Property Plant and Mine Development is being based on an assumption of $1400 an ounce. Even though spot prices are lower, we think $1400 is a healthy assumption looking forward.
Newmont did post a huge loss on its income statement for 2nd quarter 2013. The impairment used to write down its asset holdings is also deducted from income as a non-cash expense. This amount then gets to be deducted from taxable income even though no actual dollars are lost, only value. A look at the company's statement of cash flows for Q2 shows this non-cash adjustment being added back to operation cash. The net effect from this, along with depreciation and changes in operating activities, leaves the company with a positive cash flow from operational activities, even though the price of the commodity is at 3 year lows.
These types of adjustments are normal accounting activities and are transparent on its fillings with the SEC. The adjustments illustrate a downshift in the industry as a whole more so than a downshift in the company's operations and performance. At the end of the day, Newmont has productive proven mines, operational experience, and low cost (as an industry comparison) cost of revenues.