As the government refuses to appropriately rein in unsustainable entitlement programs, the dollar will continue to debase. Inflation will drag down productivity by sending capital activity abroad. Ultimately, I foresee increased uncertainty over the US debt situation and thus substantial opportunities in gold. As an IR consultant, I expect the returns to be especially pronounced amongst smaller under-followed producers, like Eagle Plains (EGPLF.PK) and Noront Resources (NOSOF.PK), when press coverage improves.
In this article, I will run you through my DCF model in Barrick (ABX) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Kinross Gold (KGC) and Freeport (FCX). I find Barrick and Freeport are meaningfully undervalued given fears over inflation.
First, let's begin with an assumption about the top-line. Barrick finished FY2011 with $14.3B in revenue, which represented a 30.1% gain off of the preceding year. I model growth rending from 20% to around 4% over the next half decade or so. This estimate is reserved to prove my point.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold eating 45% of revenue versus 3.7% and 2.5% for SG&A and R&D, respectively. I further forecast capex at 27% of revenue and taxes at 32% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I estimate that this will hover around -1.5% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 7% yields a fair value figure of $45, implying 21.2% upside. A more realistic growth projection of 20% to 15% over the next half decade would imply 81% upside. In short, Barrick has favorable risk/reward in its fundamentals.
All of this falls within the context of impressive trends in gold:
"So looking at 2011, this is the time of year we can reflect back on the total progress in the past year. I think, overall, we've made progress in a number of areas. First, I think we're pleased that we were able to meet our production and cost targets for the year. We produced just under 7.7 million ounces of gold at a cash cost of $460 per ounce. Total cost basis and on a net cash cost basis, our cash cost is around $339 per ounce. And I think that compares very favorably with the other senior gold producers and positions us around the bottom third of the cost curve.
With the rise of the gold price, we've had a significant expansion in our margins, and when you apply that to our production, the result was record financial results".
From a multiples perspective, Barrick is equally attractive. It trades at just a respective 9.1x and 6.7x past and forward earnings versus 7.7x forward earnings for Kinross and 7x forward earnings for Freeport. Assuming a multiple of just 9x and a conservative 2013 EPS of $6.02, the stock would hit $54.18. In short, Barrick is exceptionally undervalued with little downside.
Consensus estimates for Freeport's EPS forecast that it will fall by 14% to $4.16 in 2012, grow by 29.1% in 2013, and then fall by 0.9% in 2014. Assuming a multiple of 9.5x and a conservative 2013 EPS of $5.32, the stock would hit $50.54, implying 33.7% upside. Following the resolution of the Grasberg strike, the company has little limitation to unlocking value. Revisions to EPS estimates might have fallen by a net change of -3%, but the fundamentals remain stronger than ever.
Consensus estimates for Kinross' EPS forecast that it will grow by 23.4% to $0.95 in 2012, grow by 24.2% in 2013, and then fall by 12.7% in 2014. Assuming a multiple of 9.5x and a conservative 2013 EPS of $1.15, the stock would hit $10.93, implying 18.9% upside. Revisions to EPS estimates have fallen by a net change of -3.9%. The upside is not nearly as strong as that of Barrick and Freeport, so I recommend holding out for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.