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AngloGold Ashanti (NYSE:AU), the large South African miner, has been running harder and faster to keep up with the price of gold itself, and is having a hard time doing so. It is the 3rd largest gold miner in the world with twenty mines in ten countries. The company doubled its dividend payout in the 4th quarter to $0.23/share (yield of 3.1%) but the stock is down 26% this year and has underperformed gold bullion for the last two years. Why is that?

The chart below shows AngloGold Ashanti, Newmont Mining (NYSE:NEM)-- another large miner-- vs. the value of GLD, an ETF that only holds bullion and has no operating costs. You can see that both AU and NEM failed to keep up in price with GLD in the recent strong gold bullion market of the last five years. This was not the case in prior years. This is probably due to the miners retaining a large portion of the cash flow for future investments. Also, the market is apparently discounting the value of an oz of gold in the ground.

(click to enlarge)

The futures market is projecting relatively low price increases in gold over the next five years; only 1.6%/yr over the next five years.

(click to enlarge)

Source

Miners have a hard time getting their share prices to keep up with the spot price of gold. The reason is that bullion is immediately salable, while gold in the ground is valued at a significant discount to bullion for a variety of risks and costs. These include the costs to find the gold, geologic risk that it in fact is present, cost of getting the ore removed from the mine, refining and transportation costs, political risks of nationalization, work stoppages, ability to raise money for mining, commodity price risk of future vs. current prices.

A mining company is valued by making a calculation of the net present value of their current operations less SG&A expenses plus present value of future projects operating cash flow less SG&A plus dividends less capital costs. Below is a hypothetical mining company with extensive capital investment.

Current Operations

Future Operations

Production, oz

1 million/yr

1.5 million/yr

Price/oz

$1,600

1,700

Mining Cost/oz

750

850

SG&A/oz

50

50

Profit before tax/oz

800

800

Distributable Profit/yr, before tax

$800 million

N/A

Capital Costs, $/oz

n/a

$4 billion

Dividends, $/yr

$800 million

0

Mine Life, Yrs

10

10

Company Value @ 10% discount rate

$4.9 billion

$1.8

In this example, and assuming no taxes (like an MPL structure) and the mine is depleted in ten years and shut down, then it has a present value of $4.9 billion. The future operations being considered are to build new mines projected to produce 1.5 million ounces/yr but at slightly higher costs ($850/oz vs $750). The mine will cost $4 billion, which is equivalent to five years profit from the current mine. The return on this investment is a net present value of $1.8 billion, which is an 8% IRR.

Alternative scenarios of prices, margins and capital costs are shown below and give one an idea of the sensitivity of investment outcomes to key assumptions. Given that management has no control over future prices, it is difficult to justify high levels of investment since a price reduction can be devastating to shareholder equity.

Mining Company Hypothetical Returns: Alternate Scenarios

Base Case

10% Better

10% Worse

Capex, $B

$4B

$3.60

$4.40

Production, oz/yr

1,500,000

1,650,000

1,350,000

Expected gross margin, $/oz

700

770

630

NPV, $bil

1.8

3.28

0.40

IRR,%

8%

15%

2.0%

Source: Author

The sensitivity of returns to somewhat uncontrollable factors is one reason management may choose to increase shareholder dividends.

The market always discounts investment projects given a variety of risks management must address: operational, financial, political, legal, etc. Similarly, the market will reward a company that brings on a project successfully. In the case of AU, analysts following the stock have price targets of about $64 share for the next twelve months. This is about a 90% advance from current levels and suggests a degree of confidence that the company's capital projects will provide good returns to shareholders.

Disclosure: The author has no shares of AU or NEM nor any plans to buy in the next 72 hours


Source: AngloGold Ashanti Is Struggling To Keep Up