Barrick: Buy Only At This Price

Jun.27.12 | About: Barrick Gold (ABX)

At its core, Barrick Gold (NYSE:ABX) digs huge quantities of dirt out of the ground to get at the small amount of precious metals that the dirt contains. That said, its ability to move its share price is really a product of two primary factors: how cheaply it can dig up and process the dirt and how much the metals extracted can be sold for. Its ability to control cost is limited by the declining availability of high yielding mines, and although Barrick can hedge some of its production, the price it receives for the ore it extracts is ultimately controlled by the global commodity markets. The long-term trend in commodity demand is the key determinant of whether an investment in Barrick shines like gold or betrays like pyrite.

Background

Barrick Gold is currently the world's largest gold producer with production in excess of 7.7 million ounces of gold annually. The company also has massive reserves of silver and copper, with a combined operation that spans 26 operating mines and 5 continents. On the 5th of May, Barrick announced its 1st quarter performance for 2012 with better than expected results. The company also announced it would increase quarterly dividends by 33% from the previous dividend level to $0.20 per share.

The company is also seeing a new generation of management take the helm with a series of top management changes being announced. On May 5th, the company announced that the Executive Vice President and Chief Operating Officer, Peter Kinver was retiring, then followed it with an announcement on June 6th that its Chief Executive Officer Aaron Regent was being replaced by the Chief Financial Officer Jamie Sokalsky. The company stated that the reason for senior management change was lack of growth in the share price.

Current Situation and Competition

Barrick has two new mines, Pueblo Viejo and Pascua-Lama, slated to begin production sometime between mid-2012 and mid-2013. Both mines will have significantly lower cash costs than its existing mines. The company is also investing heavily (upwards of $450 million) in exploration at two mines in Nevada. These two mines, Gold Strike and Turquoise Ridge, as well as the Lumwana mine in Zambia, Africa will increase Barrick's existing gold and copper reserves. The Pueblo Viejo and Pascua-Lama mines when combined with production from current mines are expected to produce upwards of 9 million ounces of gold by 2016.

All gold mining companies face some of the same macro-economic pressures. It continues to become harder to find new high yielding low cost ore supplies and current mines face rising production costs. It is easier for Barrick and other miners to maintain mines in relatively stable countries versus in countries under social or political upheaval, although this is not always the most cost effective approach. Currently, 40% of Barrick's current gold production comes from North America. Since it is improbable that these older mines will continue to produce at the same pace as in the past, it is essential that Barrick finds new mines which will be sustainable over the long run. The mine at Pueblo Viejo, residing in the Dominican Republic and the Pascua-Lama mine which sits on the boarder of Argentina and Chile provide the best of both worlds. Cash costs are estimated to average between $400-450 per once in the beginning, leveling off to $300-350 within 5 years. These are significantly lower than current average cash costs across other mining assets. For the 1st quarter of 2012, Barrick's average cash costs for gold production were $545 per ounce.

Competition

Barrick competes against numerous miners that either focus primarily on gold production or are larger more integrated producers that mine gold as part of a portfolio of mining operations. Two of its most similar competitors are profiled below.

Goldcorp (NYSE:GG) reported 1st quarter results on April 25th. During the quarter Goldcorp saw gold production decrease by 17.7% from the same quarter the previous year. Also in year-over-year comparisons net earnings decreased in real terms dropping from $0.82 per share in 2011 to $0.59 per share in 2012. Free cash flow was negative at -$277 million compared to $225 from the previous year. Among the positive highlights were dividends paid to share holders which increased from $75 million to $109 million. Goldcorp is one of the world's fastest growing gold producers with 17 properties and 10 mines in North and South America and several precious mineral sites under development. The company saw its production costs increase over the quarter from $504 to $648 per ounce on a co-product basis, leading to lower net earnings attributable to shareholders and lower earnings per share. Over the next 5 years Goldcorp expects to grow gold production by 60% but must control rising costs if it hopes to maintain its edge as the low cost producer.

Newmont Mining (NYSE:NEM) reported 1st quarter results on April 26th. Net income from continuing operations increased by 9% to $561million, translating to $1.13 earnings per share versus $1.04 per share year over year. Cash flow from continuing operations fell dramatically by 38% to $613 million. Newmont is the world's second largest gold producer with assets or operations located in the United States, Canada, Mexico, Peru, Indonesia, Ghana, Australia and New Zealand. In June 2011, Newmont's board approved funding for a new mine in Conga, Peru, however has since suspended construction at this site due local opposition. Other sites approved by the board in Ghana and Australia won't see first production until sometime in late 2014 and into 2015. Newmont's lowest cost mine Yanacocha, which is also in Peru, is also one of its oldest and well past its prime.

Valuation

Barrick currently trades at a multiple of 8.93 times 2011 earnings which is lower than the competitors previously mentioned (Goldcorp is currently trading at 20.81 times earnings) as well as other peers such as Yamana Gold (NYSE:AUY) which trades at 21.53 times earnings and Eldorado Gold (NYSE:EGO) which trades at 22.13 times earnings.

Barrick is the largest player in its industry, but risk that its two large new mines will not start production on time or on budget has placed significant down pressure on its price multiple. A conservative price to earnings ratio of 12 times 2011 earnings is reasonable in my opinion and provides a fair value estimate of $53.76. Generally, it is better to use estimated forward earnings, but gold prices can move sharply reducing the validity of forward earnings for a gold producer. Buying a gold producer is strictly a play on future gold prices, which is in turn a bet on inflation and fear expectations. I would require a 40% discount to my fair value in order to entice me to purchase Barrick. This would equate to a target price of $32.26 per share. The stock is currently trading at approximately $36 per share, and is down from nearly $50 per share just six months ago.

Conclusion

Investors have been through the worst economic period since the Great Depression and gold has been a safe haven for many individuals, albeit some simply investing based on speculation. With the SPDR Gold Shares (NYSEARCA:GLD) currently trading near 52 week lows it appears that the speculative bubble may be slowly leaking air. All of these miners mentioned would continue to suffer if gold prices begin a long term decline. Barrick is a risky investment, but the return metrics may justify the purchase of the company's equity for long term investors at a price of $32.26 or lower.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.