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Back to Part XIV - Diversified Metals and Mining Industry

By Mark Bern, CPA, CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

This is a difficult topic for me. The prospects, as I see them, are likely to come in stages, with very different outcomes from each stage. The difficulties in the Euro Zone may get swept under the proverbial rug with declarations from EZ leaders of having successfully dealt with the regions banking and sovereign debt problems. So far, the solutions that have been discussed, even the direction of moving closer toward greater financial cooperation, will only serve as a temporary patch in the dam, which I believe will eventually burst. There will be fits and starts between now and the agreement that will serve as the solution. It won't matter one iota whether the solution decided upon seems like a real permanent solution, or just an attempt to buy more time to let the economy heal. Truth is less relevant than perception in the short term.

What might this have to do with precious metals companies? The stability, or rather the lack thereof, in the global economy, the rising debt problems faced by the developed countries and how well these issues are handled by political leaders can either ease or increase the fear that is still evident in the global investing community by the fact that precious metals prices have been on a decade-long upward trend. If fear grows, so do the prospects of rising demand for precious metals as a store of value. The precious metals companies will prosper under a scenario of growing fear. If fear is abated, even temporarily, demand may fall, and the prospect of precious metals companies will falter. In the short and intermediate term, either is possible. But in the long term, fear is warranted, in my opinion, and should favor the industry with rising prices again.

What I expect during the unavoidable fits and starts are moments when it appears that the Euro Zone union may be in peril of breaking, causing another rush to the safety of the US dollar out of the Euro. It may take such a wakeup call to get something substantial out of Europe's bureaucratic leadership. That will cause the US dollar to surge in value relative to other major currencies, especially the Euro. Such a surge would cause inflation in all nations where currencies lose value against the US dollar by causing all commodities traded in US dollar denominations to increase in price in those currencies. At the same time, those same commodities' prices will deflate somewhat in US dollar terms. Precious metals prices could actually fall in US dollar terms. When could this happen? I don't know, but if the recession in Europe deepens, I expect the US dollar to rise while precious metals prices drop. Then we will probably see a QE3 or perhaps a QE4 by that time.

But I don't think that the situation will last long. Politicians want to remain in office and will do whatever necessary to improve their chances for re-election, regardless of the country. Thus, a "solution" will be announced with great fanfare along with publicly-announced compromises that will assure the markets that all is well after all. But will all be well? It depends upon perception. If the markets buy into the solution, then things could seem rosy for a year or two; maybe longer. But eventually, the increased debt levels in the developed world will need to be addressed realistically rather than being pushed out further into the future. Eventually the future will come, and the price will need to be paid. I expect the initial price to be paid in terms of inflation. When the payment comes due, precious metals demand will increase again…dramatically, in my opinion.

The difficult question is the timing. I admit that I really don't know and I don't believe anyone else does either. All I know is that when the time comes I'll want to own some physical silver and/or gold; which I do. I will also want to overweight my equities portfolio in commodities, including precious metals companies, both miners and other companies that profit from increases in the shiny stuff.

I know that I am sounding like a gold bug, but I am not one. I own a modest stash of junk silver coins and a few ounces of gold. I like to keep a portion of my portfolio in physical precious metals as a hedge against catastrophic events and inflation. I don't know if I will ever need it, but it is just nice to know it is there just in case.

What I am trying to get across in this article is that I expect some pain before the gain for this industry. First, there seems to be a consensus among the majority of market participants that the world economy will right itself over the next few years and that the need to hoard gold and silver will abate in the near future. There is also a rising concern that the world economy is slowing more than previously expected, and that the probability of the US economy slipping back into recession is closer to 50/50, while just a few months ago, the probability of recession was probably considered somewhere closer to 10 percent, if not less. If recession hits the US economy, and problems get much deeper than originally anticipated in Europe, it will likely put downward pressure on precious metals prices. It has already begun, actually, as the market tends to be forward looking. Is the worst behind us, or yet to come? I do not know with certainty, but I believe there is still some more pain coming. I just don't know how much. Thus, I am not recommending outright purchase of any companies from this industry at this time. However, there are candidates that appeal for the longer term once we find a bottom.

How do I surmise the market expectations of future lower prices for precious metals? Gold mining stocks are well off recent highs, even those with excellent prospects for strong production increases in the next few years. Increased production with stable prices would produce increasing earnings, and we would expect the gold miners to be advancing, or at least have price/earnings (P/E) ratios near normal levels. Instead, the gold mining stocks seem to be in retreat, and the P/E ratios are below normal levels. If prices were expected to rise in the future, gold mining stocks should be nearing record highs. Thus, the evidence provided by how the market values the future prospects of gold miners tells me that the market is expecting lower prices for gold, but not a collapse. But again, it is my opinion that this will be a temporary condition that may last a few years, at most.

My first master list selection is Silver Wheaton (NYSE:SLW), a metals streaming company. What that means is that the company will provide capital to a mining company to develop a mineral-rich property in exchange for a commitment by the mining company to sell SLW all (or a set percentage) of the silver (and sometimes gold) produced from the mining operations for either the life of the mine or for a predetermined period of years (usually 20 or more) at a specific price. The price that SLW usually pays for silver is about $4 per ounce (about $300 per ounce for gold). The mining company is interested in large veins of other ores, where silver is a small residual from the mining operation. The mining company needs the money for infrastructure and SLW wants to create future stream of reliable income with high margins.

I think of SLW as a venture capital firm to the precious metals industry that, because of all of the test drill data available, can reliably predict how much silver (and gold) it will receive from each mine over the contractual period. The difference is that a normal venture capital firm invests in lots of deals knowing that most will end up worthless, but a few will be home runs. In the case of SLW, there are no misses, just a lot of singles and double that add up to a bigger future score for the home team. Even if the price of gold and silver fall, SLW will remain profitable, because its costs are so ridiculously low. But if prices increase SLW profits soar. Here are the metrics.

Metric

SLW

Industry Average

Grade

Dividend Yield

1.4%

0.6%

Pass

Debt-to-Capital Ratio

2.0%

19.1%

Pass

Payout Ratio

12.0%

12.0%

Pass

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$1.24

N/A

Pass

Net Profit Margin

75.3%

27.3%

Pass

5-Yr Average Annual Growth in EPS

33.4%

63.0%

Fail

Return on Total Capital

20.3%

13.5%

Pass

5-Yr Average Annual Growth in Revenue

23.6%

23.2%

Pass

S&P Credit Rating

NR

N/A

Neutral

SLW rates one fail, two neutral rankings and seven passes. First, the neutral ranking for the credit rating is only because the company does not have enough debt issued in a manner to justify a rating. Next, the neutral rating for dividend growth history comes because the company initiated its dividend in 2011. The company is relatively new, having been formed originally in 1994 (then known as Chap Mercantile) and held its initial public offering in 2004. It was primarily focused on reinvesting capital into additional mining projects and paying down debt for many years. Management is now confident that the company will generate enough free cash flow to fund future projects while also paying a rising dividend to shareholders. The increase from 2011 to 2012 was 100 percent. The fail came as a result of having to wait for mining projects to slowly begin to produce significant amounts of silver to sell to SLW. Each project invested in requires several years to build infrastructure and begin mining operations. I have tried to keep my assumptions about the price of silver relatively conservative, because I can't be certain where the price will be in five years. I used an average price of $18 per ounce. Please consider an article on SLW that I published last week for a more detailed report. My five-year price target for SLW is $57.50.

My next candidate, Pan American Silver (NASDAQ:PAAS), has seen its stock price hammered. This is primarily due, in my opinion, to the dilution of shareholders caused by the recent acquisition of Minefinders, which brings the low-cost Dolores mine with it. Cash cost per ounce at Dolores is in the $5-$6 range, while the cash cost per ounce for PAAS before the acquisition is averaging about $12. But the Dolores production will account for only about 14 percent of PAAS' total annual output, so the impact will be muted, at best. As long as average silver prices remain above $20 per ounce, PAAS remain very undervalued.

Metric

PAAS

Industry Average

Grade

Dividend Yield

.07%

0.6%

Pass

Debt-to-Capital Ratio

1.0%

19.1%

Pass

Payout Ratio

4.0%

12.0%

Pass

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$1.24

N/A

Pass

Net Profit Margin

30.1%

27.3%

Pass

5-Yr Average Annual Growth in EPS

24.2%

63.0%

Fail

Return on Total Capital

15.8%

13.5%

Pass

5-Yr Average Annual Growth in Revenue

18.9%

23.2%

Neutral

S&P Credit Rating

NR

N/A

Neutral

The company receives one fail, three neutral rankings and six passes. Again, two of the neutral rankings are for having practically no debt and for having initiated the dividend too recently (2010) to be rated. In the first two years since initiating the dividend, the company has increased its dividend by 25 percent and 50 percent. That is a good start, but I expect it to be more modest in the future averaging about 15 percent per year. In the case of the third neutral ranking, it is a matter of being good but just not quite good enough. The reasoning for the slower growth in revenue stems from the same source as the problem with EPS growth. Regarding the fail ranking, the company has been stymied in its attempts to move forward with development of one of its most promising properties, Navidad in Argentina. The company also sold it highest cost mines to reduce its average production cost per ounce. These two events have kept both EPS and revenue from increasing as fast as the industry. These factors and the share dilution stemming from the acquisition mentioned above have also been mostly responsible for the collapse of the stock price. The current level rivals the low attained during the great recession, even though profits have more than tripled since then. I do expect EPS to be down in 2012 before rebounding in 2013 and beyond. My five-year target price on PAAS is $45, which should bring the P/E ratio back to a still below normal 16 times expected EPS by 2017.

Finding gold mining stocks that passed the metrics is a difficult task. That may sound silly to some, but I have included three that fared the best, and each received only five pass rankings. I don't follow this industry as closely as many analysts do, and I don't dip down below the mid-majors. I like profitable companies, plain and simple. Of the three listed below, Eldorado Corporation (NYSE:EGO) appears to have the best prospects from current levels. Thus, in order to close on a bright spot, I will end the metrics assessments with EGO.

The first gold mining company on my list is Goldcorp (NYSE:GG), which may be the lowest cost producer of gold, with an average cash cost per ounce in 2011 of $223 (from GG 2011 Annual Report). That alone is one good reason for list inclusion. Should the price of gold fall more than expected, GG would be the last gold miner left standing. I like that position of sustainability in adverse conditions. Another plus is GG's forecast of increasing its production by 70 percent over 2011 levels by 2016. We will need to watch closely for cash costs of each new mine after the first few quarters of production. The company vows that it will continue to keep its cash costs low. If it can continue to produce gold for an average cash cost below $300 per ounce, including the new mines in development, there is reason to expect good things from this company in the future.

Metric

GG

Industry Average

Grade

Dividend Yield

1.6%

0.6%

Pass

Debt-to-Capital Ratio

3.0%

19.1%

Pass

Payout Ratio

18.0%

12.0%

Neutral

5-Yr Average Annual Dividend Increase

17.9%

N/A

Pass

Free Cash Flow

$0.34

N/A

Pass

Net Profit Margin

35.1%

27.3%

Pass

5-Yr Average Annual Growth in EPS

16.9%

63.0%

Fail

Return on Total Capital

8.6%

13.5%

Neutral

5-Yr Average Annual Growth in Revenue

22.2%

23.2%

Neutral

S&P Credit Rating

NR

N/A

Neutral

One fail and four neutral rankings is not stellar, but let's break them down to see what it really means. The lack of a credit rating is not alarming at all, because the company has almost no debt, and that debt it does have is short term and covered by cash. The revenue growth is within a hair's breadth of being a pass, so that does not raise any concern either. Return on total capital is low relative to the industry average, probably because of the lack of leverage. Other companies use debt to increase return ratios. I'll take the tradeoff of a lower return (within reason) for a stronger, more stable balance sheet. The payout ratio, at 18 percent, is above the industry average but still very manageable below 20 percent. Management is committed to returning more than the industry average to shareholders, but again, it remains within a reasonable range.

The growth in EPS is a fail, because the average is skewed by several companies in the industry that were losing money during the baseline year. That resulted in the overall increase for the industry to appear to be much better than should be the case. If we eliminate all companies that were losing money at the beginning of the measurement period, I strongly suspect that the average would come down significantly. This would likely put companies like GG very close to where the industry average would be if it included only companies that were profitable at the beginning. My five-year price target for GG is $51, which would provide an average annual total return of about 12 percent.

The next company on the list is Yamana Gold (NYSE:AUY), with seven producing mines and three more in late stages of development. The company expects to increase production by 60 percent from 2011 to 2014. I calculated the average cash cost per ounce for AUY at $472 per ounce, a still respectable level with gold prices remaining so high. One thing that stands out about AUY to me is that the company expands through exploration and asset development rather than through acquisitions. It has a history of finding and developing new resources and more than replacing production with newly proven reserves each year. Beyond the three mines about to come online by 2014, the company has a strong pipeline of promising projects being assessed for future development.

Metric

AUY

Industry Average

Grade

Dividend Yield

1.5%

0.6%

Pass

Debt-to-Capital Ratio

5.1%

19.1%

Pass

Payout Ratio

23.0%

12.0%

Fail

5-Yr Average Annual Dividend Increase

61.5%

N/A

Pass

Free Cash Flow

$0.22

N/A

Pass

Net Profit Margin

25.3%

27.3%

Neutral

5-Yr Average Annual Growth in EPS

16.1%

63.0%

Fail

Return on Total Capital

6.5%

13.5%

Fail

5-Yr Average Annual Growth in Revenue

66.6%

23.2%

Pass

S&P Credit Rating

NR

N/A

Neutral

Three fails is disturbing until we look deeper into the reasons. Average EPS growth of 16.1 percent in almost any other industry would be great, but due to the situation described above in my assessment of GG, this causes little concern for me. The payout ratio is a little high, but not alarming, at 23 percent. It would only require one year of an increase below the EPS growth rate to bring it down to a better level. Return on capital is a little lower than I would like, but it is the only metric that causes me concern. It will be difficult for the company to make significant improvements in this area since stockholders' equity is continuing to build up; the denominator just keeps getting larger. But the company keeps reinvesting in the business, and until it reaches a point where management decides to begin returning more to shareholders through stock repurchases, I don't see much change coming here. My five-year price target for AUY is $22.50, which represents an average annual total return of about 11.5%.

My final entry is Eldorado Corporation, which is trading at less than half its 52-week high. Granted, the price may have gotten ahead of itself when at the high around $22, but the current price below $11 looks enticing for long-term investors. I especially like the production growth forecast by the company of 30 percent or more per year over the next three years. The company boasts an average cash cost per ounce of $405 which is below costs at many competitors (source: EGO 2011 Annual Report). The company has only short term debt, and very little of it, even after its acquisition of European Goldfields.

Metric

EGO

Industry Average

Grade

Dividend Yield

1.7%

0.6%

Pass

Debt-to-Capital Ratio

2.0%

19.1%

Pass

Payout Ratio

30.5%

12.0%

Fail

5-Yr Average Annual Dividend Increase

NA

N/A

Neutral

Free Cash Flow

$0.35

N/A

Pass

Net Profit Margin

29.0%

27.3%

Pass

5-Yr Average Annual Growth in EPS

42.1%

63.0%

Neutral

Return on Total Capital

9.2%

13.5%

Neutral

5-Yr Average Annual Growth in Revenue

66.9%

23.2%

Pass

S&P Credit Rating

NR

N/A

Neutral

The one fail is because the company is returning too much to shareholders in the form of dividends. I can live with that. Of the four neutral ratings, the credit rating doesn't exist because the company has no long-term debt. Return on capital is low because the company does not use leverage. The five-year average growth in EPS is the best of the group I've highlighted and at 42.1 percent would be respectable in any industry. The neutral rating on dividend growth is because the dividend policy has not been in place long enough to rate. The stock price is well above its 2008 recession low of near $3, but earnings have grown by leaps and bounds from $0.10 in 2007 to $0.58 per share in 2011 and the prospects of further increases on the back of rising production, independent of gold price fluctuations, provides me with greater comfort. My five-year price target for EGO is $16.50 per share which translates into an average annual total return of about 13.5 percent.

Now, I'll provide the run down on the more obvious absences from this industry. Anglico-Eagle Mines (NYSE:AEM), AngloGold Ashanti (NYSE:AU), Barrick Gold (NYSE:ABX), Kinross Gold (NYSE:KGC), and Newmont Mining (NYSE:NEM) all have negative cash flow and were eliminated on that basis. Franco-Nevada (NYSE:FNV) has a trailing P/E of 325. That ratio stopped nearly me cold. When I found that the net profit margin was only 4.2 percent I abandoned further analysis of the company. ASA Gold (NYSE:ASA) and Stillwater Mining (NYSE:SWC) have not provided sustained positive earnings long enough for consideration.

This concludes my assessment of the precious metals industry. I hope you have found it interesting and informative. As always I welcome comments and will attempt to answer any questions. In this instance, though, I must request that readers refrain from asking questions regarding small cap mining companies. There are just too many for me to cover. Then again, if readers want to pose those questions to other readers for opinions, please feel free. The exchange of information is always welcome and it is how we all become better informed investors.

Source: The Dividend Investors' Guide: Part XV - The Lure Of Precious Metals