Barrick Gold (ABX) reported its second-quarter profit fell 35%, while its adjusted net earnings sank 30%. Enough is enough. This is a company that continues to struggle. Let's take a look at its present challenges and what approach it is taking to turn things around.
Barrick Gold has grown through the years, as gold prices continued to rise through takeovers and expansions. But as economic conditions have changed this mining company (and others) are having to take a good long and hard look at how they do business. Chief Executive Officer Jamie Sokalsky has been on the job a short time and he is having the company look at projects as he lowers expectations for output for the year. Past "thinking" had a "production first" mentality and the rate of return was second because gold prices continued to rise. But now the opposite form of thinking needs to take place and budgets need to tighten up in the industry. The extraction of gold from mines will be prioritized by the cost to take it out of the earth.
For Barrick, the whole turnaround might have started with the Pascua-Lama boondoggle in Chile. This mine is located (12,000-17,000 ft.) in the Andes on the boarder of Chile and Argentina. When the budget was set up in 2009 its projected development was $3 billion. Estimates were later expanded to $4 billion and then $5.7 billion. Costs for development will be 60% higher and now production has been pushed back from 2013 to 2014. What's the reason for this gross misjudgment? Among the explanations given by the company are the project's unanticipated complexity, delays to a tunnel and processing plant, and local cost inflation.
One Consequence of Pascua-Lama
Ratings agency Standard & Poor's lowered gold producer Barrick Gold's corporate credit rating to BBB-, from it previous A+ standing. It was the Pascua-Lama capital expenditure increases that caused this. One cannot continue to poor billions into a project that is not generating revenue and continue to push the revenue projections out into the future. S&P's said:
"We believe that the latest revisions to Pascua-Lama likely preclude any meaningful balance-sheet deleveraging in the next 12 months."
Execution risks surrounding Pascua-Lama may challenge the credit measures and cash flow of the company into the immediate future even more.
Pascua-Lama is not the only problem Barrick is having. It spent $7.3 billion as it took control of Equinox Minerals Ltd. and its big Lumwana copper mine. Equinox did a very poor job in waste striping and because the powers that be at Barrick underestimated the work that needed to be done at the mine, it is a struggle. It was bought at a quick auction and Barrick is having problems with production and lowering costs.
As an investor, would you be happy with the way the company is handling these projects? Most are very unhappy and banging on the drums of change. As with all responsible companies, investors want to see production producing good rates of return with healthy cash flow. Chuck Jeannes, CEO of Goldcorp Inc (G) said in a recent interview:
"From the new projects side, we've been pretty deliberate in trying to acquire and then build projects that have very strong returns"
Gold prices are not rising like they used to and gold companies have less returns to work with and this is forcing them to streamline how business is done.
The Options Play
I believe Barrick is in the beginning stages of turning itself around but I am looking to continue with a short term income strategy in the direction of the current bearish trend. There are too many short term headwinds facing the company to make a bullish play as of yet. The stock is presently trading at $34.11.
- Buy the January 2013 put with a strike of '34' (priced at $3.05)
- Sell the January 2013 put with a strike of '33' (priced at $2.54)
- Net Debit to Start: $0.51
- Maximum Profit: $0.49
- Maximum Risk: net debit
- Maximum Length of Trade: 6 months
Reasoning behind the Trade
- Pascua-Lama problems will stick with the company for a while.
- Credit downgrade will also keep the stock down.
- Increasing extraction costs plus low gold costs make for more negative headwinds.
What about a long term investment in Barrick?
My personal opinion would be to sit on the sidelines and watch this industry. It is in a transition period of becoming more responsible to investors on how cash is spent. I am not sure when a good time to enter the market would be as of yet. But personally, I would sit on the sidelines and observe right now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.