Barrick Gold (NYSE:ABX) looks overvalued to us and we recommend buying downside protection in the options market. Given its large capital expenditures on both acquisitions and organic growth, we see a large negative cash flow for the next two years, resulting in increased debt, leverage and, possibly, equity issuance. Its cost overruns and delayed start to its vaunted Pascua-Lama mine hurt its credibility with investors and recent comments from management have rung hollow. Looking beyond these problems, we see the stock's current price (about $34 per share) reflecting a 6% relative growth of gold prices vis-a-vis cost of production which we believe is unrealistic. It will survive, but we see a share price in the mid 20s as more reflective of true value.
We're agnostic on the short-term price of gold. Longer term, inflation and the desire for a monetary substitute may drive it higher. History suggests inflation risk, after a financial crisis, increases but not until the deflationary forces of deleveraging subside, which can take quite a few years. We've done a macro study on such, which we'll release at a later date, but suffice it to say that we don't expect an inflation-driven gold price increase until later in this decade at best. A thesis for rising gold prices based on growth and the need for emerging market reserves to find a new home has its merits. We just have a hard time quantifying that thought process to make an investment (or trading) decision.
One thing for sure, however, is that even if gold prices rise, gold producers, unless they can keep a lid on costs, don't feel the love. For example, Barrick Gold, in its recent presentations, stated that it is leveraged about 50 cents per share to a $100/oz change in the price of gold. That, of course, assumes that input costs (e.g., fuel, labor, etc.) do not change. In recent times, however, that has not been the case. Even though ABX is a low-cost producer, its recent "cost" for production in Q3 jumped to $592/oz from about $580/oz in the first half. That said, in ordinary times, that might be acceptable, but ABX has quite a large capital expenditure budget for the remainder of this year and well into 2014. In fact, according to our calculations, its cash/financing needs will be on the order of $3bn in addition to its need to refinance a similar amount starting with a $1.2bn credit line repayment due in April of 2013. We believe the financing needs will put pressure on equity pricing as well as the company's credit ratings.
The reasons for the major cash flow needs of the company are both previous acquisitions but also two organic projects: Pueblo Viejo and Pascua-Lama. The former, which is in the Dominican Republic, has begun producing and, according to company statements, it expects 80k oz to be produced in December this year (a bit lofty if you ask us), average 650k/annum for the next five years, and ultimately produce 25.3M oz, of which ABX has a 60% stake, over a 25-year life. Most importantly, this new production is expected to come in at a cost of ~$325/oz, well below its current average. So, by replacing more expensive mining with this lower cost production, margins should improve. The latter project, Pascua-Lama, which we will discuss below, has been a source of problems and won't affect production until late 2014.
The company reported disappointing results for Q3 but claimed increased production for the remainder of the year will improve results for 2012 in all. This is mostly due to its goal of producing 80k oz, mostly in December, from Pueblo Viejo, which looks to be an aggressive ramp-up. For the first three quarters of this year, it produced 5.4M oz of gold, and 318M lbs of silver, resulting in EBITDA of $5bn and an adjusted operating cash flow of $3.4bn. The actual cash flow was ~$350mn higher mostly due to Aussie dollar hedges that were monetized; these will get amortized into net income over time. Total capital expenditures were $4.125bn, with almost $2bn in project expense. A big cause for concern in Q4 is that, based on its stated capex spend for the year of $6.125bn, there will be $2bn spend in Q4 alone versus operating cash flow $1.3bn and a dividend payment of $200mn. Including the recently monetized hedges, this will conservatively lead to a $500 financing need for 4Q12. This can readily be satisfied with cash (it has $2.5bn) or drawing on a currently unused credit line (of $4bn). That said, 2013 will be the real challenge. Even a divestiture of African Barrick, which accounts for 6% of production, is unlikely to provide relief as it is doubtful it will get more than $350mn in the process.
Shown below are our financing needs estimates based on ABX's projections and mild assumptions on the price of gold and copper. In particular, its average cost declines from $582/oz in 2012 to $530/oz in 2014. This is due to the influence of the low-cost mines that are coming on line. We use the company's expectation that Pascua-Lama will come on line by late 2014 and with cost as projected. Given that the project has come under major scrutiny as cost projections have increased by nearly $1bn with delays (project management has been replaced by Fluor (NYSE:FLR), an outside vendor), our numbers do not factor any continued risk there. While the stock looks reasonably valued looking at EBITDA, operating cash flow, or even net income, the cash flow needs along with refinancings are significant near term. Back in April of 2012, ABX issued $2bn in debt to pay down a credit line, and its stock lost 25% versus the overall market and we expect a similar reaction this coming year.
ABX Financing Needs 2012-2014
In 2013 alone, we see a need for $1.7bn in new financing needs on top of the $1.8bn in debt coming due. In April of this year, it needs to repay an older credit line of $1.2bn. Undoubtedly, it will make use of a new credit line (undrawn $4bn) and cash to bridge finance, but it will most likely come to the capital markets for $3bn+ to preserve liquidity as market conditions allow. This will impact its credit rating as it was recently downgraded by S&P with a negative outlook.
The following year, 2014, is marginally better, assuming both new mines produce as advertised (e.g., Pascua-Lama is assumed to have zero cost/oz due to ancillary silver production), but there will still be an increase in net debt to about $14 from about $11.2bn today. While its leverage (Net Debt/EBITDA) looks quite reasonable and it can probably increase debt further with tangible equity standing at $13bn, there is always the risk of an equity offering also. We feel this is quite possible with the stock trading at 2.6 times tangible book (~$10bn in goodwill from past acquisitions). While metrics such as PE and EBITDA multiples look attractive, we feel they mask the underlying problem for equity investors in that dilution, for continued expenditure needs, is a distinct risk.
The good news is that patient investors may be rewarded down the line if all works out as the company predicts. If it manages to get to 8M oz of production by 2016, and capital budgets are restrained, its free cash flow and dividend coverage, which is currently negative, will improve. That said, projecting dividends and cash flows over a longer span of time using our models leaves us less sanguine unless gold prices can exceed cost growth by a significant margin. In particular, at a required investment IRR of 15%, we project a 6% gold price increase per annum over cost is required to make the share price fairly valued at today's $34 price. While certainly possible, we use a more conservative assumption of 3%, putting the stock in the mid $20s on our fair value model. It is important to realize that without further acquisitions and capex, production will ultimately decline leading to subdued cash flow generation.
Management has recently espoused on its conference calls of a renewed focus on a "capital allocation program" using a "dynamic portfolio approach." The whole concept was a bit muddy to us and we were actually a bit surprised that it's considered new as one would think that is management's whole premise for existence. All in all, we've not been terribly impressed with its discussions. It states that "everything is on the table" including G&A costs but we plan on taking a wait and see approach to its pronouncements - suffice it to say, we've heard it before. In the mean time, we've purchased downside protection, via out of the money, longer dated puts (we think the volatility is cheap) and are looking for attractive technical levels to get outright short the name.
Disclosure: I am short ABX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We have a long put position and looking to add to our risk both outright and via option strategies