Harmony Gold: An Inferior Way To Buy The Dip
Summary
- Harmony Gold is down more than 45% from its Q3 2020 highs, massively underperforming the Gold Miners Index.
- This sharp correction can be attributed to the company's industry-lagging margins, with Harmony announcing FY2022 guidance which projects operating costs above $1,540/oz.
- At a share price of $4.10 with annual EPS of $0.60, Harmony is cheap, but I would argue that it's cheap for a reason, and higher risk than its peers.
- Given that several high-quality names with industry-leading margins are also on sale and sitting near oversold levels, I see Harmony as an inferior way to buy the sector-wide dip.
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Investors in the Gold Miners Index (GDX) have had to endure a volatile year, with most of the volatility being to the downside. This is evidenced by a 13% decline year-to-date in the ETF, with some producers sliding over 50% from their Q3 2020 highs. Harmony Gold (NYSE:HMY) is one miner that's been hit especially hard due to its razor-thin all-in sustaining cost margins [AISC], and while production is growing, costs are increasing at a similar pace. Given that several high-quality miners with industry-leading margins are also on sale and sitting near oversold levels, I see Harmony as an inferior way to buy the sector-wide dip.
(Source: Company Presentation)
In October, Harmony Gold released its Q1 2022 results, reporting production of ~414,000 ounces at AISC of $1,691oz. The higher costs in the period were driven by lower underground grades, impacted by safety incidents at Mponeng and Tshepong, and lower grades at Hidden Valley while the company continues with its Stage 6 and Stage 7 cutbacks. Just since July, we have seen eight fatalities at Harmony's operations, giving it one of the worst fatal injury frequency rates sector-wide. Harmony continues to work towards zero loss-of-life incidents, but with six in H1 2022 vs. 6 in all of FY2020 and 11 in FY2021, this key statistic continues to trend in the wrong direction. Let's take a closer look at recent results and FY2022 guidance below:
(Source: Annual Report)
As shown in the chart below, Harmony Gold has seen a steady increase in production since it acquired AngloGold's (AU) Mponeng Mine and Mine Waste Solutions business in late 2020. This is evidenced by a new high in quarterly production of ~432,000 ounces in fiscal Q2 2021 and gold production of 400,000+ ounces in three of the last four quarters. Based on FY2021 guidance, production is expected to increase to ~1.59 million ounces of gold, a nearly 4% increase year-over-year, after lapping 26% production growth last year (~1.54 million ounces vs. ~1.22 million ounces).
(Source: Company Filings, Author's Chart)
(Source: Company Filings, Author's Chart & FY2022 Guidance)
However, while production has been steadily rising, costs have also been rising sharply. Based on guidance, this trend will continue in FY2022. As shown below, costs have increased at a compound annual growth rate of 5.8% between FY2018 and FY2021 ($1,460/oz vs. $1,231/oz), and are likely to come in above $1,540/oz this year. This would translate to a nearly 6% compound annual growth rate in operating costs, which is well above the company's compound annual growth in gold production in the same period of 3.6%. This 3.6% figure also assumes that the company meets the high end of its production guidance.
(Source: Company Filings, Company Guidance, Author's Chart)
Generally, I wouldn't write a company off for investment simply because its costs were rising quicker than production. However, the problem with Harmony Gold is that while costs are rising rapidly, they're increasing from a base figure that's already well above the industry average. In fact, in fiscal Q1 2022, Harmony had one of the lowest AISC margin figures among its peers, with quarterly AISC of $1,691/oz and an average realized gold price of $1,771/oz. This translates to an AISC margin of $80/oz, well below the average AISC margin of more than $450/oz for million-ounce gold producers sector-wide.
(Source: Company Website)
If we look at Harmony's earnings trend below, we can see that the company saw a significant increase in earnings in FY2021, with annual EPS hitting a new high of $0.60 helped by higher revenue ($2.71 billion) and margins due to the record gold price ($259/oz). However, with the gold price stuck beneath the $1,850/oz level for most of Harmony's fiscal H1 2022 (H2 CY2021), I would not expect a meaningful increase in its average realized gold price relative to the $1,719/oz last year. Besides, even if we do see an increase, this will be offset by the much higher costs expected in FY2022 (~$1,550/oz vs. ~$1.460/oz).
(Source: YCharts.com, Author's Chart)
This explains why it appears that annual EPS may have peaked last year on a medium-term basis, with FY2022 annual EPS estimates sitting at $0.46. Assuming these estimates are met, this would translate to a nearly 25% decline in annual EPS year-over-year. Some investors will argue that Harmony appears dirt-cheap based on FY2021 annual EPS, sitting at just 6.8x earnings ($4.10 / $0.60). However, when earnings are expected to decline sharply in the following year, it makes more sense to value the stock on its forward earnings. Even if Harmony beats estimates and reports $0.50 in annual EPS, the stock trades at just over 8x earnings.
(Source: Fraser Mining Institue, 2020 Report)
Currently, most million-ounce producers trade at more than 12x forward earnings, with names like Newmont (NYSE:NEM) trading at more than 16x earnings. This would suggest that Harmony is very reasonably valued, given that it has multiple operations. However, if we look at its jurisdictional profile, its operations are in two of the worst-ranked jurisdictions: South Africa and Papua New Guinea, which explains the discounted multiple.
If we combine a Tier-3 jurisdictional profile with some of the weakest margins sector-wide, Harmony clearly has higher risks than most of its peers. This is because the average million-ounce producer has more than 40% of its production coming from Tier-1 jurisdictions. The only exception is Endeavour Mining (OTCQX:EDVMF), but the company has industry-leading margins (AISC: ~$900/oz). So, while investors are taking a risk with Endeavour due to its Tier-3 jurisdictional profile, they have much less risk from gold price weakness. In the case of Endeavour, a dip below $1,550/oz would still allow the company to generate significant free cash flow. In Harmony's case, it would mostly wipe out the company's margins on an all-in cost basis.
So, is there any good news?
According to Harmony's recent presentation, the company appears confident that it can see meaningful margin expansion over the next several years. One catalyst for this is Franco Nevada's (FNV) streaming contract on the Mine Waste Solutions operation ending once 312,500 ounces have been delivered. More than 220,000 ounces of gold have been delivered to date, so this will provide a boost to production later this decade, with the 25% gold stream gone. In addition, capex is expected to decrease considerably beginning in FY2022, reducing AISC.
Finally, if the company can bring Wafi-Golpu online later this decade, which is a joint-venture with Newcrest (OTCPK:NCMGF) this would provide a massive boost to margins. The project has an estimated production profile of 130,000 tonnes of copper and 202,000 ounces of gold per annum, with negative all-in sustaining costs due to copper credits. Based on Harmony's 50% interest, this would add 101,000 ounces per annum of gold production and give Harmony copper exposure as well. However, with no special mining lease in place yet and significant work left to be done, I would be surprised if this asset was online before FY2029. So, while Harmony has a bright future with Wafi-Golpu, we're still years away from meaningful margin expansion.
Valuation & Technical Picture
While Harmony is down more than 40% from its highs, a look at its valuation shows that it's actually not trading that far from its historical cash flow multiple over the past several years. One could argue that the stock should see a premium cash flow multiple relative to its 10-year average given that it has leverage to the gold price and the gold price is performing well. While this is a valid point, I still don't see meaningful upside from current levels unless we see much higher gold prices. So, while other producers should benefit immensely even if the gold price stays between $1,750/oz - $1,950/oz, I'm less confident that Harmony will see meaningful upside in this gold price scenario, given its slim margins.
(Source: FASTGraphs.com)
Moving to a technical picture, Harmony has rallied more than 20% from its lows and is now approaching its lower resistance level at $4.35. With the next support level not coming in until $3.05, this translates to a reward/risk ratio of 0.24 to 1.0 from a current share price of $4.10. This is not ideal, suggesting that there's much more downside than upside from current levels from a trading standpoint. Generally, I prefer a reward/risk ratio of 4 to 1 at a bare minimum, and this would require a dip below $3.40 per share. The unfavorable reward/risk ratio doesn't mean that Harmony can't go higher and rally towards resistance at $4.35 - $4.40, but I don’t see the stock near a low-risk buy point here.
(Source: TC2000.com)
Many investors might argue that Harmony Gold has the most to gain from an increase in the gold price, given that its margins will increase disproportionately relative to peers being a high-cost producer. This is entirely true, but if the gold price weakens, Harmony could see a massive decrease in annual earnings per share and will not generate meaningful free cash flow if the gold price drops back below $1,700/oz.
This makes HMY a high-risk, high-reward bet. In a sector where there's already considerable risk due to how unpredictable mining can be with occasional negative surprises, I prefer to focus on low-risk, high-reward bets, with one being Agnico Eagle Mines (AEM). To summarize, I believe there are much better ways to play the recent sector-wide dip, and I would view any rallies in Harmony above $4.90 before April as an opportunity to book some profits.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AEM, GLD either through stock ownership, options, or other derivatives. 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.
Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. Given the volatility in the precious metals sector, position sizing is critical, so when buying precious metals stocks, position sizes should be limited to 5% or less of one's portfolio.
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GLTA, AP