While the rest of the world spent the last few weeks trying to predict the next March Madness Cinderella team, it seems like a small group of investors have quietly been evaluating an underdog of a different kind. No matter how hard they try, the shorts and dollar bulls seem unable to drive gold below the technical support at $1145 for any significant amount of time.
If you think that gold has built a solid enough base to stage a rally from, the next question becomes how to play the rally. Some of the more risk adverse readers may choose to recalculate their physical gold weightings here, or buy into the royalty companies. Gold has proven itself with significant buying around these levels, so I decided to initiate a long position in the miners.
Personally, I am looking for significant upside return to compensate me for the level of risk I am taking, in light of the amount of disgust for gold in the mainstream investing community. The royalty companies may not provide me with what I am looking for, considering they have not gotten beaten-up as much as I would have liked. For that reason, I decided to look at some of the majors, specifically Barrick Gold Corporation (ABX).
The main reason to shy away from Barrick Gold is because of their unhealthy levels of debt. About $1 Billion is expected to mature within the next three years, with debt costs increasing over the next three years. This gives us plenty of time to see gold rally to levels to make that debt more manageable.
Not only that, but with the dollar recently bouncing off highs, we may have seen the real value of Barrick's debt peak. In other words, as the dollar begins to fall further against the gold, Barrick is set up very nicely. They have positioned themselves dynamically to get paid twice: First, as their revenues increase from the rising gold price, and secondly from the falling cost of servicing their debt, in real terms, as the currency their debt is denominated in falls. In this case, Barrick's revenue is protected from inflation because they produce gold and copper- two materials that are sensitive to it. For those gold buyers out there who are still predicting unexpectedly high levels of inflation in the future, Barrick is the natural choice because their debt will be slowly wiped away.
In the last gold run-up to $1300/oz, the market saw Newmont (NYSE:NEM) and Goldcorp (NYSE:GG)outperform Barrick. These companies have much lower debt to equity ratios than Barrick. The interesting thing about last rally is that gold and the dollar moved higher in tandem. As the dollar begins to depreciate against gold, I believe Barrick is going to outperform both of these companies because of their debt levels. The dollar is just coming off an all time high, and for that among other reasons, the real value of Barrick's debt is coming off an all time high as well.
A common argument against my point is that as the dollar falls, mining input costs rise in local currency. Generally this is true, but Barrick has a large percentage of production inputs priced in dollars. Above a third of all gold produced by Barrick is produced in the United States. Further, Barrick is already losing money on their oil hedges, and as the dollar falls they will recoup some of their losses in real terms. Other input costs, like labor, will rise in local currency terms, but likely continue to fall in terms of gold.
Barrick's management has initiated several cost cutting initiatives, another reason I am long. As it stands right now, costs are being cut even deeper, and I have calculated that Barrick would have to sell gold at an average of $1270 to maintain a level stability that would make me, as an investor, sleep soundly on my dividend income.
I got this rough estimate by subtracting net cash provided by operating activities (of $2.293 billion) from total revenue (of $10.2 billion, to gauge the cost of attaining this revenue) and dividing the result by how many ounces Barrick produced in 2014 (6.25 million). I use this number to give us a crude estimate of the real cost of mining an ounce of gold, because I have always been skeptical of popular AISC measures.
With gold trading at $1270, Barrick would generate enough cash flow from operations to more than offset costs of mining, exploration, interest, taxes, and office costs that are shrinking anyway. Regardless, Barrick is able to produce free cash flow with gold at current levels and with a revolving credit line of $4 billion, Barrick is positioned well even if rates rise marginally, which gold buyers know is a big if. The biggest way rising rates affect Barrick is because gold will fall further and the dollar will gain. Betting on Barrick is really a bet that rates will not rise substantially.
Although production has fallen around 13% YoY to 6.25 million ounces of gold, this number is in line with 2015 guidance. As Barrick continues to sell undesirable assets, production could fall further in the future. But this is part of the process of becoming a leaner low-cost producer.
In summary, Barrick is positioned well for the next coming rally in gold. As the dollar begins to fall against gold, Barrick will rise faster than its peers because of the amount of debt it has taken on. When gold breaks above $1270, and if copper follows suit, Barrick's income statement will look even more attractive than it does now. With gold trading at those levels, I expect to see Barrick trading around $19 a share based on my analysis.
(All non-opinion company information obtained from Barrick Gold Corporation SEC filings)
Disclosure: The author is long ABX.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.