Tuesday, July 16, 2013

Can Gold Miners Drop Even Further?

Gold miners in general, which are represented in the Market Vectors Gold Miners ETF(NYSEMKT: GDX), and the world’s biggest gold producer, Barrick Gold (NYSE: ABX), in particular are not looking so good following the drop in gold prices. While on one hand, the fall in the value of the precious metal has exposed the massive debt of these miners, on the other hand, Barrick Gold has to deal with its massive mine on the Chile-Argentina border which is now looking less lucrative.
Analysts have also pointed out that some of the leading gold miners are going to write down the value of their assets in the coming quarters. While some believe that the sector has hit rock bottom, I think that it can go down even further.
The debt pile
Gold miners, who had amassed enormous amounts of debt, are now cutting down their costs and selling assets to improve their cash position in order to avoid any possible downgrade to their credit rating. According to BMO Capital Markets, in the last decade, the net debt of 55 precious metal firms has increased more than ten folds from less than $2 billion to $21 billion.
Barrick Gold is at the top of this list. The company’s debt has ballooned from $6.6 billion at the end 2010 to $14 billion in December 2012. During this period, its debt-to-equity ratio, a primary solvency ratio which measures debt as a percentage of shareholders' equity, deteriorated significantly from 34% in 2010 to 64% in 2012. Some of this rise can be attributed to the poorly timed debt-financed purchase of the copper miner Equinox Minerals for $7.65 billion, which was followed by a fall in copper prices.
Newmont Mining (NYSE: NEM) is also not doing too well as its debt-to-equity ratio has risen from 33% in 2010 to 46% in 2012 while its total debt has gone up from $4.4 billion to $6.3 billion in the corresponding period. 
With the drop in gold prices, Newmont's stock has tanked and is now trading below its 2009 levels. As a result, the company now gives an attractive yield of more than 5% which could lure some of the yield hunters, but based on its debt levels pointed out above, its fundamentals have only gotten worse. In 2009, it was trading a little above its current price levels but carried $1.58 billion less debt than today.
Moreover, the company has a gold linked dividend policy, which means that the dividend is cut with the drop in prices of gold, which happened this year in April. With the weakness in gold prices, more dividend cuts would happen in the future. Yield hunters should note that with optimistic assumptions of future gold prices, Newmont's yield could fall to just 2.8%. Therefore, I would not recommend Newmont, not even to those looking just for high yield. 
If the ratings agencies lower the credit ratings of these gold miners, then that would make borrowing more expensive, which would add to the monumental challenges they are already facing. Standard & Poor’s has warned that with the current levels of expenditures, if the gold prices remain at or below $1,300 per troy ounce for more than six months, then we will most certainly see a downgrade. With their massive debt levels, I believe that Barrick Gold and Newmont Mining face the biggest risk of a downgrade. However, radical divestment and cost cutting measures could save them.
To make matters worse, the cost of mining has been rising. According to BMO’s estimates, mining costs per ounce of gold have risen by as much as 177% in the last seven years.
The biggest write-down ever
Meanwhile, Barrick Gold’s flagship Chilean Pascua Lama gold mine project, whose operations were suspended in April due to environmental concerns, has given another bad news to its investors; Barrick Gold will now incur enormous post-tax charges of about $5 billion related to the mine due to delays and the drop in precious metal prices. This could turn out to be the biggest one-time charges ever incurred by any company in the gold mining sector.
The company has now reduced its 2013-14 capital expenditure on the project by $1.5 billion-$1.8 billion to $2.8 billion-$3.2 billion. It has submitted a new plan to the Chilean government and now aims to complete the project by the end of next year.
Negative outlook
However, investors should note that some analysts, such as Oppenheimer’s Carter Worth, believe that the situation couldn’t get any worse, which is why companies such as Barrick Gold and Newmont Mining are attractive and represent a significant upside.
However, I believe that there is a lot of uncertainty in the industry coming from falling gold prices, high debt levels, and divestment. In Barrick’s case, we need more information about how the company is managing its debt and asset sales -- which would come in its next earnings release in October.
Then there is the threat of more write-downs which could significantly damage earnings. Following Barrick’s massive $5 billion hit, Jefferies has identified that Newmont Mining and the South African mining giant Gold Fields may be next.
Meanwhile, shares of gold miners have tanked this year. Since January, Barrick Gold has dropped 55%, Newmont is down 33%, while the Market Vectors Gold Miners ETF has dropped 45%.
Therefore, due to the volatility in gold prices, high debt levels, a possible downgrade in credit ratings, and potential write-downs, I believe that these firms haven’t touched bottom yet and I believe that the outlook for both Barrick Gold and Newmont Mining is negative. The Market Vectors Gold Miners ETF isn’t any better. In fact, Barrick Gold and Newmont Mining are its second and third-biggest holdings with a total weight of 20.3%. Add Gold Fields to the equation, the tenth largest holding in the fund, and you have an ETF whose at least 25% of net assets -- represented by these three companies -- are on Jefferies’ write down radar. 
Barrick Gold is now stuck with a mine which is now looking less lucrative than before due to not only financial, but political challenges as well. Investors should also note that the write-down story for Barrick Gold with a $5 billion post tax charge is not over yet. Besides, Newmont Mining and Gold Fields, analysts from TD Securities have pointed out that total impairment charges of $10 billion could be in the making. Remember Barrick’s poorly timed copper acquisition of Equinox Minerals mentioned earlier? That still carries goodwill of $3.5 billion which could evaporate in the coming quarters.
Therefore, due to high debt levels, increasing likelihood of a ratings downgrade, and expectations of further write downs on the back of tumbling gold prices, I believe that Barrick Gold, Newmont Mining, and the Market Vectors Gold Miners ETF haven’t bottomed yet. Their shares would remain under pressure and any of these bad news would send their stock even lower. 
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I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours of this publication. I wrote this article myself, and it expresses my own personal opinion. I have no business relationship with any company whose stock is mentioned in this article.