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Industry Analysis: Precious Metals
Value Line’s Precious Metals Industry consists primarily of gold mining companies. Nonetheless, the following analysis should apply to silver and other precious metals producers. Gold mining companies range from those concentrating solely on exploration, to junior producers mining a few hundred thousand ounces at a handful of mines, to senior producers mining millions of ounces via many mines located throughout the world. Our industry has a significant concentration of senior producers.
The geographic range of senior producers’ operations exposes them to a degree of political risk. Gold miners are also subject to governmental and extensive environmental regulation. Gold production is capital intensive, with producers operating under moderate debt-to-capital ratios. Annual capital budgets can easily range between $500 million and $1.0 billion, and are usually funded internally. Increases in mineable reserves and production are primarily accomplished by exploration or acquisition, with acquisitions usually funded via cash and debt, though equity is issued on occasion. The industry’s annual output generally advances modestly. Investment returns are a function of not only metals prices, but also the quality of a mine’s proven and probable reserves and the company’s ability to realize their value.
One of the most important physical assets of a gold mining company—its proven and probable (P&P) reserves—is not on its balance sheet, but is found as a note to its annual report or SEC Form 10-K. P&P reserves form the basis from which a gold miner generates cash flow and, hence, value to shareholders.
A direct quantitative evaluation of these reserves may not be realistic (information may be incomplete or not readily available). However, an indirect valuation may be accomplished, and is often useful. This method assumes that the market value accorded the company imparts an assessment of the value of the reserves. Under this assumption, the value of the company’s P&P reserves is equal to its market value less its working capital and less the difference between its long-term assets and liabilities. To get a per-ounce valuation, divide this figure by the estimated recoverable ounces in reserves. (Note that an average recovery rate is not always given, but a figure of 80%-85% is probably reasonable.) Recent analysis shows investors valued senior gold producers’ P&P reserves between $100/oz and $115/oz.
A gold miner’s reserves are not fixed; they are reduced by annual production and primarily replenished by drilling (moving resources into the P&P category) and acquisition. An investor would always prefer additions to be made at a cost lower than the reserve’s current valuation, thereby limiting any potential dilution. However, additions at higher cost may also add value, but they would need to be particularly prospective in nature, have a low associated mining cost, or present cost synergies to existing facilities.
Finally, we mention that yearend reserve statistics are measured at what is then considered a long-term sustainable price, which may differ considerably from the current quote. Moreover, the measuring price may vary from year to year. Nonetheless, most companies provide information that allow for an apples-to-apples comparison. We note that a higher measuring price will usually have a positive effect on reserves.
Development and Operating Costs
This industry’s capital intensive nature requires many hundreds of millions of dollars be invested to develop a mining property. Accordingly, development expenditures should be allocated economically, with an eye towards minimizing cash operating costs over the life of the mine. In the last few years, gold mining companies have experienced meaningful inflationary pressures in the costs of equipment, energy, labor, consumables, etc., which have pushed development and operating costs upward. Currency translation effects have also been a factor in this regard.
Most companies present their quarterly operating statistics in good detail. Throughput statistics (tons mined, etc.) are usually shown, along with cash operating costs, royalty expenses, depreciation, depletion and amortization (DD&A) charges, and reclamation accruals for each mine (on a per-ounce basis). All else equal, the lower these expenses, singularly and in aggregate, the better.
As mentioned above, gold miners’ cash operating costs have risen sharply recently. A few years ago, senior producers’ average cash operating costs were about $200/oz; this metric currently resides in the $400/oz range. In the ensuing interim, though, bullion prices have increased at an even faster pace, which has allowed the industry to continue generating good cash flow and an acceptable return on existing mines.
Meanwhile, DD&A charges—which are reflective of the overall cost to develop a mining property and are summarized as Depreciation on the Value Line page—have not yet increased too much on a per-ounce basis, averaging roughly $100/oz for senior producers. It is possible that this figure may rise in coming years as new mines are brought into production, given the current escalation in development costs. However, a higher initial investment, if accompanied by a healthy cash flow in the early years of a property, can still deliver an acceptable return.
Gold mining stocks usually trade in line with gold prices. Moreover, the higher a company’s operating leverage, the more likely its share price is to respond to a change in bullion prices. Nonetheless, long-term investors wishing to insulate portfolios from the effects of inflation and/or financial distress, will likely find positions in producers that adhere to industry fundamentals more effective.