A Tale of Two Gold Miners: Kinross vs. Barrick
Pretty much every major gold mining company suffered as a result of falling gold prices. Not only did the market price of gold fall by some 30 percent – 40 percent, but the cost of mining gold generally rose during the bear market. So while in 2011 you had companies producing gold at $900/ounce and selling it at $1,700/ounce, in 2013 we had companies producing gold at $1,100/ounce and selling it at $1,300/ounce. This meant that profitability fell by 75 percent.
While some of the rising production costs were a result of inflation, a lot of it was a consequence of gold miners’ belief that the higher gold price was here to stay. Mining company executives wanted to produce more gold so that they could report production growth, and this meant that a lot of them decided to make acquisitions, or to start mining projects that were only economical in the higher gold price environment.
When the gold price fell, we started to see a new policy touted by executives — they now wanted to emphasize “quality of ounces” rather than “quantity of ounces,” meaning that they would focus on mining gold that was less costly to produce. They also wanted to strengthen their balance sheets, and this entailed paying off debt, slashing dividends, and issuing stock. As painful as this was, it needed to be done.
But while most large mining companies adopted this policy, some miners were more aggressive in pursuing it than others. With the prices of gold and mining shares down, I think this is an excellent opportunity to begin taking a long term position, and I think one criterion that investors should apply is the extent to which a company’s management reacted to lower prices. While it is simpler to just buy shares in the Market Vectors Gold Miner ETF (NYSEARCA:GDX), I think by applying these relatively simple screens, investors can markedly improve their long-term performance, as not only will they be choosing companies that have a stronger financial position, but they will be betting on managements that value a stong financial position.
Kinross Gold was a mess before the new CEO J Paul Rollinson took over in 2012. The company had high production costs, a lot of debt, and an aggressive definition of its gold reserves — i.e. it overstated how much gold it can mine economically. As a result the company did several things in the weak gold price environment. First, the company eliminated its dividend. While this is very painful, it saved precious capital that the company could use to pay down its debt. Second, it paid off a lot of its debt. While it still has $2 billion in debt outstanding, it is not due for a few years and it is easily manageable. Third, the company aggressively wrote down its reserves. While the company estimated that it had around 60 million ounces of gold reserves in 2012, this figure came down to just under 40 million more recently. These 20 million ounces of gold didn’t disappear. The company simply decided that with the gold price where it is it cannot mine these ounces profitably and it will wait for a higher gold price environment to do so. Finally, it got out of its Ecuadorian operations, which were not economical and which were being taxed punitively.
The end result is a company that is going to be able to mine very profitably with gold at $1,350/once and generate a lot of cash flow on a per-share basis. Furthermore, thanks to production growth in Russia and in West Africa, the company will be able to row its production slightly year-over-year. Finally, it is in a position to make acquisitions and to take advantage of the weakness that other companies are experiencing as a result of low gold prices.
A company that hasn’t reacted so well to the lower gold price environment — but which paid lip service to the idea — is Barrick Gold. Barrick actually did a lot of things similar to what Kinross did, but as the world’s largest gold miner it take a lot more to move the needle and therefore I don’t think it did enough. For starters, the company cut its dividend by 75 percent. It also issued about $3 billion worth of stock in order to pay down some debt But the company’s long term debt hardly went down year-over-year — it fell from $13.9 billion to $13 billion.
Debt to equity actually rose because of the company’s write-downs. Barrick also wrote down some reserves and it also discontinued development of its massive Pascua Lama mine. These were good moves, but I don’t think that they were enough. Furthermore, the company sold some high quality assets that were low cost producers in low risk jurisdictions such as Australia and Nevada. Meanwhile, it kept its holdings in Tanzania. Ultimately, the company didn’t really improve its finances and it saw a reduction in gold production guidance from 7 million ounces to 6.5 million ounces
Ultimately, we see many similarities between Kinross and Barrick, including share price performance. However, Kinross was clearly more radical in is effort to reformulate its business in order to appeal to more risk averse investors. As a result, I think that investors should appreciate what Kinross has done and add these shares rather than Barrick shares to their portfolios.