Gold-Mining Margins 3
Gold mining is a very tough business. Not only is it highly capital-intensive and chock-full of environmental risks, its revenues are entirely at the mercy of a volatile commodity. It requires some serious mettle to succeed mining gold.
But despite super-high barriers to entry and the countless risk factors that come with mining, the world needs gold, and somebody's got to produce it. And believe it or not, a lot of money can be made in this business.
At a high level gold mining is like any other business. Produce your product at costs less than what you sell it for, and you ought to prosper. And the wider that spread, the more you prosper. But unlike most other business, the "what you sell it for" is an uncontrollable variable that can violently move in either direction.
For gold miners the dangling carrot is a rising gold price. And naturally the best of times ought to occur over the course of a bull market for the metal. Gold has of course been party to one heck of a bull run over the last decade or so, with its price soaring by a staggering 638% from its 2001 low to 2011 high. Given this kind of gain, many gold miners have easily chomped that carrot on the way to big gains of their own.
And gold miners, represented by gold stocks, have indeed had quite a run over gold's secular bull. As measured by the venerable HUI gold-stock index, the gold stocks have leveraged gold's gains by greater than two-to-one to their own 2011 highs.
Unfortunately even though gold stocks have sported some of the best gains of the 2000s, they've always resided in somewhat of a stealth sector that has captured little mainstream attention. And typically any mainstream attention they do get is critical, with one of the biggest critiques being their perceived inability to make money.
I've long scratched my head at this assertion. And fortunately it hasn't really mattered given how much money gold stocks have made us and our newsletter subscribers here at Zeal. But since I'm an inquisitive guy, I put this assertion to the test. From a simple ground-floor perspective, is there a way to show that the gold miners at least have the opportunity to turn a profit? Because if they do, the good ones will do so.
In order to begin to answer this question I like to look at one of the most basic financial metrics, gross margin. Gross margin is calculated by subtracting cost of goods sold from revenue, and then dividing that tally by revenue. In its simplest sense, gross margin represents the percent of revenue a miner retains after incurring operating costs. The higher the margin, the more the miner retains on each dollar of revenue. Check out the bull-to-date average gross margins for the gold miners!
For gold miners gross margin is quite easy to calculate. Their cost of goods sold is called cash operating costs, reported on a per-ounce basis. These cash costs are essentially the cumulative direct input costs of mining an ounce of gold. Labor, energy, and consumables are typically the largest costs. And they combine for a dollar amount that is hopefully much less than the price of gold.
For the purposes of this exercise, I use the cash costs of the stocks that comprise the HUI. These globally-diversified miners are the biggest and best in the world, and account for over a third of the total mined supply. While certainly not all-encompassing, it is a fair representation of the industry as a whole.
For simplicity's sake I use the simple average cash costs of the HUI's primary gold miners all the way back to 2001 (red bars), the first year of gold's secular bull. This average cash cost is then scrubbed up against the average daily gold price each year (blue bars). And with these two numbers I'm able to calculate gross margin (yellow) and the associated spread (white).
First and foremost we see the price of gold consistently rising year after year, a delicious trend for the mining companies. If they can control their costs, they should be rolling in the dough. But as you can see, cost control has certainly been a challenge for the miners.
Amazingly back in 2001 the miners were producing their gold at cash operating costs of only $176 per ounce. Now this seems incredibly low today, but when you consider that the average price of gold that year was only $272, there wasn't much wiggle room if the miners wanted a shot at making money (most gold miners were not profitable in the late years of gold's preceding bear and the first few years of the existing bull).
Over the first five years of gold's bull market, cash costs rose by a staggering 43% to $253. In any other industry costs rising this sharply would spell disaster, a recipe for going out of business. For gold miners though, this rise in costs was outpaced by a corresponding 63% rise in the price they could sell their underlying product for. And this led to a growth in gross margins to the 40%+ range, which is quite impressive.
In 2006 cash costs saw an anomalous year of stability. But in 2007 they fell back into trend with a sharp ascent higher. In fact, over the last six years gold miners' cash operating costs have risen by an annual average of 19%. 2012's average cash cost of $719 is a crazy 184% higher than 2006. Put into a different light, 2012's cash costs are over $100 higher than 2006's gold price. And they're a staggering four-fold what they were at the beginning of the bull.
Again, costs rising at this rate of ascent would have spelled doom for most industries. Thankfully also beginning in 2006 gold's price really started to take off. And over the same period where cash costs rose by 184%, the price of gold rose by 176%. And led by gold's big rise in 2006 (+36%, by far the largest bull-to-date annual rise), precedent was set for an increase in average gross margins to the 50%+ range.
Yes, cash costs are rising sharply. And I discuss the many reasons for this (intentional/unintentional low-grading and huge increases in input costs among the bigger reasons) in a past essay. But as you can see, gross margins are not being pinched given the offset of rising gold prices.
Overall these robust margins and widening spreads show that the gold miners do in fact have the opportunity to turn a profit. But even though 2012's average gross margin of 57% was close to the best we've seen in this entire bull market, the vast throngs of haters just don't seem to care.
As hardened contrarians we've grown accustomed to unrighteous gold-stock bashing. And even though most of the criticism slung our way is emotionally based, fundamentals and performance be damned, there is some criticism that's perhaps justified. And it is based on the notion that costs outside of cash operating costs greatly diminish what is represented by conventional gross margins.
Provocatively while conventional cash costs cover the mine-level operating costs of producing an ounce of gold, they don't actually cover the all-in total costs of producing that same ounce. Even though cash costs are effective for peer-to-peer comparisons and they do paint a picture of potential profitability, I'll be the first to admit they are a window-dressed non-GAAP performance measure that doesn't necessarily tell the entire story.
Though I personally still don't have a problem using cash operating costs as a legitimate performance measure, this metric's criticism has prompted some revolutionary changes in the way gold miners will report on their costs in the very near future. And these changes are the product of an initiative set forth by the members of the World Gold Council that will hopefully silence the critics while also bringing positive exposure to gold stocks.
The members of the WGC are none other than the gold miners themselves, including the majority of those that comprise the HUI. And I wouldn't be able to describe this initiative better than Goldcorp CEO Chuck Jeannes does in his company's 2012 annual report.
"The traditional measure of cash costs is not a realistic view. To produce an ounce of gold, we not only incur operating costs, but we spend sustaining capital at the sites, we spend G&A to keep the lights on, and we spend dollars to explore, to sustain our future. If you put all those together, that's an all-in sustaining cash cost. It's a much more transparent and accurate way of judging the real costs of getting an ounce of gold out of the ground."
Ultimately all-in sustaining cash costs will give investors a much-more accurate snapshot of the full costs of producing gold from existing operations. And from what I gather, the WGC is looking to finalize a standard before the end of 2013.
Interestingly even though things are not set in stone, nor has it been universally adopted across the industry, we got a taste of what all-in sustaining cash costs would look like via a handful of miners (including Barrick Gold, Newmont Mining, and Goldcorp) either voluntarily reporting it in 2012 and/or projecting what it will be in 2013. And among the seven major miners that divulged these figures, the average all-in sustaining cash costs came out to $1046.
Indeed this all-in figure is quite a bit higher than the more conventional cash-operating-cost figure, to the tune of +45%. And this obviously greatly pinches the margins if these costs are inserted in place of what's conventionally used. But considering where the price of gold's been, is this all-in figure really that scary? No, not really.
If I used this all-in cash-cost figure with 2012's average gold price, gross margins would still have come in at 37%. This is a margin that is still well higher than most other industries. Wall-Street darling Apple just reported its gross margins at 38% in the first quarter. And based on the valuations of the gold stocks these days, the miners are showing that these robust margins do in fact translate to positive earnings.
Astonishingly the collective price-to-earnings ratio of the HUI was 11.6x as of the end of April. Now gold stocks have never been known to be value plays, but this insanely low P/E ratio represents the cheapest these stocks have ever been. It is well less than half their average P/E ratio over the last half-dozen years, and incredibly nearly half the current collective P/E ratio of the S&P 500 (21.0x). I never thought these words would come out of my mouth, but gold stocks are currently value plays!
When this highly-scrutinized sector gets its feet held to the fire, it delivers on margin and earnings. And while it's certainly not popular to laud the virtues of gold stocks during a time when they are universally loathed, this sector's strong structural fundamentals sets it up to continue to deliver down the road.
And interestingly miners' fast-rising costs somewhat support these fundamentals. As silly as it sounds, higher production costs can actually serve as a backstop for gold's price. The closer the gold price gets to costs, the more of a squeeze the miners will see on margin. And if they're squeezed enough, production will be cut.
And not only will squeezed margins cut production, there will be less to go around for new-project capex. If new-project capex is neglected for long enough, new production from next-generation mines will fall behind the depletion rate. Now if gold demand plummets, this supply pressure wouldn't be a problem. But if demand remains high as it is today, it wouldn't take long for economic forces to bring prices back up to levels that make gold amenable to profitable mining.
Overall it'll be interesting to see if/how 2013's gold price action affects mine production. So far we're on track to see the first year-over-year decline of the average gold price in this bull market. And if costs continue to rise, which they are expected to, margins will definitely be thinner. Will this lead to lower output and subdued pipeline development?
Time will certainly tell. But given gold's stout structural fundamentals and the fact that it is wildly oversold, we're due for a strong back half of 2013 that ought to put gross margins back in line with trend. And this will do great things for the mining companies and their respective stocks.
That's right, as crazy as it sounds we're believers in gold stocks. It's no doubt been a brutally tough market for them lately, but their carnage offers one of the best buying opportunities ever seen in this bull.
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The bottom line is despite their bad reputation, the gold miners have consistently been able to deliver some of the highest gross margins seen in the markets. Even though they've had trouble controlling their costs, gold's rising price continues to give them a nice spread to work with.
And the gold miners are trying to get on mainstream investors' radars by offering up more transparency on the cost side of things with a brand-new metric, all-in sustaining cash costs. While this performance measure will certainly pinch conventional gross margins, the miners should still have plenty of play.
May 03, 2013
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