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Gold Miners' Q'17 Preview

Adam Hamilton
Archives
Oct 13, 2017

With the third quarter's earnings season now underway, the gold miners will soon join in and report their latest results. No data is more highly anticipated by investors, for good reason. Quarterly reports dispel the dense fogs of herd sentiment that usually obscure gold stocks, revealing their operations' underlying fundamental realities. Q3'17's upcoming results are likely to prove quite bullish for this neglected sector.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports. Companies trading in the States are required to file 10-Qs with the US Securities and Exchange Commission by 45 calendar days after quarter-ends. The gold miners generally release their quarterly reports in the latter halfof this span. So Q3'17's will arrive between late October and mid-November.

After spending decades intensely studying and actively trading this contrarian sector, there's no gold-stock data I look forward to more than the miners' quarterly financial and operational reports. They offer a true and clear snapshot of what's really going on, shattering the misconceptions bred by ever-shifting winds of sentiment. Nearly all fundamental analysis is based off the data gold miners provide in these reports.

So for many years I've delved deeply into gold miners' quarterly results. They are the dominant source of information I use to winnow down the universe of gold stocks to the fundamentally-superior ones with the greatest upside potential. Every quarter after their latest earnings season ends, I research and write essays discussing the newest results from the major gold miners, junior gold miners, and silver miners.

Q3'17's analyses are coming starting in mid-November, once that 45-day post-quarter reporting deadline has passed. But before that I eagerly dive into individual companies' results as they're reported, since there's so much to digest. And even earlier right after a quarter ends, I start thinking about what gold miners' latest quarterly results are likelyto show collectively. They can actually be predicted to some extent!

In high-level fundamental terms, gold mining is a simple business. These companies painstakingly wrest gold from the bowels of the Earth, then generally sell all they can produce at prevailing market prices. So their profits are effectively the difference between current gold levels and operating costs. The former is easy to calculate once a quarter ends, and the latter can be fairly-accurately estimated for this sector as a whole.

Gold's average closing price in Q3'17 was just under $1279, up 1.7% sequentially from Q2'17's average near $1258. Higher gold prices portend better quarterly results, because gold-mining costs are largely fixed. They are mostly determined back when mines are being planned. That's when engineers carefully decide which ore bodies to mine, how to dig to them, and how to process the resulting gold-bearing ore.

Quarter after quarter, generally the same numbers of employees, excavators, haul trucks, and mills are used regardless of prevailing gold prices. There are some variable costs like diesel fuel, but they are dwarfed by massive fixed costs. Thus higher gold prices flow right through directly to the miners' bottom lines, boosting profits. And the relationship between gold's gains and higher earnings is leveraged, not linear.

The major gold miners are all included in the leading GDX VanEck Vectors Gold Miners ETF, which is the world's most-popular gold-stock investment vehicle. Every quarter I dig into the latest results from its top 34 component companies, which account for 90%+ of its total weighting. In Q2'17, these top GDX major gold miners reported average all-in sustaining costsof $867 per ounce. These AISC determine profits.

All-in sustaining costs include everything necessary to maintain and replenish operations at current gold-production levels. They include all direct and indirect cash costs of production, exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation. AISC are the most-important gold-mining cost metric by far for investors to follow.

At Q2's $1258 average gold price and $867 average major-gold-miner all-in sustaining costs, this sector was generating profits around $391 per ounce. That's pretty impressive, implying fat 31% profit margins most other industries would die for. Making the reasonable assumption that AISC will be pretty flat in Q3, its $1279 average gold price would yield profits of $412 per ounce. That's up 5.4% quarter-on-quarter!

Potential 5.4% sequential gains in quarterly earnings in Q3'17 are big absolutely, probably better than the great majority of stock-market sectors. And 5.4% QoQ profits growth on a 1.7% QoQ gold rally makes for excellent 3.2x profits leverageto gold from the major gold miners. That's the primary reason gold-mining stocks yield such massive gains in rising-gold-price environments. Their profits explode as gold rallies.

But the major gold miners' potential to bullishly surprise in their upcoming third-quarter earnings season goes well beyond that. Between Q2s and Q3s, all-in sustaining costs actually tend to fall rather sharply. Last year between Q2'16 and Q3'16 for example, the average AISC of GDX's top-34-component major gold miners fell 3.5% from $886 to $855. I fully expect to see a similar third-quarter drop in AISC this year.

The reason is global gold-mining production tends to surge between Q2s and Q3s. This phenomenon is readily evident in the latest data from the World Gold Council, which collects the best gold fundamental data available. During the seven Q3s from 2010 to 2016, world gold production soared 8.0%, 4.4%, 5.3%, 9.0%, 8.8%, 6.1%, and 7.0% sequentially quarter-on-quarter from Q2 to Q3! That averages out to +7.0%.

Such big and consistent quarterly growth in Q3s is interesting. I suspect at least a couple major factors feed into it, mining-plan management to boost managers' compensation and summer. The managers of gold miners are usually partially paid in stock or stock options, giving them big incentives to do everything they can to boost stock prices. Their annual stock-based bonuses are usually figured late in calendar years.

Thus these guys seem to plan mining to attack any necessary lower-grade ores that yield fewer ounces earlier in years if possible. Then they shift back to higher-grade ores in the second halves when stock prices matter more for compensation. Exceeding investors' expectations of production rates in Q3s also leads them to bid gold-mining stocks higher into year-ends, compounding gains from mining-plan management.

In addition most of the world's major gold mines are in the northern hemisphere, where mining is easier in the summer. The weather is warmer and clearer, with less snow or monsoon rains to slow down mining operations and mess with heap-leaching gold recoveries. I'm amazed at the number of quarterly reports I've seen over the years that attributed lower gold production to unexpected weather interfering with operations.

Because most gold-mining costs are largely fixed, production and costs are inversely related. The more ounces being produced in any quarter, the more ounces to spread gold mining's big fixed costs across. So higher production directly leads to lower all-in sustaining costs. Higher production and the resulting lower per-ounce costs will make Q3'17's results look way more bullish than from just higher gold prices alone.

Gold production varies seasonally within calendar years partially due to mining-plan timing. Gold-bearing ore was certainly not created equal, with even individual deposits seeing big internal variations in their metal-to-waste-rock ratios. Miners often have to dig through lower-grade ore to get to the higher-grade zones underneath. This still has economically-valuable amounts of gold, so it is run through the mills.

These mills are essentially giant rock grinders that break ore into smaller pieces, vastly increasing its surface area for chemicals to later leach out the gold. Mill capacity is fixed, with limits on ore tonnage throughput. So when miners are blasting and hauling lower-grade ore, fewer ounces are produced. As they transition into higher-grade zones, the same amount of rock naturally yields more payable ounces.

Regardless of the ore grades being blasted and milled, the overall quarterly costs of mining don't change much. Operations require the same levels of employees, diesel, maintenance, and electricity no matter how rich the rock being processed. So higher gold production directly leads to lower per-ounce mining costs. The big fixed costs of gold mining are spread across more ounces, making this business more profitable.

Back to the upcoming Q3'17 results from the major gold miners, where profits should surge on the order of 5.4% QoQ due to higher gold prices alone. Let's conservatively assume their gold production rose 4.0% sequentially, far below Q3's 7.0% average since 2010 and making for the worst Q3 growth in at least 8 years. Naturally 4% higher gold production should lead to a proportional increase in gold-mining profits.

That takes the projected Q3'17 profits growth in the top major gold miners included in GDX to the 9%-to-10% range quarter-on-quarter. But that doesn't take into account the lower production costs generated by higher production. Once again a year ago in Q3'16, the top 34 GDX components saw their average all-in sustaining costs fall 3.5% QoQ. Let's conservatively assume average AISCs are 2.0% lower in Q3'17.

That would drag the major gold miners' sector-wide AISC back down near $850 per ounce. Incidentally that is totally plausible, in line with Q3'16's $855. At Q3's average gold price near $1279 and $850 AISC, operating profits would surge to $429 per ounce. That's up a whopping 9.9% sequentially from Q2'17's $391! Add in that 4% higher production likely, and we're talking big quarterly profits growth around 14%.

Now don't read too much into the precise number, it's merely an estimate based on simple sector-level math. The Q3'17 profits growth in the top-GDX-component major gold miners won't exactly match, as each of these individual companies will have its own triumphs or challenges in Q3. The key takeaway here is we are set up for big quarterly profits growthin the upcoming results of the major gold miners.

While 14% quarterly profits growth would be extreme for most other stock-market sectors, it's nothing for the gold miners. Last year in Q3'16, the average gold price surged a much-larger 6.0% QoQ to $1334. That fueled a huge 41.6% QoQ surge in the total operating cash flows generated by the top 34 GDX gold stocks, and a staggering 230.7% QoQ rocketing in their total GAAP accounting profits! 14% in Q3'17 isn't a stretch.

The gold miners are truly set up to report excellent Q3'17 results in the coming weeks. I expect to see many upside surprises fueled by higher production and the resulting lower costs per ounce. That might lead to widespread favorable guidance changes for full-year 2017, upping production forecasts while lowering per-ounce cost estimates. Good Q3'17 results will make investors take notice of gold stocks again.

Any material new capital inflows from impressed investors ought to light a fire under today's beaten-down gold stocks. While they enjoyed some major technical breakouts back in August, gold's sharp pullback in September weighed heavily dragging them lower again. That leaves the major gold miners' stocks ready to rally fast if good Q3'17 results start bringing back scared or indifferent investors. The upside potential is huge.

All stock prices are ultimately dependent on underlying corporate profits. And for gold miners, nothing is more important for earnings than prevailing gold prices. Again gold-mining profits really leverage gold rallies, so their fundamental relationship is ironclad. Higher gold drives higher gold-mining profits which leads to higher gold-stock prices. And today gold stocks remain radically undervalued relative to gold.

That leaves them with lots of room to rally in the coming months if their Q3'17 results indeed manage to impress investors. The HUI/Gold Ratio is a great proxy for distilling down that core fundamental link between gold prices and gold-stock prices. It simply divides the daily close in the leading HUI NYSE Arca Gold BUGS Index that mirrors GDX by gold's daily close, revealing whether gold stocks are high or low.

As this blue HGR line shows, gold stocks remain very low relative to prevailing gold prices. This week the HGR was merely running 0.157x, which is extremely low historically. Gold stocks have only been lower relative to the metal that drives their profits briefly in late 2014, in much of 2015, and in the first few months of 2016. That happened to be late in a major secular bear driven by a deep parallel secular bear in gold.

If today's 0.16x HGR was actually righteous, it would've been seen plenty of times in modern history. But it hasn't been. Such extremely-low gold-stock prices relative to gold were only able to persist for a short spell late in a massive bear. But back in early 2016, the gold stocks soared with gold to birth a major new bull market. That persists to this day, with the HUI still up 101.5% bull-to-date since mid-January 2016.

With gold stocks in a young bull market, seeing them at deep-bear-low valuations relative to gold is truly absurd. It makes no sense at all fundamentally! Gold stocks have vast room to rally from here merely to return to normal levels relative to current gold prices. Good Q3'17 results could very well be one of the sparks, along with gold rallying, that motivates investors to resume returning and normalizing gold-stock prices.

Remember the Fed started aggressively levitating the US stock markets in early 2013, wreaking havoc on alternative investments led by gold. The gold market's last normal years were sandwiched between 2008's stock panic and 2013's radical Fed distortions. That's the best recent baseline for where the HGR ought to trade. And between 2009 to 2012, it was running way up at 0.346x. That's over double today's levels!

To simply mean revert back up to those last normal levels relative to gold, the major gold miners dominating the HUI and GDX would have to power 120% higher from here to 447! To restore some semblance of normalcy fundamentally, the gold stocks need to more than double from here even at this week's $1293 prevailing gold levels! Gold stocks certainly can't stay disconnected from their own earnings realities forever.

All markets are cyclical, including gold stocks. Extreme undervaluations relative to gold are followed by overvaluations as the pendulum swings back the other way. Mean reversions after extremes never stop in the middle. Their momentum leads them to overshoot to the opposite extreme! That makes gold stocks' coming upside far more impressive. A proportional overshootheralds radically-higher gold-stock prices ahead.

At worst in mid-January 2016, the HGR fell to an all-time low of 0.093x. That was a staggering 0.253x under that post-panic normal-year-average HGR of 0.346x. So a proportional overshoot would briefly boost the HGR 0.253x above that mean, to 0.599x. Such an upside extreme wouldn't last long, as greed wouldn't be sustainable. But it could happen in a blowoff top after gold stocks are popular following a bull.

At $1293 gold, that yields a potential HUI topping target of 775! That's a stupendous 282% above this week's levels. Is there any other stock sector with the potential to quadruple in the coming years? No way. Gold stocks are the only severely-undervalued sector left after this Trumphoria stock rally, so their upside is unparalleled. And incredibly these simple HGR-derived gold-stock targets are actually conservative.

They assume gold is static, stuck at $1293. That's exceedingly unlikely. As these Fed-levitated stock markets inevitably roll over with Fed quantitative tightening ramping up, gold itself will catch a major bid as investment capital returns. As a rare asset that generally moves counter to stock markets, gold is hostage to them. So when the stock markets suffer their long-overdue major selloff, gold will soar on capital inflows.

10%, 20%, and 30% gold uplegs from here would take this metal to $1422, $1551, and $1680. Plug in the HGR of your choice, the post-panic average or the mean-reversion overshoot, and you get some potential HUI targets so high they defy belief. And don't think a 30% gold rally is out of the question. In response to the last stock-market correction, gold powered 29.9% higher in just 6.7 months in early 2016!

Don't get bogged down in HUI upside targets, they only serve to illustrate a critical point for investors and speculators today. Gold stocks are not only radically undervalued at today's gold prices, but even more so compared to where gold is heading in its own still-very-much-alive bull market. Even if you think gold stocks only have 50% to 100% upside, that's vastly better than everything else in these overvalued stock markets.

And gold miners' upcoming Q3'17 results could very well prove the catalyst that ignites the next major gold-stock upleg. The large gold miners will likely soon report big profits growth on higher production and lower costs, easily surpassing investors' low expectations. As they start shifting capital back into this forgotten sector, gold stocks will rally. That will soon attract in other investors, fueling a self-feeding upleg.

While investors and speculators alike can certainly play gold stocks' coming upleg with the major ETFs like GDX, the best gains by far will be won in individual gold stocks with superior fundamentals. Their upside will trounce the ETFs', which are burdened by over-diversification and underperforming gold stocks. A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

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The bottom line is the major gold miners' upcoming Q3'17 results should show strong sequential profits growth. Q3's higher average gold prices alone will drive higher profits if gold-mining costs are flat. But Q3s have a long history of seeing big sequential jumps in gold-mining production directly leading to lower per-ounce costs. If that proves true again last quarter, the major gold miners ought to report excellent results.

The potent combination of higher prevailing gold prices and bigger production to spread gold mining's large fixed costs across should lead to sector profits surging rather dramatically. Investors will likely take interest and start bidding gold stocks higher again, fueling a major upleg. And since gold stocks remain so darned low relative to prevailing gold prices, their upside from here is vast as investment capital returns.

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Oct 13, 2017
Adam Hamilton, CPA

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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