Capital Expenditure Clouds Profitability

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1 Contents Introduction Gold Wave Analysis XAU Analysis API Analysis Australian Theoretical Gold Price Update Closing Comments Disclaimer Associated Products Volume 2, Issue 29, 26 August 2009 Capital Expenditure Clouds Profitability Just recently I read an interesting article which appeared on Mineweb called The Illusion of Gold Mining Profits written by Barry Sergeant. Sergeant highlights capital expenditure and its negative impact on the cash profitability of gold miners. He makes the important point that major gold mining companies, like Barrick, are facing dwindling production at existing mines and remain under constant pressure to find, buy or develop un mined gold ounces. This in turn is putting pressure on free cash flow. The issue I want to address today is the impact of capital expenditure on profitability and what it means for investors in gold mining companies. Sergeant in his article makes the following comment: Almost uniformly low "cash costs" as reported by individual companies in the gold industry are increasingly losing veneer. The definition of "cash costs" for gold miners is anything but uniform, but uniformly ignores cash capital expenditure and cash spent on acquisitions. Even so, cash costs are rising for most gold miners. There are two types of capital expenditure. One type relates to the construction or acquisition of new projects. As a company requires capital to build or expand on existing operations, this is not so much of an issue provided the company is replacing or adding value via incremental and profitable production ounces. The other type of capital expenditure refers to ongoing costs associated with existing projects (sustaining capital). In my opinion, it is this second type of capital expenditure which requires further scrutiny. Some companies churn out seemingly positive operating cash flow and accounting profits only to repeatedly return to bemused shareholders asking for more money. It is important to note that costs associated with sustaining capital do not immediately enter the profit and loss statement nor cash cost numbers even though the expenditure has been incurred. From a profit perspective, this often makes sense in that it is not reasonable to recognize all the expenditure immediately. An example of this would be prestripping costs associated with an open pit mine. Pre stripping is the removal of overburden in order to mine a section of ore in a deposit. Some companies do not recognize these costs up front because it distorts the cash costs for the period in question. Not all the gold associated with the pre stripping cost is mined during this reporting period. Many companies legitimately capitalize and then amortize these costs on a production ounce basis. There are other companies which, in my humble opinion, abuse the privilege of capitalizing expenditure and thereby conceal the true profitability of their respective projects. In the company Cash Flow Statement, investors need to pay close attention to the investment component and determine how much is actually being capitalized. Of the capitalized investment, how much is associated with existing projects and how much is spent on the construction or acquisition of new projects? Based on data provided by GoldNerds in the rolling 4 quarters to 30 June 09, the average cost per oz spent on sustaining capital costs for 42 prominent North American listed gold producers averaged US$165/oz. The average cash cost for all these companies was US$465/oz. The Global Speculator 1

2 Construction costs for projects can generally add anywhere from US$75 US$200/oz, which still implies an overall level of profitability (Total Cost US$705 US$830/oz). From an investor s perspective, you may want to consider the enterprise value (EV) per reserve oz representing the purchase price for acquiring those reserve ounces. For this same list of companies, the EV per reserve oz presently averages US$350/oz. Once you add this to the US$630/oz in cash and sustaining capital costs, you are looking at US$980/oz which exceeds the current spot price. I want to stress that this is obviously a crude number with limitations. It excludes the resource ounces over and above the reserves which could be inexpensively converted into reserves and are not given a value for the purpose of this assessment (resource ounces have no proven economic viability but are worth something). On the other hand, some of the reserves are associated with feasibility study stage projects, where construction costs are required to bring the projects into production. As we saw previously, this adds to the total cost you are paying to extract each oz of gold. Administration costs associated with running these companies have also been excluded. This leads to the obvious question. If it is costing you more than the spot price to invest in the recoverable gold associated with these companies, why bother? The simple answer is the leverage these companies offer to higher gold prices. Mining companies generally provide a leverage of 3 1 to rising gold prices because you are buying a share in the company s profitability. Increasing gold prices also mean a higher proportion of resource conversion to reserves. Many of us are bullish on the outlook for the yellow metal and a number of these companies are well run and will give our portfolios more bang for our buck. Given capital expenditure is generally ongoing and variable in nature, it needs to be monitored in the context of overall profitability. Some companies report cash costs below the spot price. Once sustaining capital costs enter the equation, these projects and companies are no longer cash flow positive. Let s consider an example. I know of a prominent company here in Australia which was building a new project whilst producing from existing projects. Excessive ongoing capital expenditure associated with the producing projects was getting masked by the construction related capital for the new project. When the company went to the market for additional capital, shareholders understandably assumed the money raised was entirely for the new project. What escaped detection was the underperformance of the existing mines. From an operating cash flow perspective, the projects appeared to be profitable. Once sustaining capital costs were considered, the projects were actually hemorrhaging cash flow. Some companies often anticipate excessive capital expenditure will eventually ease. It is amazing how other unforeseen issues and events can continue to occur depending on the quality of the project and the management involved. Analyzing a gold mining company s profitability in the context of operating cash flow performance alone can potentially be dangerous and misleading. I see many analysts refer to a company as having cash costs in the bottom quartile of industry standards only to ignore the fact that the project(s) in question are underground operations and ongoing development costs are conveniently excluded. As a rule, underground operations are more capital intensive in nature than open pit mines. Does this mean, from an investment perspective, that open pit operations are superior to underground operations? Not at all. I have seen many open cut operations suffer from higher capital expenditure associated with excessive pre stripping ratios. All I am saying is, as investors, we need to take all these factors into account when comparing projects and companies. To ignore capital expenditure can be fraught with danger. In our ongoing effort to develop a comprehensive information package for gold investors, the recently released North American version of the GoldNerds product includes a rolling 4 quarter summary of actual ongoing capital expenditure. It also provides a forward looking forecast of ongoing capital incorporating up and coming projects (this feature will soon be added to the Australian version of the product). These numbers are then integrated into a formula which adds an estimate of the future average cash cost (assuming all projects are developed), the enterprise value per mineable oz (customized indicator) and future construction capital (associated with undeveloped projects) to provide users with a useful Total Cost per oz estimate. This enables investors to effectively compare gold mining companies from a very unique and useful perspective. If you are serious about researching gold mining companies I encourage you to pay us a visit. The North American version covers most of the established producers and many of the up and coming development companies listed on the North American exchanges. The Global Speculator 2

3 Gold Wave Analysis Update COMMENTARY Not going to waste your time this month except to say our consolidation pattern is still in place with most in the precious metals community waiting for a breakout one way or the other. At this stage, I don t really care which way it goes except to say that it is harder to make money speculating on gold mining companies when the price of gold is so directionless. Directionless equates to emotionless with a lack of the associated extremes. XAU The chart below highlights key points in time when the XAU is overbought (RSI 30) and oversold (RSI 70), relative to gold. Once the respective indicators trigger (blue vertical lines), it then becomes a task of following trends in the ratio looking for definitive breaks to signify entry (green vertical lines) and exit (red vertical lines) points. The gold price wave analysis above helps us get our bearings. Right now, with the commencement of a Wave 3 rally, we should expect to see precious metals equities outperform the gold price signaling further strength in the metal. The Global Speculator 3

4 GOLD/XAU LONG TERM PICTURE GOLD XAU RATIO Extreme Key Dates Gold/XAU XAU XAU Performance Gold Price 3/11/ Gold Performance Net Position 25/05/ % 276 4% 29% 02/08/ % % 2% 09/01/ % % 36% 27/05/ % 418 1% 25% 17/02/ % % 32% 7/11/ % % 72% Current (21/08/09) % % 44% The Global Speculator 4

5 GOLD/XAU INTERMEDIATE TERM COMMENTARY The Gold/XAU ratio continues to dance around its consolidation range with no definitive break. Resistance remains at 7 with strong support at 6. Which line inevitably gets broken will largely determine the intermediate term direction of the precious metals markets. Since the last issue, the Gold/XAU ratio remains stuck at around AUSTRALIAN PRODUCERS INDEX (API) The Australian Gold Producers Index has a consistent format to that of the XAU. The relative strength comparison is with a USD gold price instead of an Australian dollar gold price. This is because Australian gold shares tend to be influenced more by the USD gold price. The Global Speculator 5

6 GOLD (USD)/API LONG TERM PICTURE GOLD (USD) API RATIO Extreme Key Dates Gold/API API API Performance Gold Price 25/07/ Gold Performance Net Position 10/10/ % 372 9% 15% 08/07/ % % 9% 05/05/ % % 125% 19/12/ % % 59% Current (21/08/09) % % 19% The Global Speculator 6

7 GOLD (USD)/API INTERMEDIATE TERM COMMENTARY During the month, the Gold/API ratio continues to test important resistance at around 2 as the index continues to underperform the metal which is bearish in its implications. The ratio looks to have support at 1.7. The Gold/API ratio is also range bound with a definitive break of support or resistance giving us our clue as to what s in store. A definitive break of 2 would be bearish and a break of 1.7 bullish. The Global Speculator 7

8 AUSTRALIAN THEORETICAL PRICE OF GOLD UPDATE Date 10 Year BB Interest Rates Headline CPI M3 Aggregate Money Supply Rate of Australian M3 Change Gold Production Av Annual Increase (1.73%) Australian Theoretical Gold Price Actual Gold Price (AUD) Actual as a % of Theoretical Jun , % 0.14% 3, % Jul , % 0.14% 3, % Aug , % 0.14% 3, % Sep , % 0.14% 3, , % Oct , % 0.14% 3, , % Nov , % 0.14% 3, , % Dec , % 0.14% 3, , % Jan , % 0.14% 3, , % Feb , % 0.14% 3, , % Mar , % 0.14% 3, , % Apr , % 0.14% 3, , % May , % 0.14% 3, , % Jun , % 0.14% 3, , % 5 Year Performance Snapshot 2008/09* 2007/ / / /05 Actual Gold 19% 26% 16% 18% 8% Theoretical Gold 13% 17% 14% 16% 6% M3 Growth 14% 19% 16% 17% 8% CPI 2.5% 4.5% 2% 4% 2.5% * This financial year so far. COMMENTARY M3 growth in Australia for 2008/09 has occurred at 14% after a jump of 1.6% in the month of June 09 (typical this time of year). The theoretical gold price finished the financial year at A$3,638/oz. If we cast our eye over the last 5 years, we see the gold price has increasingly started to outperform the Theoretical gold price as M3 growth remains entrenched over the 10% mark. The average return for gold in this time has been a tidy 17.4% pa or 87% overall. This compares favorably with the All Ordinaries Index which has averaged a return of just 2.2% pa over the same period or 11% overall. It is clear to me that we have entered a period in time where gold will continue to outperform the All Ordinaries Index as Australia enters a long uncertain economic phase. I have recently updated our Big Picture chart (below) so we can gauge exactly where we are at on the road map. The area I want to focus on this issue are the red The Global Speculator 8

9 and green lines in the bottom half of the chart which signify the 3 year moving average of M3 growth (red) and the 10 year Bank Bill rates (green). Gold has historically performed the strongest when we enter periods of excessive monetary inflation where M3 grows at 10% plus for extended periods of time. We recently started a new phase in 2003/04. To reign in monetary inflation interest rates generally need to rise. If you cast your eye back to the 1970 s, you can see that interest rates eventually rose to levels of 10% plus to reign in the monetary inflation which had taken hold on the economy at the time. Paul Volker, the US Federal Reserve Chairman at the time, instigated this move. If you fast forward to today, you can see the gap between monetary inflation and interest rates is not narrowing but actually growing. The US Federal Reserve is being forced to print money in order to buy government bonds. This is keeping international interest rates artificially low. If markets were left to there own devices, interest rates would be much higher and would better reflect the risk associated with US Government paper. When you compare the present scenario to the 1970 s things look much more serious. Interest rates can only really go one way from here and that s up. The M3 growth you see on the chart below is largely borrowed money. When you borrow to consume, you bring forward future consumption which fuels present economic growth. This automatically puts pressure on future years unless the same level of borrowing can continue. Borrowing to consume, despite what some people might think, is not a sustainable practice. At some point this debt must get repaid and banks will be unwilling to continue their loose lending standards. It is at this point that we will see the real state of the economy. My guess is it won t be pretty. We invest in Gold not because it typically does well during recessionary periods, but more so because of how the government is likely to respond to such a scenario. The US Federal Reserve has made it quiet clear they are going to intervene in our so called free markets to try and ensure interest rates remain low. They will print money and do whatever it takes. It is these actions which are bullish for the yellow metal as Fiat money becomes increasingly worthless worldwide. The recent breakout we see in gold s performance against the All Ordinaries signals a new bullish cycle for gold where it will outperform the general market for some time. There will be corrections along the way but the trend remains bullish. THE BIG PICTURE The Global Speculator 9

10 AUSTRALIAN GOLD PRICE (EFT: ASX:GOLD) Volume 2, Issue 29, 26 August 2009 CLOSING COMMENTS The precious metals markets have a really strange feel to them right now. One gets the sense that they have withstood a barrage of selling pressure in the off season and may just be building for a strong second half to the year. The technical indicators will ultimately tell us. A look at our Big Picture chart above indicates everything is bullish for the precious metals market with 2008/09 being a watershed year. The growing spread between M3 growth and longer term interest rates has to be a real concern going forward. Rising interest rates will continue to be the ultimate litmus test for economies around the world. Troy Schwensen Editor of GN North America Editor wwww.goldnerds.com.au ww.goldnerds.com.au The Global Speculator 10

11 DISCLAIMER This publication has been prepared from a wide variety of sources which the editor, to the best of his knowledge and belief, considers accurate. The editor does not warrant the accuracy of the information and forecasts contained in this publication. This information is provided for educational purposes and nothing written should be construed as a solicitation to buy and sell securities. The Global Speculator 11