IS IT IMPROVING?
Barrick Gold – A Contrarian Play Based On Improved Capital Allocation
Disclosure: I am long ABX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
After gold’s stellar performance from 2000-2010, television commercials seemed saturated with a great deal of snake oil salesmen, pitching gold coins with outrageous commission structures to market participants concerned about the strength of conventional global currencies. Despite the metals ascension, gold mining stocks have been abysmal performers, as cost inflation and poorly conceived capital projects have produced terrible returns on invested capital. Barrick Gold (ABX) is an example of a company that in the past hasn’t focused on maximizing per share value, but instead has been more interested in building the world’s largest gold mining company via acquisitions and massive capital expenditure investments. It is my belief that the recent decline in oil prices and in the stock of Barrick Gold, has finally brought about changes, which should make for a more attractive future for the company’s shareholders. Management is now concentrating on right-sizing the balance sheet and focusing on the highest returning projects, which should unveil the fact that the sum of the parts is greater than the market price being given to the whole company right now. Value investing is about buying businesses such as Barrick when they are priced with extreme pessimism and selling them when the outlook is more optimistic.
Barrick has built a powerful and diverse collection of mining assets that have considerable upside potential, but that also require heavy investment, which only makes sense in an extremely accommodative pricing environment. In broad terms, North America represents that more conservative region of Barrick’s mines, with strong returns and drastically less political uncertainty. This region was bolstered by the addition of Pueblo Viejo in 2012. South America is the company’s highest risk and most capital intensive development region, but that could also offer the highest long-term returns. The major $10 billion project in South America, which has been the source of extreme angst for shareholders, is the Pascua-Lama mine on the border between Chile and Argentina. Pascua-Lama was expected to average 825,000 ounces in the first five years and because of ample silver credits, the cash costs were anticipated to be quite low, but this project has now been curtailed due to the volatile declines in gold prices over the last year, which has put further pressure on the CAPEX budget. The controversial decision to temporarily shutter the mine could lead to political backlash, but hopefully for Barrick shareholders, when prices recover, the mine could still potentially yield solid long-term profitability.
The Australia/Pacific and African regions are home to most of Barrick’s non-core assets in my opinion, due to their higher costs and risks, so if further divestitures are needed in the next couple of years, I would expect them to come from those assets. Barrick intelligently offered 26% of Africa Barrick Gold to the public in 2010, but the company paid way too much to acquire Equinox and its disappointing mines in Zambia and Saudi Arabia. It is telling that this $7.66 billion acquisition of non-core assets, now represents nearly 40% of the current market capitalization of the company, despite contributing a great deal less than that in the value and earnings of the company. This type of poor capital allocation decision at nearly peak commodity prices destroyed incredible shareholder value both by paying too rich of a price, and through necessitating an equity issuance at an extremely unfavorable time, which diluted shareholders.
On September 30th, Barrick had cash and equivalents of $2.3 billion and $4.0 billion available under its credit facility. The company generated operating cash flow of $3.22 billion in the first nine months of 2014. ABX had approximately $1.3 billion of cumulative debt maturing by the end of 2015. On November 14th, Barrick announced that it had completed its previously announced equity offering of 163.5MM common shares at a price of $18.35 for net proceeds of approximately $2.9 billion, meaning that the company now has approximately 1.16 billion shares outstanding. The company is using $2.6 billion of the net proceeds to redeem or repurchase outstanding debt, primarily short and medium-term debt. Specifically, Barrick is using $1.1 billion to redeem the outstanding $700MM aggregate principal amount of 1.75% notes due 2014, together with the $350MM aggregate principal amount of 4.875% notes due 2014. Barrick is also using approximately $1.5 billion of the net proceeds to purchase other notes pursuant to its tender offer, which was announced 10/31/2013. This reduces net debt by 21% and eliminated $2.5 billion of debt repayments over the next 5 years.
On October 31st, Barrick Gold reported 3rd quarter financial results. The company had gold production of 1.85 million ounces at all-in sustaining costs (AISC) of $916 per ounce. Copper production was 139 million pounds at C3 fully allocated costs of $2.15 per pound. Adjusted net earnings were $.58 billion ($.58 per share), down from $.88 billion ($.88 per share) and adjusted operating cash flow was $1.3 billion, down from $1.4 billion YoY. Net earnings were $.17 billion ($.17 per share), which were down from $.65 billion ($.65 per share) in the year ago period. Realized gold and copper prices for the quarter were $1,323 per ounce and $3.40 per pound, respectively, compared to the spot averages of $1,326 per ounce and $3.21 per pound.
Management made the decision to suspend construction at the Pascua-Lama project, which will further reduce 2014 capital costs by up to $1.0 billion. In addition, the company is flattening its operating model to save an additional $500MM per year. This will include a reduction in headcount, reduced procurement costs and other initiatives. Also, African Barrick Gold (GM:ABGLF) has targeted annual savings of $185MM. ABX made the decision to sell Barrick Energy for total consideration of $435MM, including cash of $387MM and a future royalty valued at $48MM. The company also sold Yilgarn South assets to Gold Fields Limited for $266MM, consisting of $135MM in cash and $131MM in Gold Fields Limited Shares.
Barrick expects that for the full year and adjusted for the sale of the Yilgarn South mines, full year gold production is now expected to be at the low end of the original 7.0-7.4 million ounce guidance range. All-in sustaining costs are expected to be within the range of $900-$975 per ounce and the company has lowered the top end of its adjusted cost guidance to $575-$600 per ounce. Barrick increased its full year company-wide copper production guidance to 520-550 million pounds. Full year C1 cash cost and C3 fully allocated cost guidance has been reduced to $1.90-$2.00 per pound and $2.40-$2.60 per pound, respectively.
For the first nine months of 2013, Barrick has reported a loss of $7.5 billion compared to net earnings of $2.5 billion in the first nine months of 2012. The decline reflects the impact of $8.7 billion in impairment charges (net of tax and non-controlling interest effects), lower realized gold and copper prices, higher interest expense and higher income tax expense for Pueblo Viejo, primarily due to the recognition of an increase in the deferred tax liability, which will be drawn down over the life of the mine, as well as an acceleration of current taxes payable for 2012 and 2013 related to the substantive enactment of the revised SLA, partially offset by higher gold and copper sales volumes. Adjusted net earnings for the nine month period of 2013 were $2.2 billion compared to adjusted net earnings of $2.8 billion recorded in the nine month period of 2012. EPS and adjusted EPS for the first nine months of 2013 were ($7.53) and $2.16, respectively. Operating cash flow was $3.223 billion, down from $4.138 billion during the first nine months of 2012.
While Barrick has been battered over the last year due to some poor decisions, there is still tremendous value in the company’s portfolio of assets. For example, 55%+ of 2013 production came from 5 large mines at all-in sustainable costs of around $700/oz. These 5 mines had 58.2 million ounces in reserve as of December 31, 2012. Pueblo Viejo is one of the growth mines, which should reach full capacity in the first half of 2014 with AISC of $700-$750/oz. Costs will come down materially, allowing the company to significantly close the cash flow gap that has concerned investors. With the stock price so cheap, I’d expect to see further dispositions, which should highlight the higher value of the sum of the parts, despite a weak pricing environment.
At a recent price of $16.86, ABX trades at around 8 times forward earnings and 3.5 times forward cash flow. The cash flow multiple is more than 50% cheaper than historical averages and while earnings might be revised lower, Barrick is still far cheaper than it has been in years. The company has tremendous low-cost assets, which should generate reasonable cash flows. Costs and capital expenditures will go down dramatically, reducing the need for the company to access the capital markets moving forward. It is extremely difficult to predict gold prices or value this business with anything close to an approximate number, but when you look at the assets, it is tough to imagine losing money over the long-term. To make the investment even safer, one might look to sell long-term put options. The $15 January 2016 put options are going for around $280 per contract right now, which would mean that assuming the stock closes above $15 at expiration, the investor would earn 23%, or 11% annualized on the maximum risk of $1,220 per contract. The breakeven price is $12.20 per share, so the stock would have to drop 36% by expiration for you to be in a losing situation upon being exercised. If the stock appreciates significantly prior to expiration, it is very likely that the puts could be bought back at much higher than targeted annualized rates of return.