Gold Majors Head for London Johannesburg Model
Issue 41, May 2013
Gold mining majors risk becoming a “barbarous relic”, fund manager Evy Hambro told an audience in London this week. Hambro, who manages the $3.4bn BlackRock Gold & Gnrl. fund, has long called on gold miners to link dividends directly to the gold price, increasing payout ratios.
His comments represent a tug on the sleeve of an industry already absorbed by rising costs and a volatile gold price. Barrick Gold has led the sector lower in recent weeks, with shares plunging to their lowest level since 1993, when gold averaged $360 per ounce. Futures traded Thursday in New York at $1,467.
The consistently poor performance of gold majors relative to bullion has sandbagged the idea that miners necessarily outperform their underlying commodities by adding operational leverage, instead reflecting the fact that mines are depleting assets.
As one industry watcher points out, “Every day you operate, your business gets smaller.” The truism has driven the industry into expensively recycling its capital in an effort to expand production whilst replacing ounces mined, spurring outlandish capital budgets and fully priced acquisitions.
Kinross Gold’s $7.1bn acquisition of Red Back Mining in 2010 is a telling example. “Kinross will be a growth leader,” the company’s chief executive Tye Burt (since dismissed) said at the time, forecasting that gold equivalent output would double by 2015. To date, output has been flat, whilst $5.6bn has been written off the value of Red Back’s Tasiast project, Mauritania.
Emboldened by a higher gold price, majors have also shipped in leverage, only adding to their downside. In two years, Denver-based Newmont Mining has increased net debt from $385m to more than $5bn. Analysts estimate that at a gold price of $1,200, 60 per cent of cash flow would be guzzled by interest payments.
“Miners think that if people invest in mining they want growth, whereas I think generally, they want to make money,” one hedge fund manager observes. Whilst Evy Hambro has placed the onus firmly on dividends and share issuance, Scotiabank fund manager Robert Cohen has urged gold mining majors to retain at least part of their output, making them more comparable to exchange traded funds, with the advantage of being able to add to their holdings below the market price. “The industry needs to recognise that it is in the business of mining a monetary asset,” Cohen says. “Selling gold for cash is exactly the opposite of what [miners] should be doing.”
Promoter Rick Rule agrees. “It’s incumbent on the gold mining company, if they believe in their own product, to hold more of their working capital in metal. It’s very disingenuous of them on the one hand to say, ‘buy us because the gold price is going up’, and then to hold substantial amounts of working capital in the currencies they deride.”
A contradictory but higher yielding approach would be for gold miners to become single project entities, raising capital per mine, before aggressively distributing all of their free cash flow. According to US-based investor Adrian Day, this was the prevailing business model until the 1970s.
“The model has changed from being single mine companies to ongoing enterprises,” Day has said. “The problem with the ongoing enterprise model is that when you’re a Newmont Mining or a Barrick Gold, it is extremely difficult to find 5m to 7m gold ounces per year, so you end up buying it. No company wants to shrink. If it means overpaying, that’s the price you pay to keep growing. That is a mistake.”
A third course, which marries the other two, would be a return to what Rule terms the London-Johannesburg model, with companies holding stakes in high yielding, publicly-listed single mine subsidiaries.
“Income orientated investors would invest at the operating level,” he says, “and growth investors who had faith in the holding company’s ability to effectively redeploy cash would invest at that level. That was the norm for London financiers of the South African gold mining industry.”
In the current market, the closest resemblance to the model is arguably the relationship between operators and royalty companies, with the latter charged with deploying cash. Evy Hambro’s call for yield meanwhile promises to turn majors into distributive operators: retrenched mine portfolios would slash capital costs whilst increasing margins, supporting higher payout ratios.
Via falling prices however, the market has struck on a more direct route to rising yields.
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