Gold Juniors’ Q2’16 Fundamentals

The junior gold miners and explorers have soared dramatically in an amazing year, before falling hard this week.  This sharp correction is doing its job in rebalancing bull-market sentiment, crushing greed and leaving traders wary of this sector.  But gold juniors’ recently-released second-quarter financial and operational results prove their fundamentals are strengthening dramatically, a very bullish omen for stock prices.

The junior gold stocks are rightfully considered the Wild West of the gold sector.  Most of the hundreds and hundreds of these small companies won’t prove successful.  They won’t be able to secure funding to explore sufficiently, won’t be fortunate enough to find an economic deposit of gold to mine, or won’t be able to make the herculean leap from explorer to miner.  The odds are stacked heavily against the gold juniors.

Nevertheless, the elite small gold explorers and miners able to overcome and grow their businesses to larger scales will see truly-enormous stock-price gains.  The gold juniors are exceedingly important for the entire gold-mining industry, since they feed the critical gold-supply pipeline with new deposits and mines to offset the inexorable industry-wide depletion of current operations.  Success here is radically rewarded.

Many of the world’s best junior gold miners and explorers are included in the GDXJ VanEck Vectors Junior Gold Miners ETF, this sector’s leading benchmark.  GDXJ began trading in November 2009, and is the world’s second-largest gold-stock ETF after its big brother GDX which tracks larger gold miners.  As of the middle of this week, GDXJ’s net assets ran about half of GDX’s.  This testifies to junior golds’ popularity.

And it’s easy to understand why in 2016.  Between gold stocks’ fundamentally-absurd 13.5-year secular lows in mid-January and last week, GDXJ blasted 202.5% higher in just 7.0 months!  While I don’t have universal ETF data, I’d be shocked if any other sizable ETF in all the markets even came remotely close.  For comparison, over essentially that same span GDX “only” soared 151.2%.  The juniors’ gains have been epic.

But in the single trading week since GDXJ’s dazzling new bull high, this ETF has plunged 14.6% as of this Wednesday which is the data cutoff for this essay.  Seeing over 1/7th of the value of even these elite juniors included in GDXJ lopped off in a handful of trading days has really unsettled investors.  But it certainly shouldn’t have.  Gold stocks are a volatile sector, where sharp bull-market corrections are common.

This important sentiment-rebalancing phenomenon necessary to ensure healthy and long-lasting bull markets last happened in May, which wasn’t too long ago.  GDXJ dropped 14.6% in a month, which also served to eradicate greed while breeding serious pessimism.  Yet out of those very lows, GDXJ would surge another 57.2% higher by mid-August.  That bucked gold stocks’ summer-doldrums downside risks.

Now normally during major mid-bull corrections, investors assume selloffs driven purely by sentiment must be fundamentally justified.  If the junior golds are falling, surely it’s because their costs are rising and operating profits are falling.  But that’s rarely true.  Corrections are triggered when greed grows too excessive.  That enthusiasm sucks in all near-term buyers leaving only sellers, spawning sharp selloffs.

With this newest correction underway, we have the great benefit of the junior gold miners and explorers just finishing reporting their Q2’16 results.  Companies trading in the US and Canada are required by their securities regulators to file quarterly reports four times a year.  These reports are generally due 45 calendar days after quarter-ends, meaning mid-August.  So the latest junior-gold fundamentals are just available.

This week I dug through the new second-quarter reports for GDXJ’s top 34 component companies.  That arbitrary number happens to fit neatly into the tables below.  While GDXJ held a whopping 47 different stocks as of the middle of this week, the top 34 account for a commanding 93.1% of its total weighting.  They include many of the best junior gold miners and explorers in the business, a great cross section.

Each quarter I look at these companies’ 10-Qs filed with the SEC, or the equivalents for Canadian and Australian companies.  I feed a bunch of data into a spreadsheet to help me better understand how the individual companies and junior golds as a whole are faring.  The tables below summarize some of the key data, and prove that gold juniors’ fundamentals are strong and improving rapidly.  This is very bullish.

The initial columns show each top GDXJ component’s stock symbol, its exchange traded on, its current weighting within GDXJ, and its market capitalization.  GDXJ is generally market-capitalization weighted, which is the most logical way to construct ETFs for any sector.  That’s followed by trailing-twelve-month price-to-earnings ratios, which are left blank when companies are still operating at an accounting loss.

Next comes the junior gold miners’ costs, the dominant factor affecting their profitability.  Both the cash costs per ounce and all-in sustaining costs per ounce are included, along with the full-year-2016 projections for AISC if provided.  Then comes cash on hand at the end of Q2’16, its percentage of each GDXJ component’s market capitalization, and the cash flows generated from operations in the second quarter.

Finally each company’s quarterly gold production is included.  Somewhat oddly, GDXJ’s managers have chosen to include plenty of the large silver miners in their “Junior Gold Miners ETF”.  With so many gold juniors to choose from, this dilution of focus seems unnecessary.  So for the large silver miners in GDXJ, I listed their gold-only production whenever provided.  No production means a company is an explorer.

Despite this past week’s sharp bull-market correction, the junior gold stocks are thriving fundamentally.  Their costs are stable or improving, while their operating cash flows are soaring.  Investors who loved the junior golds a couple weeks ago ought to be scrambling to buy aggressively now that their stocks are considerably cheaper.  Their rapidly-improving fundamentals reveal nothing at all to be concerned about.

GDXJ’s component list remains very similar to that seen 3 months ago when I was analyzing this ETF’s top components’ Q1’16 results.  Most of the same companies are still included, although their relative rankings have naturally shifted with their market capitalizations.  The elite juniors enjoying the biggest market-cap increases, and hence stock-price gains, have seen the largest weighting increases in GDXJ.

This sector’s trailing-twelve-month price-to-earnings ratios are terrible, making junior golds look wildly overvalued from a classic valuation perspective.  Most of these companies have lost money during the past year in accounting terms, and thus have no P/Es.  And most of the junior golds that have managed to earn profits have very-high P/E ratios.  This apparently-dismal earnings situation is scaring investors away.

The reason these trailing-twelve-month P/Es look so ugly is the gold-mining industry was forced to make big non-cash writedowns late last year.  Gold sinking to dismal 6.1-year secular lows impaired the value of gold deposits and mines.  Accounting rules then forced company managers to assume gold’s deep lows would persist indefinitely.  So Q4’15 in particular saw massive writedowns of gold-mining assets.

Even though these are essentially an accounting fiction, non-cash expenses flushing once-capitalized historic costs out of balance sheets and through income statements, they affect GAAP profits.  So until last year’s big writedowns slide out of the latest four quarters’ results, P/E ratios will look ridiculous.  The strong operating profitability of gold miners won’t become apparent until Q4’16’s results, collapsing P/E ratios.

If you want more depth on the accounting issues skewing gold stocks’ P/E ratios to scary extremes, last week in my Q2’16 analysis of the larger gold miners of GDX I discussed it deeper.  Today’s P/E ratios simply don’t reflect the radical fundamental improvements in gold miners’ operations as 2016 marches on.  They will eventually, but for now investors have to look deeper to understand how gold miners are faring.

That starts with the junior golds’ cash costs per ounce.  With the magnitude of this GDXJ selloff over the past week, you’d think low-$1300s gold is a major threat to the juniors.  Nothing could be farther from the truth!  Cash costs are the acid test of gold miners’ viability, what it actually costs to wrest each ounce of gold from the bowels of the earth.  Gold miners face no existential peril as long as gold prices exceed cash costs.

Cash costs include all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q2’16, the top junior gold miners included in GDXJ averaged cash costs of just $636 per ounce.  That is actually 2.8% lower than Q1’16’s $654, showing that the gold juniors are still improving the efficiency of their mining operations despite this year’s higher gold prices.

But cash costs are misleading, as they don’t include the full costs necessary to maintain an ongoing gold-mining operation.  As gold deposits inexorably deplete, new ones must be found and developed to replenish current production levels.  So in June 2013, the World Gold Council introduced a far-superior gold-mining cost measure called all-in sustaining costs.  This is rightfully usurping cash costs’ long reign.

AISC include all direct cash costs, corporate-level administration to oversee gold mines, exploration for new gold to mine, mine-development and construction expenses, remediation, and mine reclamation following economic depletion.  They are what it really costs per ounce to keep a gold-mining business humming along at current output levels indefinitely.  And the gold juniors’ AISC remain outstanding!

In Q2’16, these elite GDXJ components reported gold all-in sustaining costs averaging a level of $887.  That’s a slight 0.7% improvement from Q1’16’s $893.  Again the junior gold miners are wringing out new operational efficiencies even while higher gold prices are removing the pressure to do so.  Even more impressively, GDXJ components’ average AISC are identical to GDX components’ average of $886 in Q2’16!

The large gold miners enjoy considerable economies of scale compared to the juniors.  Companies that manage multiple mines save on relative administration and procurement expenses compared to smaller ones operating single or fewer mines.  So it’s pretty darned impressive that the junior golds reported the same all-in-sustaining-cost structure in Q2’16 as the majors!  That’s an incredible show of fundamental strength.

The junior golds’ AISC compared to average prevailing gold levels reveal their true operating profitability that is masked by their writedown-distorted trailing-twelve-month P/E ratios.  Back in Q1’16 as gold was emerging from last year’s brutal rate-hike-fear-driven secular lows, this metal averaged $1185.  At the gold juniors’ Q1’16 average AISC of $893, those gold levels yielded operating profits of $292 per ounce.

Now that’s not bad at all considering investors were wrongly convinced the junior golds were doomed back in mid-January.  During Q2’16 the average gold price climbed 6.3% to $1259.  Thus at their latest industry-wide AISC read of $887 per ounce in that same quarter, operating profits blasted 27.5% higher quarter-on-quarter to $372 per ounce!  28% profits growth on a 6% gold rally is certainly very impressive.

This great profits leverage to gold inherent in the junior gold miners is the dominant reason why they’re so attractive to smart investors.  Profits ultimately drive stock prices, and gold-mining profits rocket higher on relatively-modest gold-price increases.  With gold itself in a major new bull market, the massive surge in gold-mining profits that’s going to generate will be breathtaking.  We’re already seeing that continue in Q3’16.

So far this quarter, gold has averaged $1341 which is another 6.5% gain sequentially.  Meanwhile the elite GDXJ gold miners projected full-year-2016 all-in sustaining costs averaging $883 per ounce.  That is also incidentally better than the major miners of GDX which are forecasting $888.  That means GDXJ’s junior miners are likely earning $458 per ounce in operating profits so far in Q3’16, another 23.1% QoQ jump!

At best year-to-date, GDXJ soared 169.1% higher by mid-August.  These epic gains were a combination of a mean reversion higher out of fantastically-bearish sentiment, and greatly-improving fundamentals.  Back in that dark trough quarter of Q4’15, GDXJ’s junior gold miners were earning $293 per ounce with AISC of $812 and gold averaging $1105.  In just two quarters, these operating margins surged 27.3% higher!

And that’s just the beginning.  Gold mines enjoy such great profits leverage to gold because mine costs are largely fixed during each mine’s planning stages.  That’s when mining engineers decide which ore bodies to extract, how to dig them, and how to process that ore to recover the gold.  These costs simply don’t change much regardless of what gold’s price does.  So higher gold translates into far-higher profits.

The best proxy of actual profitability of current operations comes from the cash flows generated by these very operations.  In Q2’16, these elite juniors of GDXJ earned collective operating cash flows of $949m.  That was a staggering 51.1% higher quarter-on-quarter compared to Q1’16’s $628m!  That trounces the 32.3% improvement over that same span seen by GDX’s major gold miners.  The juniors are killing it.

That hard data alone, operating cash flows rocketing 50%+ higher in a single quarter, provides all the fundamental justification junior golds need for their far-higher stock prices.  And that’s only going to keep improving.  Gold itself continues to mean revert out of extremely-oversold levels from late last year.  As recently as 2012 before the Fed’s gross market distortions, gold averaged a normal $1669 per ounce.

While gold will head a lot higher in this young new bull as today’s lofty stock markets artificially goosed to near-bubble valuations by central banks inevitably roll over into major new bears, consider that very-conservative 2012 example.  A $1669 gold price is only another third higher than Q2’16’s average level.  Yet at current all-in sustaining costs it would catapult gold-mining profitability 110% higher to $782 per ounce!

With Q2’16’s massive leap in operating cash flows, the cash hoards of these elite GDXJ gold juniors should have exploded proportionally.  Yet they didn’t, only climbing 4.1% QoQ to $4571m.  The reason is very bullish.  The cash-flow statements from these gold juniors showed many are spending big on mine expansions or new-mine builds.  These will eventually boost their production and thus future profitability.

One example is Pretium Resources, the largest explorer included in GDXJ under its symbol PVG.  This company is constructing an amazing new gold mine in northern British Columbia.  This $697m project is fully-funded, set to go live less than a year from now.  Pretium’s cash balance fell 22% from $367m at the end of Q1’16 to $287m at the end of Q2’16 because it invested $155m in its new mine build in H1’16!

Pretium certainly isn’t the only elite junior gold miner or explorer making big investments in growing their future production.  It’s really exciting to see the junior-gold industry hit the ground running following that existential scare late last year and early this year.  Investors would be richly rewarded if the elite junior golds merely reaped gold’s coming bull-market gains at current production levels.  Higher ones amplify gains.

I’ve been studying and trading gold stocks for over two decades now, and each quarter I wade through their operating results.  And the transformation this left-for-dead sector underwent operationally in Q2’16 simply due to higher prevailing gold prices was amazing.  If a mere 6%ish gold rally can so greatly boost the junior golds’ operating profits and cash flows, imagine what the rest of this young new gold bull will do.

So if you liked the junior golds a couple weeks ago when they were still climbing, you should love them today at correction discounts.  The best times to add new positions within ongoing bull markets are after significant selloffs, not near preceding highs when excitement abounds.  Investors looking to ride the epic coming profits growth in the junior golds can certainly take a stake in GDXJ, their benchmark ETF.

But GDXJ has serious issues that will retard its ultimate gains.  In addition to its heavy silver focus due to the high weightings of major silver miners in this “Junior Gold Miners ETF”, it is way over-diversified.  Too many holdings dilute the massive gains coming from the best individual gold juniors commanding superior fundamentals.  So why not jettison the deadweight within GDXJ and just own the best of its stocks?

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The bottom line is the gold juniors just reported an amazing Q2’16.  The modestly-higher average gold prices fueled huge gains in cash-flow generation and operating profitability.  Many junior gold miners are plowing these soaring surpluses into expanding their existing operations, ultimately leading to even higher production and greater future profitability.  The junior golds’ fundamentals are dramatically improving.

Unfortunately most investors aren’t yet aware of this hyper-bullish transformation underway.  This year’s massive surge in operating profitability is being masked by writedown-distorted P/E ratios.  And this past week’s sharp gold-stock correction has ramped up fear again scaring investors away.  For those smart enough to overcome herd sentiment and study the junior golds’ fundamentals, their stocks are really on sale.

Adam Hamilton, CPA

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