Gold Juniors’ Q3’16 Fundamentals

The junior gold miners’ and explorers’ stocks have been crushed in recent months, collateral damage from enormous gold-futures selling.  That’s naturally left investors and speculators extremely bearish on gold juniors.  But lost in all this technical and sentimental tumult are important fundamentals from the juniors’ recently-reported third-quarter financial and operational results, which proved quite strong and bullish.

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.

Some 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.  Born in November 2009, GDXJ is the world’s second-largest gold-stock ETF after its big brother GDX which tracks the larger major gold miners.  As of the middle of this week, GDXJ’s net assets ran about 4/10ths of GDX’s.  That testifies to junior golds’ popularity.

Unfortunately GDXJ has plunged in recent months in the massive gold-stock correction fueled by heavy gold-futures selling.  After peaking in early August, GDXJ dropped by as much as 34.7% over 3.5 months as of late November.  That’s why junior gold stocks are so deeply out of favor today, universally feared, despised, or ignored.  But context is essential to overcome the dangerous greed and fear that taint perceptions.

Before this latest massive correction, GDXJ skyrocketed 201.8% in just 6.7 months!  So smart contrarian investors and speculators who were able to overcome the popular fear the last time juniors were deeply out of favor in mid-Januarytripled their capital.  Even at the recent dismal correction lows, GDXJ was still up 75.7% year-to-date.  So rather than fearing these high-flying stocks, traders should be salivating at their lows!

Unfortunately the gold juniors’ ugly massive-correction technicals and miserable sentiment are distracting traders from these companies’ far-more-important fundamentals.  Exceptionally-weak stock prices and extremely-bearish psychology are always fleeting and short-lived.  It’s the core fundamentals, how the gold juniors are actually faring operationally, that will govern their stocks’ performances going forward.

In the US and Canada, publicly-traded companies are required to report their results to investors and regulators four times a year.  In normal quarters that don’t end fiscal years, these reports are due 45 days after quarter-ends.  That means November 14th for Q3, so the junior gold miners’ quarterly reports are fully released.  They reveal hard fundamental reality, which dispels the emotional sentiment clouding perceptions.

After starting first with analyzing the Q3 results from the major gold miners of GDX, then moving on to the silver miners of SIL, this week I’m concluding my usual quarterly-results trilogy with the juniors of GDXJ.  As of mid-November when these companies finished reporting their Q3s, GDXJ contained a whopping 46 component companies.  I dug deeply into the top 34, a number which fits neatly into these tables.

These 34 largest GDXJ components collectively accounted for a commanding 91.9% of this ETF’s total weighting.  Unfortunately not all of these companies reported Q3 results.  GDXJ includes gold stocks trading in Australia and Hong Kong, where financial reporting is only required in half-year increments.  So those companies skip Q1s and Q3s, although they do often provide production updates which are helpful.

I waded through all available quarterly reports and fed the data into a spreadsheet, some of which made it into these tables.  If a field is blank, that means a company didn’t report that data for Q3.  The foreign half-year reporters aside, different types of gold juniors report different data.  Exploration companies have no production or sales for example, while royalty companies don’t report normal mining expenses.

The first couple columns show each GDXJ component’s symbol and weighting in this ETF as of mid-November.  Realize not all these symbols trade in the US.  Each component’s primary listing is shown, which is on its home country’s stock exchange.  Most of the non-US stocks in GDXJ trade in Canada or Australia.  That’s actually one of the big draws of GDXJ for American investors, exposure to foreign gold juniors.

That’s followed by each company’s Q3’16 gold production, in pure-gold terms whenever available.  But some GDXJ components lump in silver as gold-equivalent ounces so the gold can’t be broken out.  The quarter-on-quarter change in production, the absolute percentage difference between Q2’16 and Q3’16, is shown.  QoQ changes are also included for all the rest of the data in these tables, illuminating trends.

I think quarter-on-quarter comparisons are more relevant at this point than year-over-year ones, because 2016 has proven a strong bull year for gold stocks while 2015 was a brutal bear year.  Sectors behave very differently in bulls and bears, rendering them not comparable in many ways.  Once this gold-stock bull transitions into its second year in 2017, conventional YoY analysis for the juniors will be more meaningful.

Next comes the GDXJ gold juniors’ crucial per-ounce cost data, in both cash-cost and all-in-sustaining-cost terms.  Finally the Q3 cash flows generated from operations and actual quarterly accounting profits are shown.  The former is the best proxy for how the gold miners are currently faring, among their most-important fundamental tells.  The gold juniors’ Q3 reports collectively reveal how this industry is really doing.

GDXJ’s managers have always made some strange decisions regarding which stocks they include as components.  Just a quarter ago in Q2 for example, a major silver miner actually had one of the highest weightings in this “Junior Gold Miners ETF”.  That was thankfully cleaned up after my Q2’16 analysis  a few months ago, making GDXJ a purer gold-junior play.  But something new and perplexing has arisen.

For weeks now if not longer, one of GDXJ’s top components has actually been the GDX major-gold-miners ETF!  This decision is dumbfounding.  Investors aren’t buying GDXJ because they want major exposure, they would buy GDX for that.  They are expecting to own junior gold miners like GDXJ advertises.  So it’s really lazy GDXJ’s managers chose to include GDX as a top component regardless of the reason.

GDX never should’ve been even a temporary placeholder in GDXJ.  If GDXJ’s managers had to remove a top component for some reason, they should’ve just shifted up all the component weightings that were underneath it.  With 46 component companies, removing one isn’t even material.  I have no idea why GDX has been a major GDXJ component at all, let alone for so long.  It impugns this ETF’s selection credibility.

While there’s no universal definition of what production levels define junior gold miners, GDXJ includes some components that are definitely not juniors.  After decades of analyzing and trading gold stocks, I’d suggest a cutoff somewhere around 300k ounces annually.  Anything under is a junior, while anything larger is a mid-tier producer up to 1000k ounces.  Across that threshold is the big league of the major miners.

Out of GDXJ’s top 34 component companies in mid-November, fully 10 produced over the 75k ounces quarterly in Q3 that could reasonably be considered junior territory.  Overall production for these leading GDXJ gold miners ran 1974k ounces in Q3, 1/5th of the 9898k mined by the much-larger major miners of GDX last quarter.  Overall top-34-component GDXJ production fell 4.1% QoQ from Q2, which is likely misleading.

If you look at the gold-production QoQ-change column above, component increases are much more common than decreases at 17 to 10.  And the average of all these changes is a hefty production jump of 6.7%, far different from the total decline!  So I suspect the reason overall production fell is because this ETF’s managers are rejiggering its components and weightings to better reflect the junior-gold-mining industry.

While that’s great news for GDXJ’s usefulness for investors going forward, the considerable changes made between Q2 and Q3 render QoQ comparisons more challenging than usual.  Keep that caveat in mind for the rest of this essay.  While GDXJ’s internals are constantly in flux which is fine since junior gold miners are always growing and shrinking, the changes made to this ETF in Q3 were bigger than usual.

With gold plunging in Q4 due to extreme futures selling, the gold juniors’ latest gold-production costs are especially important today.  The classic way of measuring gold-miner costs is cash costs.  They contain all the cash expenses actually necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.

Cash costs are the acid-test measure of gold-miner survivability, showing the gold prices necessary for these miners to pay the bills and keep their doors open.  In Q3’16, the top 34 GDXJ components that reported cash costs averaged $657 per ounce.  That was up 3.3% QoQ from Q2’s $636, but is still very low relative to prevailing gold prices.  Even gold in the high $1100s remains far from an existential threat for juniors.

Even more impressively the gold juniors’ $657 average cash costs in Q3 were right in line with the $648 reported by the major gold miners of GDX!  Since the juniors operate fewer mines on average than the majors, and therefore lack the majors’ economies of scale which lower costs, it’s amazing the juniors can run with the big dogs on cost control.  Keeping cash costs in line in Q3 speaks highly of their operational prowess.

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it actually costs to maintain a gold mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administrative expenses necessary to oversee gold mines.  All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing miners’ true operating profitability.

In Q3 these top 34 GDXJ companies which reported AISC averaged $911 per ounce.  While that was up 2.7% QoQ and was considerably higher than the majors’ $855 in Q3, it’s still pretty impressive for the gold juniors.  As the tables above show, most of the top GDXJ components actually saw their AISCs drop substantially in Q3.  That was largely a function of higher gold production, spreading fixed costs across more ounces.

These overall GDXJ all-in sustaining costs were skewed by a handful of components seeing big drops in production in Q3.  With fewer ounces shouldering the burden of costs, per-ounce costs are naturally going to be higher.  The more production falls quarter-on-quarter, the greater the upside impact on gold-mining costs.  16 of these top GDXJ components reported lower AISC in Q3, while only 9 reported higher ones.

Realize quarterly production declines aren’t necessarily a bad thing, and usually soon reverse.  The ore bodies in gold deposits certainly aren’t homogeneous, with widely-varying mineralization.  Gold miners often have to dig through lower-grade ore to get to higher-grade ore underneath.  So overall production slides in quarters where the ore mix fed into mills, which have fixed tonnage capacities, is lower grade.

But even with Q3’16’s higher average all-in sustaining costs among GDXJ’s top components, the junior gold miners were very profitable.  Gold averaged $1334 in Q3, which was 6.0% higher than Q2’s $1259 and the highest average price gold had seen since Q2’13.  At those $911 average AISCs, that yielded big per-ounce profits of $423!  That equates to profit margins of nearly a third, levels most industries would kill for.

Despite the gold juniors’ rising costs, their profits still surged 13.7% sequentially from Q2 on that mere 6.0% increase in the average gold price.  The gold miners’ great inherent profits leverage to gold is why these stocks are so alluring to investors.  They not only soar dramatically during gold bull markets, but those huge gains are actually fundamentally justified by the underlying exploding growth in earnings.

Surging operating profits should’ve fed rocketing operating cash flows and earnings for the junior gold miners in Q3, just as they did for the GDX majors.  But depending on how they are measured, the quarter-on-quarter improvements are mixed.  On average in Q3, the cash flows generated from operations by the top GDXJ components reporting them surged 15.9% QoQ!  That’s certainly impressive by any standard.

But total operating cash flows across these gold juniors were $919m in Q3 compared to $949m in Q2, a surprising 3.1% sequential drop.  But again with the big weighting and composition changes in GDXJ’s holdings last quarter, totals simply aren’t as comparable as they should be.  On top of that, Q2 ended a half-year that included more foreign-company results than the off-quarter of Q3 which they don’t report on.

Actual accounting profits looked far better for the juniors than operating cash flows in Q3.  Total profits from these top 34 GDXJ component companies, even without some foreign ones, ran $340m in Q3.  That was a whopping 119.4% higher than Q2’s $155m!  Rising gold prices work wonders for the fundamentals of gold miners, resulting in exploding profitability far exceeding the underlying gains in the gold price itself.

The gold miners’ strong Q3’16 operating results argue that their stocks’ big massive-correction selloff in recent months is wildly overdone.  The elite gold juniors of GDXJ have seen far-better earnings growth this year than almost every other sector in all the stock markets, only exceeded by the gold majors.  So instead of wallowing in fear, investors and speculators should be looking to aggressively buy the juniors low.

That’s despite gold faring much worse in Q4 than it did in Q3.  Quarter-to-date, the average gold price has fallen 6.2% to $1251 per ounce.  And that indeed virtually assures the junior gold miners’ fundamentals won’t look as good this quarter as they did last quarter.  Regardless, the juniors’ costs are so far under even current prevailing gold prices that they are still going to do fine.  They will easily ride out this gold swoon.

Let’s assume the gold juniors’ AISCs don’t improve in Q4, staying at $911 per ounce.  It’s actually highly likely they will improve substantially in Q4 as those Q3 production shortfalls at some GDXJ components reverse.  So steady costs are conservative.  On top of that, assume gold doesn’t bounce in Q4 which is unlikely after such extreme gold-futures selling.  Thus gold’s current QTD average of $1251 will hold strong.

This implies the GDXJ junior gold miners will still earn an impressive $340 per ounce in the current dark Q4!  While indeed down 19.7% from Q3’s levels, that still represents hefty 27% operating margins.  These are very high by almost every other industry’s standards.  And when gold inevitably bounces after the heavy futures selling passes as always, the operating profitability of the juniors will again leverage gold’s gains.

Considering the junior-gold sector as represented by GDXJ has plunged 35% at worst in recent months on a likely quarterly-profits drop around just half that, the selling is excessive.  It never had anything to do with fundamentals, which remain very strong.  The entire massive correction was a sentiment thing, investors and speculators succumbing to their own fear and rushing to sell low instead of acting rationally.

Gold won’t linger near these lows for long, which means neither will the junior gold stocks.  Gold tends to be an anti-stock trade.  Futures speculators jettisoned gold like crazy since the election because the stock markets and US dollar were both soaring on surprise euphoria after Trump’s win.  But when the hard challenges of changing things crush the fantasy, stock markets will roll over again and gold will return to favor.

While investors can certainly buy GDXJ to ride the coming enormous profits growth in the junior miners as gold rebounds, I’ve long preferred handpicking individual stocks.  GDXJ suffers from serious over-diversification, which really retards its ultimate potential gains.  The best juniors with superior fundamentals will trounce GDXJ, which is why I’d much rather own the best individual stocks and forgo the rest.

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The bottom line is the junior gold miners’ fundamentals in recently-reported Q3’16 were very strong and bullish.  Despite higher all-in sustaining costs, the higher gold prices still led to improving operating cash flows and exploding accounting profitability.  This year the gold juniors have enjoyed a truly amazing fundamental transformation.  And it is only just starting like gold’s young bull market, which will soon return.

But unfortunately today most investors and speculators aren’t paying attention to the gold juniors’ strong fundamentals.  Instead they are all wrapped up in the fearful prevailing sentiment.  That’s a big mistake as always.  While the gold juniors’ operating profitability will indeed decrease in Q4 if gold prices stay low, gold’s bull is far from over.  When it starts powering higher again on weaker stock markets, juniors will soar.

Adam Hamilton, CPA

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