Gold Miners’ Q2’16 Fundamentals

The gold miners’ stocks have skyrocketed this year as investors started returning to this long-abandoned sector. Many have tripled, quadrupled, or even quintupled since mid-January alone! But are such epic gains fundamentally justified? Much insight into this crucial question for investors can be gleaned from the gold miners’ latest quarterly financial and operational results. Their Q2 reports just finished coming in.

Companies trading on the US stock markets are required by the Securities and Exchange Commission to file quarterly earnings reports four times a year. For normal quarters that don’t end fiscal years, these 10-Q reports are due 45 calendar days after quarter-ends. They are a great boon to financial-market transparency and investors seeking to understand companies, yielding a treasure trove of information.

The gold miners are no exception, so about 6 weeks after quarter-ends I eagerly look forward to digging into their latest quarterly reports to see how they’re faring. And the just-reported second quarter of 2016 proved an exceedingly-strong one for gold stocks. Their benchmark HUI NYSE Arca Gold BUGS Index soared 38.4% higher in Q2 on a mere 7.4% gold rally! Gold stocks’ 5.2x upside leverage to gold was extreme.

The gold stocks began 2016 at fundamentally-absurd price levels relative to gold, the overwhelmingly-dominant driver of their profits and hence ultimately stock prices. Coming out of mid-January’s crazy 13.5-year secular low, the gold stocks were certainly overdue to soar in a massive mean-reversion rally. But with the HUI skyrocketing 182.2% at best in just 6.5 months by early August, the gains have been huge!

So this once-a-quarter look we get into the gold miners’ operations and thus fundamentals is supremely important. Collectively this red-hot sector’s Q2’16 10-Qs greatly illuminate whether or not its blistering recent stock-price gains are fundamentally justified, whether or not today’s far-higher gold-stock prices are sustainable, and whether or not their powerful new bull still has legs. Investors greatly need this insight.

The definitive list of gold-mining stocks to analyze comes from the most-popular gold-stock investment vehicle, the GDX VanEck Vectors Gold Miners ETF. Its composition and performance are very similar to the benchmark HUI. GDX utterly dominates the gold-stock-ETF space, with no meaningful competition. Its net assets of $10.8b are running 33.3x those of the next-largest normal 1x-long major-gold-miners ETF!

Being included in GDX is the gold standard for gold miners, as it requires deep analysis and vetting by elite analysts. And due to ETF investing eclipsing individual-stock investing, major-ETF inclusion is one of the most-important considerations for picking great gold stocks. As the vast pools of fund capital flow into leading ETFs, these ETFs in turn buy shares in their underlying companies bidding their prices higher.

As of this week, GDX included a whopping 49 major “gold miners”! Despite being advertised as a “Gold Miners ETF” GDX also includes major silver miners, silver streamers, and gold royalty companies. GDX isn’t as pure as its name implies, but nevertheless it’s what we’ve got. This week I dug into the 10-Qs of the top 34 GDX-component companies, a number chosen because it fits neatly into the two tables below.

Collectively these 34 top GDX-component stocks account for 91.9% of its total weighting, a commanding sample. While the great majority of these companies’ Q2’16 results were released on time, a few didn’t make that 45-day cutoff. They are either foreign companies operating under inferior financial-reporting standards, or companies with June 30th fiscal year-ends. Audited annual reports have 90-day filing deadlines.

The tables below summarize some of the key data I collected from quarterly reports for these top 34 GDX components. If data wasn’t provided by a particular company, I left the relevant cells blank. The tables start with market-level information including each company’s stock symbol, exchange traded on, current weighting in GDX, market capitalization, and trailing-twelve-month price-to-earnings ratio. Blank means no P/E.

That’s followed by Q2 financial data starting with cash costs per ounce of gold mined, all-in sustaining costs per ounce, and AISC guidance for full-year 2016. Next comes quarter-end cash balances, their percentage of each company’s market cap, and Q2’16’s cash flows generated from operations. That’s followed by each company’s quarterly gold production. Silver miners’ gold-only production is listed if reported.

Collectively these 34 elite gold miners produced 9924k ounces of gold in Q2. That translates into 308.7 metric tons. According to the World Gold Council’s just-released Q2’16 Gold Demand Trends report, the definitive research on world gold supply and demand, total global mine production ran 786.9t of gold in Q2. Thus the top 34 GDX component companies account for nearly 4/10ths of the world’s total, a major chunk.

I last did this fundamental analysis of GDX’s top 34 components 3 months ago, looking at Q1’16 data. It’s really illuminating to see trends evolve quarter-on-quarter. Interestingly the big gold-stock gains in Q2 were not increasingly concentrated in these major gold miners dominating GDX’s weighting. The top 34 accounted for 96.7% of its total weight a quarter ago, but only 91.9% today. That’s likely a bullish sign.

Broadening participation, investment capital flowing into an increasing number of companies, is a key hallmark of young bull markets. The great cornucopia of bargains left in the wake of bear markets is a target-rich environment for value investors. But later as bulls mature and threaten to peak, the gains get concentrated in fewer and fewer stocks. Greedy investors chase the narrowing leaders, abandoning the rest.

GDX’s Q2’16 gain ran 38.8%, slightly besting the HUI’s 38.4%. If you add up the market capitalizations of these top 34 GDX components, they’re running $217.1b now compared to $171.5b 3 months ago. While these market caps are from about 6 weeks after quarter-ends when I do this analysis, they rose 26.6% quarter-on-quarter. Stock-price gains outpacing market-cap gains implies dilution isn’t yet a problem.

The gold miners are notorious for issuing new shares to fund mine purchases from other companies, new mine builds, and expansions of existing mines. Since mainstreamers including bankers generally don’t like gold or understand its potential, bank loans are often hard to come by. So far we haven’t seen big share issuances by the gold miners despite their sharply-higher share prices. That’s good for investors.

The gold miners’ trailing-twelve-month price-to-earnings ratios look atrocious. They are either off-the-charts high or nonexistent due to accounting losses over the last 4 quarters. With such terrible profits, how can anyone argue today’s far-higher gold-stock price levels are fundamentally justified? Investors need to understand both why the gold miners’ P/E ratios look so ugly, and why that will soon change.

Back in the 1990s before I founded Zeal, I worked as a Certified Public Accountant for an elite Big-Six firm auditing mining companies. One of the core principles we CPAs must adhere to is conservatism. That demands we anticipate possible future losses but not gains. Gold-mining assets have to be written down if lower gold prices impair their value, but are not subsequently revalued higher when gold recovers.

Back in mid-December, gold was crushed to a dismal 6.1-year secular low of $1051 right after the Fed’s first rate hike in 9.5 years. Thus gold miners suffered one of their toughest quarters ever in Q4’15. As is always the case at major bottoms, traders overwhelmingly assumed gold would keep on spiraling lower indefinitely. Gold-mining managers feared the same, and were forced to act on gold’s lower prevailing prices.

Generally-accepted accounting principles demanded they write down the carrying values of gold mines and exploration deposits on their books. The historical costs put into developing those assets were slashed to much-lower values assuming $1050 gold would persist indefinitely. The economics of gold mining are such that lower gold prices often sharply reduce the profitability and viability of extracting deposits.

So Q4’15 in particular, and to a lesser extent Q3’15 leading up to it, saw massive writedowns of gold-mining assets’ carrying values. These flowed through the income statements as losses, even though they are merely an accounting construct with no cash implications. A gold mine built for $700m written down to $500m generates $200m in accounting losses, but these are paper losses with no cash outlays at all.

Gold miners’ price-to-earnings ratios look so outrageous today because those non-cash writedowns due to extreme secular gold lows are still masking rapidly-growing operating earnings as gold recovers. The trailing-twelve-month P/E ratios extend to the past 4 quarters. So writedowns won’t roll off the books until Q4’16 in most cases, although some gold miners did their writedowns in mid-2015 instead of the end.

Once these writedowns fade into the past in the upcoming quarters, gold miners’ large and growing operating profitability will translate into big accounting earnings. That will vastly collapse industry P/E ratios, and expose the serious value inherent in gold stocks that’s now obscured. Gold stocks can’t be analyzed in conventional valuation terms until trailing-twelve-month accounting profits actually reflect operations.

Back in Q4’15, gold miners’ very survivability was called into question thanks to gold’s dire secular lows. Yet they were never at risk as evidenced by low cash costs, which are the acid test of any gold miner’s viability. They include all cash necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.

While no one is questioning gold miners’ viability in Q2’16 with gold averaging $1259 per ounce, cash costs are still important to consider. Among GDX’s top 34 companies these cash costs averaged $617 per ounce in Q2’16. That’s up 5.8% sequentially from Q1’16’s $583. But at just under half prevailing gold levels in Q2, this industry’s cash costs remain low and impressive. They rose for a couple reasons.

When gold prices are lower, mine managers often cherry pick their best ores to mine to ensure sufficient cash flows. This includes delaying digging through lower-grade ore to get to higher-grade ore below. But as gold prices mean revert higher out of last year’s extreme secular lows, that high-grading pressure abates. Mine managers can choose ore to mine more strategically, and lower-grade ores increase costs.

Mine costs and operational throughputs are essentially fixed. So if a mine is processing the same rock tonnage but recovering less gold, fixed costs are spread across fewer ounces raising cash costs. Another factor is oil prices, which rocketed 35.5% higher from Q1 to Q2 on an average basis. Diesel fuel is one of gold mining’s bigger variable costs, so higher oil prices make fueling excavators and haul trucks more expensive.

All-in sustaining costs, introduced by the World Gold Council in June 2013, are a far-superior measure of gold-mining costs and therefore operating profitability. AISC include all direct cash costs, but add on everything necessary to maintain and replenish operations at current levels. This includes exploration for new gold to mine, mine-development and construction expenses, remediation, and mine reclamation.

All-in sustaining costs also include the critical corporate-level administration to oversee the gold mines. This new metric is radically more important than classic cash costs since AISC reflect the true costs of maintaining gold mines as ongoing concerns. In Q2 these top 34 GDX components’ average AISCs weighed in at $886 per ounce. That was up 6.4% from Q1’16’s $833, essentially the same rise as cash costs.

Gold stocks are such a lucrative investment during gold bull markets because of their extreme profits leverage relative to gold. For the most part, mining 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 don’t change much regardless of what gold’s price does.

At Q2’16’s average $1259 gold price, $886 AISCs yield strong per-ounce profits of $373. That’s not only up 6.0% from Q1’16’s $352 operating profits despite higher costs, but 38.7% better than Q4’15’s $269 margins. Yet between Q4’15 and Q2’16, the average gold price only climbed 14.0%. Higher gold prices translate into much-higher profits for gold mining, making gold stocks exceedingly attractive during gold bulls.

It’s really impressive the elite gold miners were able to hold the line on all-in sustaining costs in Q2’16, despite mixing in more lower-grade ore and dealing with much-higher oil prices. As gold continues to mean revert higher on coming massive investment buying, gold-mining profitability will continue to leverage and amplify gold’s gains. That’s going to slash this industry’s P/E ratios once writedowns roll off.

The gold miners’ outlook for full-year-2016 AISCs improved slightly in Q2 as well, coming in at $888 per ounce which was slightly lower than Q1’s $890. Last year’s trial by fire helped these companies figure out how to thrive at $1050 gold, let alone Q2’s $1259 or today’s $1350 or much higher. These low costs are going to fuel much-higher operating profitability even in the current Q3, with gold averaging $1342 so far.

That suggests industry Q3’16 operating profits are running about $454 per ounce, already another 22% higher than Q2’s on a mere 6.5% quarter-on-quarter gold rally! Investors who understand gold miners’ amazing profits leverage to gold prices are the ones who’ve been aggressively buying this year and are already enjoying monster gains. By the time operations are reflected in P/Es, gold stocks will be much higher.

One key accounting number known with absolute certainty is cash on hand. If gold miners are really generating big operating profits masked by last year’s accounting writedowns, that should be evidenced in growing cash hoards. At the end of Q2, these elite top GDX gold miners had $12.0b in cash on hand. That was indeed up 13.2% sequentially from Q1’s $10.6b, definitely a strong quarterly build for this industry.

With all the short-term fictions inherent in the GAAP earnings that feed P/E ratios, a much-better read on current profitability comes from operating cash flows. They reveal current profitability or lack thereof from gold-mining operations. If gold miners are truly improving fundamentally, it must be evident in their OCFs. And their latest quarterly results proved this is indeed the case, with cash generated soaring in Q2.

Q2’16’s total operating cash flows from these elite top GDX miners weighed in at a relatively-hefty $4.1b. That’s a whopping 32.3% better than Q1’16’s $3.1b, on that mere 6.3% increase in the average gold price! Even with gold’s $1259 across Q2, the gold miners are already generating major cash flows hand over fist from mining and selling their gold. Imagine how Q3’s OCF will look with gold averaging $1342 so far.

And it’s certainly not like $1350 gold is the end of this young new bull. Investors today remain radically underinvested in gold just as lofty overvalued central-bank-goosed stock markets are overdue to roll over into major new bears worldwide. Gold is one of very few assets that generally moves counter to the stock markets, making it the ideal portfolio diversifier. Investors are going to flood back in as stock markets turn south.

All that buying will push gold prices much higher, as I explained in depth last week. Back in 2012 right before the Fed’s unprecedented open-ended third quantitative-easing campaign started levitating and grossly distorting stock markets, gold averaged $1669. Much-higher gold prices are going to lead to far-higher gold-mining profitability, as gold-mining costs are largely fixed. That means far-higher gold-stock prices!

Gold miners’ latest quarterly results just released for Q2 proved they are not only fundamentally strong today, but rapidly strengthening. This industry that was left for dead in late 2015 is going to see the best operating-profits growth by far in all the stock markets in 2016, helping to justify the epic gains in gold-stock prices already seen this year. They are rooted in big real operating-profits growth, not ethereal sentiment.

As gold-stock prices continue to rise in coming quarters, driven by soaring profits fueled by higher gold prices, great gains are still to be won. It won’t be benchmarks like GDX and the HUI that see the largest gains though, but the best individual gold miners’ stocks with superior fundamentals. These gains will be reaped by prudent investors who do their homework, rather than settling for GDX’s sector-average performance.

At Zeal we’ve spent literally tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when. This has resulted in 833 stock trades recommended in real-time for our newsletter subscribers since 2001. Their average annualized realized gains including all losers are running way up at +17.6%! And that’s excluding the huge unrealized gains on our books today.

They’re running as high as 575% this week, with many doubles, triples, and quadruples this year alone! We’re also starting a major new gold-stock and silver-stock deployment to ride the coming upleg.

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The bottom line is the major gold miners just reported an outstanding Q2’16. Despite being masked by writedown-distorted P/E ratios, these companies are enjoying major surges in operating profitability driven by the higher prevailing gold prices. That trend has persisted strongly into Q3, so fundamentals for the gold-mining industry are continuing to improve dramatically. That’s why investors are flooding back in.

Gold stocks are ready to surge again as investment demand drives gold prices higher. The gold miners’ inherent profits leverage really amplifies gold’s gains, and higher earnings entice in more investors leading to higher stock prices. Gold stocks’ young new bull is just getting started, with the biggest gains yet to come. The smart investors will be fully deployed long before P/E ratios reflect this industry’s turnaround.

Adam Hamilton, CPA

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