Spotting Value in Gold Mining Stocks

By: Adrian_Ash

"...Why are gold-mining stocks lagging the gold price so badly – and what can mining exec's do to fund their operations from here...?"

WHAT'S UP with gold mining stocks?

Back in late 2003, when the Gold Price stood at just half today's level, the Philadelphia index of gold & silver mining stocks traded at 30 times earnings. Today, the price/earnings ratio has slipped to 26 times, yet the spot gold market has jumped to a 27-year high.

Does that gap between the miners and the object of their mining represent a chance to nick a little value before the world's gold stocks play catch up?

Catch-up could pay handsomely if the bulk of new analysts' reports come good. Both J.P.Morgan Chase and Fortis, the Dutch investment bank, foresee gold hitting new records above $850 within the next 12 months.

Citigroup alsos forecast a test of that all-time high, with "competitive currency devaluations" by the major economies making a price of $1,000 per ounce "or higher" very possible.

In the gold-mining sector itself, Barrick Mining, the world's largest single gold producer, says the Gold Price may rise to $800 per ounce by the end of this year. Ian Cockerill, the CEO of Gold Fields – the world's fourth largest gold producer – says he is "quite comfortable talking about $1,200 an ounce. That will happen in 24 months or so. It could be quicker."

But while both gold-mining analysts and executives are bullish on Gold Prices, the stocks they promote may struggle to rise alongside the gold bullion market, reckons John Hathaway, portfolio manager of the $1.1 billion Tocqueville Fund in New York .

"The Fed would like to think there is no inflation," Hathaway tells Barron's magazine in an interview this week, "but the cost of building a mine is up by roughly 50% in the last five years.

What's more, "you would think if your product price went up by 100% in a five-year period – which gold basically has – that the companies would be rolling in cash," says Hathaway. "But returns on equity are low. Newmont Mining's return on equity is less than 2% in the latest 12 months. Gold Fields' is 8%. Randgold Resources' is about 11%."

By way of comparison, the ROCE at the world's biggest mining firm, BHP Billiton, stands at nearly 39% today.

The reason for gold miners lagging so badly? The cost of mining for gold is certainly rising at a record clip. Environmental groups are also hampering new and ongoing mine-works with legal challenges and direct action, too. And the dangers, meantime, of digging deep below ground to extract one tonne of rock bearing only a few grams of gold ore continue to kill and injure gold-mining employees.

All this looks very bad for public relations. Gold's sudden return to newspaper and evening news headlines the world over will only draw fresh fire from the anti-gold-mining lobby.

For one example of the woes hitting gold miners, pity poor AngloGold Ashanti , the world's third largest gold-mining producer. It learned on Monday this week that a ZAR 2.6-million lawsuit (US$376,000) from a former employee suffering from silicosis has now been postponed until early '08. The court case was originally scheduled for June, and each delay adds – if only incrementally – to the firm's ongoing legal costs.

The company also halted blast works on Monday at its Mponeng mine near Carletonville, Johannesburg , after a rockfall killed four workers last Friday. Almost 30 employees have been killed at AngloGold mines in South Africa so far in 2007.

And meantime, AngloGold's biggest corporate investor – Anglo American, the world's second largest diversified mining group – announced on Monday that it will sell half of its remaining 41% position in the gold miner.

"It's been their strategic view all along," reckons Nazeem Hendricks of Argon Asset Management in Johannesburg , "because in their view AngloGold was non-core."

But being "non-core" – even in a world of soaring Gold Prices – just doesn't fit today's model of giant, diversified natural resource groups, led by BHP Billiton. Especially if soaring Gold Prices fail to show up on the bottom line. AngloGold Ashanti 's earnings fell more than 14% between April and June from the first quarter of this year. The triple-whammy of bad news out on Monday knocked the share price nearly 7% down for the session.

What can the gold-mining industry do to cap its underperformance, and start taking advantage of the ongoing bull market in gold? Bernard Swanepoel knows a thing or two about digging gold ore out of the ground. He also knows a thing or two about effective stock-market promotion, too.

Head of Harmony Gold during its spectacular growth from a single-mine operation in 1996 to the world's fifth-largest producer in 2007, however, even Swanepoel got whacked by the ugly side of gold mining economics in summer this year.

Whether jumping or pushed, Swanepoel left Harmony after cash-costs soared 40% and output slumped by more than 10% between April and June. Looking at the future of world gold-mining output, he now believes that financing new gold projects demands a "re-invention".

"Prefund a new gold mine with shareholder equity. Impossible? I think not," he writes in an article for MiningMX.com .

"I'm not against debt, financial engineering, or tax efficiency or synergies or scale benefits," says Swanepoel, "but if investors aren't prepared to buy the story as a standalone, then perhaps we are doing it for the wrong reasons and just forcing current shareholders to follow reluctantly."

Responding to complaints about poor management by mining-fund managers at last week's Denver Gold Forum, Swanepoel suggests splitting the world's largest companies into smaller equities, focused on individual projects.

"Let's unbundle them!" he urges. "Let's relist the mines separately and give fund managers choice! Those mines that are cash generative can be high dividend yield stocks (like South African platinum shares); the developing mines can be growth stories (like Banro Corp. and Great Basin Gold); while gold bugs can buy into undeveloped properties such as Wits Gold."

Could Swanepoel's gold-mining revolution revive global gold mining stock investments? It's signal that he refers to "debt [and] financial engineering", even if he does say he's got nothing against them in principal. Last year, 2006, saw a record $17.6 billion spent in corporate takeovers and mergers by the gold-mining sector. Now that leveraged loans have dried up – with total world M&A activity dropping by 42% between June and Sept., and Britain's biggest banks warning that corporate borrowers face a tougher time raising finance than even private households – the frenzy of buy-ups and buy-outs in gold-mining stocks looks to be pausing, if it's not spent.

As it is, the widely respected GFMS consultancy based in London believes that total world gold-mining output will slip another 1.6% between July and Dec. 2007. Last year saw the lowest world gold-mining output in a decade.

Gold-mining output continues to drop, in short, even as the price of gold that's now above ground trades at fresh 27-year highs. This only adds to the case for owning the metal itself. Whereas investors in gold-mining stocks, on the other hand, might be forgiven for asking why they're risking their money in dangerous and risky gold-mining ventures.

By Adrian Ash
BullionVault.com

Gold price chart, no delay | Free Report: 5 Myths of the Gold Market
City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2007

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