Gold Mining Stock Margins

By: Zeal_LLC    Sep 03, 2010

Gold mining is a tough business.  In the quest to meet growing global demand these miners are constantly barraged with challenge after challenge.  They are attacked by environmentalists, targets of governmental meddling, purveyors of a science that is not exact, and must always fight to renew their finite resources.

Gold miners are also at the mercy of fluctuating gold prices.  Prices can be radically different from when a mine initially commences development to when it pours its first gold years later.  Even on a month-to-month or week-to-week basis, miners can see material differences in their revenues based on what prices are doing.  But thankfully, this blitz of opposing forces proves worthwhile in a secular bull market.

With the price of gold going from an average of $272 in 2001 to $1165 in 2010, pulling gold from the ground has become a lot more alluring.  And the miners able to deliver gold to market at these record-high prices have seen huge increases in revenues.  So long as this revenue growth outpaces costs, these miners have had the potential for fast-growing margins and stellar profits.

And this potential for profits leverage is what makes the stocks of these miners so appealing to investors.  The venerable HUI gold-stock index is up a whopping 1155% from its 2001 low to its latest interim high for a reason.  Gold miners should be cashing in on a secular bull in their underlying metal.  But as always, there is much more than meets the eye in this wild and wacky industry.

Even though the miners are generating higher revenues, the challenges don’t go away.  In fact, there are even more challenges today than there were 10 years ago.  And prudent gold-stock traders must be aware of and understand these challenges in order to profit in this arena.

Over the years I’ve written a series of essays on gold-mining challenges, and one of the most transparent challenges is on the cost front.  As we’ve learned over the course of this bull, miners have really struggled to control costs.  And the hopes of only moderately-rising expenses are pure fantasy for most.

To really understand these costs across the industry and at an individual-company level, analysts and investors alike have a couple different options.  They can either meticulously dig in the financial statements and craft their own cost measures, or use a common metric that most miners offer as part of their headline performance data.  I prefer the easy option, and this “cash cost” metric indeed provides a high-level summary of the expense side of producing an ounce of gold.

Fortunately most miners submit to a canned format of calculating cash costs according to a standard (non-GAAP) implemented by the Gold Institute (GI) back in 1996.  Prior to this standard gold miners were very creative and non-uniform in how their expenses were presented to investors.  And while not all miners submit to today’s standard, or comply to a tee, the GI-coined “Production Cost Standard” has since become a relatively uniform metric across the industry.

According to this standard, total cash costs are calculated by adding cash operating costs (direct mining expenses, stripping and mine-development adjustments, third-party smelting/refining/transportation costs, and then adding back byproduct credits if applicable) to royalties and production taxes.  This number is then divided by total ounces produced to get a per-ounce figure.

Now bear in mind that cash costs are not the complete tell-all of a miner’s strategic health, future direction, or ability to generate cash flow.  But this standard performance measure does offer investors a pretty good idea of its interim financial standing.

Cash costs tallied across the greater complex also offer a read on how the industry is trending.  And thanks to a unique dataset that we painstakingly compile in-house here at Zeal, we can get this industry read.  With quarterly cash-cost figures cataloged for all the major gold stocks trading in North America since 2001, we are able to calculate average annual cash costs.  And with the average annual gold price thrown into the mix we are able to calculate gross margins.

For purposes of this analysis I used the simple average cash costs of the nearly two-dozen companies in our pool.  And since these companies collectively produce about half of the global mined supply of gold each year, I would say this is a fair representation of the industry as a whole.

Focusing on cash costs first, you can’t miss the upward trend over the course of gold’s bull.  It’s also hard to miss the change in slope just over halfway through this timeline.  Early on the miners were able to control costs for the most part.  In each of the first six years cash costs increased by an average of 8% per year, which is equivalent to about $15 per ounce per year.

Conditioning was among the main reasons for this early moderate rise in cash costs.  Over the entire decade of the 1990s the gold price averaged a ghastly-low $350, and the gold miners were forced to adapt.  And those miners that survived the ravenous secular bear preceding this bull were producing gold from mines with very favorable mineralization.  They learned to operate under lean cost structures.

But these somewhat-restrained rises in costs were smashed coming into 2007.  In the last four years cash costs have progressively blasted higher, increasing by an average of 22% per year, or about $75 per ounce per year.  At $554, 2010’s average cash costs are 214% higher than they were in 2001.  Even more astonishing is today’s cash costs are double 2001’s average gold price!

There are a number of reasons for this meteoric rise in cash costs.  And provocatively one of the biggest reasons is the rising gold price.  These historic highs are allowing miners to develop deposits that would not have been economical several years earlier.  And the newer mining operations that pull from lower grades and more complex ores are naturally going to have higher operating costs.  More and more of these higher-cost mines have come online in recent years, thus driving up industry cash costs.

And speaking of lower grades, this higher gold price affords the option of a sneaky system of selectivity that you won’t hear many executives openly discuss in their conference calls.  What is commonly referred to as “low-grading” is an opportune way to extend a mine’s life without compromising too much on the revenue front.  This of course only works in a rising-gold-price environment.

In simple terms, low-grading involves mixing and/or shifting the ore that is being mined.  Mixing is nothing more than intentional dilution.  Occasionally you’ll see miners mix higher-grade reserves with waste rock, tailings, or lower-grade ore in order to preserve the higher-grade stuff for later if gold prices are lower.  You’ll also see operators shift mining to lower-grade portions of a deposit, again to preserve the higher-grade material for future use.

These methods will obviously drive per-ounce costs higher since it costs the same to process a ton of ore regardless of the grade.  While investors aren’t usually keen on this strategy, it helps secure longevity in a business that is constantly fighting time.

Another major factor influencing these sharply-rising costs is energy-related expenditures.  From fueling a mining fleet to generating power in processing facilities, mining is an energy-intensive business.  Gold miners are therefore very sensitive to energy costs.  And with the price of oil going from $50 in early 2007 to nearly $150 in mid-2008, miners were indeed seeing their energy costs skyrocket.

Last but certainly not least of the major factors negatively impacting costs are the effects of byproduct credits.  Gold mineralization is often accompanied by other minerals, predominantly economic grades of copper, silver, lead, and zinc depending on the specific geological makeup of a given deposit.

As noted in the formula above, it is customary for gold miners to use the revenues from the sales of these byproduct metals to credit cash costs.  And with silver and the base metals enjoying huge bull markets of their own, these byproduct credits have had material impacts on gold’s net cash costs.  The higher the prices of these metals, the lower gold’s cash costs will be.  But if the prices of these metals decline, the resulting lower revenues make for less of a byproduct credit.  And this naturally leads to rising cash costs.

Interestingly all these major byproduct metals peaked and turned south around the same time cash costs started to balloon.  Zinc saw its high in Q4 2006, and even after a strong 2009 recovery it is still trading well less than half its high.  Lead saw its high in Q4 2007, with its subsequent price activity very similar to zinc’s.  Copper saw its first major high in Q2 2006, ground sideways for a couple years, and then got a huge panic haircut.  Even after a major recovery its price is still well below its 2006 high.  Silver saw its high in Q1 2008, and so far has been unable to challenge those levels again.  Overall this byproduct weakness over the last several years has indeed had an adverse affect on gold cash costs.

Ultimately with the cost of doing business rising at such an astronomical pace, you’d think this industry was broken and failure was imminent.  Not many businesses can withstand a more than double in unit costs over a short period of time and survive.  But thankfully gold mining is not your typical business.  Incredibly, thanks to the rising gold price these miners are seeing their margins as robust as they’ve ever been.

As you can see in this chart, increases in the average gold price have easily outpaced cash-cost increases.  With gold’s average price rising by 328% since 2001, well ahead of cash costs’ 214% rise, gross margins have actually improved.  Assuming the miners are selling their gold at spot, the price/cost spread has grown by over $500 per ounce since 2001.  And even with these sharply rising cash costs, a simple gross-margin calculation shows that business is doing just fine.

Gross margin is defined as the proportion of each dollar of revenue that the company retains as gross profit.  And with GMs over 50% each of the last 5 years, these miners should be in pretty good shape.  But of course there is more to what these raw GM numbers tell us.

Gross margins over 50% are certainly nothing to complain about, but with such sharply rising revenues shouldn’t we see consistent growth on the margin front?  We should, but we don’t.  Interestingly over gold’s entire bull market the vast majority of GM growth occurred over only two years, 2002 and 2006.  If you look closely you’ll notice two major stretches of flat GMs.  These stretches highlight the toll of rising cash costs.

Even though the average gold price was up 43% from 2002 to 2005, gross margins were flat.  And then from 2007 to current even though gold is up 67%, we again see no growth on the GM front.  Thanks to these rising cash costs, margins have just not opened up as one would expect with gold achieving record highs.

It is also important to keep in mind that “gross” margins are indeed gross.  Not included in Gold Institute cash costs are depreciation, depletion, and amortization costs (DDA), along with reclamation and mine-closure costs.  These non-cash expenses, charges/credits for the capital investment that was made in the past, are tacked on to cash costs to create what the GI classifies as “Total Production Costs” (still non-GAAP).

These margins thin even more when we consider miners’ expenses outside of operating a mine.  Such endeavors as procuring mineral rights and exploration require significant capital.  And if economic grades of gold are actually found, developing a mining operation comes with an enormous price tag.  It can cost northwards of $1.0b just to build a decent-sized mine!

Since mining is inherently a risky and capital-intensive business, gold miners need higher margins in order to maintain and grow their pipelines.  Don’t let these robust gross margins have you believing that gold miners are swimming in cash.  This just isn’t the case considering non-cash opex and capital outflows on the exploration and development fronts.

As long as gold demand continues to rise, which it will, this industry will be faced with a lot of supply pressure.  And in order to handle this pressure the miners will need to continue to spend a lot of money to build out the necessary infrastructure to replace depleted mines and build additional mines at a fast-enough pace to meet demand.

Overall the gold price should continue to trend higher over the course of this bull based on its solid fundamentals.  But with more higher-cost mines coming online, cash costs are likely to continue to trend higher as well.  Thankfully this current cost-and-margin picture tells us that even though miners have yet to control costs, rising gold prices allow them to maintain margins that should allow for healthy financials.

So as investors we need to ask ourselves how these miners are managing their margins.  And we need to ask this question because many don’t do a good job of it.  You’d be amazed to find that a lot of gold miners with strong gross margins have unhealthy financials and future direction.  But the miners that do successfully manage their margins have and will continue to leverage gold’s gains, and thus greatly reward their shareholders.

Fortunately it is not too late to capitalize on the potential fortunes of owning gold-mining stocks.  As a group they still have a lot of room to run higher, in the near term and over the course of this bull.  In fact, most gold stocks are bargains at today’s prices.  The stock-panic overhang still has this sector well undervalued relative to its historical relationship with gold.  And even better, now is one of the seasonally strongest times to buy.

The bottom line is even though cash costs are on the rise, the sharply rising gold price allows gold miners to maintain strong margins.  But though these margins show the potential for legendary profits, they don’t tell the entire story considering the challenging business these miners are in.

These robust margins have and will make the stocks of these companies very attractive to investors.  And it is critical for these margins to remain high if the miners are going to have any chance of meeting gold’s growing demand.