Leaders and Laggards

We have recently discussed the odd dichotomy that can be observed within the gold sector – there is a group of stocks that is doing extremely well lately (in fact, a number of sub-groups have acted well for quite a while), and another group that is lagging terribly in terms of performance. Many of the laggards happen to be domiciled in Canada (their production is however spread over numerous jurisdictions in many cases).

Night view of KGG’s Tasiast operation in Mauritania

Photo credit: Kinross Gold

As a trader, one is supposed to focus on leaders, not laggards (either on upside or downside leaders, depending on the direction one trades in). However, leaders can at times switch, i.e., a laggard can easily become a leader. This is what happened for instance to TSLA in 2013, and in the gold sector it happened just recently to South African producers (HMY, DRD, AU, SBGL).

A chart illustrating the vast discrepancy between leaders and laggards in the gold sector – the ratio of Canadian producer Goldcorp (GG) to South African producer Sibanye Gold (SBGL). SBGL’s outperformance over the past few months has been truly extraordinary, as major stocks in this sector normally tend to be directionally aligned – click to enlarge.

When we discussed HMY in early December, one point we were trying to get across was that its terrible technical performance just prior to the turn in late November was clearly out of tune with a quite obvious change in the fundamental picture. In this particular case, the technicality of year-end tax loss selling was likely the main factor that led to a temporary mispricing of the stock – something that has happened several times already. This created an interesting opportunity.

However, no such explanation is available for other laggards in the sector which have made new lows in January. In the meantime it has occurred to us that market participants are apparently simply ignoring positive fundamental developments in a number of cases and are still punishing companies for mistakes that their managers have made years ago. Ironically, most of these companies are actually run by different managers these days.

We also suspect that due to large outflows from gold, resp. resource focused funds and ETFs, a great many positions have been mindlessly liquidated irrespective of anyone’s “opinions”. Quite possibly a number of these funds happened to be overweight in names that have been under pressure of late and underweight in those that have begun to rally.

This brings us to the particular laggard we want to discuss today, senior Canadian gold producer Kinross (KGC). Note here that we are proceeding from the assumption that regardless of upcoming short term gyrations in the gold price, gold won’t fall out of bed completely anymore, i.e., we are assuming that the gold price will manage to stay above its most recent lows.

Spot gold daily over the past year. We are proceeding from the assumption that the support area indicated above is going to hold, or at least won’t be violated significantly this year – click to enlarge.

With gold in USD terms close to its descending 200-day moving average just before the release of the US payrolls report, a correction certainly wouldn’t surprise us. We would however also point out that if gold manages to ignore a strong payrolls report again (as it did last time) and continues to exhibit strength, it would have to be taken as a signal that the market’s character has changed significantly.

We believe the chances that gold will remain above its 2015 lows are quite good. Moreover, since we have no crystal ball, we want to focus on the company’s fundamentals based on ceteris paribus conditions. Obviously, a falling gold price would worsen its fundamental outlook and a rising one would brighten it.

Kinross Gold is Worth a Close Look

As we have noted on Monday, technically Kinross (KGC) looks pretty awful. It is a terrible laggard within the sector. Regarding the company’s fundamentals, we only know what everybody else who cares to take a look knows as well. We have no insights beyond the publicly available information. It is therefore certainly possible that the market knows something we don’t.

However, we don’t think so. Usually, the market “knows” very little. If that were not the case, great buying or selling opportunities would never emerge, but they do emerge with unwavering regularity. So instead of blindly following the old saw that “the market is always right”, one should from time to time allow for the fact that the market can be completely wrong, especially near turning points. After all, what did the market “know” when HMY traded at 52 cents in late November? Evidently, nothing – it even ignored glaringly obvious developments (such as the surging Rand gold price). Here is what KGC’s daily chart looks like:

KGC daily, up to Tuesday’s close. The stock has made a new low for the move only in mid January (in fact, amulti-decade low). The insert on the left hand side shows the geographical distribution of KGC’s production – click to enlarge.

The best thing one can say about KGC’s price chart at this point is that the January decline may have created a double bottom, as it reversed very close to the September low. Other than that, it still looks like a downtrend, albeit one that has been losing momentum of late.

KGC’s previous management made a number of terrible mistakes. In hindsight, the biggest one was the multi-billion dollar, extremely dilutive takeover of Redback Mining near the peak of the gold bull market. The takeover looked expensive even under then prevailing conditions, and obviously it looks even more so today. Enormous capital spending will be required to fully realize the potential of Redback’s crown jewel, the Tasiast mine.

However, KGC’s new management has so far made all the right moves to deal with the changing environment. It has taken very large write-downs to bring the valuation of assets on its books closer to reality, it has cut back on overambitious expansion plans and the associated capital spending, and has strongly focused on cutting costs. Recently it has made an opportunistic acquisition of two producing North American assets, which it bought from ABX (Barrick) in cash.

Evolution of KGC’s all-in sustaining costs per ounce of production from 2012 to Q3 2015. As we will explain further below, costs are likely to decline noticeably further and are very likely to come in better than guidance again.

In spite of the recent acquisition, the company’s balance sheet remains strong. Most importantly though, management has consistently under-promised and over-delivered over the past several quarters. Costs have declined significantly and cash flow margins have improved accordingly. Normally the market should reward such consistent performance – but evidently it hasn’t in this case. As a result, KGC is now significantly undervalued compared to its peers.

Below are a few comparison charts from a recent investor presentation (the complete presentation can be viewed here, pdf). First up, Enterprise value vs. estimated 2016 EBITDA and price vs. estimated 2016 operating cash flow:

Kinross compared to its peers: Enterprise value vs. estimated 2016 EBITDA and price vs. estimated 2016 operating cash flow. At the current juncture the stock seems extremely undervalued – click to enlarge.

The next chart shows a peer comparison of net debt vs. EBITDA – ironically, ABX (Barrick Gold), one of the recently by far best performing Canadian gold mining stocks, is also one of the most highly indebted ones. KGC by contrast appears to have quite a bit of leeway to either withstand further gold price weakness, or to deploy funds for acquisitions and/or capex if/when appropriate.

A peer comparison of net debt to EBITDA – once again, Kinross is clearly among the better positioned gold mining groups – click to enlarge.

Even more glaring is the difference in terms of free cash flow yield. KGC positively towers above its peers – which shows once again how undervalued the stock has become in relative terms.

Peer comparison of annual production and free cash flow yields. In terms of the latter, KGC’s peers are dwarfed at the moment – click to enlarge.

As can be seen from these comparisons, the market has clearly “overlooked” that there is some value in KGC. So what is the problem?

Geographical Diversification – the “Problem” is Really an Advantage

As far as we can tell, the market was inter alia disappointed with management’s decision to downsize the planned expansion of the Tasiast mine. And yet, this was actually the correct decision. Instead of spending a huge amount of money all at once in order to reach potential maximum capacity right away, it was decided to take a step-by-step approach and implement a smaller expansion initially.

Kupol during the winter months

Photo via laatloop.com

Naturally, this is taking more time, as a new plan had to be made. The Tasiast mine has a gold resource of 21 m. ounces, but expanding production to fully capture the inherent potential is costly – and risky. Management rightly concluded that with the gold price close to $1,100/oz., the risks were simply too great. The company’s financial flexibility would have been impaired and it would likely have had to forego opportunities such as the recent acquisition of immediately cash flow-accretive assets from Barrick.

Another perceived Achilles heel of KGC are its Russian assets – this has become especially acute since the Ukraine crisis, as investors are applying a larger political risk discount to Russian assets since then. And yet, this makes actually very little sense. Russia is not Venezuela or Zimbabwe. It is a capitalist country and under Mr. Putin’s administration – whether one likes him or not – legal certainty has vastly increased (it remains far from perfect, but it is a far cry from what obtained when a bunch of oligarchs ruled the country through their sock puppet Boris Yeltsin).

Kinross (and predecessor company Bema Gold, which it has taken over in 2003) has been active in Russia for decades. In other words, it has a lot of experience in handling the political wrinkles of investing there. Its Russian assets are responsible for approx. 30% of its total production (or around 780K oz.). They are actually among the highest grade and lowest cost major gold mines in the world. KGC’s year-over-year cash costs in Russia have declined to just $469 per ounce as of Q3 2015 – more than $100 lower than the average of the previous year.

This is no doubt mainly due to weakness in the ruble – just as weakness in the Rand has lowered the dollar costs of production for South African miners dramatically and improved their margins accordingly, ruble weakness is doing the same for gold mining operations located in Russia. Since Q3 2015, the ruble has weakened significantly further – we expect therefore that the decline in production costs in Russia has accelerated.

USD-RUB, daily. Since Q3 2015, the ruble has weakened even further vs. the USD – click to enlarge.

In short, we don’t regard KGC’s Russian exposure as a disadvantage that should be expressed by a discount in its share price, we rather see it as the exact opposite: a huge cash cow that deserves to be rewarded by a premium. The market may well underestimate the potential impact of the weak ruble.

Admittedly, one cannot rely on this weakness persisting – in fact, we expect that the ruble will recover significantly this year. However, KGC’s costs in Russia will remain at the very low end of the global range even then. In the meantime it gets to enjoy a large short term cash flow boost.

Currency and Commodity Price Effects on Margins

Consider in this context the ratio of KGC to South Africa’s SBGL:

The ratio of KGC to SBGL has plummeted to a new all time low in January – click to enlarge.

And now take a look at the production and cost update SBGL has released earlier this week, which we reproduce below. It shows what the Rand’s weakness has done for its dollar-based costs and overall margins – the relevant passages are highlighted:

Westonaria 1 February 2016: Sibanye (JSE: SGL & NYSE: SBGL) advises shareholders that, consistent with the trend throughout the year, the operational results for the December 2015 quarter improved further, particularly with regard to the cost performance.

Group gold production of approximately 12,800kg (411,500oz) was marginally higher than during the September 2015 quarter, but costs improved noticeably. Total cash cost (TCC) and All–in sustaining cost (AISC) for the quarter of approximately R330,000/kg and R400,000/kg respectively, were each approximately 5% lower quarter-on-quarter. Costs in dollar terms are approximately 14% lower than during the September 2015 quarter, benefiting from the 9% depreciation in the average rand:dollar exchange rate quarter-on-quarter. Total cash costs for the December 2015 quarter will be approximately US$720/oz with AISC of approximately US$907/oz. These costs compare favorably with Sibanye’s global gold peers and place it amongst the lowest cost producers in the industry. The average exchange rate for the December 2015 quarter was R14.21/US$.

Gold production for the year ended 31 December 2015 will be in line with revised guidance at approximately 47,800kg (1.54Mozs), reflecting the impact of the relatively poor March 2015 quarter and the Eskom load shedding in the June 2015 quarter. TCC for the year of approximately R350,000/kg (US$850/oz) and AISC of approximately R420,000/kg (US$1,030/oz) are also in line with previous guidance in rand terms, but significantly lower than previous guidance in dollar terms. The average gold price received for the year ended 31 December 2015 was R475,508/kg (US$1,160/oz) resulting in a TCC margin of 28% and an AISC margin of 11%.

The operational issues that affected performance in 2015 are unlikely to be repeated. Gold production guidance for the year ending 31 December 2016 is forecast to increase to approximately 50,000kg (1.61Moz), with TCC forecast at approximately R355,000/kg and AISC at approximately R425,000/kg. The recent sharp depreciation of the rand to over R16.00/US$,means that costs in dollar terms are likely to be significantly lower than in 2015; assuming an average exchange rate of R15.00/US$ for 2016, TCC is forecast at US$735/oz and AISC at US$880/oz. All-in cost is forecast to be R440,000/kg (US$915/oz), due, inter alia, to the initiation of the Kloof and Driefontein below infrastructure projects and the development of the Burnstone mine which were approved in 2015.

Due to the weaker rand, the rand gold price year to date has averaged approximately R575,000/kg, which is approximately R100,000/kg higher than in 2015. Should this gold price persist throughout 2016, the Group TCC margin will increase to approximately 38% and the AISC margin to approximately 25%.”

Considering that KGC has been able to lower costs at its North and South American mines significantly as well – not least due to the large decline in energy costs, which has continued beyond Q3 as well – we have every reason to expect that cost guidance will once again be beaten (the company’s Q4 earnings report is due on February 10, but the effect of the decline in the oil price relative to gold will likely only be fully reflected in Q1 2016).

The gold-oil ratio: gold has soared relative to industrial commodity prices, which should have a significant impact on gold mining margins – click to enlarge.

Conclusion

It is true that one should normally avoid laggards – but this premise occasionally needs to be reexamined and modified a bit, especially near turning points. If there is a large discrepancy between fundamentals and what a price chart seems to be suggesting, it more often than not indicates that the market has simply failed to wake up to the underlying fundamental changes (unless the price is influenced by market participants who are privy to information that is not publicly known).

This is true both near highs and near lows. Consider for instance that as late as October 2007, Fannie Mae traded close to $70/ share, and mortgage insurer ABK was still going for a very generous $70 share as well – in spite of the fact that subprime lenders had been collapsing left and right since February of 2007 already (in 2011 ABK’s stock price had declined to less than 2 cents). In short, the market is often very wrong at these junctures.

If one looks at the track record of KGC’s new management and compares the stock’s valuation to that of its peers, it seems that a reversion to the mean is way overdue.

One must certainly pay attention to political risk. After all, KGC’s promising Fruta del Norte project in Ecuador has fallen prey to the new socialist government, which essentially expropriated the company by demanding wind-fall taxes that clearly rendered the project uneconomic (we have discussed this case in detail in “The Limits to Resource Nationalism”).

However, one must also be careful not to overestimate this factor. Russia is not comparable to Ecuador or other socialist countries. For all the drawbacks that are undoubtedly still detectable in Russia (especially in terms of corruption), one cannot accuse Russia’s political leadership of complete economic ignorance. We are therefore inclined to regard KGC’s Russian assets as undervalued crown jewels rather than a drawback.

Lastly, if the company’s management continues with its strategy of under-promising and over-delivering, the market is bound to eventually take notice. This is one laggard that could easily become a leader in due time. Perhaps an opportunity will present itself soon if gold and gold stocks indeed pull back from their 200-day moving averages in the context of the upcoming release of US payrolls data.

Charts by: StockCharts, Kinross Gold, BarChart