Gold and the Dollar

Gold Stock Valuation Comparison

About once every quarter we do a valuation comparison of some of the large and mid-size gold producers. In the past when we've done this we've compared ratios such as price/earnings, price/sales and market price per reserve ounce using information contained in the latest quarterly reports. We've also looked at how each company's price/earnings ratio would be affected by an increase in the gold price in order to compare the amount of leverage offered by the stocks.

This time, though, we are going to compare relative values using a different approach. Rather than focusing on price/earnings ratios and considering how earnings will be impacted by an increase in the gold price as we've done in the past, we are going to focus on the option value of each gold stock. By this we mean we are going to determine what a gold mining company is worth by calculating the value of its gold reserves at various gold prices. This approach is actually a modified version of the one used by John Doody, editor of the Gold Stock Analyst newsletter, with the main difference being that we use the total production cost in our calculations whereas Mr Doody uses the "cash cost" reported by the companies. We prefer to use total cost per ounce, rather than cash cost, because there are inconsistencies in the way different companies report their cash costs and because it is the total cost, not the cash cost, that determines how much shareholder wealth is generated. (Note: We calculate the total cost to produce an ounce of gold by deducting earnings from revenue and then dividing the result by the total number of ounces produced. In this way we are sure to capture ALL costs in our calculations.)

In the below tables EV stands for "enterprise value" and TEV stands for "theoretical enterprise value". The enterprise value for each company is calculated by adding the company's net debt to its stock market capitalisation, where net debt is total debt minus cash minus the marked-to-market value of any gold hedges. In other words, EV represents the current total market value of each company. TEV, on the other hand, is what each company's gold reserves are theoretically worth at a particular gold price. It is calculated by multiplying a company's net profit margin per ounce of gold (the assumed gold price minus the total cost to produce an ounce of gold) by that company's total proven and probable reserves. For this exercise we've calculated each company's TEV at $350, $425 and $500 and also calculated the percentage change that would be needed to bring the current market price into line with the calculated TEV. In other words, the percentages shown in the final three columns reflect the gain that the market would bestow on each stock at various gold prices if the valuation criteria we have used in compiling this table were the market's only consideration.

In the first table the companies are shown in order value, from best value at the top to worst value at the bottom, assuming a gold price of $350. In the second table the companies are once again shown in order of value, but this time assuming a gold price of $500.
 

Company Name	Symbol	Recent Price (US$)	Ent. Value (US$M)	2003 Prodn. (Koz)	Total Cost per ounce	Resv. (Moz)	EV $ per oz Res.	TEV at $350	TEV at $425	TEV at $500	Gain at $350	Gain at $425	Gain at $500
Harmony Gold	HMY	13.94	2473	3096	288	49.0	50	3032	6707	10382	23%	171%	320%
Randgold Resources	GOLD	17.73	439	380	171	2.9	151	521	739	957	19%	68%	118%
Gold Fields Ltd	GFI	12.44	5785	4360	293	79.0	73	4512	10437	16362	-22%	80%	183%
Wheaton River	WHT	1.16	672	800	301	7.7	87	375	953	1530	-44%	42%	128%
Anglogold	AU	31.34	7820	5600	292	72.0	109	4204	9604	15004	-46%	23%	92%
Lihir Gold	LHG	0.93	1082	600	317	16.7	65	557	1809	3062	-49%	67%	183%
Northgate Exploration	NGX	1.12	283	450	316	3.8	74	131	416	701	-54%	47%	148%
Newmont	NEM	32.07	14244	7200	294	87.0	164	4833	11358	17883	-66%	-20%	26%
IAMGOLD	IAG	5.14	696	430	286	3.6	193	230	500	770	-67%	-28%	11%
Barrick Gold	ABX	18.19	9994	5450	313	87.0	115	3217	9742	16267	-68%	-3%	63%
Glamis Gold	GLG	11.79	1329	250	276	5.4	246	400	805	1210	-70%	-39%	-9%
Goldcorp	GG	11.74	2122	536	243	5.5	386	591	1004	1416	-72%	-53%	-33%
Meridian Gold	MDG	11.3	980	320	241	2.1	467	230	387	545	-77%	-60%	-44%
Agnico Eagle	AEM	11.68	1064	375	301	4.0	266	195	495	795	-82%	-54%	-25%
Kinross Gold	KGC	6.96	2105	1900	329	15.0	140	316	1441	2566	-85%	-32%	22%
Durban Deep	DROOY	2.61	543	1000	350	16.3	33	0	1223	2445	-100%	125%	350%

Company Name	Symbol	Recent Price (US$)	Ent. Value (US$M)	2003 Prodn. (Koz)	Total Cost per ounce	Resv. (Moz)	EV $ per oz Res.	TEV at $350	TEV at $425	TEV at $500	Gain at $350	Gain at $425	Gain at $500
Durban Deep	DROOY	2.61	543	1000	350	16.3	33	0	1223	2445	-100%	125%	350%
Harmony Gold	HMY	13.94	2473	3096	288	49.0	50	3032	6707	10382	23%	171%	320%
Lihir Gold	LHG	0.93	1082	600	317	16.7	65	557	1809	3062	-49%	67%	183%
Gold Fields Ltd	GFI	12.44	5785	4360	293	79.0	73	4512	10437	16362	-22%	80%	183%
Northgate Exploration	NGX	1.12	283	450	316	3.8	74	131	416	701	-54%	47%	148%
Wheaton River	WHT	1.16	672	800	301	7.7	87	375	953	1530	-44%	42%	128%
Randgold Resources	GOLD	17.73	439	380	171	2.9	151	521	739	957	19%	68%	118%
Anglogold	AU	31.34	7820	5600	292	72.0	109	4204	9604	15004	-46%	23%	92%
Barrick Gold	ABX	18.19	9994	5450	313	87.0	115	3217	9742	16267	-68%	-3%	63%
Newmont	NEM	32.07	14244	7200	294	87.0	164	4833	11358	17883	-66%	-20%	26%
Kinross Gold	KGC	6.96	2105	1900	329	15.0	140	316	1441	2566	-85%	-32%	22%
IAMGOLD	IAG	5.14	696	430	286	3.6	193	230	500	770	-67%	-28%	11%
Glamis Gold	GLG	11.79	1329	250	276	5.4	246	400	805	1210	-70%	-39%	-9%
Agnico Eagle	AEM	11.68	1064	375	301	4.0	266	195	495	795	-82%	-54%	-25%
Goldcorp	GG	11.74	2122	536	243	5.5	386	591	1004	1416	-72%	-53%	-33%
Meridian Gold	MDG	11.3	980	320	241	2.1	467	230	387	545	-77%	-60%	-44%

Notes and conclusions:

1. According to the above tables, HMY and GOLD are the only stocks that are under-valued at their current stock prices assuming a gold price of $350. However, the tables should be viewed as a rough guide of relative value rather than as an accurate representation of absolute value. This is because investors don't just take into account the current value of reserves when assessing what a gold stock is worth. For example, our table doesn't take potential reserve or production growth into account, although this will be an important consideration for most investors. Also, there will generally be some premium in the price of a gold stock to reflect the possibility that the gold price will be higher at some future time than it is now.

2. At current exchange rates and a gold price of US$350 Durban Deep cannot make a profit, therefore at this gold price its TEV is zero. In other words, if we knew with 100% certainty that the gold price would always be US$350 or lower and that the US$/Rand exchange rate would always be 7.8 or lower, then Durban would effectively be worthless. The value of Durban is, of course, in the potential for a spectacular increase in earnings if there is a substantial improvement in the gold price, as reflected in the second table.

3. With one exception (see below), the percentage increases in market value at gold prices of $425 and $500 will tend to be under-stated. This is because we haven't taken into account the increases in reserves that would occur at the higher gold prices. (A substantial increase in the gold price typically results in an increase in reserves because at the higher gold price it becomes economically feasible to mine resources that were previously considered to be uneconomic). 

4. There is a distinct possibility that the percentage increase in the ABX stock price at $500 would be lower than that shown in the above tables due to its large hedge book. For example, if the gold price rose from $350 to $500 then the negative marked-to-market value of ABX's hedge book would increase by around US$2.5B. In the above tables we've only taken into account the current marked-to-market value of ABX's hedge book.

5. We haven't considered the effects of exchange rate changes on company revenues and costs. It is, however, extremely likely that any substantial rise in the gold price would be accompanied by substantial weakness in the US$, thus partially offsetting the benefit of the higher US$ gold price for those companies which have most of their operations outside the US. 

6. When both current value and leverage are taken into account, HMY looks very attractive. In our opinion, HMY should be the first choice for anyone wanting exposure to a major SA gold producer. GFI also looks attractive. Despite its excellent leverage we would avoid Durban due to the risks associated with this company. We don't see any reason to take the risk of owning Durban when Harmony offers almost as much leverage but has better assets, a stronger balance sheet and vastly superior management.

7. Randgold Resources (NASDAQ: GOLD) scored very well in terms of current value, although its low cost of production means it offers less leverage to the gold price than several other producers. The Morila mine in Mali is one of the world's best gold mining assets (GOLD owns 40% of Morila). Furthermore, GOLD has a very strong balance sheet and excellent potential to grow its reserves. The good relative value offered by the shares can, however, probably be explained by the 'Kebble factor'. Roger Kebble is the chairman of GOLD and, in the past, companies controlled by the Kebble family have tended to be run more for the benefit of the Kebbles than for the benefit of shareholders in general.

8. Northgate Exploration (TSX: NGX) and Wheaton River (TSX: WRM, AMEX: WHT) both scored quite well in terms of current value and leverage. Furthermore, both of these stocks offer significant exposure to copper as well as gold. (Note: These companies report copper production as a by-product of gold production, that is, copper revenues are used to offset the cost of gold production in the companies' financial reports. However, the above tables were prepared as though copper was a co-product, that is, the gold-equivalent of each company's copper production and copper reserves have been added to their gold production and gold reserves to determine the figures for the above tables). Of the two, NGX probably has the greater upside potential. This is because its Kemess North project, which has not been taken into account for the purposes of our comparison since resources are yet to be converted to reserves, is likely to provide a large addition to reserves over the next 1-2 years. We like NGX near its current price.

9. MDG, GG, AEM and GLG all scored poorly in terms of both current value and leverage. The main problem with each of these stocks is the low amount of gold reserves relative to market capitalisation, so the valuation problem could be addressed via additional exploration success and/or the conversion of existing resources to reserves. In fact, the high current valuations suggest that the market is already anticipating substantial additions to reserves. In this regard, GLG and GG appear to have better prospects than AEM and MDG.

10. KGC did not score well in our valuation analysis, primarily because the first set of results issued by the post-merger Kinross were poor. If we assume that KGC's management will be able to generate a much better operational performance in the future then KGC would look far more attractive from a valuation perspective. However, we have no basis on which to make such an assumption.

11. As discussed in the latest Interim Update, valuation is often not an important driver of stock price in the short or even the medium-term. In fact, it is not uncommon for stocks to remain over-valued or under-valued for years at a time before a valuation discrepancy is addressed by the market. Also, a stock that seems 'cheap' or 'expensive' might be priced that way for a reason that is not readily apparent based solely on a review of the publicly-available data. As such, we wouldn't be surprised if some of the relatively over-valued stocks in the above table out-performed some of the relatively under-valued stocks over the next 6 months. We have found, however, that if we are not confident that a stock we own offers reasonable value then we are vulnerable to being 'shaken out' of the position at the first sign of price weakness. 

Gold Stocks - Technical Update

Below are charts of the Amex Gold BUGS Index (HUI) and the HUI/gold ratio. Gold stocks have now spent 12 months consolidating in dollar terms and in terms of the gold price. 

Upside breakouts in the above charts are highly probable over the next several months. In fact, it is likely that the HUI will trade in the 200-250 range before the end of this year. As far as we are concerned, the main question that remains to be answered is whether the upside breakouts will occur over the coming few weeks (scenario 'a') or whether there will be another sharp pullback before a major advance begins (scenario 'b').

When we originally described scenario 'b' we were talking in terms of the HUI dropping all the way back to the 100-110 range before a major advance to new highs got underway. However, we think the odds are now strongly against a decline of that magnitude, primarily because the HUI has just moved up to within 5 points of a new 6-year high but gold investors don't seem the slightest bit exuberant and the mainstream financial press is taking no notice. Everyone is talking about the stock market. "Is this a new bull market?" "Gee, the tape action and the market's internals look strong!" "Is it too late to buy tech stocks?" "Should I buy tech/natural-gas/homebuilding/banking stocks now or wait for a pullback?" Meanwhile the gold sector, which is clearly in a long-term bull market, gets ignored. As such, there probably aren't a lot of weak hands in the market with jittery fingers ready to click the SELL button at the first sign of trouble. Therefore, the worst case is probably a drop to near the uptrend-line shown on the above chart.

Currency and Gold Market Update

The below chart shows that the Swiss Franc has broken its short-term downtrend. A test of this year's peak is therefore likely in the near-term.

In the 4th June Interim Update we said "...on an anecdotal level the fact that almost everyone - dollar bears and dollar bulls - expects the dollar to rebound from current levels might be a sign that a decisive break below the recent lows is going to occur before a decent rebound gets underway." We've also stated that a drop, by the Dollar Index, to the bottom of its 2-year channel (see chart below) represents the maximum downside risk in the short-term. The channel bottom would currently be reached with a drop in the cash Dollar Index to around 89, so given Friday's upside breakout by the Swiss Franc and despite the recent weakness in the gold price it appears as though the Dollar Index is going to spike below 90 before a substantial rebound gets underway.

Below is a daily chart of August gold futures. The move below the 18-day moving-average at the beginning of last week was predictably followed by a quick drop. However, when we consider what is currently happening in the currency market and in the gold sector of the stock market we see no reason to be bearish on gold despite its recent break below short-term support. As stated in last week's Interim Update, gold has good support in the $340-$345 range and given the recent strength in gold shares this support is likely to hold. In fact, there is a reasonable chance it won't even be tested. 

Once again we'll look to the performance of the gold price relative to its 18-day moving average for clues as to what to expect in the short-term, simply because this moving average has done such a good job of defining support and resistance over the past 7 months. With reference to the below chart, notice that after the gold price closed below its 18-day moving average (the green line) in early-February it was not able to achieve consecutive daily closes above this MA until mid-April. As such, we'll consider consecutive daily closes above the 18-day moving average to be evidence that a bottom is in place and that a new short-term uptrend is underway.

Below is a chart of the gold price in terms of the euro. The euro gold price has just moved marginally below its long-term channel bottom, a bearish development if there is some follow-though to the downside. The more likely outcome, however, is that gold will strengthen relative to the euro over the next few weeks, thus avoiding a break in the long-term uptrend.

In summary, here's what we have:

a) The gold price has moved as low as it can go against both the euro and the S&P500 Index without causing long-term price channels to be broken.

b) The Dollar Index looks weak and appears to have short-term downside risk of 3-4%.

c) Gold stocks have recently been strong relative to the gold price and relative to the S&P500 Index.

In the short-term (the next few weeks) it is therefore likely that gold will rise in US$ and euro terms and it will rise relative to the S&P500 Index. As discussed above, we'll be watching the performance of gold relative to its 18-day MA for confirmation that a new short-term uptrend is in progress. Also, although it is going to have to fight its central bank every step of the way we expect that the Yen will benefit from future dollar weakness to a greater extent than either the euro or the SF. There are a few reasons why Yen strength relative to the euro makes sense here, one being that while the euro looks extremely overbought from a medium-term perspective the Yen has spent the past 2 years building the sort of base that could support a large rise.  

Update on Stock Selections

Last week's drop to the mid-4.40s might be 'all she wrote' as far as the latest pullback in the silver price is concerned. If this is the case then the silver price is about to move up to resistance in $4.80-$4.90 range. 

The pattern that has been followed by silver over the past year is similar to a pattern we've seen in other markets. Based on what happened in these other markets we think the next move to 4.80-4.90 will result in an upside breakout and that silver will surprise most traders (most traders will assume that 4.80-4.90 is going to hold) by not only moving above 4.90 but also moving well above 5.20. So, it is worth having some exposure to silver here. As advised in the past, one of the best ways to do this is to buy shares in Western Silver (TSX: WTC, AMEX: WTZ).

Aquiline Resources (TSXV: AQI) recently commenced a drill program at its Calcatreu gold project in Argentina, so there should be a steady stream of news from AQI over the next several months. Due to AQI's small market cap of around US$5M, good results from the drill program would likely have a substantial effect on the stock price.

The QQQ June $24 put options in the TSI Stocks List will expire worthless at the end of this week. The QQQ December $25 puts (QAVXY) recently added to the List are, however, likely to fare much better. We like the risk/reward on these options at their current price of around US$0.80.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/