Investment commentary: Searching for value amidst a wave of writedowns, pt. 2

Last week we looked at an opportunity that may have opened up with the recent writedowns taken by senior gold producers.

The idea is that since asset value is a critical component of equity valuation, any writedown of assets should lead to a commensurate depreciation in stock value. While this is the case for most miners discussed in part one (“Searching for value amidst a wave of writedowns,” T.N.M., Aug. 26–Sept. 1/13) an opportunity can be seen in the stocks of Goldcorp (TSX: G; NYSE: GG) and Newcrest Mining (TSX: NM; ASX: NCM).

In Goldcorp’s case, while its stock price has held up better than most, it has still managed to overshoot to the downside relative to its writedowns. The company wrote down roughly $2-billion worth of assets, but its market cap has lost $4 billion since the beginning of the year.

On the flip side, Newcrest Mining has suffered writedowns of $5.3 billion, but its market cap has “only” come off by $4.3 billion.

Of course, it’s possible that the market is pricing in further writedowns in the case of Goldcorp, while at the same time believing the worst is over for Newcrest.

To see how much merit there is to such a counter-argument, let’s delve a little deeper into some of the key metrics for each company. And if Goldcorp still looks sound, it is reasonable to assume that its stock has been unfairly punished for being part of the out-of-favour gold sector, while Newcrest’s stock perhaps hasn’t been punished enough.

When comparing the assets of the two companies, it is important to pay credence to the seismic shift in perception that has occurred over the last few years, and the quandary such a shift has put seniors in.

Investors are no longer asking for growth of resources and production at any cost. Instead they are demanding tighter leashes on projects, with managers driving higher margins by reducing expenditures and bolstering profits so that more free cash flow can be generated, which would find its way into investors’ hands via a dividend.

But such a feat is hard to pull off when a company’s production portfolio is made up of the big, cost-heavy projects that seniors have been investing in for the past 10 years.

While there are a number of ways to drive down costs and grow margins, the most time-tested and obvious one is to start with a high-grade deposit with good metallurgy.

The problem is that most high-grade deposits are either in political no-go zones, or are too small to affect a senior’s reserves and production growth profile.

In this regard, Goldcorp holds the edge over Newcrest, as its principal assets are higher grade and lower cost, while presenting less political risk to investors.

Standard & Poor’s recently downgraded Newcrest’s credit rating to BBB- from BBB, while Moody’s lowered it to Baa3, which also points to a higher risk profile for the company.

Much of Newcrest’s troubles come from its US$8.9-billion acquisition of Lihir Gold in 2010. The chief asset acquired in that acquisition was the large-scale Lihir gold mine in Papua New Guinea. And while the mine doesn’t suffer from the low grades that other out-of-favour mines now suffer from, it is in a political risky region, and has relatively high cash costs because of the ore’s refractory nature. 

Newcrest’s other principal asset — the Telfer mine in Western Australia — while benefiting from being in a more stable political jurisdiction, has higher costs due to its remote location and lower grades. Proven and probable reserves at Telfer have an average grade of only 0.71 gram gold and 0.09% copper — and that includes underground reserves, which are generally higher grade than open-pit reserves.

Even after taking into account its copper by-product credits, Newcrest’s cash costs have marched steadily higher from just US$327 per oz. in 2010 to US$464 per oz. in 2011, and then up to US$567 per oz. last year for a whopping 73% increase.

Goldcorp’s cash costs have also risen — along with almost all other producers as an industry-wide phenomenon — but the company has done a far better job containing the increases. Over the same time period, Goldcorp’s after by-product credit gold costs have gone from US$271 per oz. in 2010 to  US$223 per oz. in 2011 and US$300 per oz. last year, which is just a 35% increase.

With most of its production coming out of Canada and Mexico, Goldcorp doesn’t have much political risk. And perhaps most importantly, its flagship mine, Red Lake in Ontario, produced 507,700 oz. gold last year from a high-grade deposit that shows little signs of slowing down, as the company extends the High Grade zone at depth.

When these factors are considered alongside the market’s inefficient handling of the writedowns, the case for a long position in Goldcorp’s stock, combined with a short position in Newcrest’s stock, looks convincing.

If gold prices rebound, low-cost, high-margin companies with assets in safe jurisdictions, like Goldcorp, should outpace companies like Newcrest that show lower grades, higher costs and greater political risk.

As for when such a turnaround in the gold price may occur, there have been some promising signs — the first of which is related to the very writedowns we have been discussing. While the stock prices of all five of the companies mentioned in part one of the article dipped slightly after the writedowns were announced, they all seem to have stabilized in the interim.

Did the market simply do a good job of anticipating the writedowns earlier this year when the big losses in equity values came? And if so, is it a sign that the worst is over?

The basket of gold miners represented by the Market Vectors Gold Miners ETF (NYSE: GDX) offers more encouragement. The GDX has risen more than 10% recently, which shows that capital is flowing back to gold in a meaningful way.

Also important is the gold price itself. Since breaking above  US$1,300 per oz. on July 22, prices have generally stayed above the US$1,300 per oz. level. Many onlookers consider a gold price of US$1,200 per oz. as a key metric, since below that level as much as half of global production becomes unprofitable.

As for unpredictable events that could drive the gold price going forward, investors should keep an eye on talks around the U.S. federal debt ceiling.

While the U.S. Treasury has been using its full bag of tricks to conceal how desperately it needs to raise the ceiling, experts say those strategies will be exhausted by the fourth quarter, and the debt ceiling debate will again move to centre stage.

Given how sensitive gold has been to talk of inflation and debt, expect activity around the yellow metal to pick up, as temperatures in Washington rise on both sides of the political aisle.