Gold Juniors’ Q4’16 Fundamentals

The junior gold stocks corrected hard in recent weeks, setting them up to blast higher on Wednesday’s less-hawkish-than-expected Fed.  That started to dispel some of the serious bearish sentiment that has been mounting in this sector.  The junior gold miners’ fundamentals justify much-higher stock prices, as evidenced in their recently-reported fourth-quarter operating and financial results.  They remain very bullish.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports.  Required by securities regulators, these quarterly results are exceedingly important for investors and speculators.  They banish all the sentimental distortions surrounding prevailing stock-price levels, revealing the underlying hard fundamental realities.  This greatly helps in re-anchoring perceptions.

After spending decades intensely studying and actively trading this contrarian sector, there is no gold-stock data I look forward to more than their quarterly reports.  These offer a true and clear snapshot of what’s really going on, overcoming all the misconceptions bred by the ever-shifting winds of sentiment.  If you have capital deployed in this sector but don’t watch the quarterlies, you’re shooting yourself in the foot.

Normally quarterlies are due 45 calendar days after quarter-ends, in the form of 10-Qs required by the SEC for American companies.  But after the final quarter of fiscal years, which are calendar years for most gold miners, that deadline extends out up to 90 days depending on company size.  The 10-K annual reports required once a year are bigger, more complex, and require fully-audited numbers unlike 10-Qs.

So it takes companies more time to prepare full-year financials and then get them audited by CPAs right in the heart of their busy season.  As a gold-stock trader this additional Q4 delay is irritating, since the data is getting stale by Q1’s end.  But as a CPA and former Big Six auditor of mining companies, I have some understanding of just how much work goes into an SEC-mandated 10-K annual report.  It’s enormous!

This extended Q4-reporting window naturally delays the analysis of Q4 results.  While I can start digging into the first three quarters’ results 5 or 6 weeks after those interim quarter-ends, I have to wait longer for the fiscal-year quarter-ends.  Thankfully the great majority of gold miners have reported by 8 or 9 weeks, so we don’t have to wait until early Q2 to analyze Q4 results.  The junior gold miners’ Q4’16 was quite strong!

The definitive list of elite junior gold stocks to analyze comes from the world’s most-popular junior-gold-stock investment vehicle, the GDXJ VanEck Vectors Junior Gold Miners ETF.  Born in November 2009, GDXJ is the second-largest gold-stock ETF after its big brother GDX which tracks the larger major gold miners.  This week GDXJ’s net assets ran about 46% of GDX’s, testifying to the gold juniors’ relative popularity.

Being included in GDXJ is the gold standard for gold juniors, as it requires deep analysis and vetting by elite analysts.  And due to ETF investing eclipsing individual-stock investing, major-ETF inclusion is one of the most-important considerations for picking great gold stocks.  As the vast pools of fund capital flow into leading ETFs, these ETFs in turn buy shares in their underlying companies bidding their prices higher.

This week GDXJ included a whopping 53 “junior gold miners”!  That term is used rather loosely, as this ETF also includes advanced-stage explorers not yet mining gold, primary silver miners, and gold-royalty and mine-finance companies.  GDXJ’s component stocks trade primarily in the US, Canada, Australia, and the UK.  But this junior gold miners’ ETF includes one major component that undermines its credibility.

Rather dumbfoundingly, GDXJ’s third-largest component this week is actually that GDX major-gold-miners ETF!  This decision makes no sense at all.  Investors don’t buy GDXJ because they want major exposure, they would buy GDX for that.  They are fully expecting to own junior gold miners like GDXJ is advertising.  It’s unacceptable for GDXJ’s managers to include GDX as a top component regardless of the reason.

This issue first arose a quarter ago in Q3’16, when I assumed GDX was a temporary placeholder.  Even that wasn’t justified though.  If GDXJ’s managers had to remove a top component, they could’ve simply shifted up all the component weightings underneath it.  But now after well over an entire quarter of GDX tainting GDXJ’s mission, its ongoing inclusion is troubling.  GDX’s own components are far from gold juniors.

There’s no universal definition of gold-production levels that would qualify individual miners as juniors, mid-tiers, or majors.  But after decades of analyzing this sector, I think a 300k-ounce-per-year maximum cutoff for junior-dom is a generous limit.  That translates into 75k ounces per quarter.  Out of 31 of the top 34 GDX components reporting gold production in Q4’16, only 3 had less than 75k.  Two were major silver miners.

So GDX should’ve never been included as a GDXJ component, it is misleading and makes GDXJ’s very name false advertising.  Many of GDXJ’s normal components are bigger than junior-tier too.  Out of 27 of GDXJ’s top 34 components that have reported Q4 gold production as of this week, fully 12 produced over 75k ounces last quarter!  There is also significant overlap in holdings terms between GDXJ and GDX.

Last week I dug into the Q4’16 results of the top 34 GDX components, the elite major gold miners.  GDX and GDXJ together have 104 component companies across the past couple weeks.  Fully 20 of these gold miners are included in both GDX and GDXJ!  With the same fund company running both these leading ETFs, great value would be added for investors by making GDX and GDXJ inclusion mutually-exclusive.

Anyway, I’ve been wading through the Q4’16 results of the top 34 GDXJ components in recent weeks.  That arbitrary number was chosen because it fits neatly into the tables below.  These elite junior gold miners account for 84.9% of this ETF’s total weighting, which is certainly a commanding sample.  Not all of these companies have reported yet due to the delayed fiscal-year-end reporting window, but most have.

I fed all available data as of this Wednesday into a spreadsheet, some of which made it into these tables.  Unfortunately some companies don’t sufficiently break out Q4, rolling it into full-year annual results.  It’s not surprising this is more common after weak fourth quarters, like Q4’16.  GDXJ plunged 28.8% then, driven by the Trumphoria stock-market surge blasting gold to one of its worst quarters ever at a 12.7% loss.

So when GDXJ components only reported full-year results to mask Q4 weakness, some fields had to be left blank.  Other companies hadn’t reported Q4 yet, while the foreign ones trading in Australia, the UK, and South Africa only report in half-year increments.  Since Q3’16 and Q4’16 were such wildly-different quarters for gold miners, half-year results can’t simply be divided by two.  Clean Q4 data can’t be inferred.

In these tables the first couple columns show each GDXJ component’s symbol and weighting within this ETF as of Wednesday.  While most of these gold stocks trade in the States, not all of them do.  So if you can’t find a symbol here, it’s a listing from a company’s primary foreign stock exchange.  Next comes each company’s Q4’16 gold production in ounces, which is mostly reported by them in pure-gold terms.

Most gold miners also produce byproduct metals like silver and copper.  These are valuable, as they are sold to offset some of the considerable costs of gold mining.  Some companies report their quarterly gold production including silver, a construct called gold-equivalent ounces.  I included that instead if no pure-gold numbers were reported.  Operational and financial reporting varies widely from company to company.

That’s followed by the quarter-on-quarter change, the absolute percentage difference between Q3’16 and Q4’16.  This offers a more-granular read on companies’ performance trends than year-over-year comparisons.  QoQ changes are also listed for the rest of the data, which includes cash costs per ounce of gold mined, all-in sustaining costs per ounce, operating cash flows generated, and actual accounting profits.

After spending lots of time digesting these elite gold juniors’ latest quarterly reports, it is fully apparent that gold stocks’ recent sharp selloff wasn’t fundamentally righteous at all.  Gold-stock traders got scared because gold was sliding on an extraordinary surge in futures-implied Fed-rate-hike odds, not because of bad news from these miners.  That means the recent anomalous pre-Fed selloff needs to fully mean revert.

Despite GDXJ managers’ fast-and-loose definition of junior gold miners, GDXJ’s components definitely collectively operated on a much-smaller scale than GDX’s.  The top 34 GDXJ miners that have reported so far produced 2190k ounces of gold last quarter.  That is just over a fifth of the 10,317k ounces mined in Q4 by the top 34 GDX components.  So GDXJ remains quite different from GDX despite the component overlap.

According to the World Gold Council which is the definitive arbiter of global gold supply-and-demand data, the total world mine supply in Q4’16 was 810.9 metric tons.  GDXJ’s top 34 components produced just 68.1t, or about 1/12th of the total.  That compares to almost 4/10ths for GDX.  On average the GDXJ junior gold miners are much smaller than the GDX majors, but GDXJ’s component list could still improve.

The collective top-GDXJ-component gold production in Q4 was amazingly strong.  Because this leading junior-gold-stock ETF had plunged 22.0% between early February and early March, traders assumed this stricken sector must have some serious fundamental problems.  Never mind that GDXJ had rocketed 50.1% higher between late December and early February, already regaining over 5/6ths of Q4’s losses!

The gold juniors have always been exceptionally volatile, which is a key reason they are so attractive to contrarian investors.  These elite GDXJ components’ Q4’16 results prove that they were suffering no fundamental impairment operationally.  Their 2190k ounces of gold produced last quarter soared by an incredible absolute 10.9% quarter-on-quarter from Q3’16’s results!  The junior gold miners continue to thrive.

Much of GDXJ’s quarterly production jump was due to mine expansions and new mines ramping up at a fair number of these companies.  Whenever you see double-digit quarterly increases in production at a miner, odds are major new operations are being brought online.  The junior gold miners couldn’t grow at such a scale if they were in any fundamental peril, like severely-constrained cash flows stressing them.

The most-important ongoing measure of gold miners’ fundamental health is their per-ounce costs.  As long as they can produce gold for well under prevailing prices, they will generate strong operating cash flows and ultimately profits.  Gold averaged $1218 per ounce in Q4, which was down a sharp 8.8% from Q3’16’s $1334 average.  But as long as the junior gold miners’ costs are well under gold levels, they fare fine.

The main reason why gold-mining profits are so highly leveraged to gold prices is mining costs are essentially fixed during mine-planning stages.  No matter where prevailing gold prices are, running the actual mining operations requires largely-constant costs.  Miners generally employ the same number of people, operate the same number of haul trucks and excavators, and run the same mills quarter after quarter.

So gold-mining profits, and thus potential stock prices, are determined almost solely by the difference between mining costs and current gold levels.  Whenever gold stocks see a sharp selloff like in recent weeks, the resulting bearish sentiment implies this sector suffered a big fundamental impairment.  But the excellent collective Q4’16 cost data of these elite GDXJ gold juniors decisively proves this isn’t the case.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce.  Both are useful measures.  Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, showing the worst-case gold levels necessary to keep the mines running.  All-in sustaining costs reveal where gold needs to trade to maintain current operations indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q4’16, these top GDXJ-component gold miners that reported cash costs averaged just $615 per ounce.  That’s a major 6.3% sequential improvement from Q3, and just around half current gold levels!

Rather impressively, the junior gold miners of GDXJ actually reported lower cash costs last quarter than the major gold miners of GDX at $628.  Larger operational scale, running more mines, allows for more sharing of company-wide costs which improves operational efficiencies.  Yet juniors’ excellent cost control enabled them to best the majors in cash-cost terms last quarter despite running fewer and smaller gold mines.

These elite juniors’ exceptional cash costs in Q4’16 were largely a function of their rapidly-increasing production.  As those big fixed costs of gold mining are spread across more ounces, naturally the per-ounce cost drops.  And with cash costs so darned low even compared to gold’s deep Q4 low of $1128 in mid-December right after the previous Fed rate hike, the junior gold miners were in no fundamental danger at all.

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a gold mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administration expenses necessary to oversee gold mines.  All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing miners’ true operating profitability.

The top GDXJ components’ much-higher production last quarter also led to outstanding all-in sustaining costs.  They averaged just $855 per ounce among the gold miners reporting as of the middle of this week!  That is a major 6.2% absolute QoQ decline from Q3’s $911, which is amazing.  The juniors’ AISC were well under the GDX majors’ as well, which reported average AISC in Q4 of $875 as discussed last week.

With gold again averaging $1218 last quarter, and the elite juniors able to mine it indefinitely at $855 per ounce, they were still generating a hefty $363 per ounce in operating profits in Q4’16!  That’s still a margin of nearly 30%, levels most industries would kill for.  These Q4 profits were only down 14.2% from Q3’s $423 per ounce, which was driven by GDXJ’s top components’ AISC and gold averaging $911 and $1334.

This reveals how fundamentally-absurd it was for the junior gold stocks as represented by their leading benchmark GDXJ to plummet 28.8% in Q4!  That was over twice the drop in operating profits, exposing how irrational and excessively-bearish sentiment was a bigger factor in the juniors’ steep selloff than deteriorating fundamentals.  This was true both last quarter and in recent weeks before Wednesday’s Fed surge.

So far in Q1’17, gold is averaging over $1214 which is stable from Q4’s $1218.  Assuming juniors’ all-in sustaining costs remain consistent with last quarter’s, the economics of mining gold this quarter are virtually identical.  At the top GDXJ components’ latest average $855 AISC, these elite juniors ought to be collectively earning $359 per ounce this quarter.  There was no fundamental justification to dump them!

These GDXJ gold miners themselves have largely verified this with their all-in-sustaining-cost outlooks for full-year 2017.  Of these 34 top GDXJ components, 14 had given current-year cost guidance as of the middle of this week.  That averaged $902 per ounce in AISC terms, which is likely overstated.  The gold miners have big incentives to overestimate costs early each year so they can exceed expectations later on.

So this year’s all-in sustaining costs among the top junior gold miners are unlikely to rise from last year’s levels between $850 and $900.  Thus when gold inevitably mean reverts dramatically higher as stock investors and futures speculators return, gold-mining profits will explode higher.  That will really entice capital back into these still-beaten-down junior gold stocks, catapulting them much higher from here.

Given Q4’s sharply-lower gold prices on that Trumphoria-stock-rally-fueled mass exodus, I expected to see lower operating cash flows among these top GDXJ juniors.  And indeed that was the case, as they fell 18.7% QoQ to $747m among the ones reporting.  This drop was mitigated by Q4’s sharply-higher gold production, as well as the constantly-shifting composition and weightings of GDXJ’s component companies.

But these latest operating cash flows are still understated considerably due to the delays in Q4 reporting to compile full-year results.  When I did my Q3’16 analysis on GDXJ’s top components, 29 of the 34 had reported total operating cash flows of $919m.  In this latest Q4’16 iteration, only 18 of these 34 have reported as of the middle of this week.  So the final fourth-quarter GDXJ OCF number is still heading higher.

The same is true of the top GDXJ components’ accounting profits.  They actually totaled a $10m loss last quarter.  This is partially due to non-cash writedowns of asset values due to gold’s sharp, anomalous Q4 plunge.  But I could only find net profits for 17 of the top 34 GDXJ companies due to the Q4-reporting limitations, compared to 27 of 34 in Q3’16.  So the junior gold miners’ collective profits are likely understated too.

As I had explained to our subscribers in recent weeks, the sharp drop in gold-stock prices between early February and early March was not fundamentally-righteous.  Gold-stock traders spooked by gold’s retreat on soaring Fed-rate-hike odds fueled way-disproportional gold-stock selling.  And as usual, the high-flying juniors bore the brunt of this sector’s fear-fueled dumping.  They plunged to seriously-oversold levels.

Despite gold thriving in Fed-rate-hike cycles historically, gold-futures speculators have long irrationally feared them.  So it wasn’t surprising gold surged and the thrashed gold stocks soared following the Fed’s latest rate hike this week.  Gold stocks’ pre-Fed lows also coincided with a major seasonal lull before their usual big spring rally.  This battered sector is due for a strong new upleg in the coming months!

This week’s less-hawkish-than-expected-Fed surge was only the start.  And these recently-reported Q4 results from the elite junior gold miners of GDXJ prove big gains are fundamentally justified.  The juniors are earning big operating profits even at today’s low prevailing gold prices.  And as gold itself continues to mean revert higher out of Q4’s Trumphoria anomaly, the junior-gold-mining profits will rocket again.

While investors and speculators alike can certainly play gold juniors’ coming rebound rally with this leading GDXJ ETF, the best gains by far will be won in individual gold stocks with superior fundamentals.  Their upside will trounce the ETFs’, which are burdened by over-diversification and underperforming gold stocks.  A carefully-handpicked portfolio of elite gold and silver miners will generate much-greater wealth creation.

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The bottom line is the elite gold juniors’ fundamentals in just-reported Q4’16 remained quite strong and bullish despite gold’s sharp post-election plunge.  While operating cash flows and profits suffered as expected, this industry’s critical all-in sustaining costs remained far below prevailing gold prices.  That means the gold miners continue to generate big operating cash flows to expand operations and pay down debt.

And once gold itself inevitably mean reverts higher, gold-mining profits are going to soar again like they did last year.  Investors and speculators alike are radically underdeployed in gold thanks to their huge Q4 selling.  So gold investment demand will surge as these extreme Trumphoria-distorted stock markets roll over.  That will fuel big fundamentally-justified gold-stock buying, catapulting this sector far higher.

Adam Hamilton, CPA

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