AuRico Gold has overhauled its operations, selling some gold mines and investing in new underground production facilities at its key Young Davidson property, but that might not be enough to offset the fact that its earnings quality appears less than robust.
The price of gold price has lost its glitter, falling 10% in the last six months to only $1,600 an ounce, far from their peak of just below $1,900 an ounce back in 2011. That is bad news for gold-mining companies like AuRico Gold Inc. (AUQ.N),who, like many of its peers,responded to the skyrocketing prices of a few years ago by investing in new projects only to find that now those projects are coming onstream, the market environment has changed for the worse.
Unsurprisingly, this transforms the profitability of these new projects and jeopardizes the earnings quality of those profits that remain at gold-mining companies. Indeed, AuRico, a Canadian company with mines in Ontario and Mexico and new projects coming online in British Columbia and Mexico, scores only 5 out of a possible 100 on the StarMine Earnings Quality (EQ) Model, signaling that its earnings aren’t coming from sustainable sources.
AuRico responded to the deteriorating market environment and the lower price of gold by disposing of several of its mines in 2012. These asset sales included the $700 million sale of the Ocampo mine in Mexico to Minera Frisco (MFRISCOA1.MX) (one of the companies owned or controlled by the world’s richest man, Carlos Slim), last December. While the proceeds from these transactions will help fund AuRico’s current projects and made it possible for the company to begin paying shareholders an annual dividend of 16 cents a share (payable quarterly),they leave it with only two significant gold mines in its portfolio. These are the El Chanate mine in Mexico and the Young Davidsonmine in Canada, which the company described in its preliminary annual results in January as being the primary driver of growth in production.
Although AuRicohas posted profits in each of the last four quarters, that net income hasn’t kept pace with its need for cash, and the company’s free cash flow has been negative in each of those quarters, as depicted in the chart above. Earnings that aren’t backed by strong cash flows tend not to be sustainable and are one reason that the company posted such a weak earning quality score.
One explanation for this negative cash flow is the cost of expanding AuRico’s underground mining operations at the Young Davidson mine. While the company already is conducting open pit mining operations at the site, its cash flows should improve once the underground facility becomes operational. But while the higher gold production should be be good news for the company, the costs involved in extracting the ore also are important to consider. The new facilities trigger a new concern: the company ischanging its accounting policy and, going forward, it will capitalize the cost of the underground mining operations until the main shaft is completed. Meanwhile, revenue from the gold extracted from the mine will be deducted from that capitalized cost. Thus, capitalized costs will make the true cost of producing eachounce of gold less transparent until the mine becomes fully operational. The company estimated that the all-in cost (defined as cash costs, sustaining capital, corporate general and administrative expense and exploration expenses) of producing an ounce of gold from the open pits at the Young Davidson location in 2013 will be somewhere between $1,250 and $1,350. That’s uncomfortably close to gold’s current market price; should AuRico’s actual extraction costs turn out to be higher than they are in the current open pit facilities (and since they are capitalizing these costs, making it hard to tell for now), then the company’s margins are likely to be take a further hit.
The chart below shows that the company’s operating efficiency is suffering, possibly due to the higher cost of extracting gold from its current mines.In the last five quarters, AuRico’s return on its net operating assets has been declining, falling to 3.5%, a full 7 percentage points below the industry median. That is significant since our research has found that companies with low returns of this kind tend to demonstrate less ability to sustain their current earnings over the coming quarters. Net operating asset turnover, one of the inputs into return on net operating assets, has also been decreasing for the last five quarters.This is a more reliable indicator of the sustainability of future returns than profit margins, the other input into calculating the return on net operating assets. And by this measure, AuRico Gold is an industry laggard.
Over the last 90 days, analysts have cut their estimates for AuRico’srevenue, EBITDA and earnings per share by more than 20% each for the current year, ending December 31. The company has yet to report its 2012 earnings, but analysts are expecting a figure of 34 cents a share, down from 86 cents a share reported for 2011. AuRico’srecent announcement of its plan to pay out 20% of its operating cash flow in the form of dividends to its investors may prove less appealing in practice than in theory if the company’s cash flows remain volatile and its earnings quality continues to be weak.
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