- Newmont released its Q2 results this week with a surprise miss, though this was partially due to this being a kitchen sink quarter.
- While revenue and production were satisfactory, it was margins that left a lot to be desired, impacted by rising energy prices, labor inflation, and lower productivity at some mines.
- Although this was disappointing, I don't see any change to the long-term thesis, even if I have revised my price target lower to reflect the less attractive medium-term margin outlook.
- At a current share price of $44.50, Newmont is becoming more reasonably valued and paying a dividend triple that of the S&P 500, so further weakness should present a buying opportunity.
For investors in the Gold Miners Index ( GDX ) who are already tired of the daily beatings, the beginning of the Q2 Earnings Season certainly didn't alleviate the pain. This is because Newmont's ( NEM ) earnings actually turned the ferocity of the beatings up a notch, switching from a proverbial belt to a studded club after NEM dragged the sector to new 52-week lows. While there's no sugarcoating the underwhelming Q2 report, this is not 2015, and this is a disciplined business that has been through more challenging times in its 100+ year history. So, while I am not long the stock, I believe further weakness should present a buying opportunity.
Cortez Complex Operations (Nevada Gold Mines Presentation)
Last week, I exited the remainder of my position in Newmont at $54.00 after my stop was hit at $53.00 per share. While the dividend was attractive, I did not have a high conviction on the stock heading into earnings. The reason was that it was trading at a premium to its peer group on a P/NAV basis but was as sensitive (if not more sensitive) than some of its more beaten-up peers to cost creep from a labor/energy standpoint. The reason? Its relatively high exposure to Western Australia, where a tight labor market is an understatement and the fact that it did not have significant hedges on diesel exposure like some of its peers.
Following the earnings report, the decision to exit the position turned out to be a case of barely dodging a land mine, with costs increasing sharply and coming in well above my estimates. This was evidenced by all-in sustaining costs of $1,199/oz vs. $1,035/oz last year, translating to considerable margin compression on a year-over-year basis ($637/oz vs. $788/oz). However, there are several points worth unpacking in this news release, which could be gleaned from actually reading the news release vs. highlighting the stock as a "Sell" at $44.50 solely based on a couple of bullet points. Let's take a closer look below:
Q2 Earnings
Newmont released its Q2 results this week, reporting quarterly production of ~1.45 million ounces of gold and ~1.46 million attributable ounces of gold sold. These figures represented a 1% and 5% increase from the year-ago period. Meanwhile, quarterly gold-equivalent ounce [GEO] production was up 10% year-over-year to ~333,000, pushing H2 production to ~680,000 GEOs. Unfortunately, this slight increase in total sales (~1.79 million ounces vs. ~1.69 million ounces) was overshadowed by much weaker metals prices, which saw a significant effect from unfavorable mark-to-market adjustments on provisionally priced sales.
The impact from this alone was a $0.19 hit to quarterly earnings per share vs. Q1, more than offsetting the increased sales from higher grades at Boddington, Ahafo, and Tanami. This led to Newmont reporting a significant miss of $0.46 in quarterly EPS vs. $0.83 in the year-ago period and flat revenue on a year-over-year basis at ($3.06 billion). The lower revenue and higher operating costs were severely impacted by the sharp declines in average realized prices, which came in at $1,836/oz for gold, but fell even more severely to $2.99/lb for copper, $17.42/oz for silver, and $1.08/lb for zinc due to the considerable lag in concentrate sales finalizing. The realized price for silver is below market prices due to the stream at Penasquito.
Newmont - Average Realized Prices (Silver/Copper) (Company Filings, Author's Chart)
Fortunately, the company still had a decent quarter from a free cash flow standpoint, generating $514 million in free cash flow, an 11% decline year-over-year, but higher when adjusting for the increased capital expenditures in the period ($519 million vs. $415 million). This benefited from a slightly higher average realized gold price despite the sharp decline at quarter-end (where a large portion of quarterly dore production was sold) and the higher sales volumes. However, while the production and revenue performance was satisfactory (although below estimates due to the decline in commodity prices at quarter-end), the margin performance and outlook left much to be desired.
Newmont - Quarterly Free Cash Flow (Company Filings, Author's Chart)
Costs & Margins
While Newmont had impressive margin performance on a by-product basis in Q2 2021 despite relatively weak gold prices (~$1,820/oz), this trend did not extend in Q2 2022. In fact, all-in sustaining costs [AISC] on a by-product basis soared to $1,261/oz, up from $918/oz in the year-ago period. Meanwhile, gold AISC increased to $1,199/oz, up from $1,035/oz in Q2 2021. This led to a nearly 20% decline in by-product AISC margins, impacted by higher energy and materials costs (diesel, steel, cyanide, natural gas) and labor inflation for contracted services. Without the help of significant by-product credits due to the lagging concentrate sales, this led to a poor margin performance.
Newmont - AISC, AISC Margins, Gold Price (By-Product) (Company Filings, Author's Chart)
In addition to this, and an item worth highlighting, the profit-sharing agreement at Penasquito led to a $65/oz increase in its North American businesses' AISC alone in Q2, which had nothing to do with the Q2 production. Instead, it was related to $70 million in profit-sharing related to the 2021 results and a one-time item that hurt performance even further. In 2022, this is expected to add additional costs of $15 million at a $1,800/oz gold price, translating to a $4/oz increase in North American AISC, a less significant impact than what was seen in the Q2 results.
Drill Core (Newmont Presentation)
While the Q2 results were rough, and we appear to be seeing some moderation in commodity price inflation, labor inflation was also an issue, as were COVID-19-related impacts in Australia. This labor tightness was exacerbated by the Western Australia border re-opening in March, leading to higher COVID-19 cases, with one-third of the Boddington workforce and half of the Tanami workforce testing positive in Q2. Given this more challenging situation combined with inflationary pressures, Newmont noted that its previous estimate of 5% cost inflation was far too low, and it's now looking at an up to 12% increase (7% on top of the 5%). The result is an outlook of $1,150/oz AISC or higher vs. $1,050/oz/oz as of December 2021.
Assuming an average realized gold price of $1,800/oz for FY2022 would translate to AISC margins of $650/oz this year, down from $726/oz in FY2021. However, these AISC estimates still might end up being on the low end, in which case AISC margins could dip to closer to $620/oz on a full-year basis. As discussed previously, I was not overly worried about Newmont's short-term margin compression, which looked highly likely given the inflationary pressures sector-wide. The reason was that it had consolidated Yanacocha (100% ownership) and had two other very high-margin projects in the wings (Ahafo North, Tanami Expansion). Finally, investments in technology/innovation paved a path towards clawing back lost margins post-2023.
Tanami Expansion (Company Presentation)
Unfortunately, while this outlook has not changed, the cost increases were higher than I anticipated, and its projects are now being pushed out a little further due to delays. Adding insult to injury, capex estimates have been revised higher by 15% at Ahafo North with a 2025 outlook, while the Tanami Expansion has also been pushed into 2025 with a 25% capex increase. Not only does this make these projects a little bit less robust, but the margin improvement won't arrive as early as I expected.
Still, these are phenomenal projects even after capex increases, with Ahafo North on track to contribute 300,000 ounces at sub $775/oz costs for its first five years. Meanwhile, the Tanami Expansion will increase the mine life and add 150,000 to 200,000 ounces for its first five years at much lower costs. Finally, Yanacocha is a huge deal, as is the increased ownership to 100%, with this asset set to enjoy sub $800/oz all-in sustaining costs for the first five years and add incremental production of more than 500,000 GEOs per annum.
However, while there is a path to clawing back lost margins even at a flat gold price with these high-margin projects and rolling out Autonomous Haulage across a portion of the portfolio (Boddington already outfitted with these trucks), this looks to be a post Q1 2025 opportunity now (not mid- 2024). So, without help from the gold price, the margin outlook isn't nearly as attractive in 2023/2024, with what looks to be a production profile of ~6.0 million ounces of gold at ~$1,160 to $1,200/oz costs. This is a slight downgrade to the investment thesis, but nothing that would detract from the business long-term.
So, What's the Good News?
While the tough quarterly report is hard to swallow, there is a lot to like about Newmont. Not only is it paying a 5.0% dividend which I believe to be sustainable as long as gold prices stay above $1,625/oz, but this is not 2015, and the company has a strong balance sheet with $4.3 billion in cash and $7.3 billion in liquidity. For this reason, the company can still buy back shares (~$500 million left in available buybacks under the current program), it can pay out its $2.20 annualized dividend, and invest in its key projects to maintain its position as the world's leader in annual gold production.
Newmont Portfolio (Company Presentation)
So, while I can't guarantee the dividend is held at $2.20, its cash balance easily supports continuing to pay its dividend. For this reason, I would view the chance of a dividend cut in the next 18 months as less than 10%. Meanwhile, the company has a very attractive development pipeline which it gets very little respect for. Meanwhile, after yesterday's drop, the stock is back to trading at only a slight premium to net asset value, which we don't often see.
Lastly, we have likely seen peak gold production, Newmont has a very strong balance sheet, and the juniors trade at their lowest levels in years. Given Newmont's liquidity and position of strength vs. most juniors in a position of weakness (diluted at lower and lower prices), it could potentially provide an opportunity to add a low-capex, high-margin project to the portfolio at highly discounted prices. This is made possible by Newmont's discipline to wait for lower prices before doing any deals, which has certainly turned out to be a smart move.
Based on the view that we've seen peak or will see peak gold production by 2024 as weaker operators fold, I expect upward pressure on the gold price long-term. I also expect that the floor is considerably higher than where the metal has found its footing previously, given that the cost profile for the sector has changed materially. This means there's no reason to get hung up on long-term margin contraction, and even at current levels, AISC margins of $600/oz are far better than where the sector was in 2015. For those unfamiliar, Newmont's AISC margins were below $125/oz in FY2015, and it had negative free cash flow.
Valuation
Based on an estimated 788 million shares at year-end and a share price of $44.50, Newmont trades at a market cap of ~$35.0 billion. This leaves the stock trading at one of its smallest discounts to net asset value and at just ~17.4x FY2022 earnings estimates. Historically, the stock has traded at ~24x earnings over the past 20 years, and the gold price currently trades in the upper portion of this 20-year range. However, given the difficulties facing the sector (labor tightness, continued COVID-19 headwinds, inflationary pressures), I believe a more conservative earnings multiple to be 23.3 (3% discount).
Newmont - Historical Earnings Multiple (FASTGraphs.com)
After multiplying this figure by FY2022 estimates of $2.56, I see an updated fair value for Newmont of US$59.65. This translates to more than 33% upside from current levels, which, combined with a 5.0% dividend yield, translates to double-digit return potential. That said, I prefer a minimum 30% discount to fair value to justify starting new positions in large-cap producers. Based on this required discount, I would need to see the stock dip below US$41.75 to make me more interested in buying the stock. My conservative view doesn't mean the stock has to drop this low. However, in my opinion, this is where the lowest-risk buy zone lies.
Summary
Newmont had a rough Q2 report, but to say it was an unusual one would be an understatement. This is because the company had large mark-to-market impacts, saw a hefty profit-sharing bill from Penasquito, was impacted by above-average labor tightness exacerbated by the Western Australia border re-opening and dealt with a near parabolic rise in diesel prices. Looking ahead, we could see some moderation in materials costs and labor productivity from extremely unfavorable levels in Q2, and Boddington Autonomous Haulage Fleet continues to deliver, expecting record throughput in H2.
From a bigger picture standpoint, this business is run by experienced, conservative, patient, and transparent leadership. In fact, Newmont's CEO, Tom Palmer, is one of the best in the sector. Not only has he taken care of employees and ensured their safety, but he's also navigated the company through one of the most difficult two-year periods in its history, excelling in every area that is controllable (operational performance, safety, social responsibility). In addition, the company preserved the cash made while the sun was shining in 2020 so that they could weather the proverbial storms that the sector is currently experiencing.
So, for long-term investors, I don't see any change to the investment thesis, and one could argue that it's even better, given that we have confirmation that this team is disciplined and equipped to lead the sector (not the aggressive moves of the past cycle). This will allow them to continue to invest in the business to make 2025-2030 much brighter, and investors are being paid to wait for these long-term returns. So, while I am on the sidelines, for now, I remain long-term bullish, and I would view pullbacks below US$41.75 as low-risk buying opportunities.
For further details see:
Newmont: Further Weakness Should Present A Buying Opportunity