Gold Stocks Mega Mergers Are Bad for Shareholders / Commodities / Gold and Silver Stocks 2019

The world’s two biggestgold miners both announced mega-mergers over the past 5 months or so.  These huge deals briefly garnered someinterest in the usually-forgotten gold-stock sector, and fleeting praise fromWall Street analysts.  But gold-stockmega-mergers are bad news for gold-miner shareholders on all sides.  They reveal the serious struggles of majorgold miners, and really retard future upside in their stocks.

For decades the largestgold miners in the world have been Newmont Mining (NEM) and Barrick Gold (ABX).  These behemoths have long dwarfed all theirpeers in operational scope.  While thegold miners are in the process of reporting Q4’18 results now, their latest completeset remains Q3’18’s.  As after every quarterlyearnings season, I analyzed them in depth for the major gold miners of GDX back in mid-November.

The GDX VanEck VectorsGold Miners ETF is the world’s leading and dominant gold-stock investment vehicle.  In Q3 alone NEM and ABX mined a staggering1286k and 1149k ounces of gold!  To putthis in perspective, the average of the next 8 largest gold miners rounding outthe top 10 was just 508k ounces.  Newmontand Barrick have long been in a league of their own, with commensurate marketcapitalizations.

In mid-November NEM andABX were worth $17.1b and $14.9b, granting them massive 11.0% and 9.5%weightings within GDX.  These two goldgiants alone accounted for over 1/5th of GDX! That gives them outsized influence in not only that ETF, but in the entire gold-stock sector.  GDX is the sector benchmark of choice forgold stocks these days, so the fortunes of NEM and ABX stocks really affect overallperformance.

Gold-mining stocks aregenerally divided into three tiers based on their production.  Anything over 1000k ounces annually isconsidered a major, which works out to 250k per quarter.  NEM and ABX produced so much gold in Q3 they exceededthis threshold by a colossal 5.1x and 4.6x! They are really super-majors.  Mid-tier gold miners produce between 300k to1000k ounces every year, while juniors are under 300k.

Back on September 24th,2018, Barrick Gold shocked the gold-stock world.  It announced it was merging with Randgold(GOLD), which was really an all-stock acquisition of GOLD by ABX worth$6.5b.  Barrick shareholders would own2/3rds of the new combined company, while Randgold’s would own the rest.  To avoid confusion, this essay uses the classicABX and GOLD stock symbols to represent Barrick and Randgold.

ABX had been Barrick’s tickerfor decades, but was just recently abandoned on January 2nd.  With this mega-merger finished, the newcompany took over the excellent GOLD symbol going forward.  That is a wise decision, as anyone who types “gold”into any brokerage account will see Barrick Gold.  Years ago before Randgold got that covetedsymbol, another major miner had it and really seemed to benefit from it.

In Q3 Randgold was the10th-largest gold miner in the world producing 309k ounces.  Added on top of Barrick’s 1149k, the newcombined 1458k would take back the top-gold-miner crown from Newmont which produced1286k that quarter.  Apparently sizematters a lot when you’re a gold-mining executive.  But with both ABX and GOLD suffering chronic decliningproduction, that mega-merger reeked of desperation.

Newmont’s leadershipwasn’t happy with losing the pole position among global gold miners.  So it soon got to work on looking for a mega-mergerof its own.  On January 14th, NEM announcedit was acquiring major miner Goldcorp (GG) in an all-stock deal worth $10.0b!  That looked like one-upmanship taking it toBarrick.  NEM and GG shareholders wouldown about 2/3rds and 1/3rd of the new combined colossus.

Goldcorp was the world’s7th-largest gold miner in Q3’18, producing 503k ounces of gold.  Added on to Newmont’s 1286k, that creates anew monster running at an unprecedented 1789k-ounce quarterly rate!  If bigger isbetter, these new combined super-major gold miners ought to be the best seen inhistory.  But unfortunately in goldmining that isn’t true, and these new giants will likely fare worse than ifthey hadn’t merged.

In their merger announcements,the CEOs of all 4 of these major gold miners tried hard to sell their deals as wonderfulnews for shareholders.  They argued thatsynergies and cost savings would make these new combined titans more effectiveat producing superior returns for their shareholders going forward.  And as always with any large merger, Wall Streetanalysts universally applauded these mega-mergers as good.

Sadly the opposite is likelytrue, these deals are bad news for allthe owners of Newmont and Barrick as well as former owners of Goldcorp and Randgold.  These new giant super-majors are even badnews for the gold-mining sector as a whole.  The odds are really high that their stockswill really underperform the smaller major, mid-tier, and junior gold miners incoming years.  That will hurt this entiresector on multiple fronts.

Contrary to their CEOs’marketing propaganda, none of these four major gold miners approached thesedeals from positions of strength.  They’veall been struggling with weakeningproduction and rising costs.  Goldmines are wasting assets that are constantly depleting, and it is increasingly challengingto find new gold to mine economically at the scale and pace the majorsneed.  These mergers didn’t solve that coreproblem!

This table looks at thequarterly production, its year-over-year change, and all-in sustaining costsper ounce mined of Barrick, Randgold, Newmont, and Goldcorp during today’s secular gold bull.  It started in late Q4’15 out of deep 6.1-yearsecular lows in gold.  Barrick deletedRandgold’s old website, so there is no Q4’15 GOLD data.  And as of Wednesday afternoon NEM and GG hadn’tyet reported full Q4’18 results.

Barrick and Newmontdidn’t just effectively dilute their shareholders by 50% for somerelatively-meager cost-saving synergies, but because they can’t grow their production internally.  ABX’s gold mined each quarter has beenfalling sharply on balance for years!  Ithas seen brutal YoY drops as high as 25.5%, which ought to be impossible for aworld-class gold major.  7 of the last 9 quartershave seen big declines.

Barrick’s averagequarterly production since Q4’16 plunged an astounding 8.6% YoY.  The reason Barrick’s management blew $6.5b instock buying Randgold is they desperately needed more production to mask theprecipitous drop in their own.  Barrick’stotal 2018 production of 4525k ounces was 18.0% below the 5516k it mined only acouple years earlier in 2016.  At bestadding Randgold just regains those losses.

And GOLD has beensuffering the same production struggles as ABX. Over its past 4 reported quarters, Randgold’s gold mined has fallen anaverage of 7.4% YoY.  Can bringing tworapidly-depleting major gold miners together magically make a strongerone?  I doubt it.  Barrick’s reported production will enjoy a bigtemporary boost for its first four quarters as a merged company, and then waning production will again be unmasked.

While the new giant Barrickwill have more capital to develop new gold mines and expand existing ones, itseems unlikely that will be enough to turn this super-major around.  Barrick and Randgold operated about 12 and 4gold mines respectively pre-merger.  Sobringing another few online in coming years might not move the needle enough tooutpace depletion.  And it takes over adecade to permit and build new mines.

The entire gold-miningindustry has been greatly starved of capital largely since 2013, with 2016being a modest exception.  Thus the big investmentsnecessary to find new large-scale gold deposits and slowly advance them to minebuilds have been severely lacking.  So thiswhole industry’s pipeline of new gold to mine has been crippled, all butpinched shut.  Declining miners mergingdoes little to solve this problem.

Newmont has fared waybetter than Barrick in recent years, actually enjoying strong production growthon balance from Q4’16 to Q4’17.  But thispast year even mighty NEM has started to suffer from waning goldproduction.  It averaged 5.9% YoYdeclines in the first three quarters of 2018. I suspect NEM is just a little behind ABX in rolling over into depletionoutpacing mining growth.  ABX’s mergerforced NEM to act.

While Goldcorp was longcelebrated as the world’s best major gold miner, it has been struggling foryears with slowing production.  Over thelast 9 quarters GG only saw one modest production gain, with its gold mineddropping a colossal 11.0% YoY each quarter on average!    Soalthough GG produces about twice as much gold as Randgold, it might be a worseacquisition target due to its faster pace of shrinking production.

Like ABX and GOLD, it’shard to imagine combining two more weakening majors NEM and GG will yield a wayto stop and reverse their falling production. Again for their first four quarters together this new giant Newmont willappear to see big annual production growth.  But once that post-merger comparison rollspast, the declining gold across all its mines will again be revealed.  Mega-mergers can’t negate mine depletion.

Randgold didn’t even botherreporting industry-standard all-in sustaining costs, which is why they’re not includedabove.  But its cash costs were often onthe high side, so it’s likely the new combined company will drag overall miningcosts higher.  Barrick’s major-leadinglow AISCs aren’t likely to last with GOLD’s mines thrown in the mix, which meanshigher costs and lower overall profitability for Barrick going forward.

Newmont should benefit morefrom Goldcorp’s lower cost structure.  NEM averaged $975 AISCs in the first threequarters of 2018, way higher than the $877 average in Q3’18 amongthe GDX gold miners.  GG’s AISCs averaged$886 over that 9-month span, so the new combined Newmont should benefit fromlower costs.  But that may not last long,as weakening production eventually pushes per-ounce costs higher.

Gold-mining costs arelargely fixed quarter after quarter, with actual mining requiring the samelevels of infrastructure, equipment, and employees.  So slowing production yields fewer ounces tospread mining’s big fixed costs across. If these new super-major gold behemoths can’t arrest their depletingproduction, their costs will inevitably rise in the future hurting profitability.  Again these mega-mergers didn’t solve thatproblem.

So it looks like the managementsof Barrick and Newmont just issued $6.5b and $10.0b of new stock so they couldreport big merger-driven production surges fora single year!  Once those pre- andpost-merger year-over-year comparisons pass, the vexing waning-productionproblems at all four of these predecessor gold miners will again become apparent.  But that’s not even the biggest reason thesemergers are bad news!

Even before these mergersas apparent in mid-November when I analyzed Q3’18 results, both Newmont and Barrickalready had very-large market capitalizations of $17.1b and $14.9b.  That again granted them massive 11.0% and 9.5%weightings in GDX.  Like most stockindexes and ETFs, GDX’s components are weighted by market cap.  Goldcorp and Randgold ranked 6th and 7th thenin market cap and weightings.

Adding NEM and GG togetheras of mid-November would catapult their market cap and GDX weighting to $25.1band 16.0%.  Adding ABX and GOLD togetheryields a similar $22.3b market cap and 14.5% total GDX weighting.  So these two super-majors alone could accountfor a crazy 30.5% of GDX’s weighting!  That is almost scarily concentrated, althoughwe don’t yet know how GDX’s managers will deal with this.

As of this week the newcombined Barrick only has an 11.1% GDX weighting, while Newmont is at 8.2% sinceits mega-merger is not yet consummated. It will be interesting to see whether the new companies’ weightings goingforward are kept in market-cap proportion or somehow limited.  I hope it’s the latter, as many of the othergold miners in GDX have far-better growth prospects than these new super-majors.

ETF weightings aside, higher market caps create plenty ofproblems of their own.  I’ve writtenessays in the past on pickinggreat gold stocks, and surprisingly market capitalization is the single mostimportant factor for future gains.  Thegold stocks with the largest market caps usually significantly underperformtheir smaller peers.  These new super-majorsare so darned big that they really compound this problem.

In mid-November when Ianalyzed the GDX miners’ Q3’18 results, the average market cap of its top 34component stocks was $4.3b.  Excluding NEMand ABX, that fell to $3.5b.  It takesproportionally more capital inflows, investors buying shares, to push a largerstock higher than a smaller one.  If thesuper-majors are worth $24b, it takes 6xas much buying of their stocks to drive the same gains as on a $4b company!

Imagine the differentforces involved turning a supertanker versus a tugboat.  The bigger any stock in the stock markets,the more inertia it has and thus the more capital is needed to overcome thatand move the stock.  And market-capissues are not just a size thing in gold stocks.  Smaller major, mid-tier, and junior goldminers have way fewer gold mines and much-lower production, which makes it far easier to grow output.

While Newmont is a temporaryexception since it was bucking the major trend and growing production in 2017,Barrick, Randgold, and Goldcorp all really underperformed their sector inrecent years.  This chart looks at the indexed performance in ABX, GOLD, NEM,and GG stocks compared to the leading sector ETFs of GDX and the smaller GDXJwhich largely tracks mid-tiergold miners under 1m ounces annually.

Both GDX and GDXJ fellto all-time lows back in mid-January 2016 when this gold-stock bull wasborn.  So all 6 stocks are indexed to 100as of that day, revealing their relative performance since.  Despite their heavy weighting in GDX, themajor gold miners generally lag their key sector benchmarks.  ABX, GOLD, and GG have really struggled inrecent years as their managers failed to stem big production declines.

This chart is pretty damning,showing why the managers of Barrick and Newmont are desperate to show risingproduction even if only for a year after their wildly-expensive mega-mergers.  ABX and GOLD have both been reallyunderperforming their peers, scaring investors away while putting serious pressureon managements to turn things around. NEM resisted that, but its production started to decline too in 2018.

And GG has been abasket case, actually managing to fall below its deep secular lows of early 2016in recent months!  That’s a sad fate for whatwas the world’s best major gold miner for many years.  NEM buying this dog is likely to drag down NEM’sstock performance to some midpoint between what it has done and how GG hasfared.  For the most part the largestgold miners haven’t been good investments.

The much-larger marketcaps coming from combining struggling majors into super-majors is highly likelyto exacerbate this underperformance trend. The new Newmont and Barrick are way bigger and far more ponderous, andwill require a lot more share buying to move their stock prices materiallyhigher.  But why will most investors evenbother to buy these titans when many smaller mid-tier gold miners are thriving?

This next chart adds asingle additional mid-tier gold miner to illustrate their outperformance.  I chose IAMGOLD (IAG) for this example for acouple reasons.  It produced 882k ouncesin all of 2018, which makes it a larger mid-tier gold miner nearing that 1000k+major threshold.  And IAG is unremarkablefundamentally.  It mined the same 882kounces in 2017, so there was no production growth at all last year.

And its 2018 all-insustaining costs are expected to come in on the high side near $1070 per ounce,which is worse than most of the majors. So there’s really nothing special about IAG operationally suggesting itshould far outperform.  If I wanted tocherry pick, there are other mid-tier miners that have trounced what IAG hasdone in recent years.  Yet even IAG wildlyoutperformed the majors and sector ETFs during this gold bull.

If Newmont and Barrickwere the only gold-mining stocks, they’d certainly be worth owning during asecular gold bull.  But why own thesemassive supertanker-like gold miners when smaller major, mid-tier, and juniorgold miners’ stocks are performing way better? The smaller miners not only have lower market caps easier to bid higherwith much-smaller capital inflows, but plenty also have superior fundamentals.

They tend to have justa few or less gold mines, making it much easier to grow production by expandingexisting mines or building new ones.  Thoseexpansion events act as major psychological catalysts to get investors interestedin those stocks, fueling disproportionally-large buying to catapult themhigher.  There is really no reason to deploycapital in large majors when mid-tiers are easily running circles around them.

Even if like me you don’town Newmont or Barrick and have no intention of investing in them, they couldcause problems for the entire gold-stock sector.  Their hefty GDX weightings mean their stockshave way-outsized influence in how that leading ETF fares.  If these super-majors’ giant stocks lag, theyare going to retard GDX’s upside which in turn will leave traders less optimisticand more skeptical on gold miners’ outlook.

So mega-market-cap goldminers could significantly slow the overall sentiment shift from bearish backto bullish which is necessary to attract in buying.  If capital inflows diminish because of the perception this sector isn’trallying enough, the bull-market uplegs will unfold slower and maybe endsmaller.  Even more problematic, thesuper-majors’ high weightings in GDX suck ETF capital away from more-deservingminers.

Most investors prefer sectorETFs over individual stocks, so lots of capital will flow into GDX as investorsget interested in gold stocks again.  GDX’smanagers have to allocate any differential buying pressure into its underlyingcomponent companies in proportion totheir weightings.  The newly-mergedBarrick and Newmont will likely command much-bigger weightings, starvingsmaller component miners of capital inflows.

But despite these mega-mergersbeing bad for everyone except the managers of those companies paying themselveshuge compensation, all is not gloom and doom. If the new Newmont and Barrick continue to suffer waning productionafter their initial merger-boost year, investors will shift capital out of theminto the other gold miners.  That willgradually throttle their market caps and thus weightings in GDX, mitigating damage.

And if these super-majorstaint the performance or expected upside in GDX enough, GDXJ may very well usurp it as the gold-stock sector benchmarkof choice!  While falsely billed as aJunior Gold Miners ETF, GDXJ has really become a mid-tier gold miners’ ETF.  It has been increasingly outperforming GDX,and that trend could accelerate since GDXJ will hopefully never include the largermajors led by NEM and ABX.

With so manyfundamentally-superior smaller gold miners to pick from, investors have no needto own the larger majors.  Plenty ofmid-tier miners are still growing their production organically, by expandingtheir existing mines or building new ones. Their upside as gold continues marching higher in its bull market is enormous,dwarfing what is possible in the giant majors struggling with waningproduction.  Avoid the latter!

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The bottom line isgold-stock mega-mergers are bad news for everyone in this sector.  Combining major gold miners alreadystruggling with slowing production doesn’t solve the problem, but only masks itfor a single year.  The resultingsuper-majors’ massive market capitalizations saddle their share prices with biginertia.  They are going to require much-largercapital inflows to rally materially, really retarding their upside.

Their higher weightingswithin sector ETFs will lead to worse perceived sector performance, delayingthe necessary sentiment shift from bearish back to bullish.  And the super-majors will suck up more of thecapital allocated to gold-stock ETFs, starving smaller and more-worthy goldminers of buying.  Thankfully some ofthese problems can be avoided by shunning Newmont and Barrick, and stickingwith great mid-tier miners.

Adam Hamilton, CPA

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