Junior Gold Stocks Q3'18 Fundamentals / Commodities / Gold and Silver Stocks 2018

The junior gold miners’stocks have spent recent months mostly languishing near major multi-year lows.  That spawned a sentiment wasteland riddled bybearishness and bereft of bids.  But thesecompanies’ battered stock prices aren’t fundamentally righteous, as proven yetagain by their latest earnings season.  Faringfar better in a challenging third quarter than stock prices imply, they need tomean revert way higher.

Four times a yearpublicly-traded companies release treasure troves of valuable information inthe form of quarterly reports.  Companiestrading in the States are required to file 10-Qs with the US Securities andExchange Commission by 40 calendar days after quarter-ends.  Canadian companies have similar requirementsat 45 days.  In other countries withhalf-year reporting, many companies still partially report quarterly.

The definitive list ofelite “junior” gold stocks to analyze comes from the world’s most-popularjunior-gold-stock investment vehicle.  Mid-monththe GDXJ VanEck Vectors Junior Gold Miners ETF reported $4.1b in netassets.  Among all gold-stock ETFs, that wassecond only to GDX’s $9.0b.  That isGDXJ’s big-brother ETF that includes larger major gold miners.  GDXJ’s popularity testifies to the greatallure of juniors.

Unfortunately this famecreated serious problems for GDXJ a couple years ago, resulting in a stealthymajor mission change.  This ETF is quiteliterally the victim of its own success. GDXJ grew so large in the first half of 2016 as gold stocks soared in amassive upleg that it risked running afoul of Canadian securities laws.  And most of the world’s smaller gold minersand explorers trade on Canadian stock exchanges.

Since Canada is thecenter of the junior-gold universe, any ETF seeking to own this sector willhave to be heavily invested there.  Butonce any investor including an ETF buys up a 20%+ stake in any Canadian stock,it is legally deemed to be a takeoveroffer that must be extended to all shareholders!  As capital flooded into GDXJ in 2016 to gainjunior-gold exposure, its ownership in smaller components soared near 20%.

Obviously hundreds ofthousands of investors buying shares in an ETF have no intention of taking overgold-mining companies, no matter how big their collective stakes.  That’s a totally-different scenario than asingle corporate investor buying 20%+. GDXJ’s managers should’ve lobbied Canadian regulators and lawmakers to exempt ETFs from that 20% takeoverrule.  But instead they chose aninferior, easier fix.

Since GDXJ’s issuercontrols the junior-gold-stock index underlying its ETF, it simply chose to unilaterally redefine what junior goldminers are.  It rejiggered its index tofill GDXJ’s ranks with larger mid-tier gold miners, while greatly demoting truesmaller junior gold miners in terms of their ETF weightings.  This controversial move defying long decadesof convention was done quietly behind the scenes to avoid backlash.

There’s no formaldefinition of a junior gold miner, which gives cover to GDXJ’s managers pushingthe limits.  Major gold miners aregenerally those that produce over 1m ounces of gold annually.  For decades juniors were considered to besub-200k-ounce producers.  So 300k ouncesper year is a very-generous threshold. Anything between 300k to 1m ounces annually is in the mid-tier realm, where GDXJ now traffics.

That high300k-ounce-per-year junior cutoff translates into 75k ounces per quarter.  Following the end of the gold miners’ Q3’18earnings season in mid-November, I dug into the top 34 GDXJ components’results.  That’s simply an arbitrarynumber that fits neatly into the tables below. Although GDXJ included a staggering 70 component stocks mid-month, thetop 34 accounted for a commanding 82.9% of its total weighting.

Out of these top 34GDXJ companies, only 3 primary goldminers met that sub-75k-ounce-per-quarter qualification to be a junior goldminer!  Their quarterly production is renderedin blue below, and they collectively accounted for just 3.8% of this ETF’stotal weighting.  GDXJ is inarguably nowa pure mid-tier gold-miner ETF, not ajunior one.  But its holdings include theworld’s best gold miners with huge upside potential.

I’ve been doing thesedeep quarterly dives into GDXJ’s top components for years now.  In Q3’18, fully 31 of the top 34 GDXJcomponents were also GDX components!  These are separate and distinct ETFs, a “GoldMiners ETF” and a “Junior Gold Miners ETF”. So they shouldn’t have to own many of the same companies.  In the tables below I highlighted the symbolsof rare GDXJ components not also in GDX in yellow.

These 31 GDX componentsaccounted for 79.2% of GDXJ’s total weighting, not just its top 34.  They also represented 31.7% of GDX’s totalweighting.  Thus nearly 4/5ths of this“Junior Gold Miners ETF” is made up by nearly 1/3rd of the major “Gold MinersETF”!  These GDXJ components also in GDX areclustered from the 11th- to 30th-highest weightings in that latter larger ETF.  GDXJ is mostly smaller GDX stocks.

In a welcome changefrom GDXJ’s vast component turmoil of recent years, only 4 of its top 34 stocksare new since Q3’17.  Their symbols arehighlighted in light blue below.  Thus thetop GDXJ components’ collective results are finally getting comparable again inyear-over-year terms.  Analyzing ETFs ismuch easier if their larger components aren’t constantly in flux.  Hopefully changes going forward arerelatively minor.

Despite all this, GDXJremains the leading “junior-gold” benchmark. So every quarter I wade through tons of data from its top components’ latestresults, and dump it into a big spreadsheet for analysis.  The highlights make it into thesetables.  Most of these top 34 GDXJ goldminers trade in the US and Canada, where comprehensive quarterly reporting isrequired by regulators.  But others tradein Australia and the UK.

In these countries andmost of the rest of the world, regulators only mandate that companies reporttheir results in half-year increments.  Mostdo still issue quarterly production reports, but don’t release financialstatements.  There are wide variations inreporting styles, data presented, and release timing.  So blank fields in these tables mean acompany hadn’t reported that particular data for Q3’18 as of mid-November.

The first couplecolumns of these tables show each GDXJ component’s symbol and weighting withinthis ETF as of mid-November.  While just overhalf of these stocks trade on US exchanges, the other symbols are listings fromcompanies’ primary foreign stock exchanges. That’s followed by each gold miner’s Q3’18 production in ounces, whichis mostly in pure-gold terms excluding byproduct metals often found in goldore.

Those are usuallysilver and base metals like copper, which are valuable.  They are sold to offset some of theconsiderable costs of gold mining, lowering per-ounce costs and thus raisingoverall profitability.  In cases wherecompanies didn’t separate out gold and lumped all production intogold-equivalent ounces, those GEOs are included instead.  Then production’s absolute year-over-yearchange from Q3’17 is shown.

Next comes gold miners’most-important fundamental data for investors, cash costs and all-in sustainingcosts per ounce mined.  The latterdirectly drives profitability which ultimately determines stock prices.  These key costs are also followed by YoYchanges.  Last but not least the annualchanges are shown in operating cash flows generated, hard GAAP earnings, sales,and cash on hand with a couple exceptions.

Percentage changesaren’t relevant or meaningful if data shifted from positive to negative or viceversa, or if derived from two negative numbers. So in those cases I included raw underlying data rather than weird ormisleading percentage changes.  Thiswhole dataset together offers a fantastic high-level read on how the mid-tiergold miners as an industry are faring fundamentally.  They actually did relatively well in Q3.

While this new mid-tierGDXJ is generally excellent, some decisions by its managers are utterlybaffling.  Out of all the world’s gold minersthey could’ve added over this past year, they inexplicably decided on the giantlargely-African AngloGold Ashanti.  It producedan enormous 851k ounces of gold last quarter, the largest in GDXJ by far.  It and the rest of the South African majors definitelydon’t belong in GDXJ!

Remember thatmajor-gold-miner threshold has long been 1m+ ounces per year.  AU’s production is annualizing to well over3x that, making this company the world’s3rd-largest gold miner last quarter. Why on earth would managers running a “Junior Gold Miners ETF” evenconsider AngloGold Ashanti?  It is as farfrom junior-dom as gold miners get.  The sameis true with the rest of the troubled South African gold miners.

AU, Gold Fields,Harmony Gold, and Sibanye-Stillwater mined 851k, 533k, 379k, and 309k ounces inQ3’18, all are majors.  Yet they accounted for 13.1% of GDXJ’s totalweighting.  They are riddled with allkinds of problems too, from shrinking production to high costs to increasingstealth expropriations from South Africa’s openly-Marxist anti-white-investorgovernment.  Their inclusion heavily skewsand taints GDXJ.

These South Africanmajors’ Q3 production of 2.1m ounces was a whopping 41% of the GDXJ top 34’stotal!  And it still fell 7.0% YoY due toSouth Africa’s tragic death spiral. Excluding them and the amazing Kirkland Lake Gold which has grown sofast it was moved exclusively into GDX over this past year, the rest of theGDXJ top 34 grew production 3.4% YoY in Q3.  The South African majors’ cost impactis even worse.

Mining in that country isvery expensive thanks to very-old very-deep mines and endless new governmentinterference via stifling regulations. In Q3 the South African majors’ cash and all-in sustaining costs came inreally high averaging $925 and $1088 per ounce. The rest of GDXJ’s top 34 averaged $629 and $877, a massive 32.0% and19.4% lower!  The South African majors are really retarding GDXJ’s performance.

As struggling majors farlarger than mid-tiers and juniors, they need to get kicked out of GDXJ posthaste.  They can be left in GDX where they belong.  AU effectively took KL’s place, which makesno sense at all fundamentally.  KirklandLake produced 180k ounces of gold in Q3 at $351 cash costs and $645 AISCs.  So unlike AU, KL remains solidly in the mid-tierrealm and has been performing incredibly well operationally.

While GDXJ’s managers reallydropped the ball including those South African majors, they deserve big praisefor upping the weighting of the outstandingAustralian miners.  They are NorthernStar Resources, Evolution Mining, Regis Resources, St Barbara, and Saracen Mineral.  Their collective weighting in GDXJ grew to21.7% at the end of Q3’s earnings season, nearly 2/3rds higher from their 13.3%a year earlier.

Unlike AU’s dumbfoundinginclusion, the Australians’ rise is well-deserved.  Their production surged 8.9% YoY to 686kounces, or 23% of the GDXJ top 34’s total excluding those South African majors.  And the Australian miners are masters at developinggreat gold deposits and controlling costs, as their cash costs and AISCs in Q3averaged just $586 and $724!  It’s fantasticGDXJ offers American investors this Aussie exposure.

GDXJ’s component list andweightings are a work in progress, and are gradually getting better.  For years I’ve pointed out things like theSouth African majors that weren’t right, and GDXJ’s managers eventually seem tocome around and change things for the better. Greatly helping that process is investors buying the better individualstocks like KL and shunning laggards like AU, readjusting their relative marketcapitalizations.

GDXJ and GDX are essentiallymarket-cap weighted, with larger companies rightfully commanding larger weightings.  These leading gold-stock ETFs’ managers can overridethis by deciding which gold miners to include in each ETF.  So they can easily purge GDXJ of thedeteriorating South African majors and add real mid-tier gold miners.  But the true core problem is having so manyof the same stocks in GDX and GDXJ.

Such massive overlapbetween these two ETFs is a huge lost opportunity for VanEck.  It owns and manages GDX, GDXJ, and even theMVIS indexing company that decides exactly which gold stocks are included ineach.  With one company in total control,there’s no need for any overlap in the underlying companies of what should betwo very-different gold-stock ETFs. Inclusion ought to be mutually-exclusive.

VanEck could greatlyincrease the utility of its gold-stock ETFs and thus their ultimate success bystarting with one big combined list of the world’s better gold miners.  Then it could take the top 20 or 25 in termsof annual gold production and assign them to GDX.  Based on Q3’18 production, that would run downnear 139k or 93k ounces per quarter. Then the next-largest 40 or 50 gold miners could be assigned to GDXJ.

Getting smaller goldminers back into GDXJ would be a huge boon for the junior-gold-miningindustry.  Most investors naturallyassume this “Junior Gold Miners ETF” owns junior gold miners, which is wherethey are trying to allocate their capital.  But since most of GDXJ’s funds are insteaddiverted into much-larger mid-tiers and even some majors, the juniors areeffectively being starved of capital intendedfor them.

That’s one of the bigreasons smaller gold miners’ stock prices are so darned low.  They aren’t getting enough capital inflowsfrom gold-stock-ETF investing.  So theirshare prices aren’t bid higher.  Theyrely on issuing shares to finance their exploration projects and minebuilds.  But when their stock prices aredown in the dumps, that is heavily dilutive. So GDXJ is strangling the veryindustry its investors want to own!

Back to these mid-tiergold miners’ Q3’18 results, production is the best place to start since that isthe lifeblood of the entire gold-mining industry.  These top 34 GDXJ gold miners that had specificallyreported Q3 production as of mid-November produced 5063k ounces.  That surged by a massive 18.8% YoY, implyingthese miners are thriving.  But that isheavily distorted by that huge 851k-ounce boost from AU’s addition.

Without the world’s 3rd-largestgold miner, the rest of the GDXJ top 34 saw their production slip 1.2% YoY to4212k ounces.  That reflected the peak-gold challenges the gold-miningindustry is facing, as I discussed a couple weeks ago while reviewing the GDX majors’ Q3’18 results.  The GDXJ top 34 are still outperforming theGDX top 34, which saw their gold production retreat 2.9% YoY in Q3 buckinghistorical trends.

Sequentially quarter-on-quarterfrom Q2’18 the GDXJ top 34’s production surged a dramatic 13.3%!  And AU was already one of GDXJ’s topcomponents then.  That partially came fromnew mines ramping up at the world’s best mid-tier gold miners.  It is far easier for them to grow productionoff lower bases than it is for the majors off high bases.  That’s a key reason why the mid-tiers’ upsidepotential trounces that of the majors.

For all GDXJ’s faults,it does still offer investors exposure to much-smaller gold miners.   The average quarterly production of all thetop 34 GDXJ miners reporting it in Q3 was 163.3k ounces.  That is 43%smaller than the 288.8k averaged by the top 34 GDX miners last quarter.  And again AU’s crazy inclusion really skewsthis.  Ex-AU, the GDXJ average falls to 140.4k.  Without all the South African majors, it is110.8k.

These annualize to 562kand 443k, both solidly in the mid-tier realm. Analyzing GDXJ’s production and costs requires breaking out those heavily-distortingSouth African majors that have no place in a mid-tier gold-miner ETF.  Again their production fell 7.0% YoY in Q3,while the rest of the GDXJ top 34’s ex-KL grew3.4%!  Production and costs tend tobe proportionally inversely related because of how mining works.

Gold-mining costs are largely fixed quarter after quarter,with actual mining requiring the same levels of infrastructure, equipment, andemployees.  The tonnage throughputs of themills that process the gold-bearing ore are also fixed.  So gold produced varies with ore grades eachquarter.  The more gold that is recovered,the more ounces to spread gold mining’s big fixed costs across.  That lowers per-ounce costs.

There are two majorways to measure gold-mining costs, classic cash costs per ounce and thesuperior all-in sustaining costs per ounce. Both are useful metrics.  Cashcosts are the acid test of gold-miner survivability in lower-gold-priceenvironments, revealing the worst-case gold levels necessary to keep the minesrunning.  All-in sustaining costs showwhere gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturallyencompass all cash expenses necessaryto produce each ounce of gold, including all direct production costs,mine-level administration, smelting, refining, transport, regulatory, royalty,and tax expenses.  In Q3’18, the overallcash costs of the GDXJ top 34 surged 8.4% higher YoY to $663 per ounce.  That was still largely in line with the pastfour quarters’ $612, $618, $692, and $631 averaging $638.

But that sharp jump wasmostly the result of the South African majors’ deepening troubles.  Again their average cash costs last quarter werea whopping $925!  Without them, the restof the GDXJ top 34 averaged $629 per ounce which was only up 2.8% YoY and belowthe rolling-four-quarter mean.  So themid-tier gold miners of GDXJ are holding the line on cash costs, a sign theiroperations are fundamentally sound.

Way more important thancash costs are the far-superior all-in sustaining costs.  They were introduced by the World GoldCouncil in June 2013 to give investors a much-better understanding of what itreally costs to maintain gold mines as ongoing concerns.  AISCs include all direct cash costs, but thenadd on everything else that is necessary tomaintain and replenish operations at current gold-production levels.

These additionalexpenses include exploration for new gold to mine to replace depletingdeposits, mine-development and construction expenses, remediation, and minereclamation.  They also include thecorporate-level administration expenses necessary to oversee gold mines.  All-in sustaining costs are themost-important gold-mining cost metric by far for investors, revealing goldminers’ true operating profitability.

The GDXJ top 34 reportedaverage AISCs of $911 in Q3, up 3.8% YoY. But like cash costs, this was roughly in line with the $877, $855, $923,and $886 seen in the past four quarters. But again that was skewed quite a bit higher by those wrongly-includedSouth African majors, which reported $1088 average AISCs in Q3.  The rest of the top 34 averaged $877, whichis actually better than the $885 four-quarter average.

So the South Africanmajors are really tainting GDXJ’s collectiveoperational performance, with lower production and higher costs dragging downthis entire ETF.  Those giant strugglinggold producers are an albatross around the neck of the many great mid-tier goldminers in GDXJ!  If you are a GDXJinvestor, contact VanEck and urge them to boot the South African majors out ofGDXJ to help it thrive going forward.

Gold-mining earningsare simply the difference between prevailing gold prices and all-in sustainingcosts.  And both sides of this equationmoved the wrong way in Q3, squeezing the mid-tier gold miners’ profits.  Q3’18’s average gold price of $1211 was 5.3% lower than Q3’17’s.  And with overall GDXJ top 34 AISCs 3.8%higher at $911, that really cut into margins. These gold miners were collectively earning $300 per ounce.

That implied solid 25%profit margins absolutely, which aren’t bad. But they still plunged 25.4% YoY from Q3’17’s $402 per ounce, which amplifiedgold’s decline by 4.8x.  But gold-mining profits leverage to gold is exactly why the gold stocks make such compelling investments.  Gold stocks were weak in Q3 because gold waspounded to a deep 19.3-month low in mid-August on extreme all-time-record gold-futuresshort selling.

Left for dead andneglected, the gold miners’ stocks are the last cheap sector in theselofty bubble-valued stock markets.  Their fundamental upsideas gold mean reverts higher on speculators’ gold-futures buying and new investment demand asstock markets roll over is enormous.  This is easy to understand with a simpleexample.  In the last four quartersincluding Q3’18, the top 34 GDXJ gold miners’ AISCs averaged $894.

During gold’s lastmajor upleg in essentially the first half of 2016, it powered about 30% higherdriven by surging investment demand after stock markets suffered back-to-backcorrections.  That was even small by historicalgold-bull-upleg standards.  If we merelyget another 30% gold advance from its recent mid-August low of $1174, we’relooking at $1525 gold.  That would work wonders for gold-mining profitsand stock prices.

At $1525 gold and $894AISCs, the mid-tier gold miners would be earning $631 per ounce.  That’s 110% higher than Q3’18’s $300!  If gold-mining profits double, gold-stockprices will soar.  Indeed during that last30% gold bull in the first half of 2016, GDXJ rocketed 203% higher!  So the gold-stock outlook is wildly bullish with gold itself dueto power higher as the stock markets roll over on the Fed’s record tightening.

The rest of the top 34GDXJ gold miners’ fundamentals were mixed last quarter.  Cash flows generated from operations totaled $1.3bin Q3, down 21.2% YoY.  That’s reasonablegiven average gold’s 5.3% YoY retreat and their leverage to it.  Cash on hand remained high at $5.4b, down just5.3% YoY.  So these mid-tier gold miners have plenty of capital to build and buynew mines to continue growing their production.

Revenues only slipped0.4% YoY to $4.1b, which means the softer gold prices were largely offset by higherproduction.  But GAAP profits looked likea disaster, with the GDXJ top 34’s plummeting to a $379m loss in Q3’18 from being$212m in the black in Q3’17!  That wasfar worse than the lower gold prices warranted, but thankfully it was mostlythe result of big non-cash charges flushed through income statements.

Tahoe Resources reporteda massive $170m impairment charge on its suspended Escobal silver mine that isbeing held hostage by the corrupt Guatemalan government.  Yamana Gold wrote off $89m after selling amine in Argentina.  Explorer NOVAGOLD reportedan $81m loss from discontinued operations on the sale of one of itsprojects.  These three unusual items alonewiped out $340m of profits from GDXJ’s ranks.

Without them, the top34 GDXJ gold miners’ earnings would’ve fallen to -$39m from +$212m.  That isn’t great, but it doesn’t reveal anyserious issues a rising gold price won’t quickly solve.  Interestingly if KL was still includedinstead of AU, that would’ve added another $56m in Q3’18 profits.  The mid-tiers’ overall earnings shoulddramatically leverage and outpace gold in coming quarters as it inexorably meanreverts higher.

While GDXJ shouldcertainly no longer be advertised as a “Junior Gold Miners ETF”, it offersexposure to some of the best mid-tier gold miners on the planet.  It’s really growing on me, I like this newGDXJ way better than GDX.  That beingsaid, GDXJ is still burdened by overdiversification and way too many goldminers that shouldn’t be in there.  Theyare either too large, are saddled with inferior fundamentals, or both.

So the best way to playthe gold miners’ coming massive mean-reversion bull is in individual stocks with superior fundamentals.  Their gains will ultimately trounce the majorETFs like GDXJ and GDX.  There’s no doubtcarefully-handpicked portfolios of elite gold and silver miners will generatemuch-greater wealth creation.  GDXJ’scomponent list is a great starting point, but pruning it way down offers far-biggerupside.

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The bottom line is themid-tier gold miners reported solid fundamentals despite a challenging thirdquarter for gold prices.  Excluding the SouthAfrican majors, they were able to grow their production nicely while holdingthe line on costs.  That portends dramaticoperating-cash-flow and earnings growth in the coming quarters as gold meanreverts higher on big investment buying. The mid-tier gold miners’ stocks will soar on that.

Gold stocks are not onlyunloved and dirt-cheap today, but they are a rare sector that rallies stronglywith gold as general stock markets weaken. While virtually no one was interested in these leveraged plays on goldupside in recent months, that will change fast as these lofty stock marketsroll over.  And the mid-tier gold miners’recent Q3 earnings season proved they remain ready to fundamentally amplifygold’s gains.

Adam Hamilton, CPA

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