Friday, August 8, 2014

Glittering Goldcorp: How do you evaluate a gold miner and its earnings report?

Gold and precious metals are a perennial favourite for many investors and speculators. It is often viewed by many as a hedge against the risk of inflation destroying our wealth, and the business model can often be relatively clear to understand.

The primary determinant of price movements for many gold stocks is, quite understandably, the price of gold. To recognize whether or not a gold miner is operating effectively, however, you must pour through the quarterly and annual earnings statements. In this article, we will look at Goldcorp's recent earnings release for July 31, 2014 to help understand how to evaluate a gold producer's performance.

According to the company, Goldcorp (TSE: G, NYSE: GG) is "one of the world's fastest growing gold producers. Its low-cost gold production is located in safe jurisdictions in the Americas and remains 100% unhedged." This statement illustrates a number of important points that should be examined more closely when evaluating a gold company for investment:

1) Production levels is one of the primary performance indicators for a gold mining company. The vast majority of a mining company's value lies trapped within the Earth. Unlocking this value is a very expensive and complex process. Increasing or decreasing production levels gives an investor some indication of operational growth in the company, and helps the investor track whether or not the company is on target for any growth plans. 

In the quarter we are examining, Goldcorp notes production of 648,700 ounces, compared to production of 646,000 ounces in the second quarter of 2013, which is a positive sign as production is increasing slightly.

2) Reserves are the metals a mining company still has trapped in the ground for future production. If reserves are declining quarter after quarter, the company will have to start building up reserves so that production does not hit a stand still or eventually decline as existing reserves become more difficult to reach. 

There are a couple of primary ways that mining companies increase reserves: 

1) They can do it the old fashioned way, by discovering and developing their own mining opportunities. This becomes increasingly more expensive over time as the easier to find deposits are developed and exhausted. 

2) They can acquire existing discoveries or developments from other companies. This method tends to be more common for massive multinational gold miners like Goldcorp or Barrick. The significant danger with this method is overpaying for developments that do not pan out, and then the company has to "write down" or essentially take an accounting loss when they admit their mistake. 

Mineral reserves are expected to have economic viability, which means an actual likelihood of being developed in the future, whereas "mineral resources" do not necessarily pass this economic viability test. It is important to note the distinction between the two in a company's reports. Goldcorp's reserves are broken down by mineral type, and it is essentially up to the investor to decide whether or not there appears to be significant value located there. 

3) Geo-political risk is important to examine for all investments, but with mining companies it tends to be particularly relevant. Gold mining operations that exist in stable and developed economies often have less risk of being shut down due to political concerns, and their value is generally easier to determine. Operations in Canada, the United States, and Australia, therefore, deserve a premium to those produced in less stable countries, such as those located in South America and Africa. 

In the image below, we can see the geographical distribution of Goldcorp's 2014 production levels. Note the strong presence in Canada, Mexico, and the United States. This is a positive sign as these areas are generally investment friendly environments for miners. It is important to keep an eye on the location of production, as it can shift over time as companies seek new reserves to replace declining ones. 

4) All-in-costs, or essentially the total costs that the company calculates it takes to produce one ounce of gold, is important to look at when examining a mining company because it helps us to determine something like a break even point for the company. These costs may vary between mining companies as the metric is not completely standardized, but for Goldcorp these costs include: by-product cash costs, sustaining capital expenditures, corporate administrative expense, exploration and evaluation costs and reclamation cost accretion and amortization.

Essentially, all-in-costs are the miner's way to help define the total costs associated with producing gold. For Goldcorp, the all-in-sustaining cost is estimated to be $852 per ounce of gold. By product costs can be a little confusing, but essentially if a gold mine is also producing copper, the money that the company earns from selling the copper is deducted from the costs of production, and it lowers the all-in-sustaining costs of producing gold. 

5) Gold prices are often the primary factor determining the price fluctuations in gold company stock. The difficulty here for the investor is that gold prices act relatively independently of the decisions made by company management. Gold prices can swing wildly from year to year, and company management can try to limit the effects of price changes in the price of gold by implementing hedging strategies. 

Hedging strategies primarily sell certain amounts of future production levels (futures) for an agreed upon price. Hedging bets can make a company money if they sell future production at say $1500 per oz and gold prices on the global market decline to $1000. On the other hand, hedging can lose significant amounts of money if future production is sold at a price lower than the actual market price that materializes in the future. In the case of Goldcorp, they have decided to not hedge their sales, which indicates they they are very bullish, or confident that gold prices will rise in the future.

Below is an image illustrating gold prices in U.S. dollars. It highlights prices inflation adjusted and in nominal dollars. Gold prices, though often seen as a natural hedge against inflation, or something that will naturally keep pace with rising prices, are often unpredictable. Because of this, gold mining companies will experience large swings in their share prices as the price of gold rises and falls with changes in investor sentiment and concerns about inflation over time.  

The information above provides a good introduction to understanding some key information to look for when examining the earnings report of a gold mining company. Remember, as for any investment, it is important to consider other factors, such as earnings per share, dividends, investment alternatives, et cetera. 

Thanks for reading, and Happy Investing!

Thursday, July 24, 2014

Loblaw: Losses never looked so good. Understanding Adjusted Earnings and Free Cash Flow.

Loblaw (TSE: L) announced earnings recently (Loblaw Press Release), opening with the statement by Galen Weston that "the second quarter of 2014 marked the opening of the next chapter for Loblaw, combining the number one food retailer in Canada with the number one pharmacy and beauty retailer."

The acquisition of Shoppers Drug Mart by Canada's largest grocery chain marks a clear avenue for future expansion by the retailer, and millions of dollars in synergies as it combines the operations of the two companies into a more efficient Canadian corporate behemoth.

Including the results from Shoppers, Loblaw announced revenue of $10,307 million, an increase of 37.1% over the second quarter of 2013. Adjusted basic net earnings per common share were also up 17.2% to $0.75 compared to $0.64 in the second quarter of 2013.

The headline numbers, however, highlight that the company lost $1.13 per share in the second quarter of 2014, due primarily to costs associated with the purchase of Shoppers. This distinction provides us with an important lesson in "adjusted earnings," which can be used regularly by a number of publicly traded companies.

Adjusted earnings figures are used when a company believes that earnings for a particular financial period are distorted either positively or negatively by "one-off" or unusual events. In this case, the distortion is the artificially high loss caused by costs incurred due to buying Shoppers Drug Mart. Since Loblaw will not be incurring those costs regularly in the future, it does not believe that those costs reflect the company's true performance in the last quarter. To help shareholders better understand the company's true operational performance, it reports what the company would have made if you exclude the irregular costs. In this case, the difference is quite large, from an actual loss of $1.13 per share, to a profit of $0.75 per share.

Intelligent Investors should beware of adjusted numbers, and investigate why the adjustments were made, and if they seem reasonable. In this case, it is clearly understood that the costs are associated with the purchase and integration of another major Canadian retailer. This will not be a standard or common occurrence for Loblaw in most quarters, so the adjustment is most likely reasonable.

Many investors, such as Olstein, are calling for an end to adjusted earnings, as they think it misleads investors. However, the Intelligent Investor simply needs to investigate why the earnings are being adjusted, and how often the company utilizes adjustments. If the company regularly adjusts earnings by a large margin, be careful, but otherwise, the practice can be perfectly reasonable.

To help better understand how the company is performing, it is always helpful to look at Free Cash Flow during the quarter. Free Cash Flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. This can be calculated by taking operating cash flow, and subtracting capital expenditures. In the case of Loblaw, the company had Free Cash Flow of $801 million for the quarter, a very healthy number.

Loblaw now has its fingers in a number of very profitable business pies. It is engaged in the financial business through its thriving credit card division (PC Financial now has over $2.5 billion in credit card receivables), the clothing business through Joe Fresh, the real estate business through Choice Properties, the drug business through Shoppers Drug Mart, and of course, the good old fashioned grocery business through entities such as Loblaws, No Frills, and Real Canadian Superstore.

For those Intelligent Investors looking for portfolio diversity, a decent dividend, and strong Free Cash Flow, take some time to look at Loblaw.

Happy Investing!

Sunday, January 5, 2014

What Does the Investor Need to Know About Financial Statements? The Cash Flow Statement

They say that "cash is king," and indeed, cash forms the lifeblood of any business. For the Intelligent Investor, it is cash that is used to pay dividends, buy back stock, and fund daily operations. When companies experience a cash squeeze, they find themselves at the mercy of lenders and often find it difficult to concentrate on their long-term corporate goals. This can lead to hurried and poor decision making. Healthy levels of cash lead to the flexibility corporation's need for continued success.

So how can the investor examine the cash flows of a potential business opportunity? They should start by referencing the "Statement of Cash Flows" found within a companies financial statements. The Statement of Cash Flows should be publicly issued every three months with the quarterly reports, and can be found in the Investor Relations section of most publicly traded companies' websites. 

Whereas balance sheets present a snapshot in time for a companies overall financial health, the cash flow statement shows activities over a period of time. Because the ever important earnings per share numbers are not found within the cash flow statement, this statement is often overlooked by investors. However, it is crucial for properly understanding the health of any business. 

What does the Cash Flow Statement commonly look like and what does the investor need to know? At its most basic level, the cash flow statement is segmented into three parts:

Section # 1) Operating Cash Flows
Section #2) Investing Cash Flows
Section #3) Financing Cash Flows
Net Cash Flows

Each section can have a positive or negative balance, and the sum total of these three sections will result in a number titled "Net Cash Flows." Generally, a negative number is displayed in brackets. Net cash flow helps the investor to identify whether or not the business had a net inflow or outflow of cash during the period of time being measured. It is very important for the Intelligent Investor to remember that a positive or negative net cash flow is not necessarily good or bad, it all depends on HOW the inflow or outflow of cash was realized. This can be understood by examining the three sections highlighted above. 

The investor must act like a detective to discover the story behind the net cash flow number. You can begin doing this by asking some basic key questions:

1) Is the Operating Cash Flow positive or negative? Why? 2) Is the Financing Cash Flow positive or negative? Why? 3) Is the Investing Cash Flow positive or negative? Why?

By examining the information listed below for a hypothetical corporation, we can see the following: 

1) Operating cash flow is positive, primarily due to large income levels experienced during the period, there is not excess depreciation being added into this equation. This is a good sign. 

2) Financing cash flow is positive, and this is primarily from a share issuance. As an existing investor, you generally do not want there to see more shares issued, as this decreases your stake in the company. This could be a warning sign... especially if these funds are needed to pay off debt or to pay dividends. 

3) Investing cash flow is negative, and we can see that this is due to the purchase of new fixed assets. If these assets contribute to increased profits in the future, this may be a worthy cash outflow, and not a negative sign. If, however, there are large inflows of cash from asset sales... you should investigate why. Sometimes it is a sign that a company may be experiencing trouble and selling existing assets to raise money to cover other obligations. 

Hypothetical Statement of Cash Flows for Acme Corporation

Operating Cash Flows
Income for the period +$64,795
Depreciation +$2,000
Equity Income -$5,000
Minority Interest +$2,000 

Net Operating Cash Flows = + $63,795

Financing Cash Flows
Proceeds from a Share Issue +$10,000
Repayment of Debt -$2,000
Dividends Paid -$1,000

Net Financing Cash Flows = +$7,000

Investing Cash Flows
Acquisition of Fixed Assets -$15,000

Net Investing Cash Flows = -$15,000


Total Increase or Decrease in Cash (Net Cash Flow) = +$55,795

The Intelligent Investor must always look for warning signs within the cash flow statement, such as: 

1) a business continuing its operations through the use of debt and equity financing (borrowing money or issuing shares), and using that money to fund losses highlighted at the start of their Operating Cash Flows. 

2) a business that is essentially "borrowing from Peter to pay Paul," which may appear as outflows of cash in the form of dividend payments, but inflows of cash in the form of share issuances or the issuance of new debt. This might be evident by seeing new shares being issued and/or new borrowing happening, while at the same time relatively large dividends are being paid.  

3) a business that is experiencing higher levels of depreciation than it is investing in new assets. This might result in positive cash flow numbers for a period of time because decaying assets are not being replaced with new ones, but eventually this might cause trouble as technology becomes obsolete or assets need to be replaced to maintain day to day operations or keep attracting customers. 

An interesting cash flow statement to examine is the one issued for Exxon Mobil (NYSE: XOM), which generally experiences positive levels of Operating Cash Flows, and negative levels of Investing and Financing Cash Flows. This means that the company is taking large positive influxes of cash from sales to its customers (Operating Cash Flow), and utilizing that cash to heavily invest in new assets (Investing Cash Flow), and return profits to shareholders via share buybacks and dividend payments (Financing Cash Flow).

Below you can see a graphic illustrating this activity from 2008-2012.   

As with the Balance Sheet, you can dig deeper into the Cash Flow Statement, and I encourage you to do so. Please ask if you have any questions, and Happy Investing!