Why and How I'm Buying the Downtrodden Gold Miners

Gold miners have taken a beating over the last year and a half. But things may be getting better for the sector. Investors with a safety-first attitude may want to start considering the downtrodden gold producers again.

Apr 14, 2014 at 8:21AM

The last year has been very tough on gold miner shares. Still, producers of the precious metal, like Barrick Gold (NYSE:ABX), Newmont Mining (NYSE:NEM), and Kinross Gold (NYSE:KGC) may be starting to look like interesting investment considerations. Here's why I'm keeping a watchful eye on the miners and how I'm beginning to accumulate the downtrodden stocks.

A bullish case can be made
Gold pricing is a key variable for gold miner success. While one can't dispute that gold has suffered over the past 18 months, there are compelling reasons why pricing could advance. One of these is the increased risk of international economic turmoil. A serious Chinese economic crisis would certainly be troubling. After years of capital misallocation by the government, a loss of manufacturing competitiveness, and the fraying of a highly leveraged financial system, it looks like the country may be headed for such a calamity.

China is not the only region that could threaten worldwide financial stability. South America has issues as well, with Brazil facing its quickest rate of inflation in 11 years and Argentina's finances appearing on the brink of collapse. Europe also has to contend with the economic fallout from its dispute with Russia over the Ukraine.

Safety first for gold miners
Though possible financial turmoil could push gold prices higher, there is no certainty as to when the rise might happen. Making sure that a miner will survive until then is a priority. When it comes to investing in a gold producer, it's safety first!

There are a couple of measures that can be used to judge the survivability of a miner. The first is positive free cash flow. This indicator shows if the company is producing more cash than it spends. It's determined by subtracting expenditures for property and equipment from cash provided by operations; these figures can be found on the company's cash flow statement. A positive amount indicates that the miner has some funds flow to make it through tough times.

A second measure is called the current ratio. This calculation measures a company's assets that can be readily turned to cash versus its liabilities due within a year. The higher the ratio is, determined by dividing balance sheet current assets by current liabilities, the greater the chance is that there are sufficient resources for the company to pay what's due in the near term.

Three interesting gold producers
Miners have certainly suffered from the gold price collapse. The Market Vectors Gold Miners ETF has plunged over 60% from its 2012 high. Companies are taking steps to handle the dismal environment, however. Focused on cost cutting and reduced capital purchases, this attitude toward cash conservation should help the producers benefit significantly when gold prices do advance. Some intriguing miners include:

Barrick Gold Corporation
Barrick Gold, the world's leading gold miner in terms of production and reserves, might be the most leveraged to a gold price turnaround.

The company has instituted a spending reduction program to improve its financial condition. Barrick expects to cut administrative costs by about $500 million this year and to slash capital expenditures. That planned 50% year-over-year drop hopes to generate another $2.4 billion in cash savings.

Though making significant improvements, Barrick might not be investable quite yet. Its free cash flow is subpar given the company's large debt burden. A reported cash flow deficit of around $397 million last quarter and an uncomfortably high debt to quarterly sales level of 4.47 times, almost double some competitors, is just too onerous.

Though the miner is working to reduce borrowings and has an adequate current ratio of 2.16 times current assets to current liabilities, achieving positive free cash flow appears necessary to offset concerns about Barrick's large debt holdings.

Newmont Mining Corporation
Newmont Mining, another major gold producer, has also aggressively dealt with gold's downturn.

The company delivered $1 billion in cost savings last year, divested $600 million of non-core assets, and reduced dividend obligations by linking them to the price of gold. A planned 25% cut in fixed asset purchases should free up another $500 million in cash this year, with a similar reduction expected for 2015.

Newmont appears adequately safe. It reported positive free cash flows over the last two quarters, a rare feat in the industry. The producer's current ratio is slightly concerning, however. The measure of 1.79 times is barely sufficient. An improvement from the prior quarter's 1.60 times and a manageable debt level are the only reasons the current figure is somewhat acceptable.

With positive free cash flow, a seemingly manageable debt burden, and a plan to boost liquidity, Newmont may be the most attractive investment consideration in the mining space provided that you monitor the current ratio very closely.

Kinross Gold Corporation
Kinross Gold, a smaller gold producer, is of more speculative interest. After a tough year in 2013, the company implemented a "quality over quantity" strategy.

Undertaking a comprehensive review of its mining operations, Kinross plans to save $585 million this year by chopping capital spending. These savings are sorely needed, as cash flow appears problematic. The company reported a substantial free cash flow deficit of around $143 million in its latest quarter. This kind of cash loss undermines the company's otherwise excellent safety profile. Its current ratio is one of the best in the industry at 3.37 times, and debt levels appear steady and manageable.

Lucky enough to encounter gold's collapse with plenty of liquidity, Kinross may be an investment consideration provided that you act under the assumption that cost savings can generate at least some positive free cash flow this year.

Bottom line
Gold producers have had a disastrous last 18 months, but the damage may be subsiding. Companies like Barrick Gold, Newmont Mining, and Kinross Gold have adapted to a difficult environment, and the price of gold may improve over time. With safety in mind, investors may want to start investigating the miners now, before the market takes notice and recognizes the improvements the industry has achieved.

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Bob Chandler owns shares of Kinross Gold (USA) and Newmont Mining. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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