Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Investors in gold stocks are experiencing an up-down day today, as shares of Newmont Mining (NYSE:NEM) surge -- and those of Barrick Gold (NYSE:ABX) fall back. For this, you can thank the analysts at Morgan Stanley, who chose today to upgrade the former and downgrade the latter.
Want to know what inspired Morgan Stanley to warm up to one and give the other the cold shoulder? Read on.
Upgrading Newmont Mining
We'll start with the "good" news today. This morning, analysts at investment bank Morgan Stanley upgraded Newmont Mining stock from equal weight to overweight. Newmont is showing "stronger execution," and has a "steadier production profile" and a "relatively de-risked project pipeline" than does Barrick Gold, explains Morgan Stanley in a note covered on StreetInsider.com (subscription required). The analyst also believes the company's production reserves will last longer, and generally prefers Newmont's balance sheet over Barrick's. Based on these factors, Morgan Stanley is raising its target price on Newmont Mining stock to $40 a share.
Now, that sounds like good news. Of course, Newmont stock currently sells for about $39, which means that even if everything Morgan Stanley says is right, then an investment in Newmont Mining stock today can only be expected to produce about a 2.5% profit for investors over the course of the year -- which hardly seems something to get excited about.
Downgrading Barrick Gold
The news for Barrick Gold investors is even less encouraging. Rating the stock underweight with a $12 target price (about 9% below where Barrick trades today), Morgan Stanley warns that although "the equity may appear cheap," it could nonetheless remain so and underperform the market. The analyst is using a new valuation method on Barrick's "Tanzania operations," moving away from valuing it based on its "net asset value," and using a "market valuation" instead.
Unfortunately, StreetInsider doesn't provide much more detail than that, but what might such a "market valuation" look like for Barrick stock...and for Newmont?
Valuing the gold companies
Newmont Mining boasts a market capitalization of $20.8 billion and net debt of $900 million on its balance sheet -- thus an enterprise value of $21.7 billion. Barrick, although its market cap is only three-quarters that of Newmont ($15.4 billion), carries $4.2 billion in net debt on its balance sheet, giving Barrick an enterprise value of $19.6 billion. Thus, the market value of both gold companies is actually very similar.
At first glance, the valuations attributed to the companies' assets also look similar. Newmont's enterprise value is about 11% higher than Barrick's, and S&P Global Market Intelligence data show Newmont having 68,470 troy ounces of gold in proved and probable reserves -- 6% more than Barrick's 64,549 troy ounces.
But now consider how the two companies appear when valued on the cash they produce from mining and selling these reserves. Over the past year, Newmont has generated $1.3 billion in positive free cash flow from its business -- much more than its GAAP earnings of $47 million reflect. In contrast, Barrick Gold, despite having a similar market cap and similar reserves, generated half the cash profit that Newmont did -- $689 million.
So yes, it's true that Barrick's stock "may appear cheap" at just 10.7 times earnings (as reflected on Yahoo! Finance) versus Newmont's valuation of 443 times GAAP earnings. But when you compare these two gold stocks based on the actual cash they produce, Newmont really does look like the relative best bargain at 16.7 times free cash flow compared to Barrick's enterprise value-to-free-cash-flow ratio of 28.4.
To that extent, I have to agree with Morgan Stanley's decision to upgrade Newmont Mining relative to Barrick Gold. Newmont, it seems to me, is less expensive that Barrick.
That being said, I have to point out that most analysts who follow these stocks see Newmont growing its earnings at less than 11% annually over the next five years. That may be better than the single-digit growth rates being projected for Barrick, but if you ask me, both of these stocks still look too costly for the relatively modest growth rates that Wall Street is expecting them to produce.
In fact, when you consider that today's guest analyst is predicting only 2.5% profits for buyers of Newmont Mining stock -- the stock it's recommending -- and a loss for investors in Barrick Gold...I kind of suspect Morgan Stanley agrees with me on that point as well.