Kinross Gold: Deeply Discounted Global Gold Producer

Originally posted in January 2018

Selected Modern History of Gold & Monetary Policy

In July of 1944, one month after the D-Day Invasion of Normandy and with the Soviet Red Army advancing through Eastern Europe, all 44 Allied nations met in Bretton Woods, New Hampshire to discuss the post-war international monetary order. While Soviet representatives refused to ratify the agreement, enough Allied nations signed on in order to establish the Bretton Woods international monetary system. The Bretton Woods system was based on a reserve currency, the US dollar, that would be convertible to gold. Since at the time, the US held an estimated two thirds of the world's gold reserves, Bretton Woods was highly favorable to the US. It gave afforded our nation fiscal and monetary autonomy and an outsized influence over the global economy.

In 1971, when the Nixon regime removed the U.S. dollar from the gold standard, the price of gold was well under $50 an ounce. Government-backed dollar-to-gold convertibility had long subsidized gold buying and protected prices from rapid appreciation. When the dollar became free-floating fiat, market-based pricing mechanisms took over, and by 1980 gold had risen to over $500 an ounce.

Three decades later, the global financial crisis caused nearly all the former members of the Bretton Woods System to institute aggressive expansionary monetary policies. This systematic monetary weakness helped drive the price of gold above $1,800/oz. for multiple weeks in the late summer of 2011.

Gold Supply & Demand

The long-term growth of the gold mining industry reflects consistently high global demand for physical gold.

Since 1900, gold prices have risen at more than twice the rate of inflation, reflecting an increase in demand beyond just dollar devaluation. Over the last century, annual world gold production has risen from around 500 metric tons in the early 1900's to a current 5-year plateau around 3,200 metric tons. In this time of increasing production (made possible by improvements in technology and capital allocation), the average ore grade (grams of gold per ton of ore mined and processed) dropped from over 10g/ton to currently about 1g/ton in the world's remaining 500 largest gold deposits. Despite the strong headwinds of declining ore grades and mine depletion, global gold demand was so strong over the last century that production increased sixfold and price per ounce increased more than 25X.

There are indications that production rates have reached or are soon to reach a limit and send the price of gold higher. For instance, estimates of China's annual production, the world's highest-producing nation, have dropped from 478 metric tons in 2014 to 415 metric tons in 2017. Ian Telfer, the Chairman of Goldcorp claims that, "At $1,300/oz. gold, we found it all," and predicts that we are reaching "peak gold" either this year or next. Of course, production rates are relative to the current demand for gold. At $1,250/oz. we very well may be at peak gold, but when gold prices reach $2,500/oz., miners will begin construction on formerly uneconomic projects and profitably exploit lower grade ore deposits. If, as mining executives claim, the industry has "already found" all of world's the high-quality gold deposits at $1,300/oz., the remaining profitable mines should become even more valuable. "Peak gold" is a concept that has yet to reach the consciousness of the mainstream investor. However, many industry leaders are calling it imminent.

The price of gold is, of course, critical to a successful investment in the gold mining industry. While the marginal global gold supply may be in decline, global demand for physical gold shows no sign of slowing. Global gold buyers represent some of the deepest and broadest markets in the world (Indian jewelry, Russian and Chinese central bank purchases, and financial asset purchases). According to Jim Rickards, the worlds' largest foundries are already finding it impossible to source enough gold dore for refinement to meet existing orders. A diminishing supply of physical gold combined with increasingly strong demand will lead to higher prices and make gold mining investments highly profitable.

Selected History of the Gold Mining Industry

In recent years, the gold mining industry has been through plenty of adversity. Higher labor and resource acquisition costs are generational trends. Before and after the Global Financial Crisis, unprecedented expansionary monetary policy by the world's central banks led to a sharp increase in gold prices. This in turn, led to many miners making investments in marginal projects which become almost worthless at lower gold prices. Gold mine owners and operators also have had to manage a number of political and social issues like the ebola outbreak in West Africa, economic sanctions in Russia, and increased environmental concerns. Also, gold mining corporations historically have a bad reputation for empire building (I.e. Management teams that promise incredible growth but fail to earn profits and return value to shareholders). As a result, these companies have been shunned by a large group of investors.

More promising industry trends include increasingly prudent capital allocation, a renewed commitment to the return of excess cash to shareholders, and a significant decrease in cost to mine per ounce. These improvements have allowed many miners to be sufficiently profitable even at lower gold prices.

Kinross Gold Corporation: The Company

Kinross Gold is a 25 year-old gold mining company based in Toronto, Canada. The company has a total of nine operating mines, two in remote Siberia, three in the United States, two in South America, and two in West Africa. Mine-level information like AISC costs, estimated mine lives, and resource reserves are readily available on the company's website. In 2018, Kinross expects to produce 2.5 million gold ounces across it nine mines, which would tie Kinross with GoldCorp (2.5Moz) as the 4th highest-producing gold miner in the world, behind AngloGold Ashanti (3.3-3.5Moz), Barrick Gold (4.5-5.0Moz), and Newmont Mining (4.9-5.4Moz). Kinross also has five other mining projects in development and three additional advancing opportunities. Very impressively, the company has been able to ramp annual production from 83Koz. in 1993 to 2018E production of 2.5Moz.

Kinross Gold may be in the very top-tier of global gold producers, but it trades at a deep discount to its gold-mining peers. According to CapitalIQ, the average TEV/EBITDA multiple of Kinross' ten closest peers is 9.4x, while Kinross trades at 4.0x TEV/EBITDA. In this group, the only company that trades at a cheaper valuation than Kinross is IAMGold, which trades at 2.7x and has suffered mightily in recent years from ineffective capital allocation and an inconsistent operations record.

Kinross' management team, on the other hand, has a strong track record of operational excellence and opportunistically investing in long-term assets. For six years in a row, the company has met its financial guidance and new projects have consistently been completed on time and on budget. Kinross also owns and operates all of the mines and development projects in its diverse portfolio, a model that promotes accountability. Recent evidence suggests that Kinross has one of the most effective management teams in the entire gold mining industry. CEO Paul Rollinson and his team have done a fantastic job of acquiring quality gold mining assets at favorable prices and utilizing the company's superior technical acumen and operational excellence to extract additional value for stakeholders.

KGC provides a compelling value proposition to investors with a medium or long-term investment horizon. The company has a strong balance sheet and great financial discipline. They even managed to pay off $1B in debt over the last six years as the gold price dropped from $1,800/oz to $1,300. Kinross' portfolio includes nine operating mines with varying remaining lives and five development projects to extend the companies runway. On average, Kinross' operating mines have an average estimated life over ten years and the company's reserve replacement ratio is well over 100%. Perhaps the most exciting metric for investors is that in Q1 2018, the company produced $364mm in adjusted operating cash flow. Giving the company an LQA Adjusted Operating Cash Flow of $1.456B on a $5.217B Total Equity Value.

There are a few causes for concern at the company. Of course, the company's performance is heavily dependent on outside forces like the price of gold. Kinross also has an estimated 2018 All-In Sustaining Cost of $975 per ounce, which is slightly above the industry average. AISC is a measure used in the gold mining industry to account for all of the cash costs of mining operations as well as estimated sustaining costs like administration, reclamation, and exploration. The company's cost of sales, however, is only $730 giving them a solid gross margin of $570/ounce at $1,300 gold. Most recently, a wave of West African nations seeking possible renegotiations of mining contracts in Tanzania, DRC, Senegal, and Burkina Faso has increased uncertainty for miners in the region. Twenty percent of Kinross productions comes from mines in Ghana and Mauritania, so the May 8th disclosure of communications possibly seeking changes to the current agreement sent Kinross' stock plunging.

However, on the same day that the stock dropped more than ten percent because of a one sentence letter from the Mauritanian government, the company reported fantastic quarterly earnings with record profitability. Financial markets have mostly focused on the challenging environment that Kinross has faced, and investors have chosen to ignore the strength and grace with which the company has overcome each of its challenges. Kinross shows that it is willing to think independently and will operate in challenging environments that most firms can not. For example, the company successfully operates two mines and one processing plant in remote Siberia, more than 200 kilometers from the nearest town. These mines have become two of the most profitable mines in Kinross' portfolio and have both been in production for over ten years. The point is that the market is fully discounting Kinross' challenges, but does not give the company a sufficient premium for the strengths and opportunities it possesses.

The Bottom Line

The bottom line is that Kinross is an elite company but trades at a deep discount to its peers and the market as a whole. The company's "Quality over quantity" management philosophy allowed it to survive the 2012-2014 gold industry storm and remain very profitable at current gold prices. Kinross' recent financial and operational track records make it one of very few gold mining management teams that can be trusted both as an excellent operator and a shrewd capital allocator. Whether gold prices rise quickly or remain lower for longer, Kinross can remain solidly profitable using an assets-in-place strategy or acquire new mining assets to take advantage of rising prices.