A gold miner with some shine left

While gold equities are no longer cheap as a group, we still see upside in Goldcorp.

Kristoffer Inton 9 March, 2016 | 6:00PM

Gold started out 2016 with a bang. After a lacklustre 2015 that saw prices plummet to roughly $1,050 per ounce, levels not seen since 2010, gold skyrocketed nearly $200 per ounce in a little over a month. Gold currently trades at about $1,220 per ounce. However, resurgent investor demand for gold rests on tenuous circumstances. Historically, safe-haven rallies have proved short-lived, and we see near-term downside if fears of a severe recession end up being unwarranted.

Because of stronger investor demand than we expected, we raised our forecast for 2016 gold prices to $1,100 per ounce from $950. But despite the near-term strength, we continue to believe investment demand will wane over the next few years, and we maintain our 2017 forecast of $1,050 per ounce and 2018 forecast of $1,150 per ounce. Our view is predicated on continued interest rate hikes, moderate inflation, and global market stabilization that reduce gold's appeal as a safe haven.

We continue to forecast gold climbing to $1,300 per ounce by 2020 (or $1,163 per ounce in constant 2015 dollars, assuming a 2.25% inflation rate), as rising Chinese and Indian jewelry demand more than make up for waning investor demand. In the second half of 2015, Chinese purchases totaled about 275 metric tons, roughly stable with 2014 levels of 285 metric tons, while Indian purchases rose to nearly 400 metric tons from about 360 metric tons in 2014. We continue to expect jewelry demand to overtake investor demand as the prime mover for the gold market.

 Goldcorp's (GG) shares remain undervalued as a result of uncertainty surrounding its recently opened projects and an upcoming CEO change. We think investors fear that the company won't deliver on recently opened Cerro Negro in Argentina and Eleonore in Canada, but they shouldn't. We understand why the market is spooked, having seen projects underdeliver (like  Yamana's (AUY) Brazilian assets, which it's now divesting as Brio Gold) or even fail to open despite tremendous capital outlays (like  Barrick's (ABX) Pascua-Lama project on the border of Chile and Argentina).

While Goldcorp's projects have not been without their hiccups, production ramp-up at both mines is on schedule. Cerro Negro and Eleonore should be massively accretive to Goldcorp's free cash flow. Not only will operating cash flows swell as output ramps to full capacity, but consolidated capital expenditures will fall sharply as the company wraps up its investment cycle. This should drive higher free cash flow generation in the coming years. We think investors' fears that the projects aren't going to deliver create an opportunity to buy into Goldcorp's burgeoning free cash flow at a discount.

In December, longtime Goldcorp CEO Chuck Jeannes announced his retirement, effective this April. Jeannes had been CEO since 2007, leading the company through a significant investment cycle that has helped drive meaningful production growth over the past several years. David Garofalo, current president and CEO of Hudbay Minerals (HBM), will replace Jeannes as CEO. Before leading Hudbay, Garofalo spent more than a decade as CFO of  Agnico Eagle Mines (AEM), one of the most consistent operators in our coverage. We think Garofalo brings great experience to Goldcorp and is a suitable replacement for Jeannes.

In January, Garofalo said Goldcorp could explore mining opportunities in Europe and Africa, in stark contrast to the company's current Americas-focused portfolio. We think this commentary may have spooked some investors, who are wary of the problems  Eldorado Gold (EGO) has in Greece or almost all gold miners have in South Africa. However, we think Garofalo's statement makes sense. First, he said that any new country would have to meet the company's criteria, including low political risk and the existence of a mining code. Adhering to these criteria should prevent Goldcorp from running into the same geopolitical problems many others face. Second, with few large gold deposits readily available in the Americas, we think the strategic shift could help the company avoid overpaying--a real possibility, given the high level of demand for assets in the Americas.

Expect strong and growing free cash flow

Goldcorp has a production base mostly in stable jurisdictions throughout North and South America, a sharp contrast with some gold miners willing to accept higher geopolitical risks. While the company has relied on acquisitions to fuel growth, we think it has built a portfolio of high-quality, low-cost mines that can generate strong free cash flow.

Goldcorp's portfolio is anchored by the long-lived Red Lake complex in western Ontario. Not only has this asset been a stable and meaningful producer for many years, it has been so at very low production costs. We expect Red Lake, located in a prolific gold district with many high-grade ore bodies, to remain a significant contributor for the long term. Located in Mexico, Penasquito is Goldcorp's other major mine, producing significant gold ounces along with silver, lead, and zinc. These byproducts help keep the mine's production costs very low.

We expect Goldcorp's production to be about 3 million ounces in the near term, as recently completed projects at Cerro Negro and Eleonore ramp up and partially offset declining production at the company's older mines. With low production costs, these mines will further improve Goldcorp's cost profile.

Our long-term nominal gold price forecast is $1,300 per ounce in 2020. Investment demand will weaken further as the Federal Reserve raises interest rates, weighing on near-term gold prices. However, Chinese and Indian jewelry demand should fill the gap left by investment demand beginning in 2017. Strong preferences for gold in these countries drive high income elasticity, and rising incomes should result in robust jewelry demand growth. Strong demand will lead to a production shortfall, requiring a higher incentive price to encourage additional mine production. However, cost deflation caps the potential upside from an otherwise strong demand story. Depreciation in producer currencies, lower oil prices, and general mine cost deflation stemming from the end of the Chinese-driven commodity boom will drive average industry costs nearly 20% lower by the end of 2016 from 2014.

No moat for now

We believe Goldcorp has no economic moat. Goldcorp's coproduct cash costs of around $600 per ounce and all-in sustaining costs around $900 per ounce place the company on the lower end of the industry cost curve. In addition, its current level of proven and probable reserves imply a mine life estimate of roughly 20 years at current levels, above the average of our coverage universe.

All else equal, this is a recipe for a moat. However, the company has fueled its prolific growth through fully priced or overpriced acquisitions, which significantly raises the hurdle rate. In 2002, Goldcorp produced roughly 500,000 gold ounces from its Red Lake mining complex. Through a series of acquisitions that include Glamis Gold in 2006 for $8.2 billion, certain assets from Placer Dome in 2006 for $1.6 billion, and Andean Resources in 2010 for $3.6 billion, Goldcorp grew rapidly, producing almost 2.7 million ounces in 2013. For the most part, the company has acquired mines with attractive operating costs. However, it has paid full prices to obtain the assets, undertaking some deals amid historically high gold prices. As a result, we think it is unlikely that the firm will generate economic returns in excess of its cost of capital, barring a return to materially higher gold prices. We do expect the company's costs to decline further into the lower end of the industry cost curve, as sizable low-cost mines ramp up over the next few years.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Agnico Eagle Mines Ltd81.82 CAD3.67
Barrick Gold Corp19.14 USD2.13
Eldorado Gold Corp9.17 USD6.88
Hudbay Minerals Inc4.05 CAD-4.03
Yamana Gold Inc3.63 USD9.19

About Author

Kristoffer Inton

Kristoffer Inton  Kristoffer Inton is an equity analyst for Morningstar, covering gold, coal and cement companies. Before joining Morningstar in 2013, he was an investment banking associate for Guggenheim Securities in New York. He holds a bachelor’s degree in finance with high honours from the University of Illinois.