For many primary gold producers, Q213 was a breathtakingly bad
quarter. It wasn't so much the massive drop in earnings many
reported - those had been, for the most part, expected - but the
so-called "impairment charges" announced.
(Impairment is the opposite of appreciation, that is, the
reduction in quality, strength, amount or value of an asset.
"Impairment charges" means that a company reduces or "writes down"
the value of the assets on its books.)
The gold price averaged $1,630.45 in Q1 this year, falling to
$1,413.64 in Q2. The downturn squeezed profit margins, obviously,
but it did the greatest damage to the value of many company assets
that are based on gold.
But what will happen to those same assets if the gold price is
on the rise again? What does it mean for us as investors? I'll
answer these and more questions below.
First, here's a look at the amount of write-downs the six
largest primary gold producers announced last quarter.
(click to enlarge)
The explanation the companies gave for these impairment charges
was essentially the same in every case: short- and long-term gold
price assumptions that hadn't panned out. Total losses for just
these six producers were
. That's a lot of dough to send to money heaven for a relatively
small industry. Food for thought.
Here's what you need to know as an investor in this sector.
How does an impairment charge occur?
In public companies, management must report a reasonable value
of company assets to shareholders and the public. If labor or other
production costs rise, they may have to reassess the value of the
In this case, the price of gold - the product many of our
companies sell - dropped 13.3% in just three months, and did not
seem likely to rebound immediately. Of course, that changed the
amount of earnings investors could expect from a gold mine.
Companies had to revise the net present value of projects in
development, or the book value of mines in production, with the new
reality for gold in mind.
But isn't gold always fluctuating?
Yes, but the accounting is (meant to be) conservative. The last
thing any management team wants is to be forced to tell the market
that its projections were wrong and profits are much less than
anticipated - or worse, nonexistent. Shares would plummet,
management would have a major credibility problem (perhaps a legal
one as well), and heads would roll.
What companies are supposed to do is look out to the horizon and
project the lowest (safest) reasonable price assumptions they can,
for the foreseeable future. Some are better at it than others, and
some mining companies that used too aggressive price assumptions in
their economic studies ended up, in the worst-case scenario,
On the other hand, it's just as bad if management overreacts to
temporary price swings. A long-term view should position the
company so that short-term price fluctuations - up or down - don't
seriously affect the value of a project. In other words, they try
to allow for normal volatility.
How do they know how much to write down?
If management believes prices have changed so much that it
affects the value of company assets, they conduct a formal
"impairment test." If an asset doesn't pass, the amount of the
charge is the difference between the old book value and the
recoverable value, or the fair market value for the asset at that
point in time.
So the companies that had no write-downs are more
The better ones are - others may simply be refusing to face the
fact that gold is still below the three-year trailing average that
was typically used as a price assumption. A cautious gold company
that, say, valued an asset assuming $1,100 gold should not have
needed to file an impairment charge last quarter (all other things
being equal). Gold has averaged $1,303.33 so far in Q3, well above
the price that returns were projected from.
For example, major gold producers Yamana (
) and Agnico-Eagle (
) were able to avoid impairment charges last quarter. As the chart
above shows, all producers currently rated a Best Buy in
had no write-downs. As an owner of these stocks, I was glad to see
this. It also confirmed that we've selected management teams that
are both shrewd and conservative.
What happens when a write-down turns into a
While a write-down is a mere reduction in value, a write-off
eliminates that value altogether. For some companies, a project may
not just be less profitable, but completely uneconomic at lower
gold prices. If total production costs were $1,400 per ounce, for
example, that project would have zero value at today's prices. This
sometimes happens with low-grade mines.
This is the reason so many projects have been suspended or moved
to the back burner over the last few months - and rightly so. We
believe gold will move back up and hit new highs, but that's not
the conservative stance corporate management should take,
especially when deciding to invest billions of dollars building a
large new mine.
These projects can be revived when gold prices go up again, but
they will need to be reevaluated when things change, particularly
regulatory and cost factors.
What happens if the price of gold goes back up?
In the past, companies were stuck. Until very recently,
impairment charges were a one-way street. Once you took the charge,
you lived with it. But there are some new rules that permit the
accounting to go both ways.
Here's an interesting consequence for speculators:
Once a company has written down an asset, that loss no
longer trickles down to the bottom line in the form of depreciation
Suppose you have a mine written down to zero, because operations
provide effectively zero return at lower prices, but the company
keeps mining because management believes prices will go up, and
mine closure would be both expensive and hard to reverse. Then
prices do rise, and the mine starts making money hand over fist,
with no depreciation to impact net income.
That's why it's so important to separate still-viable assets
that are written down from those that really were based on foolish
assumptions and are never likely to be profitable.
Should I sell my companies that reported
Not necessarily. As I said above, it's not the end of the world
if a company is forced to write down an asset. The question is
whether the company will be able to survive the current price
environment and have a shot at better profits in the future.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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