Two Scenarios That Could Boost Barrick Gold’s Stock Price


Barrick Gold Corporation (NYSE:ABX) is the largest gold mining company in the world. However, like most gold producers, the company has been adapting to an environment of low gold prices. Gold prices averaged roughly $1,266 per ounce in 2014, as compared to $1,411 per ounce in 2013. [1]

The decline in prices has primarily been due to the fall in investment demand for gold due to strengthening economic conditions, particularly in the US. Gold as an investment is often viewed as a hedge against inflation and economic weakness, and investors typically shift towards other asset classes such as equities and interest-bearing securities with an improvement in macroeconomic conditions. With improving macroeconomic conditions, the Federal Reserve is expected to raise interest rates some time this year. Expectations of an interest rate hike in 2015 have played a role in the reduction in gold prices, and we have factored in similar expectations in our model.

Though short-term demand for gold will be influenced by expectations of an interest rate hike, long-term strength in gold demand will continue to be governed by the jewelry demand for gold, which constitutes roughly 55% of the global demand for the metal. [2] The jewelry demand for gold is positively correlated with economic growth, particularly growth in emerging economies, which account for the bulk of the jewelry demand for gold. If economic growth picks up faster than expected, there may be a significant increase in both gold prices and the demand for the metal, which would positively impact the prospects of gold mining companies such as Barrick.

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Barrick is also involved in the mining of copper with operations located in Chile, Zambia, and a mine under construction in Saudi Arabia. However, the company intends to idle its Zambian copper mining operations at the end of March in response to a change in the taxation regime governing mining companies in Zambia. We have factored in the cessation of mining activity in Zambia in March in our model. However, if the changes in the taxation regime are rolled back, the company will continue to operate its Lumwana copper mine in Zambia. This would positively impact the prospects of Barrick Gold.

In this article, we will take a look at how these possible scenarios would impact Barrick Gold’s stock price.

Increased Jewelry Demand for Gold

The demand for gold can broadly be classified into demand for gold as an investment, demand for gold in industry, central bank purchases, and the demand for gold jewelry. The jewelry demand for gold is the largest component of the overall demand for gold, accounting for around 55% of the overall demand for gold. [2] The demand for gold jewelry is strongly connected to cultural traditions in many countries, particularly in China and India. In addition, the demand for gold jewelry is aspirational, and tends to rise with increasing income levels. China and India are the two largest consumers of gold jewelry, accounting for nearly 56% of the jewelry demand for gold. [3] The trends in gold consumption by these two countries will largely determine the trends in demand for gold jewelry.

China is the world’s largest consumer of both gold and gold jewelry. Private sector demand for gold in China stood at 1,132 tons of gold in 2013, out of which the demand for gold jewelry stood at 669 tons or around 59%. This accounted for around 30% of the global jewelry demand for gold. [4] China is characterized by robust trends in urbanization, and industrialization. These have led to rising income levels in China. As per estimates by Ernst and Young, China’s middle class population will grow to around 500 million by 2020, as compared to 150 million in 2010. [5] These robust trends in growth in income levels are expected to result in an approximately 20% growth in Chinese private sector gold demand to 1,350 tons by 2017, as compared to demand in 2013. [4] Jewelry demand for gold from China is expected to rise by around 17% to 780 tons in 2017. [4] India is expected to witness trends in urbanization and growth in income levels comparable to China over the same period. As per estimates by Ernst and Young, India’s middle class population is expected to grow from 50 million in 2010 to around 200 million in 2020.  [5] This would boost gold jewelry consumption at similar rates to those anticipated for China.

However, these estimates of growth in gold consumption are contingent upon the pace of economic growth in these countries, particularly China. There are question marks about the pace of Chinese economic growth, with a slowdown in economic activity, particularly in manufacturing, dragging down the expected GDP growth rate to 6.8% and 6.3%, in 2015 and 2016, respectively, from 7.4% in 2014. [6] However, if Chinese growth recovers faster than expected, it would provide a fillip to global gold demand. In addition, Indian GDP growth is expected to pick up in 2015 and 2016, partially due to the efforts of the reforms-oriented new government. [6] In the scenario of a faster than expected global economic recovery, driven by China and India, global demand for gold would rise at rates mentioned previously, which are higher than those currently factored into our model.

In order to model this scenario, we have  factored in higher gold prices, shipment volumes, and a corresponding increase in margins. In this scenario, we will assume that the company’s capital expenditure increases in response to higher production and shipment volumes. However, whereas absolute capital expenditure will rise, we have kept capital expenditure expressed as a percentage of EBITDA (as forecast in our model) at the same levels as in the base case scenario. However, in absolute terms the company’s capital spending will increase due to higher EBITDA generated by the company in the Increased Jewelry Demand scenario. If we factor in all these assumptions into our model, it increases our price estimate by around 26% from $11.55 to $14.61.

Thus, in the event of increased jewelry demand for gold, an upward adjustment in valuation could potentially follow for Barrick Gold.

See our analysis for the Increased Jewelry Demand scenario here

Restart of Mining Operations in Zambia

Zambia’s parliament approved the government’s proposal to hike mining royalty rates in the country at the end of last year. Starting in 2015, corporate income taxes on mines have been replaced by increased royalties. The new regulations will result in an increase in the current royalty rate from 6% for all mines to 8% for underground mines and 20% for open-pit mining operations. [7] This increase in royalty rates will threaten the viability of Barrick’s Lumwana open-pit copper mining operations, which would be subject to the revised royalty rates of 20%.

Taking the change in mining tax regime into consideration, the company has decided to idle its mining operations in Zambia at the end of March. We have factored this eventuality into our model. However, the company management is still engaged in negotiations with the Zambian government over the possibility of rolling back the changes to the country’s tax regulations. [8] If Barrick is successful in convincing the government to roll back the changes in regulation, the company can continue to operate the Lumwana mine. This would significantly boost the company’s copper shipments for the year.

In order to model this scenario, we have modified our shipment forecasts to account for the additional output from the Lumwana mine. In addition, we have suitably modified the copper mining division’s margins and capital expenditure forecasts, in order to account for the increase in output. If we factor in all these changes to our model, it increases our stock price estimate for the company by 12% from $11.55 to $12.95.

Thus, in the event of a restart of copper mining operations in Zambia, an upward adjustment in valuation could potentially follow for Barrick Gold.

See our analysis for the Restart of Mining Operations in Zambia scenario here

 

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Notes:
  1. Historical Gold Prices, Kitco []
  2. Gold Demand Trends 2014, World Gold Council [] []
  3. Global Gold Jewelry Market, World Gold Council []
  4. New report predicts sustained strong gold demand in China in next four years, World Gold Council [] [] []
  5. China and India: tomorrow’s middle classes, Ernst and Young [] []
  6. World Economic Outlook 2015, IMF [] []
  7. Barrick Said to Plan Suspending Zambian Mine After Tax Changes, Bloomberg []
  8. Barrick Gold’s Q4 2014 Earnings Call Transcript, Seeking Alpha []