Exploring Declining Grade

In 1905 the Bingham Canyon mine opened mining a copper grade of 2%. Last year the grade they mined was 0.63% and the reserves they have left to mine have a grade of 0.54%. In 2003 Goldcorp’s Red Lake mine mined a gold grade of 77.5 g/ton, and 28 g/ton in 2006. These are a couple examples of a trend of declining grade in individual mines and within the industry as a whole as the best deposits tend to be mined first. This post looks at declining grade in a single mine. I suspect that declining grade affects costs exponentially rather than linearly, and I will examine that next post.

There is no question that grade is related to profitability. Looking back to Goldcorp’s 2003 financial reports, when it was much simpler company with just two gold mines, Wharf and Red Lake, it is absurdly easy to see the contrast in the two mines. For 2003 the Wharf mine had an operating profit of $100,000 and on the $24,900,000 in revenue, it left an operating margin of 0% reported on the financial reports. The average grade mined for the year was 0.9 g/ton. Red Lake had an operating profit of $153,000,000 on $224,000,000 in sales, or a monstrous 68%!

Indeed, in 2003 Goldcorp reports that from the 602,845 ounces it produced, 532,028 from Red Lake and 70,817 from Wharf, earnings were $85.7 million with an average gold price of $364. At a price of $600/oz, assuming 40% of the increase goes to taxes, at this rate you’d expect 600,000 oz of gold to earn about $170 million, or each 100,000 oz of gold produced to earn just over $28 million. If you correct for the fact that the Wharf ounces contributed nothing to earnings -- all $85.7 million in earnings came from Red Lake’s 532,028 ounces – Red Lake would have earned about $30 million per 100,000 oz had gold been $600/oz. Goldcorp actually earned more that year by selling off stockpiled gold, but that is an independent action in terms of individual mine’s profitability.

In 2006 Goldcorp’s Red Lake produced 665,600 oz, had an average price of $609 and contributed $177.1 million to the earnings. That is below the $203 million one would expect if Goldcorp had remained as profitable assuming 40% going to taxes. In fact, only 32% went to taxes and controlling interests, so with 32% used instead, one would expect $216 million towards earnings. The calculation I did here was:

($30 million +(($609-364)/oz)*(1-0.32)*100,000oz/$1,000,000)*(665,600oz/100,000oz))

where the $30 million per 100,000 oz was calculated above, the $609-364 is the increase in gold price realized, the 1-0.32 gives the 68% that should go to earnings, the 100,000oz/$1,000,000 converts the number to millions of dollars per 100,000 oz and the 665,600oz/100,000oz corrects the number of ounces to what Red Lake actually produced.

To put this change of how much more Red Deer ought to have earned based on how well it did in 2003, use the calculation $216/$177 -1 = 22%. There would be 2-3% inflation per year, but overall, profitability per ounce at Red Lake declined at a rate of 6.8% per year.

But even that does not include Goldcorp’s vision for 2006. They write in their summer 2004 Outlook:

It is December 2006, and the winter freeze has already engulfed Ontario’s northwest, but operations at Goldcorp’s Red Lake Mine are running at a feverish pace with the completion of a new 7,150-foot shaft that now gives greater access to the world’s richest gold deposit.

The $100 million project, which was completed on schedule and within budget, has increased production from 510,000 to 700,000 ounces per year and lowered costs from $80 per ounce to $70 per ounce. What’s more, the shaft has been constructed with excess capacity so that when ongoing exploration uncovers additional reserves, production will be able to increase accordingly. This will help achieve Goldcorp’s ultimate goal of increasing the company’s annual production to 1 million ounces.

Their vision was to reduce cash costs by $10/oz, which at that 32% tax rate should add even another $6.80*665,600/1,000,000 = $4.5 million, or, ignoring that they missed their production target by 5%, earnings ought to have been $220 million, or 24% more than they achieved.

Missing their production goal by about 5% is a relatively minor problem. But their cash costs of $195/oz are 179% above there vision!

How can a vision go so wrong?


In 2003 they mined 242 thousand tonnes of ore and in 2006 they mined 769 thousand tonnes of ore, a 218% increase, but because of the decline in ore grade they only mined an extra 25% more gold.

The costs are given per ounce of gold produced, but the numbers may make more sense trying to look at them as cost per ton.

So, in 2003 the grade was 77.5 grams per ton, or 77.5/31.1 = 2.49 oz per ton. With costs of $80/oz, $80*2.49= $199/ton. So the cost per ton of ore processed was $199.

In 2006 the grade was 28grams per ton, or 28/31.1 = 0.90 oz per ton. With costs of $195/oz, $195*0.90= $175/ton, or a decline of almost 14%, almost identical to the 14% decline in costs outlined in Goldcorp’s vision.

In this example, the rising price of gold has completely hidden perilously increasing costs due to declining grade and enabled a healthy profit margin to be maintained, but it is a rapidly declining margin relative to production, cost per oz of gold increased 179%!

Goldcorp’s remaining proven and probable reserves average 22.24 g/ton. They have 1.55 million ounces at a grade of 41.48 g/ton, and then the probable grade declines to 18.57 g/ton for 3.64 million ounces. If we use the $175/ton of ore processed, the cost per ounces for mining a 41.48 g/ton gold ore grade would be (31.1/41.48)*175 = $131 per ounce of gold. The 18.57 g/ton would have a cost (31.1/18.57)*175 = $293 per ounce of gold, and considering the average of the grade, 22.24 g/ton you get cost per ounce of gold of $245.

What this means to investors is that failing to pay attention and assess the quality of the reserve grade and whether it is maintaining, improving or declining could cost you dearly in your investments. It means that you absolutely cannot look at a gold stock, or any other metal for that matter, and mentally calculate that if they are doubling their production profits should double. It also means that the values of assets in the ground are highly dependent on grade. This simple look suggests that Goldcorp’s 1.55 million ounces of proven reserves in Red Lake are worth about $160/oz more than the probable reserves of 3.64 million ounces, and by the time Goldcorp starts mining the reduced grade, gold will need to be about $830/oz to maintain profits at Red Lake, not improve profits.

It is utter nonsense to add up the reserves and resources of grossly different metal grades and come up with some kind of valuation without correcting for the grade quality.

Many things affect profitability, but declining grade seems to be is the most ignored or unrecognized source of implosion of value and earnings.

Read More......

Fantasy Girl Revist - Google Googlplexed

In the fall I was writing my blog over on Stockhouse and I wrote this 10 part series which I titled Fantasy Girl and a subtitle for each post. Half the posts were taking detailed look at why Google's earnings would not keep up, as in the news story Google's Profit Falls Short, Shares Drop. The other half were looking at Goldcorp and the serious valuation problems with that one for investors. Those parts I worked on polishing up further and turned it into my post, How I Discovered the Gold Bubble.

For the Google related part of the series I intended my posts to show how when growth rates are unreasonable large applying that PEG dogma is nonsense by starting with an absurd rate of interest and hoped people would make the connected that their expectations from Google were also absurd.

I like Google's products and services and use the all the time, however, when too many people get on a boat it sinks. Here's my original analysis of Google from November 2006.

Fantasy Girl - Up 10,000,000,000 % Part I

Have you ever had a day where you could say you were up 10,000,000,000%?

Are you sure?

Just what kind of daily percent would you have to make each trading day to make 10,000,000,000% in a year?


Compounding interest is a wonderful thing. I do this math thing where my spreadsheet calculates my percent change for the day, and my annualize change if I did that percent each of the 240 trading days of the year.

The formula if you let D be your day's earnings, O be your day's open is:

Annualized rate of return = (1 + D/O)^240 - 1

The D/O gives you your percent increase for the day, and taking it to the power of 240 compounds it much the same way you might to a simply compounding interest calculation for 10 years.

So, what percent?

Well, I found out yesterday, and wow, what a lesson on compounding interest. 10 billion percent it said, and I went to correct my error, only there wasn't an error. At that point my portfolio was up 8%, and wow, the annualized rate of return if you could do that everyday is 10 billion percent! And a different stock, with a small holding, went up, so I changed it, and wow, up 13 billion %, and up more, and then 33 billion %.

But wait, that's not a lot of extra dollars causing that jump. Huh? I looked at the percents, 8.1% gets you 13 billion, and 8.5% gets you 33 billion, and well, 10.1% gets you over a trillion %.

In absolute terms, the increases are small compared to compounding effects. By comparison, to go from 0%, to 0.1%, the same absolute difference, as 8% to 8.1% the annualized rate goes from zero to 27%, a small percentage difference compared to from 10 billion to 13 billion %.

And herein lies part of the problem in how we can get ourselves into enormous trouble with our portfolio when past growth rates of a company are used to project future valuation. The bigger the growth, the company experienced, ie, already had, the harder it is to ever meet that crazy expectation.

In the next few posts I'll examine the financial difference between using past growth numbers and future growth numbers, and how some of the those past growth numbers are setting investors up for financial ruin.


Fantasy Girl - 300 Billion! Part II

The main idea from the first post in the first Fantasy Girl series was that as the rate gets higher, the magnitude of the difference in compounding increases dramatically with tiny increases in the rate use. The two examples have a mere 0.1% difference in rate. Compounded rate = (1 + daily rate)^240 - 1

	Daily rate	Compounded rate
A	8%	10,000,000,000%
B	8.1%	13,000,000,000%
B minus A	0.1%	3,000,000,000%
C	0.0%	0%
D	0.1%	27%
D minus C	0.1%	27%

The tiny increase in rate in these two examples is 0.1%, but the absolute difference becomes unimaginable as the rate gets absurd.

But, what would happen if you did that 0.1% per trading day for say, 12 years?

Year	Total interest
0	0%
1	27%
2	62%
3	105%
4	161%
5	232%
6	322%
7	436%
8	581%
9	766%
10	1001%
11	1299%
12	1679%

Well, if you started with $10,000, in 12 years you'd have $177,88, and $167,880 of "wealth" has been created.

But, just how did that wealth get created?

There are many paths to that wealth. Some will create wealth that will be sustainable, and some could be described as lying in wait for nuclear melt down.

How about taking a look at say ... Google (GOOG), and later, a much smaller company.

Google's market cap is $153 billion dollars. Google's share price is up about 33% in two months. About $38 billion dollars of market cap.

And just what is the annualized rate of growth if you increase by 1/3rd in 3 months?

(1.33^6 -1) = 213%

Oh boy, if we keep going like this, we should see $1100/share by next summer and a market of $300 billion. What a great company... And wow, this company is everywhere, it can do anything...

But....

Part III a closer look at what Google's financials are saying...


Fantasy Girl - Googlplex 10^100^10 - Part III

Googolplex - 1 followed by a googol of zeros

Recap:

• As growth rates increase even marginally, they have exceptionally larger effect on the end numbers.
• Google has a market cap of $153 billion and its share price is up 33% in two months, creating $38 billion of market cap.
• To continue at the current growth rate, Google would be up 210% by the end of the year.
  

Oct 19, 2006
EXTRA, EXTRA READ ALL ABOUT IT
Google Revenues increase 70%

The PEG Ratio says that if price/earning is less than the growth rate, you've got an undervalued stock, although the Motley Fool suggests it should be 0.5 or less to be undervalued (http://www.fool.com/Pegulator/pegulator.htm). For correct use, the PEG is dependent on an expectation of 5 years of growth at the rate used for the earnings per share.

So, just what have Google's earnings per share been?

Quarter	Earnings/ share	1% increase over last Quarter	2Annualized Quarter Growth	3Annual Growth to Q1/05
Q1 2005	1.29	n/a	n/a	n/a
Q2 2005	1.19	-7.8%	-27.6%	-27.6%
Q3 2005	1.32	10.9%	51%	4.7%
Q4 2005	1.22	-5.5%	-20%	-7.2%
Q1 2006	1.95	59.8%	553%	51%
Q2 2006	2.33	19.5%	104%	48%
Q3 2006	2.36	1.2%	5.3%	41%

1This is a quarterly rate of return (loss). 2The rate must be taken to the 4th power to get the annualized rate. 3This is what the rate of return is if it was constant back to Q1 2005.

The headline said 70% growth, where is it in the earnings?

Seriously, time to apply the PEG ratio, using the 5 year standard that it was based on. So, being optimistic, lets say that overall annual rate of 41% will be continue over the next 5 years. Keep in mind that a 41% annual growth rate means we are looking for 1.41^5-1 = 457% over the next five years. If you don't appreciate why we are looking at 457% growth over the next 5 years, go back and read www.stockhouse.ca/blogs.asp?page=viewpost&blogID=459&postID=6959.

So P/E = $505/(2.36+2.33+1.95+1.22) = 64.2

Hmmm, 64.2 is not less than 41. 457% of sales growth over the next 5 years will not be enough. 64.2/41 = 1.56

Double hmmmm. At 1 - 1.3 the Motley fool is saying a stock is overvalued. At 1.7, it is saying short!

But, there is something even more serious to notice here, the gross rapid decline in the quarterly growth rate in 2006. The decline in that growth rate is like a nuclear melt down.

And seriously, 1.642^5-1 = 1094%. To force the PEG to be one, we need 1094% in growth of earnings over the next 5 years. And that's for the current share price to catch up to itself, without growing at this absurd rate of 450% per year. We need even more growth in real sales and real wealth if the stock continues to create market cap out of thin air.

But, given this, I predict the next headline will read an even great rate of growth. Next post I'll explain how the numbers can be used to show this, and I'll even predict when the nuclear meltdown will occur.

And even more seriously, earnings per share are 1.6% of the share price. You can do better in the bank and your money is safe.

Fantasy Girl - Googlplex^Googlplex - Part IV

Googol - 10^100

This is the 4th post in a series on valuation and growth when growth rates are big.

Recap

• Google's 2 month growth rate on share price ($380->$505) is 210% annualized.
• Correct use of PEG says earning must be expected to increase by 1094% in the next 5 years without any further increase in share price.
  
• Quarterly data on earnings per share show dramatic declines in growth.
  

Perceptions of Growth - Google's Next Quarterly Report

The last quarterly headline read "Revenue Up 70%." And the next report will probably read something like "Earnings up 90%." Remember the 3 billion percent difference in annualize return between 8 and 8.1% from part 1? Yet it didn't seem so extreme using 0% and 0.1%. A large past growth rate easily hides rapidly declining growth. Here's how.

First, we need to look at earnings per share and increases in earnings per share over the previous quarter, and the quarter one year ago.

Quarter	Earnings/ share	% increase over last Quarter	% increase over Quarter 1 year earlier	Quarter increase annualized
Q4 2004	0.71	n/a	n/a	n/a
Q1 2005	1.29	82%	n/a	997%
Q2 2005	1.19	-7.8%	n/a	-28%
Q3 2005	1.32	10.9%	n/a	51%
Q4 2005	1.22	-5.5%	72%	-20%
Q1 2006	1.95	59.8%	51%	552%
Q2 2006	2.33	19.5%	96%	104%
Q3 2006	2.36	1.3%	78%	5.3%

If you just compared Q3-06 to Q3-05, you'd see a 78% growth in earnings, and that's exceptional. But, where in the news was the headline:

Google's Growth in Q3 Earnings Decline by 94%

(1-1.3/19.5) * 100% = 94%

We are playing with exponential growth here, so it is fundamentally important to consider the exponential growth consequences.

But, lets look at how the headlines will read for Q4, based on 3 projections I got from MarketWatch, a low estimate of $2.31, a mean of $2.72, and a high of $3.13. Notice earnings in Q4 2005 were down. That's going to be great for punching the numbers to make things look good... Might even be able to get away with increasing projections to $1000 per share!

Q4 2006 Estimate	% increase over $1.22	% increase over $2.36	Annualized Growth Rate	PEG = one @
2.31	89%	-2.1%	-8.2%	$795
2.72	123%	15.3%	76.5%	$1150
3.13	156%	32.6%	209%	$1500

So, there you have it, the next headline:

Q4 - Google's Earnings up 89%

And the red elephant hides in plain view. PEG wrongly used supports share prices at a low of $800 and a high of $1500, creating an additional $90 to 300 Billion in market cap, out of thin air. I need one of these money trees in my back yard.

But what of Q1 - 2007? Notice that jump from $1.22 to $1.95 between Q4 and Q1? That's going to play havoc with the numbers. MarketWatch estimates are a low of $2.10, a mean of $2.98 and a high of $3.28

Q1 2007 Estimate	% up over $1.95	% up over $2.31	% up over $2.72	% up over $3.13	Annualized Rate Over $2.32	Annualized Rate Over $2.72	Annualized Rate Over $3.13	PEG = one @
$2.10	7.7%	-9.1%	-23%	-33%	-32%,	-65%	-80%	$73
$2.98	53%	29%	9.6%	-4.8%	176%	44%	-18%	$550
$3.28	68%	42%	20.6%	4.8%	307%	111%	21%	$725

There's a lot more red elephants in that chart, and the growth over the same quarter in the previous year is much smaller than what Q4 projects. I predict there's going to be a lot of pain right about here.

One more thing, that by looking at the PEG calculation between three estimates and 2 quarters and finding a share price valuation that varies by a magnitude of TWENTY ($73 vs $1500) simply says the PEG is grossly misused and is best left for Voo Doo economics.

Part V, a different kind of valuation...

Fantasy Girl - Scrooged - Part V

"But you were always a good man of business, Jacob." Ebenezer Scrooge

Recap

• Google's market cap: $153 billion, $38 billion created in past two month.
• Q4 PEG could support $800-$1500 share price, creating up to $300 billion more market cap.
  
• Q1/07 PEG could suggest a share price as low as $73, destroying $130 billion in market cap.
• Oops, easy come, easy go, $6 billion of market cap gone today 11/27/06.
  

How does your bank treat you?

Ultimately, sound investment is about a company's ability to generate earnings relative to the investment. Sure, there is tons of money to be made on greed, fear, and speculation, but that isn't realistic or fair valuation.

Your bank:

• Wants security for 6%
• Good credit rating for 10%
  
• Has legal recourse against you
  

Google, earnings per share from the last 4 quarters comes to a mere 1.6% of share price, you have no legal recourse and you are risking your savings. By banking standards, for fully secured, earnings per share needs to be in the $30/share range $7.50 per quarter at the very minimum. Currently, Google's earnings per share aren't even keeping up with the rate of inflation!

So, just how much do you expect Google to grow to reach market staturation? At some point all companies reach maturity and have limited growth prospects. Where is that for Google, and how many years?

Say the company grows to earnings of $50 per share in 10 years to reach market maturity, and at that point because Google is a big secure company, that's about where earnings will stay. This is a highly optimistic quarterly growth rate for earnings of 4.3%.

Lets examine 3 examples:

1. You want 6% return on your money and you are confident Google can to it.
2. For that kind of speculation, you want 10% return on your investment today.
3. You think growing to earnings of $50/share is highly unlikely, and you want 15% because of the high risk you are taking because it is highly unlikely.
   

For $50/share earnings to be 6%, the share price would be $833.

% return wanted (r)	(1+r)^10	Present Value of Shares
6%	1.79	$465
10%	2.59	$321
15%	4.04	$206

So, with a low expectation of return (6%), and highly optimistic growth projections (>400%), a fair share prices would be $465. But wouldn't bonds be safer?

With a 10% expected rate of return, and a highly optimistic growth projection, $321 would be a fair share price.

And finally, if you don't think it is likely, and want 15% return because of the high risk of not making it, $206 is a fair share price.

Some created wealth is sustainable, but some is simply waiting for nuclear melt down. So Barrons called Google richly valued today.

Can we say Google Bubble?

Next a little gold dust fantasy.

www.forbes.com/2002/09/13/400fictional_5.html

Read More......

How I Discovered the Gold Bubble

I have been investing in the stock market and one of my investment "finds" started to have a sell-off when I thought it was undervalued. I needed to be sure that I had properly assessed my stock of interest, so I started on a journey of comparing two stocks for market valuation.

The stock that interested me is Northern Orion. The stock that I decided to compare it to was Goldcorp. I chose Goldcorp because Northern Orion owns 1/8th of the Alumbrera mine and Goldcorp owns 3/8th. It seemed that they should have similar valuation based on this one interest.

What I discovered was that Northern Orion was trading for about 10c on the dollar compared to Goldcorp. I still strongly believe that Northern Orion is undervalued, I never expected to find a gold bubble in mature gold stocks, one that in my mind is as serious as the tech bubble.

Read my analysis and decide for yourself. Aside from the copper concern, the majority of these concerns apply to mature gold stocks and will make them under perform beyond anyone's expectations.

The over valuation of Goldcorp

Goldcorp is a company with 702 million shares that took over Glamis in late 2006. Currently a check on any stock website is still not showing the 280 million extra shares from that takeover and is enormously understating market cap. At a share price of about $28.50, Goldcorp has a market Cap of $20 billion.

To understand why Goldcorp is overvalued, these things need to be examined and evaluated:

1. The leverage of earnings of both copper and gold.
2. The price elasticity of gold bullion to gold stocks, ie, market cap.
3. The increasing cost of acquisitions.
4. The roll of the life of a mine - increasing rates of depletion.
5. The roll of lower quality gold properties.
6. The roll of depreciating mines.
7. The level of reserves to market cap.

Major Concern #1 - negative leverage of copper

When I looked at Goldcorp, it was prior to the Glamis merger. At that time I found from reading the financials that in Q2/06 64% of earnings came from one mine for Goldcorp, the Alumbrera mine, and for the first 9 months of 2006 60% of earnings came from Alumbrera. Alumbrera is copper, not gold. I'm not entirely sure for Goldcorp, but for Northern Orion in Q2/06 they got $4.44/lb average. When 60% of earning come from one mine, where the price of the commodity is going down, that is huge in terms of loss of income for the business.

Before the merger, there were 60% of the number of shares that there are now. This means that for the year, it can be expected that about 1/3rd of earnings for the entire company will have come from copper.

If you look at the average price of $1.01 prior to the bull on copper, copper increased to roughly 440% of its previous price. I truly believe this leverage effect of earnings on Goldcorp has been grossly under appreciated in terms of how Goldcorp can never again have the stellar performance of the past.

Alumbrera has a twofold effect on earnings for Goldcorp. First, for 2005, the earnings were not subject to the 20% royalty, so earn estimates for Goldcorp for Alumbrera for 2005 based on those copper prices will be less. The upside is that 2006 only saw gross earnings without that royalty payment for Q1, so 2006 earnings are not completely plumped up by an unrealized 20% decline in copper prices due to the royalty kicking in.

The second effect is that copper prices are going down and copper LME stocks are going up. Traditionally demand for copper is lower this time of year, so even though copper stocks are going up, that may turn around this quarter, but copper stocks are increasing rapidly. The other thing about copper, every producer that can has increased their existing output as best they can. This has in the shorter term increased supply, but in the longer term shortens mine life.

I have not done the required homework, so I really don't know how much of the new production is new mines, and how much is increased output of existing mines. But, my overall sense from my reading is that producers have gone for the fastest path to increasing production, which was to eliminate inefficiencies in current operations, Alumbrera is not exception, production has been increase by 10%.

The other thing that may have happened as well is that mines have not kept up on maintenance the requires reduction in output. As copper prices decline, those scheduled maintenance needs will happen, so in some respects, In the short term there may be an unsustainable increase in production. If I'm wrong, copper prices will decline further this year and will probably settle in the $2.25 range. I do not see copper averaging at $3.40 as predicted in the BMO analyst report, but possibly in the $3 range, but the recent decline in copper price and increases in stock make that an unlikely prospect.

The effect of the decline in copper prices is enormous for Goldcorp, as such a high percentage of its earnings were from copper. With 168 million pounds of copper, every dollar decline in copper requires gold to go up $54 at current production rates just to offset it. So, from the high of $4.44 to today's low of $2.51, based on a production of 2.8 million ounces, gold has to go up $92/oz for Goldcorp's earning to remain constant. I have taken into consideration that 20% royalty in this calculation.

Major, Major, Major Concern #2 - reduced leverage of Gold.

This concern is more a concept than actual numbers, but this concept will play out in earnings. It mathematically has to. I believe that the concept of leverage of earnings is being utterly ignored in analysts and brokers alike, and not recognized in terms of its ability to never again give repeatable results regardless of what the price of gold does now.

The simplest and most dramatic way to demonstrate this concern is to do a mathematical analysis using ratios. I teach ratios to kids in grade 8.

Say you have a producer who when gold was $300/oz managed to make $10/oz profits and the earnings/share worked out to 4%. Say the share costs $1. Now say gold is $600/oz. So now profit is $310 and a simple ratio gives earnings (310/10)x4 = 124%. This kind of leverage of earnings made gold such a stellar performer up to now in the market, but mathematically, it can never be repeated. The leverage ratio here is 31, utterly enormous. Share price would then adjust, go up 31 times, to $31 and the return would again be 4%.

What has happened is share prices have adjusted to market cap and shares have gone way up, so earnings are again 4%. Market cap has also gone up 31 times. If it was 1 billion, now it is 31 billion. Keep everything else constant, costs are still $290 for the sake of this analysis of the reduced effects of leverage.

So, now say gold goes up another $300, to $900. Now profit is $610. The leverage effect is now (610/310)x4 = 7.9%. The leverage effect now is 1.97. The reduced leverage effect of increasing prices is 31/1.97 is 15.8. This is a decimal number. I also teach percents to kids in grade 8. This is a reduction of leverage of 1580%, providing costs remain constant.

Leverage of earnings early in the bull run played a dramatic effect on the increase in earnings on gold shares from increases in gold prices in a way that I believe is *unrecognized and unrepeatable*.

This incredible leverage of earning early in the bull run, in my assessment, is probably responsible for erroneously justifying P/E of 25 to 50 are acceptable for gold stocks because profit grow rapidly with increasing gold prices. The stellar leverage is a one time only deal. It declines further with every dollar increase in the price of gold.

Major Concern - Price Elasticity of Bullion versus Market Cap Concern

This is a simple mathematical analysis that I've talked about with high school students in the classroom in terms of what I see happening with gold stocks in general.

Take gold at say a price of $625/oz. Say you buy an ounce and the gold price goes up to $725, or by $100. Your investment has increased by 16% and you own the gold bullion.

For simplicity, say the market cap of Goldcorp is $20 billion (it was very close to that). Their production forecast is 2.8 million ounces of gold, which at @ a $100 increase in the price of gold would bring in an additional $280 million. So, the absolute value of how much earnings could go up relative to market cap is 280/20000*100% = 1.4%. So, if earnings were 4% they could go up to 5.4% if gold went up $100, but taxes also have to be paid.

The price elasticity of the raw numbers of what you actually have is the bullion is 11 time better to own right now than the gold stock, if you believe that gold is going to go up in value.

What is really remarkable here, is that not only is the level of earnings pathetic with the stock in comparison to bullion, you not longer own the gold, or essentially you have a very negative return. The gold has been sold.

Major concern - Increasing cost of Acquisitions

The cost of replacement properties has increased dramatically. I've pasted a recent report at the end. At the beginning of the bull run reserves cost about $33 oz. The Glamis take-over cost $175/oz. This is around $140/oz increase in acquisition costs.

The exact numbers don't matter, for simplicity, there is about $140/oz increase in gold replacement costs. Previous analysis was just looking at all things constant. All things aren't constant, and in fact work against profitability. Costs are increasing. Gold needs to go up to about $750/oz just to maintain earnings in terms of what those replacement cost are.

For Goldcorp, $140/oz in increased costs translated to 2% less to earnings per share.

Major concern - The life of a mine - increasing rates of depletion

Some of the spins I've read on the life of mine gives that a short mine life is a good thing because mines stop producing and it gives constant demand.

My spin on it is very different.

Red deer, a Goldcorp's second largest contibutor to earnings, has a mine life left of 12 years. Alumbrera has a mine life left of 10 years. Prior to the merger, those two mines were making 80% of Goldcorp's earnings. There are 23 properties listed. It means that one, and sometimes two mines need to be built every year just to keep up, never mind growth. Replacement is enormous...

In the shorter term for Goldcorp you see production going from 2.8 million ounces to 3.5 million ounces. From that point on you see a rapid decline in output due to the end of the life of the mines, with 60% of the 3.5 million ounces in mines that come to the end of their life within 12 years.

The rate of depletion of Goldcorp gold reserves without replacement looks something like this:
2005 - 40.5 million ounces
2006 - 38.5 million ounces, 2 million mined, depletion, 5%
2007 - 35.7 million ounces, 2.8 million mined, depletion, 7.3%
2008 - 32.6 million ounces, 3.1 million mined, depletion 8.6%
2009 - 29.3 million ounces, 3.3 million mined, depletion 10.1%
2010 - 25.9 million ounces, 3.4 million mined, depletion 11.6%
2011 - 22.4 million ounces, 3.5 million mined, depletion 13.5%
2012 - 18.9 million ounces, 3.5 million mined, depletion 15.6%

This means that Goldcorp is in a squeeze position of having to constantly be acquiring new properties to keep this monster machine going. It puts Goldcorp at major risk for increasing costs, and indeed, the costs never stop because of the constant need for recapitalization.

Major concern - depreciating mines

Mines are depreciating assets. The average life of a gold mine is 14 years.

To my way of thinking in terms of valuation, that means that earnings need to be 7% to make up for the average depletion rate plus inflation plus whatever it is you expect for the risk you take. Strictly my opinion here, but without strong other mathematical reasons and evaluation, a P/E of 10 is the minimum as to where you start, and then make adjustments up or down based on the fundamentals of the gold stocks. How much is being added to reserves and how much is being mined. If new reserves are being added at the same rate as the depletion, a P/E of 12-15 may be justified.

Another way of looking at it for Goldcorp based on the 41 million ounces of reserves and 3.5 million ounces of production fore casted in the future, well, that means that in 41/3.5 = 12, so in 12 years all you own is empty holes, with the gold all mined and sold.

12 years of earnings at 3%, if Goldcorp can even manage that, gives earning returned over the life its reserves that is only 36% of market cap. With a P/E of 12 you'd get 100% of market cap returned, with no time cost of the investment. With an estimate of 2006 earnings at $1.03, a P/E of 12 would give a share price of $12.38.

Goldcorp has a higher rate of depletion than average, so imho, even a P/E of 8 for it is generous.

Major concern - Lower quality properties available for replacement.
Again, from the source below, there has been a drastic reduction in property finds with more than 2.5 million ounces. With production rates fore casted to be going up to 3.5 million ounces, there needs to be 1-2 of these properties per year found and purchased just as a replacement activity. The low supply should further increase costs of acquiring these properties.

Lower quality properties generally means higher mining costs.

Major concern - value of reserves to market cap

Goldcorp's web site reports for 2005 the following reserves:

40.5 million oz gold @$425 = $17 billion
687 million oz silver @$10 = $6.9 billion
1.5 billion lb copper @$1.35 = $2 billion
3.7 billion lb lead @$0.50 = $1.9 billion
8 billion lb zinc @$1.25 = $10 billion
Total: $38 billion

It isn't corrected for the 2 million ounces of gold production for 2006, but that can slide...

And there are properties that haven't been properly assessed. There may be 10 million ounces in those properties, or there may be 100 million ounces. The properties have not be assessed.

However, what they can show gives a mere 2.2 times the market cap (using $17 billion market cap).

It seems prudent that market cap to what they can show at bearish prices should be at least 5 times the known reserves. This valuation alone puts Goldcorp's share price at $10.80.

Summary of concerns about Goldcorp

• Negative leverage of copper - gold must go up $90 to cover.
• Declining leverage of gold - leveraged increases in earning can never match early performance -- it is mathematically impossible.
• Price elasticity of the bullion is 11x that of the stock.
• Increasing cost of acquisitions means that gold must go up $140 just to cover.
• Depreciation of mines is higher in the gold industry than any other mining industry.
• Quality of replacement properties is declining, meaning costs will increase.
• Availability of replacement properties is declining meaning acquisition costs can further be expected to increase.
• The ratio of reserves to market cap for Goldcorp is disgraceful.

At the end of my analysis of Goldcorp I was truly horrified that anyone would be recommending this stock. Certainly if any of my analysis has merit, many reputations will be seriously hurt. But personally, I wouldn't buy Goldcorp at $10. I simply don't see growth potential at that price.

My Conclusions:

• Gold prices must increase $230/oz to maintain earnings for Goldcorp.
• Assets are depleting at a much higher rate than earnings.
• Goldcorp is trading at about 3 times its value.
• All Gold companies are facing increasing costs, reduced leverage, and greater difficulty for finding replacement properties.

(stocks with higher costs to at the start of the bull run have not increased to the degree that low cost producers increased, they simply never had the same leverage of earning to pump up their stock prices.)

The Under Valuation of Northern Orion

I stated that I saw Northern Orion has being grossly undervalue. All of its earning come from copper, so it too should expect much lower earning from its existing operations. My interest in Northern Orion came not from it current earnings, but it massive reserves and massive growth prospects, comparable to the potential of Goldcorp 6-7 years ago. Northern Orion has massive increase in earning opportunity even in a declining-copper price market.

Points that favor Northern Orion

1. Market cap to reserves is enormous.
2. Strong cash position.
3. Expected cash from warrants can provide some capital costs.
4. Good cash flow from Alumbrera.
5. Aqua Rica property is well studied and Northern Orion has applied for building permits.
6. Production increase is forecast to increase by 660% when the new mine starts.
7. Low cost producer because of net credits of gold and molybdenum.
8. Lower depletion rates.

Reserves to Market Cap for Northern Orion

Northern Orion has two properties, its 1/8th interest in the Alumbrera mine and Agua Rica.

The Alumbrera mine has 10 years of life left, Northern Orion's share is 50 million pounds per year of copper and 75,000 ounces of gold, exactly 1/3 of what Goldcorp gets from this mine.

Simple extrapolation, total reserve of this property is 1/2 billion pounds of copper and 750,000 ounces of gold, which at $1.35 for copper and $400 for gold is $0.675 billion for copper and $0.300 billion for gold, or about $1 billion.

The Agua Rica property is Northern Orion's hidden gem.

The feasibility study gives this total as to what can be mined over a 23 year period. This is more conservative than just looking at the reserve because recovery rates are taken into account. There are 6 million ounces of gold in the reserve, but only 3 million ounces are considered recoverable as about 50% of the reserve is not recoverable in the mining process. There are 13 million ounces in the resource. There are 21.4 billion pounds in the resource for copper and 1.7 billion pounds for molybdenum.

The recoverable metal estimates for Agua are
7.6 billion pounds of copper @1.35 = $10.3 billion
3 million ounces of gold @400 = $1.2 billion
360 million pounds of molybdenum. @12 = $4.3 billion

The two properties combine give $17 billion at $1.35 for copper, $12 for molybdenum and $400 for gold.

Diluted, Northern Orion has 221.5 million shares. At $3.70/share that gives a diluted market cap of $820 million ($560 million undiluted).

So, at bearish prices reserves to market is 21 times. A valuation of 1/10th production forecasts at bearish prices gives a valuation of $7.40.

Strong Cash Position and Warrants

Northern Orion has $180 million in cash in the bank. Should the fully diluted market cap be realized, it will have an extra $160 million from warrants. That's $340 million dollars, leaving only $400 million of market cap for valuation of the rest of the assets.

If you take the bearish value of what's in the ground, $17 billion and compare it to the rest of the market cap, well, that's 42 times the market cap less cash position.

Strong cash flow from Alumbrera

For 2005, with average copper prices at $2.37 equity earning were $46,755,000, and cash flow was $75,500,000. Earning per share at this price was $0.31. This is in the "ball park" of where copper prices can be expected and cash flow for the size of the company is strong.

Over the three years to bring the new mine to production, it is reasonable to expect another $150 million to retained earnings which can be used towards the construction costs of the new mine. Quarter 2/06 had cash flow of around $56 million alone. This drastically reduced estimate takes into account strong declines in copper prices, but is still strong cash flow.

Aqua Rica is ready for building.

The Aqua Rica property has an strong investment in drilling and feasibility studies and is at the point that permits have been applied for to build the new mine. The down side is that it is expected to take 8-10 months to get the permits approved.

Production growth is enormous compared to current operations.

The new production is expected to be:

• 368 million pounds of copper
• 120,000 oz gold
• 15.4 million pounds of molybdenum.

The increase of cash flow at prices of $2 for copper, $425 for gold and $12 for molybdenum is $736 million for copper, $51 million for gold, and $185 million for molybdenum, for a total of $970 million dollars.

At a price of $2.37 for copper Alumbrera earned $0.31/share. A simple ratio extrapolation for a $2 price with a 660% increase in production gives (2/2.37) x (7.70) x 0.31 = 6.5 x 0.31 = $2/share earnings. This doesn't take into account there would also be molybdenum, which is like a bonus production. 185/221.5 = $0.84, so earnings should go to somewhere between $2-3/share.

The cash flow situation is that Northern Orion will have in the range of a half billion to pay for the new mine and will need to finance $1.5 billion. Their assets and cash flow are strong enough to do this without further dilution.

The new mine production is going to generate a cash flow in the range of what Alumbrera generates, only this will be 100% Northern Orion owned. To put this into perspective, Northern Orion's cash flow can be expected to be in the range of 40-50% of Goldcorp's 2007 cash flow, yet it has a market valuation 1/20th of that of Goldcorp. ($820m vs $17 billion) Further, the difference in the mine life (23 years) and availability of replacement reserves means that Northern Orion would not be subjected to they same types of increasing costs.

Low cost producer due to gold and molybdenum cash credits, lower depletion rates

Aqua Rica's cash costs for production would make it one of the lowest cost producers. This is the type of circumstance that led to the stellar growth and returns for Goldcorp, with a difference, depletion rates are lower. After the new mine is built, the shorter term, depletion rates are very high and cash flow is higher. Total production for 2012-2016 for copper would be 418 million pounds. It declines to 368 million pounds in 2017 when Alumbrera has come to the end of its life, and in 2022 the highest streams of copper are expected to be mined and production further declines to 300 million pounds for another 13 years.

The rate of depletion of Northern Orion's copper reserves looks something like this:
2006 - 8.1 billion pounds
2007 - 8.05 billion pounds, 50 million mined, depletion, 0.6%
2008 - 8 billion pounds, 50 million mined, depletion 0.6%
2009 - 7.95 billion pounds, 50 million mined, depletion 0.6%
2010 - 7.7 billion pounds, 250 million mined, depletion 3.1%
2011 - 7.28 billion pounds, 420 million mined, depletion 5.5%
2012 - 6.86 billion pounds, 420 million mined, depletion 5.8%

The cash flow is such that capital cost can be paid back while there is the higher production from the new mine as well as the continued cash flow from Alumbrera.

With longer mine life, Northern Orion is never in the type of squeeze position that mature gold stocks are in. Over the long term, they are not subjected to the same squeeze to keep production going to ensure maintenance of earnings, never mind to increase them.

Summary of under valuation of Northern Orion

• The value of what's expected to be sold at half of today's market prices is $17 billion, 22 times the diluted market cap, and using a value of market cap being 10 times bearish price estimates give a today value for Northern Orion of $7.40.
• Earnings per share can be expected to increase to about $2/share even if copper is $2/lb. With a target P/E of 10, once production is in full swing, target price can be $20/share. With a target P/E of 8, target price can be $16.00.
• Northern Orion has a strong cash position, 35% of it undiluted market cap in cash, and 46% of its diluted market cap taking into account the cash from warrants.

My Conclusion: Northern Orion is grossly undervalued. It is a strong buy to $7 based of property holdings alone.

Everywhere I look, I think I've been conservative towards Northern Orion, and actually generous towards Goldcorp. For example, I've stated 10 times bearish prices for Northern Orion, using bearish prices, whereas for for Goldcorp I've suggested it should have 5 times the reserves at bearish prices relative to market cap. The estimate for Northern Orion puts copper at $1.35, highly, highly bearish. The estimate for Goldcorp uses reserve, for Northern Orion the estimate is corrected for the non-recoverable percentage in the mining process.

Copper prices have declined faster than expected, but there is a new mine entry barrier price. Northern Orion's entry price is much lower than average due to low production costs, and the enormous reserve was acquired at very low costs.

The recent Phelps Dodge merger puts an in the ground valuation for copper at $0.70. Their average production costs are $0.50/pound. With Northern's Orion's net of metal credits production costs at -$0.02, it is simply far more competitive. Another tiny cap stock, Equinox, shows production costs of $0.70/lb.

Starting at a copper price of about $2.25 high cost producers start to have problems raising capital costs, and it increase from there. The sell off of Northern Orion indicates how true that is in terms of being able to attract capital for investment as copper prices decline. Copper was able to stay at around $1/lb for so long because land and capital costs had long been paid for, and the long life of mines enabled them to simply continue as ongoing concerns, without capital for replacement or new investment. And, at those prices, mines were going bankrupt.

Gold Takeovers Reach Record on Lack of New Supplies

By Choy Leng Yeong

Dec. 27 (Bloomberg) -- Gold-company acquisitions this year surged to the highest level in at least a decade, and the industry may continue its buying spree in 2007 as producers struggle to find new deposits.

Goldcorp Inc.'s $8.5 billion acquisition of Glamis Gold Ltd. was the biggest of 357 deals valued at a total of $24.3 billion this year, data compiled by Bloomberg shows. That eclipsed the $16.2 billion spent last year on 341 transactions, including Barrick Gold Corp.'s $10 billion purchase of Placer Dome Inc.

Producers are rushing to boost supply because mines are being depleted faster than new reserves are being found, and a six-year rally in gold prices is providing cash to buy assets. The number of discoveries of at least 2.5 million ounces has declined for eight straight years, according to Metals Economics Group in Halifax, Nova Scotia.

``The driving force behind the M&A is that you have difficulty finding new gold mines,'' said Graham Birch, who helps manage $27 billion at BlackRock Investment Management in London. ``It's all about trying to get access to reserves.''

From 1992 to 2005, the world produced 1.1 billion ounces of gold, or 1.8 times more than the new resources discovered among deposits of at least 2.5 million ounces, Metals Economics Group said.

The drop in new reserves followed years of reduced spending on exploration as gold fell to a 20-year low of $253.20 an ounce in 1999. Worldwide exploration budgets fell to a 12-year low of about $780 million in 2002, said Jason Goulden, director of corporate exploration strategy at Metals Economics.

`Scramble for Land'

``There is a scramble for land,'' said Ian Cockerill, chief executive officer of Johannesburg-based Gold Fields Ltd. ``From about 1996 until about a couple of years ago, there was a marked decline in the amount of exploration dollars. The industry is staring down the barrel of the gun that says, `Where are the replacement ounces coming from?'''

Gold Fields, the fourth-largest producer, earlier this month completed a $1.53 billion purchase from Barrick of half of the world's biggest deposit, the South Deep mine in South Africa. Gold Fields is buying shares in Western Areas Ltd., which owns the rest of South Deep. The deal will increase the company's reserves by about half.

The price of gold has more than doubled to $630.30 an ounce today from a 20-year low in 1999. The precious metal reached a 26- year high of $732 on May 12. The rally, fueled by investors seeking a hedge against inflation or an alternative to the dollar as it fell against the euro, has spurred demand for new reserves.

Cost of Reserves

The cost of reserves rose to a record $120 an ounce in 2005, compared with a low of $33 in 2000, said James Lowrey, a senior analyst at Metals Economics, which tracks more than 1,450 companies and deals of at least $50 million since 1995.

Gold Fields CEO Cockerill admits he paid top dollar for the South Deep mine at $104 an ounce. ``It is certainly one of the more expensive acquisitions that we have made'' compared with the company's historical average of $60, he said. ``But then again, it's a very special ore body.''

The mine, west of Johannesburg, contains as much as 29.3 million ounces, equal to about a third of the world's annual gold production. Gold Fields plans to study the viability of expanding annual production to 1 million ounces, from the 800,000 ounces expected yearly by 2011.

Vancouver-based Goldcorp spent about $175 for each ounce of reserves it acquired in the Glamis deal last month, and Toronto- based Iamgold Corp.'s $1.1 billion stock acquisition of Cambior Inc. valued each ounce at about $117, Lowrey of Metals Economics estimated.

Doing Deals

Doubling resources is a ``big rationale for doing this deal,'' said Goldcorp Chairman Ian Telfer, who has made more than eight acquisitions in the past four years. The purchase of Glamis helped Goldcorp overtake Johannesburg-based AngloGold Ashanti Ltd. as the world's third-largest gold producer by market value.

Citigroup Inc. was the top investment bank with five deals worth $11.6 billion, accounting for 48 percent of the market share. It advised Glamis on its takeover by Goldcorp. JP Morgan ranked second with $11.4 billion and seven deals, including Glamis.

Global gold production in the nine months ended September fell 2.2 percent to 1,804 metric tons from a year earlier, London- based researcher GFMS Ltd. estimated. The lack of new supply will help boost gold prices by $200 over the next two years, topping $800 an ounce, Telfer said.

``There is definitely a sense that the industry -- which is really good for gold -- is kind of flat to shrinking,'' said Barrick Chief Executive Officer Gregory Wilkins. ``Placer was important for positioning the company for dealing with the industry challenges.''

Gold-Company Shares

Shares of Toronto-based Barrick, which completed its acquisition of Placer Dome in March, rose 6 percent this year. Denver-based Newmont Mining Corp., whose bullion sales may plunge 14 percent this year, has fallen 15 percent, the biggest drop among the 16 companies in the Philadelphia Stock Exchange Gold and Silver Index.

Newmont, which spent $225 million to boost its stake in a mining project in western Australia this year, cut its 2006 sales forecast three times, most recently in September, because of lower output in Ghana and Uzbekistan. The company said Sept. 27 that its gold sales may fall 14 percent this year to 5.6 million ounces from 6.5 million in 2005.

Freeport-McMoRan Copper & Gold Inc., owner of the world's biggest gold mine, last month agreed to buy copper producer Phelps Dodge Corp. for $25.4 billion. Kinross Gold Corp., Canada's third- biggest gold producer, agreed to purchase rival Bema Gold Corp. for $2.84 billion in stock to expand in Russia.

Barrick's Wilkins said his acquisition strategy won't be affected by short-term changes in prices, which have fallen 14 percent from the 26-year high reached in May.

More Bids

Barrick may make a bid for New Orleans-based Freeport to boost reserves and lower operating costs, CIBC World Markets Inc. said in a research note on Dec. 15. Both companies have declined to comment. Barrick on Dec. 7 failed in its $1.71 billion hostile bid for Vancouver-based NovaGold Resources Inc.

Kinross Chief Executive Officer Tye Burt said takeovers may get a boost from the recent slump in prices.

The decline may bring ``more targets into a price zone'' to encourage acquirers, Burt said. ``In a strong commodity price environment, it's always tough to reach price agreements. Everyone's trying to protect their production profiles.''

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