Expect Big Write-Downs in This Sector

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Warren Buffett, the Sage of Omaha, once said: "It's only when the tide goes out that you learn who's been swimming naked." The interesting thing about the markets is that there's always a "tide" in some market. That's why it's crucial to make sure that you're not "swimming" in that particular market. I believe that the current "tide" we are witnessing is the tide in gold prices. And it's now officially over. Gold prices have fallen from $1,900 per ounce to less than $1,300. A retreat of over 30% means that the gold market has officially entered a bear market territory. That means all we have to do now is to look for the naked swimmers out there...

The first naked swimmer to admit it 

Bloomberg data show about $17 billion in write-downs for gold miners over the past 18 months. That's how much money gold miners "wrote off" on their balance sheets. In other words, these companies paid way too much for assets, but they're just now being forced to admit it. The first company to raise the flag was Australia-based Newcrest Mining (NASDAQOTH: NCMGY.PK)The company just announced that it would write down $5.75 billion this month. The company had six producing mines, three of which are not profitable at gold's current spot price. This month, Newcrest's shares are down more than 40%. 

This write-down is especially noteworthy for two main reasons. First, the sheer size of this write-down is amazing. When a $6.8 billion company like Newcrest is forced to write down $5.75 billion, or 85% of its market cap -- it means that something is terribly wrong. Also, this write-down is the biggest one-time charge in the history of the gold mining industry. If Newcrest willingly decided to write-down such a massive sum at one time, I believe the company expects a further decline in gold prices.

Second, Newcrest couldn't have been alone on its pricey acquisition spree (which resulted in the massive write-down). Gold producers spent $195 billion on acquisitions over the last decade. And some of the world's biggest gold miners are now in trouble.

Other naked swimmers out there

The acquisition spree in the gold sector has been going on without stop. Only last year, billionaire Carlos Slim and his Minera Frisco bought out a competing Mexican miner for $750 million. Back in 2010, Kinross Gold (NYSE: KGC) bid $7.1 billion for the rest of Red Back Mining. Even giant Barrick Gold (NYSE: ABX) took part in this party. In 2011, it completed a buyout of its Canadian rival, Equinox Minerals, for $7.3 billion, only to write down $4.2 billion in impairment charges as a result of an ill functioning mine in Zambia. 

The pending trouble 

While gold price is falling, costs are not. Diesel prices aren't falling right now. So these miners are looking uglier and uglier. In fact, the combination of costly past acquisitions together with a crash in prices is horrifying. Take Kinross Gold for example. In the first quarter of 2013, the company extracted and sold 650,000 ounces of gold at a total cost of $890 million. This translates into a cost-per-ounce of $1,370. This means that at today's gold spot price of $1,237, Kinross is actually losing $133 on each and every ounce it produces. That's not a recipe for success.

And all the other gold miners are in the very same situation. If the current price environment continues, operating margins will be diminished. Barrick, for example, will see its operating margin drop from 44% at 2012 gold price level (of roughly $1,650) to only 25% at today's level of $1,237.  

The Fool looks ahead

Right now, trying to find value in gold miners is a very tricky (and costly) endeavor. I strongly recommend to let this falling knife fall, and only then -- look for some value investments. Eventually, gold prices will stabilize and companies will stop writing down their assets. It'll be a much safer bet. 

Gold has outshined the stock market with strong returns since 2000, but more recently has given way to big declines. The Motley Fool's new free report, "The Best Way to Play Gold Right Now," dissects the recent volatility and provides a guide for gold investing. Click here to read the full report today!

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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