Poor Capital Allocation Tarnishes Gold Miner

Kinross also announced that it will not pursue the Tasiast mill expansion at this time. Given the uncertainty of the project, we had not included its development in our explicit forecast. We have mixed feelings about the decision. Although we understand the desire to protect the balance sheet amid gold price volatility, we thought the expansion had significant potential to transform Tasiast into one of the biggest and lowest-cost mines in Kinross' portfolio. No other project in the pipeline appears as near term or impactful as the Tasiast expansion did. Although the project could still be revived, the company seems to have shifted focus for now.

Acquisition Path Full of Missteps Kinross is a senior gold miner, with production split roughly evenly among the United States, South America, Russia, and West Africa. The company has historically relied on acquisitions to fuel growth. However, many of the acquired assets have been disappointing, underperforming original expectations or not even opening. We think these poor capital-allocation decisions continue to weigh on the company today through a middling cost profile and underwhelming growth pipeline.

Kinross' largest mines are Kupol in Russia and Paracatu in Brazil. Kinross acquired Kupol in 2007 as part of its Bema Gold purchase. Despite its remote location, the mine operates with low costs thanks to high-grade deposits. In 2010, the company acquired the nearby Dvoinoye deposit. Given the proximity to Kupol, the deposit leverages existing facilities, further supporting low production costs. Paracatu is second in production only to Kupol. While not low cost, the mine has significant reserves, implying a mine life beyond 2030.

Kinross' acquisition history has more than its share of missteps, the largest being the acquisition of West Africa's Red Back in 2010 for more than $7 billion. Kinross believed the potential of the assets, particularly Tasiast in Mauritania, justified the hefty price tag. However, with the expansion economics looking less and less attractive, the company impaired nearly the entire purchase price over the next three years. While an expansion is still on the table, it's unlikely to deliver what was expected.

Ultimately, gold prices still have the greatest impact on our valuation. Our long-term gold price forecast of $1,283 per ounce in 2018 is based on the marginal cost of production for gold miners on an all-in sustaining costs basis. This includes both the cash costs and sustaining capital expenditures necessary to sustain current production levels. Our long-term gold demand forecast assumes solidly increasing demand, driven by China and other emerging markets. China and India already constitute an overwhelming share of gold retail demand. Given gold's cultural importance in both countries, we expect rising household incomes to propel continued demand growth.

Production Costs, Disappointing Acquisitions Prevent Moat We do not think Kinross possesses an economic moat, since its mediocre production costs weigh on its ability to generate returns in excess of its cost of capital. When we consider Kinross' long-term competitive advantage, we look at the company's operations in three parts: Americas, Russia, and West Africa. While Kinross' Russian assets operate at low costs that could be moatworthy, they constitute only about one fourth of overall production. Kinross' assets in the Americas and West Africa do not operate at costs low enough to earn a competitive advantage. Therefore, on an aggregate basis, the company's total production costs are not low enough to earn an economic moat.

We think Kinross' history of disappointing acquisitions weakens its ability to dig a moat. From 2008 to 2013, the company recognized more than $11 billion in impairments stemming from underperforming acquired assets. We believe this demonstrates the firm's overinflated asset basis that weighs on its ability to earn excess economic profit. The biggest example of an acquisition misstep is the 2010 acquisition of Red Back for more than $7 billion, in which Kinross acquired West African assets Chirano and Tasiast. However, underwhelming mine plans, downgraded planned mill sizes, and construction decision deferrals have led to the write-down of nearly the entire purchase price over the three years after the acquisition. Although smaller in scale than Red Back, Kinross' $800 million Aurelian acquisition in 2008, which gave the company the Fruta del Norte development project in Ecuador, is another example of an investment decision that overinflated the invested capital base. In 2013, the entire development project was canceled because the company was unable to reach an agreement with Ecuador on key economic and legal terms. As a result, Kinross wrote down the entire carrying value of the project. Given its overinflated invested capital base stemming from large but disappointing acquisitions, we think it is unlikely that Kinross will earn a narrow Morningstar Economic Moat Rating, even if it is able to improve its relative cost position.

Kinross' cash costs and all-in sustaining costs currently sit above the industry average, and we do not anticipate the company's disadvantaged cost position to improve relative to its peers. In light of the lower gold price environment, gold miners have shifted their focus from maximizing production to maximizing cash flow. Naturally, this has included a variety of cost-saving programs that target production costs, general and administrative expenses, exploration expense, and others. While Kinross has pursued similar initiatives, we don't think its reduction efforts will be meaningful enough improve its cost position. Furthermore, even when a miner pursues cost-reduction efforts, some costs are more difficult to reduce than others, as a company cannot change the nature of a mine's geology. Therefore, we believe Kinross' cost position will remain stable relative to the industry.

Gold Price Leverage Heightened by High Costs We think Kinross has very high fair value uncertainty. Like most gold producers, Kinross is highly leveraged to gold prices, and we believe this is exacerbated by its all-in sustaining costs of $1,000-$1,100 per GEO, above the industry average. At today's gold prices, the company has a weaker ability to generate free cash flow relative to some of its competitors. Should gold weaken further, Kinross may have to make drastic decisions to protect its cash flow.

Kinross carries a moderate amount of geopolitical risk relative to other gold miners. On one hand, roughly half of production is based in the Americas, roughly split between the U.S. and Brazil/Chile. On the other hand, the remaining production splits between a little more than one fourth in Russia and a less than one fourth in West Africa. In particular, Russia is a country of high uncertainty, given a volatile political situation and risk of expropriation. In all of its non-U.S. operations, the company faces some risk of changes in mining and royalty legislation.

We think Kinross has a high level of execution risk on future acquisitions and development projects relative to its gold mining peers. Kinross has had some large and expensive failures in the past. For example, it acquired Aurelian and its Fruta del Norte development project in 2008 for $800 million. In 2013, Kinross canceled the project and wrote off all of its carrying value because it was unable to reach an agreement with the Ecuadoran government on economic and legal terms. An even bigger disappointment, the company acquired Red Back and its West African assets in 2010 for more than $7 billion. Since then, the company has written off nearly the entire value of the acquisition, as expectations for Tasiast's potential have diminished over the years. Given this spotty record of execution, we think investors should be skeptical about the company's ability to deliver on development projects.

Stewardship Is Poor We believe the management team has often exercised poor stewardship of shareholder capital. It has repeatedly issued large amounts of shares (more than tripling the diluted share count since 2006) to finance its acquisition-dependent growth strategy. Furthermore, we think many of these acquisitions underperformed and destroyed value. These acquisitions have led to significant impairment charges, as Kinross has recognized more than $11 billion of impairments of goodwill and plants, property, and equipment since 2008. The largest and consequently most value-destructive transaction was the 2010 acquisition of Red Back for over $7 billion, more than $5 billion of which was recognized as goodwill. The acquisition boosted production by roughly 500,000 ounces and exposed Kinross to West Africa. However, underwhelming mine plans, downgraded planned mill sizes, and construction decision deferrals have led to the write-down of nearly the entire purchase price over the three years after the acquisition. The disastrous outcome of the Red Back acquisition was intensified by the company's decision to fund the entire purchase with equity, using a combination of shares, warrants, and options. In general, we think the company has tended to bite off more than it can chew with its acquisitions, as many of the assets acquired recently have either underperformed or have yet to be opened.