If we display a chart of Harmony Gold Mining Company Limited (NYSE: HMY), we can see that stocks over the past 15 weeks or so have lost nearly 40% of their value. In the short term, equities have managed to stay above their June lows, but the underlying trend continues to be bearish, so investors should be careful when planning an entry here. We say this because once stocks lost their 200-day moving average in early May, selling intensified on the downside. Selling eventually stalled at 2021 lows, but stocks now have considerable resistance to overcome before returning to bullish mode once again.
The stock price trajectory of mining companies is closely tied to the current price of the commodity they mine. Shares of Harmony, for example, rallied sharply above their 200-day moving average in February this year, when the price of gold soared well above $2,000 an ounce. Does this mean that the opposite (a weakening HMY stock price) will continue to occur in a weakening gold price environment? This may very well be the case, but aside from the fact that higher costs on the front-end need to be controlled to maximize margins, the risk/reward games still come down to the relationship between the stock’s valuation and its inherent profitability.
Here’s how Harmony currently fare in those departments.
Many investors who invest in the gold mining space think that inflation is good for mining companies, and it usually is. The problem, however, is that gold mining companies such as Harmony have high fixed costs (Harmony has already announced solar intentions to combat upstream electricity costs) which inevitably rise in times of inflation. Investing in physical gold or an exchange-traded fund (“ETF”) that tracks the spot price of gold is a great hedge against inflation, whereas a mining stock like Harmony may not be protected against rising prices as many might believe.
Why do we state this? Well, when we look at Harmony’s income statement over the past four quarters, things start to become more transparent. Over the past four quarters, Harmony has generated nearly $2.64 billion in sales, of which $609.6 million turned into gross profit. This gives the company a gross margin of 23.1% over the last twelve months. This is slightly below Harmony’s 5-year average of 24.1% and significantly below the industry average gross margin of 32.4%. Harmony’s net income of $119.2 million currently equates to a net profit margin of 4.52%, again lagging the industry (8.81%) by a significant margin.
So, all things being equal, Harmony’s cost of revenue is about $0.77 for every $1 of product sold. Now here is the kicker. Even if Harmony only realizes 5% inflation on upfront costs over the next 12 months and there is no change in the price of metal sold by Harmony, the company’s cost of goods sold will increase approximately 4% or $0.04 to $0.81 for every $1 of product sold.
Should the above scenario materialize, this trend would put sustained pressure on Harmony’s earnings, which could even mean that we are seeing negative earnings for a while. The reason is that the company’s gross margins are simply not high enough, to begin with. However, the sector, which has higher average gross margins, will not see the same negative impact on its profits over time due to its lower cost of goods sold, all other things being equal.
We can see this “pressure” in the company’s valuation, as Harmony’s forward GAAP earnings multiple is currently only 16.90, which is well above the industry’s 10.95. This earnings multiple translates to an earnings return of around 6%, whereas industry earnings are currently yielding 7.5%. Additionally, Harmony’s below-average dividend yield of 1.52% further lowers expected returns relative to the broader sector (2.14%).
Suffice it to say that when you factor in the above, Harmony actually needs higher gold prices relative to the industry as a whole due to its lower margins and lower yield. We classify HMY as holding at best at its current price as the risk/reward profile is not sufficiently skewed in our favour. We look forward to continued coverage.