A reader asked for tips on parsing the jargon in company financial statements to get at what we really need to know. Seems like a good idea.
But first, I want to say that being able to get into workshop topics like this is one of the great benefits of going to conferences like the Sprott Natural Resource Symposium, July 30-August2, 2019. That’s my next public appearance, and I love helping people out on subjects like this. It’s also simply fun to meet and spend time with readers… as well as drag the occasional mining company CEO into the pit for a grilling. If you’re serious about making money in the resource sector, you should make a serious effort to be there.
Now, the first thing I’d say about company financial statements is that, yes, they are boring, but they can be sources of very important information. They’re written by lawyers and accountants to be precise, not fun. But if they should be comprehensible. Apart from property and plant descriptions that can be full of technical geo-jargon, the financial reporting itself should be clear. If it’s not, that’s a red flag.
Another basic is that I look at exploration companies quite differently from miners in production.
Pure exploration companies have no revenue—they add value by discovery, if at all—so there’s no earnings per share or other usual metrics to look at. But a producer should make money. Even is commodities are highly volatile, and that’s reflected in a miner’s financial results, a producer should deliver to the bottom line. If not, there’s a problem and all the standard financial metrics apply.
It would take a book to go through balance sheets, income statements, and all the rest line by line. Maybe someday I’ll write that book. For now, here are key points I look for…
- Net income. A low all-in sustaining cost (AISC) of production is good, and I understand that EBITDA may be a more representative figure for a company’s financial performance, but the bottom line is the bottom line. I’m not a company manager. I’m a stock speculator. And experience shows that failing to deliver to the bottom line tends to hurt share prices. I wouldn’t sell a great company just because they have a bad quarter—that can happen in mining simply due to excessive rain or the like—but I need to be convinced that the loss is one-off, and not a portent of worse to come. If I’m going to buy a producer, I want one that can deliver at least something to the bottom line through thick and thin.
- A strong balance sheet. I want to see lots of cash—enough to sustain operations if commodity prices drop for a few quarters. I want to see little debt: less than average for the peer group is good. The lowest quartile is better. If there is significant debt, it better be for a good reason, like a great acquisition, and the company needs to have a credible path to quick repayment.
- Earnings growth. By this I don’t mean the hope for higher commodity prices leading to higher EPS. Anyone can hope for higher copper, oil, or whatever—hope is not a business plan. I also don’t mean exploration potential, which is never certain. I mean new mines or wells coming online. Credible growth could come from M&A targets coupled with a track record for achieving them. It could even come from changes in taxes or the application of new technology. Wherever it comes from, I want to see real growth ahead, because resource extraction is a self-depleting business by its nature. If you’re not growing, you’re dying.
- Justification for adjustments. A lot of financial statements have adjustments and non-GAAP figures reported. That’s not necessarily a bad thing. AISC is a useful, non-GAAP figure. But especially when it comes to adjusting earnings, I want to be able to follow—and agree with—the reasoning for the adjustments. Otherwise, I simply ignore them and look at the non-adjusted figures.
- Use of funds. As per the above, it probably won’t surprise you that when it comes to resource producers, I want to see cash put back into the ground to secure future growth. Dividends are okay for a very cash-rich company, but I don’t personally buy stocks for dividends. I buy share price appreciation, and that comes from growing the business, not giving all the money away. I generally dislike share buybacks, even if they tend to support the prices of my shares. I’d rather see the money put into the ground to secure real growth that will drive my shares higher.
Explorers & Developers
- Cash in the bank. If you’ve watched me grill CEOs, you know I always ask them what they plan to do in the coming quarters, how much it will cost, and how much they have in the bank. By looking at a company’s corporate presentation or press releases, you can get the first two pieces of information, and by looking at the balance sheet, you can get the third. If there’s not enough money to do the work it will take to deliver whatever potential value I’m being asked to speculate on, it’s a red flag. Unless, of course, the company is strong enough to raise the money in a great private placement I might get invited to. In fact, looking at exploration company balance sheets is one way I find potential private placement opportunities before they are announced. It’s not inside info—it’s simply obvious when a company doesn’t have enough cash to do what needs to be done. As a general rule, however, I like to see at least a year’s operating cash in the bank, and ideally, two or more years’ worth.
- Watch the cash flows. Since money spent on exploration is often capitalized, not expensed, it doesn't always show up on the income statement. I always look for exploration and other capitalized expenditures on the statement of cash flows to see how much cash a company is burning in addition to the expenses on the income statement. Add them up, divide by month, and you get a burn rate. As above, a healthy explorer can last for a couple years at the current burn rate.
- Share structure. There’s lots to say about this, but the main thing is to watch for massive batches of warrants or options at prices way below market. These can crush share price performance, even if a company does deliver positive results on the ground. A bloated share structure (hundreds of millions of shares issued and not much to show for it) can also be a sign profligate management. Conversely, if the number of shares issued is too small, there’s not enough float for good trading liquidity.
- G&A ratio. There’s no ideal ratio here. Even promotion plays a necessary role in the success of an explorer or developer. But if more money is going to pay for a fancy office than is going into the ground, that’s a clear red flag.
Finally, I want to say that you should look beyond the financial statements themselves, to the management discussion and analysis (MD&A) that comes with them. These can be a great source of information companies are required to disclose, but that they don’t want to highlight in their press releases. Each is different, so I can’t tell you exactly what to look for, nor where. Just be aware that sometimes things happen that the regulators force management to disclose to the public, but that they can argue are not so major as to require a press release. This stuff often shows up in the MD&A.
That’s my quick take. Come see me at my next public appearance, and I’ll be glad to get into more “how to” issues like this with you.