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11/4/15

Having your cake and eating it

Here's a question received from reader 'DB' this morning:

I'm really not sure why it's such a big deal that companies are not including depreciation in their cost reporting.

If I'm comparing a potential investment into two companies and wish to compare the cost base of those two companies, does it matter if the mine cost US$1bn to build or US$100m to build (and that capital is depreciated accordingly)? Surely what matters is what it is doing today.

Good question, and one connected to the recent posts on the increasingly useless metric we know as All In Sustaining Cost (AISC) (see the past couple of days on Detour Gold and Primero Mining).

Okay DB, in conceptual terms think of it this way. When a company constructs or acquires a project it will make its case for investment in said new mine by explaining the NPV of the project, i.e. what cash profit it can reasonably be expected to generate over its mine life. That's (nearly always) done on a 100% equity basis and if they manage to convince the world the capex gets raised. But if instead the company take out a big chunk of debt to pay for at least part of the capex, or it does a streaming deal, or something similar that doesn't show up in the "above the line" operational results of the company once the mine goes into production. With 100% equity is that the dilution is understood and built into the share price automatically. But if a debt (or other) financing deal is done, it won't affect the day-to-day operations but it will affect the corporate bottom line, i.e. what shareholders (equity) get for their return. In practical terms, what you get is a company that boasts wonderful made-up operational metrics (things like "operational profits adjusted for non-cash charges" and other such non-GAAP bunkum), but we then scratch our heads and wonder why that operational profit isn't being turned into net profit. The reason is that the "profits" (which they aren't) is being used to pay off something that got between the company and its shareholders. And this is why we can't ignore depreciation of a project, it's the indicator that shows when the project is expected to "get to zero" and it's therefore completely necessary to discount its effect every quarter.

Or if you like, think of it backwards. You can't mine a lump of rock and then assume it's still an asset. It's not like making Barbie dolls, or growing wheat, non-renewable is exactly that. You need to show the world that you as a business can make a profit on what's there in the ground before it's mined and then all gone.