Jefferies downgraded a slew of gold miners today, arguing that “with short reserve lives, rising costs, rising political risks, and a stagnant commodity price” the entire group remained unattractive and overvalued. Putting aside the fact that Jefferies only downgraded the group after a more than 50% decline, is the sector still overvalued?
I’ve been doing some digging on the gold miners in the past week. I decided to look further into their fundamentals after the GDX vs. GLD ratio hit new all-time lows over the past month:
When I see a ratio chart like this of two related assets, I am intrigued. There is likely a good fundamental reason for the ratio hitting a new low. But that is quite a re-pricing of miners vs. the underlying commodity.
Clearly, precious metals miners have a lot of leverage to the price of gold and silver. Not many businesses would fare well if their revenues were cut by 25-50% in less than a year. But how much cushion do these miners have?
Here is my fundamental synopsis of the top 3 names in the GDX, representing about a third of the ETF:
1) GG – Goldcorp is a Canadian company with major interests in Canada, the U.S., Mexico, and Central and South America. The stock has held up better than most of its peers because of the quality of its mining assets. In other words, its marginal costs for its operating mines are much lower than most, around $700-$900/oz for gold. It continues to generate solid free cash flow even with gold around $1100-$1200/oz, a huge advantage relative to the sector. It looks a bit expensive on a pure Price/Earnings basis, but that’s in large part due to its historical growth profile. On a historical basis relative to itself, it is at its cheapest P/E valuation in the past 10 years.
2) ABX – Barrick is another Canadian company, with its primary regions as North America, South America, and Australia Pacific. It is valued as a distressed name (5x P/E, 0.7x Book Value) because it has a much larger debt load than its large cap peers, so cash flow concerns become more severe with gold prices down here. The company expected to generate negative free cash flow at gold prices 20% above where they are today, so it has become a slippery slope from a liquidity perspective for ABX. They took off their gold hedges several years ago, hedges that were in place to prevent a liquidity crunch that they’re now experiencing. Terrible management.
3) NEM – This is a higher quality name than the other “cheap” stocks in the space. It’s trading around book value, but does not have the liquidity concerns of a name like ABX. Its stated marginal costs for its gold projects are around $900/oz, and 2/3 of its sales are in the U.S. or Australia/New Zealand, stable, high quality mines. I anticipate that it will still have trouble producing a profit below $1100/oz in gold, but its asset base is much better than its peers. If I were an investor at this point, I would prefer to see it conserve cash and cut its dividend as a conservative business decision. A 5% dividend on a stock that’s moving 5% per day is not exactly the main attraction.
The real risk in the sector lies with those companies that have near-term liquidity risk as gold prices decline. ABX is one such large cap name, but many of the small cap names (and the majority of the names in the GDXJ ETF) are of that nature. If gold prices stay here, many will go out of business.
Not all precious metals miners are created equal. Among the big three, GG and NEM both look investable, particularly if gold prices do actually turn higher, but even if they just stabilize and don’t go lower. I am not sure if that happens or not, but for a short-term trade, they might be of interest as trading vehicles.
We are not doing anything here, but a couple potential trades we looked at in GG and NEM:
GG: Buy the Aug 24/29/34 Call Butterfly for $1.35. This trade plays for a short-term bounce that stalls at prior resistance around 29-30. It’s cheaper than simply buying a call spread outright, since implied volatility is high.
NEM: Buy the Dec 28/38/48 Call Butterfly for $2.75. This is a bit more premium outlay for a longer-dated trade, and it targets NEM’s range for most of the past 9 months. The ideal scenario for this trade would likely be that we saw the low in gold for the year, and it consolidates between $1250 and $1500 per ounce for the balance of the year.