Interactive Investor

Stockwatch: Well-positioned for gold rush

12th April 2016 11:14

Edmond Jackson from interactive investor

Should you consider gold miners? Warren Buffett has nothing to do with the yellow metal, saying its price vagaries are speculative and mining stocks offer no margin of safety. But a sea-change in sentiment may indeed be underway, with gold attracting buyers amid desperation at deciphering the global economy.

It has only needed a marginal change in behaviour - employing gold as a portfolio hedge - for its price to rise nearly 17% this year. Initially, that looks like missing the boat, and gold mining equities have risen sharply, too, but what really counts is whether gold has definitively ended a five-year bear market.

If it can consolidate to hold above $1,200/ounce (£850) like it is doing, this level is seen as defining a new bull market, in which case you are better off owning mining equities than the precious metal. This is because miners offer leverage to commodity prices, i.e. a modest rise in physical gold above production costs means a larger jump in operating cash flows.

Attempting to price prospects in

Naturally, price/earnings (PE) multiples have risen in anticipation. In the FTSE 100 there is £6.2 billion Randgold Resources on 40 times expected earnings and yielding only 0.75% - it's also a potential target for short-sellers if gold drops back, since it is a liquid (besides highly-priced) stock. Its price has soared from 4,188p to 6,655p this year. At the other end of the market is £1.5 million AIM-listed Greatland Gold - loss-making, yet still enjoying a fillip from 0.06p to 0.2p.

A median approach is to consider £1.2 billion mid-cap Centamin, which, at 100p, trades on about 19 times expected earnings and yields just over 1.5%. The table also shows good strength in net tangible assets per share, over 70p, which may help limit downside.

Appreciate the inherent speculation here: you are largely taking a view on gold prices in the hope forecasts will revise upwards.

Just one risk is gold tending to trade inversely with the US dollar. Recently, the Federal Reserve has deferred another interest rate rise, which has weakened the dollar, but if a tight US jobs market creates an inflationary spike, then this might involve the shock of a sudden rate rise, i.e. the dollar trending back up.

A strong dollar in recent years partly explains the bear market in gold. Or, faced with such a quandary, the crowd-preference for gold may yet stay intact.

Centamin development coincides with higher gold prices

The essential case for this stock is its key mining operation moving from a phase of capital investment to generating cash, perfectly timed for gold prices trending higher - a potential "double whammy" of top-down and bottom-up drivers.

Centamin's principal asset is Sukari, Egypt's first "modern mine", which started production in 2009 and shows consistent progress towards an annualised production rate of 450,000 to 500,000 ounces with an estimated 20-year mine life.

A latest production update for first-quarter 2016 shows total gold production of 125,268 ounces, a 6.5% increase on the previous quarter and 15.7% up on first-quarter 2015. Full-year guidance of 470,000 ounces is maintained, as "continued optimisation of the expanded Sukari processing and mining operations supports the potential for further productivity increases over the coming quarters".

Be aware: this is Centamin's only producing asset, despite exploration also in West Africa. Reflecting classic mining risks and the Arab Spring, revolutionary spirit was a likely motivator for an Egyptian court annulling Centamin's licence in October 2012.

When gold surprised on the upside this year, it changed perception radically and re-rated producersThe stock plunged below 30p later that year, when operations were suspended amid a payment dispute, although this was significantly resolved within a week. The company's website still makes investors aware of an ongoing court case, apparently with a political agenda, with management confident of a ruling in its favour. Challenges to foreign ownership are one reason why mining stocks are perennially high-risk.

Meanwhile, investors are shrugging this off to focus on Centamin's strong cash flow profile, as portrayed in the 2015 annual report and a recent investor presentation, worth digesting.

The cash flow statement on page 113 of the annual report shows net cash from operations up nearly 60% to $185.5 million (£129.6 million), which amply covered $70.7 million investment activities and $33.8 million distributed via dividends. The presentation cites a total $231 million cash and liquid assets at end-2015.

While plenty of other miners are over-indebted, Centamin has no borrowings, so is further positioned to increase shareholder returns. No capital expenditure for expansion is planned this year and the aim is to distribute 15-30% of free cash flow to shareholders. The board can, therefore, justifiably boast "an industry-leading dividend", which ought to have better growth prospects than forecasts in the table.

Note, however, that the profits trend up to 2015 moving negatively versus turnover, which is not all weak gold prices. The fall in operating margin from 57.3% to 12.7% also reflects rising industry costs (see note 6 on page 125 of the annual report), a factor that became well-reflected in mining equity valuations by the end of 2015.

So, when gold surprised on the upside this year and oil bounced strongly from last February lows, it has changed perception radically and re-rated producers especially.

Extent of any near-term gold correction is key

Centamin's five-year chart shows its current price of 100p - up over 60% this year - yet to regain levels of up to 155p in 2011, although earnings per share then was nearly twice what is forecast now.

Also, Company REFS shows the annual average PE multiple in mid-single figures from 2012-14 and 13 times last year, so, in simple valuation context, the rise to 100p looks high enough.

But with gold around $1,250/ounce, the extent of correction will show how robust the new trend is. If a genuine bull market is taking shape, then Centamin is well-positioned to capture it. On this basis, the Centamin shares offer useful risk/reward as part of a diversified portfolio.

For more information see their website.

Centamin - financial summaryConsensus estimates
year ended 31 Dec2011201220132014201520162017
Turnover (£ million)219262306304343  
IFRS3 pre-tax profit (£m)12512211252.439.4  
Normalised pre-tax profit (£m)12712311754.643.760.1114
Operating margin (%)57.346.638.417.912.7  
IFRS3 earnings/share (p)11.511.210.24.63  
Normalised earnings/share (p)11.711.310.64.83.45.16
Earnings per share growth (%)198-3.3-5.6-55.3-29.451.417.4
Price/earnings multiple (x)    29.819.716.8
Cash flow/share (p)9.212.513.76.611  
Capex/share (p)6.913.415.754.2  
Dividends per share (p)   0.51.91.81.1
Yield (%)    1.91.81.1
Covered by earnings (x)   8.61.72.95.6
Net tangible assets per share (p)4854.463.567.470.4  
Source: Company REFS

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