Improving Gold Equity Outlook May Trigger Dividend Revaluations

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Includes: ABX, AEM, AU, AUY, EGO, G, GDX, GFI, GG, GLD, GLDX, GOLD, HMY, IAG, KGC, NCMGY, NEM
by: Tim Wood

Gold equity investors have been cheered by recent company promises to improve dividends. The pledges have been underwritten by thickening margins, especially over the last 18 months, as gold prices outpaced input costs for the first time in several years.

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Being in the business of literally pulling cash out of the ground means that precious metal miners must pay higher and high dividends to maintain their claim as an option on bullion prices that is more attractive than merely physical gold.

To halt the filching of market share by exchange-traded gold, equities have no option but to return to an era of princely dividends; one reminiscent of what South African gold stocks yielded in the 1970s.

There is evidence that the new mood on dividends is no mere flash in the pan. We foresee precious metal dividends becoming this decade’s equivalent of last decade’s anti-hedging movement as investors eschew risk and financial engineering.

$2 billion in 2011?

The only large producer that has not followed the trend to restore dividend yields is Randgold Resources (NASDAQ:GOLD), which has yet to announce a dividend this year. It may not provide a dividend at all as it deals with operational setbacks and because of the demanding schedule to bring its joint venture Kibali project to account.

Apart from Randgold's relatively small increase of 18% to $0.20 per share, it has been a bumper dividend season that could see the leading gold producers - who mine at least 400,000 ounces per year - pay out a record $2 billion in cash dividends to investors for 2011. MineFund is forecasting payouts totalling at least $1.7 bn this year.

The top gold companies paid out $1.45 bn in 2010, up from $1.05 bn in 2009 and $937 million in 2008. The growth in dividends should be placed in the context of payouts topping $800 million as far back as 2003 when gold prices were a thousand dollars an ounce lower than they are today.

The ground for higher dividends is also being prepared by expanding output.

Absent mergers and acquisitions, we expect the 13 members of the MineFund Gold Equity Index to expand output by 3% in 2011. Aggregate gold production is forecast to rise to 35.12 million ounces this year from 34.26 million ounces last year when production grew 7% almost entirely because of acquisitions. Since 2005, production has increased 22%, or 6.3 million ounces.

The high rate of growth reflects the merchant banking bent of the industry. But it has been an expensive fashion because of the excessive dilution suffered by investors.

Fortunately, along with the pledges to improve dividends, there has also been a turn toward arresting the dilution by focusing on stabilizing or increasing gold reserves per share. There is a high correspondence between reserves per share and stock returns for precious metals miners.

One confirmation of the need for higher dividends is the relationship between the amount of production devoted to dividends versus equity leverage to gold prices (see chart above). Note that the trend lines align quite tightly. Combined with the competition from exchange traded gold and self-mutilation through relentless dilution, this provides most of the story behind the persistent relative weakness in gold stocks since 2005. (Click for an interactive version of the GELX.)

It is clear that even though producers have aggressively grown output and enjoyed rising metal prices, dividend payouts have failed to keep pace.

In the early part of last decade it was common for senior gold companies to divert well over 5% of a quarter’s production value for direct wealth transfers to investors. The impact has been masked by headline increases in the amounts paid out thanks to morbidly obese share registers.

Once the preserve of the senior companies, dividends are now a very competitive weapon for the upcoming challengers. Until recently the majors felt comfortable to nibble away at the relative value of dividends, keeping more of the cash within the companies.

As a result, the gap between the leading and following gold producers has narrowed, and is expected to be eliminated by the end of this year. The wild card is AngloGold (NYSE:AU) which, now unburdened from its hedge book, may aggressively raise its payout this year. Even so, the net effect should be minor.

Indeed, without the huge reversal of trend from Goldcorp (NYSE:GG) (see chart below), the senior cohort in 2011 would have been easily bested by the smaller cohort for the first time ever. Goldcorp has firmly recovered the leadership role it once commanded as the best dividend paying gold stock. Overall, the whole group is moving toward a 4% average payout, but should likely pursue 5% to sway investors more firmly.

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Goldcorp’s new dividend policy has been an important factor in driving its recent value gains which has seen it widen its distance from Newmont (NYSE:NEM) and Newcrest (OTCPK:NCMGY), and helping it to start threatening Barrick’s (NYSE:ABX) number one status, albeit with a way to go.

Value Signals

It is notable that the Gold Equity Leverage Index has fallen to its lowest level since the tail-end of the Lehman Brothers blowup. Whilst the index has been useful as an early warning indicator for weaker gold prices, it must be viewed agains investment flows into physical gold products.

Exchange traded gold enjoyed a remarkable 2010. For every $1 increase in the gold price, global gold funds were able to attract an average additional $0.12. By contrast, gold equities suffered, failing to show greater leverage except in one month. Even then it was paltry.

A notable trend change is in process. Having lost ground in February, exchange-traded gold is expected to decline below 1x leverage to the gold price for the first time since December 2009. That is despite record high bullion prices, and a high average price for the year-to-date.

Something is clearly afoot. We can’t be sure, but it does suggest a swap may be in the offing that could favor gold equities. Whatever the case, more needs to be done to confront the challenge posed by exchange-traded gold.

While lower gold prices are an obvious risk, it is also a fact that MineFund’s Gold Equity Index is flashing several value signals. In relative terms stocks are trading at steep discounts. Every single stock in the index has gold reserves that can be bought for less than $600 per ounce (90 day moving average), or less than half their implied reserve value (See table below. Interactive data.)

That is far out of balance when considered against recent transactions that priced reserves at considerably more than $1,000/oz.

The new interest in rewarding investors with dividends may be the catalyst needed too address those discounts. Be sure to shop for gold stocks that have shown a reliable dividend history; one where they have grown the payouts consistently and don’t feel jealous of the money being returned to investors. Click to enlarge:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Note: The previous version of this article incorrectly stated that Randgold had not declared a dividend for 2011. Randgold has declared a dividend: "Following the significant improvement in earnings for the year, the board has proposed to increase the annual dividend by 18% to 20 US cents per share from the 17 US cents per share for the previous year. In line with current best practice, the proposed dividend will be put to shareholders for approval at the AGM, and is expected to be paid by the end of May 2011". MineFund apologizes for the error.