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Gold is currently hovering around 6.5 month highs, as the disappointing U.S. job growth data, released on Friday, increased speculation that the Federal Reserve will announce another round of quantitative easing (QE3) at this week's policy meeting. This ease in the monetary policy will be a gateway for augmenting inflation, leading to an increase in the demand for gold, which is looked upon as an inflation hedge. We recommend investors to increase holdings in physical bullion and/or SPDR Gold Trust ETF (NYSEARCA:GLD) as we expect gold prices to trade even higher. However, since gold has already surged a lot, we see that the upside is limited relative to gold equities, which are currently trading at cheap valuations and are offering handsome dividend yields and sufficient capital gains. Yamana Gold Inc. (NYSE:AUY) remains our favorite gold player, while we are also bullish on Barrick Gold Corporation (NYSE:ABX) and Goldcorp Inc. (NYSE:GG).

Yamana Gold Inc.

In our previous article, we recommended a long position in Yamana Gold Inc. due to its lucrative growth prospects, inexpensive valuations, and sustainable dividend yield. The company's C1 Santa Cruz and Ernesto/Pau-a-Pique mines in Brazil are set for first gold pour in 4Q2012 and commercial production by mid-2013. The company has also announced an 18% QoQ (and 117% YoY) increase in quarterly dividends, which also adds to our bullish thesis on the stock. Once these new mines start production, we expect further dividend increase(s) given the company's recent history of increasing dividends once it realizes new levels of sustainable cash flows.

Barrick Gold Corporation

Barrick is the world's largest gold producer and engages in the production of copper and silver as well. According to its 2Q2012 report, the company has adopted "a renewed focus on maximizing shareholder value through a disciplined capital allocation program, which includes optimizing Barrick's portfolio of assets and maximizing returns on investment and free cash flow".

Barrick's new Pueblo Viejo mine in Dominian Republic has achieved first gold production last month and the commercial production is expected in the fourth quarter of 2012. The company has also begun preliminary talks regarding the sale of its majority stake in African Barrick Gold plc, although no conclusion has been reached till yet.

The company's Pascua-Lama project has already experienced persistent inflationary and other cost pressures, and lower than expected productivity. A more detailed update on its budget and schedule is expected in Q3, which might act as a negative catalyst if the project continues to pose similar problems. As a result, we are cautious on the stock in the near-term. However, it can be a good value play for long-term investors.

Goldcorp Inc.

This Vancouver-based company is one of the world's fastest growing senior gold producers. The company's financial position is strong, as GG has cash and cash equivalents of $1.2 billion, and an undrawn credit facility of $2 billion, while its convertible senior notes (which are due in 2014) amount to $862.5 million.

Upcoming catalysts in Q3 include an update on the Cochenour project in the Red Lake district (whose production is scheduled to start by 2014) and results of the Camino Rojo feasibility study.

Valuation

The following table is a summary of the important valuation metrics for gold companies. The figures for price per adjusted operating cash flows (P/OCFa) are taken from Credit Suisse (NYSE:CS) estimates. The valuations reflect that GG is the most expensive, while ABX is the cheapest of the lot.

ABX

AUY

GG

Forward P/E (1 year)

8.21

12.74

15.36

P/OCFa (FY2012)

11.9x

14.1x

21.0x

Share price performance

-11.25%

21.37%

-2.81%

Dividend Yield (%)

2.0%

1.5%

1.3%

Source: Yahoo Finance, Credit Suisse estimates, and Google Finance

The following table provides Credit Suisse's target prices for each of these three companies, using:

(1) Adjusted operating cash flows (reflecting short-term returns for near-term investors), and

(2) Conventional NAV (reflecting long-term growth prospects).

Then, a single target price is calculated giving equal weight to each of these two valuation techniques. Lastly, the values are compared with the current prevailing prices, so as to reflect the available further upside.

ABX

AUY

GG

OCFa-based TP (A)

56

26

47

NAV-based TP (B)

35

21

46

Weighted Average TP (50% of A + 50% of B)

45.5

23.5

46.5

Current share price

40.16

17.83

43

Expected Upside

13%

32%

8%

Source: Credit Suisse, Qineqt's calculations

AUY remains our favorite player due to the above-mentioned reasons, along with the fact that it is leading to the maximum upside. ABX and GG are other potential buys in a decreasing order of preference.

Source: 3 Gold Stocks To Buy For A Big Upside