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https://seekingalpha.com/article/4671302-gdx-more-pain-in-store-for-beaten-down-gold-miners
GDX: More Pain In Store For Beaten Down Gold Miners
Feb. 18, 2024 11:25 PM ETVanEck Gold Miners ETF (GDX)NEM, GOLD, RING, ABX:CA, NGT:CA38 Comments
Stuart Allsopp profile picture
Stuart Allsopp
6.07K Followers
Summary
VanEck Gold Miners ETF is trading at multi-year lows relative to gold, but this merely reflects the ongoing deterioration in the sector's fundamentals.
Declining profits and free cash flows, along with deteriorating balance sheets, are contributing to the sector's challenges, with dividends set to be slashed.
Weak fundamentals leave gold miners highly susceptible to falling gold prices, with previous cash crunches resulting in the GDX trading below book value, which is still 30% below current valuations.
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SeventyFour
The VanEck Gold Miners ETF (NYSEARCA:GDX) is trading at multi-year lows relative to gold, but there may still be pain ahead for the sector as free cash flows remain under pressure and balance sheets continue to deteriorate. Since my last update on the ETF in June last year, the slight increase in gold prices has failed to arrest the ongoing decline in profits and free cash flows, and the market remains highly susceptible to a crisis of confidence. The latest decline in gold prices amid fading hopes of early rate cuts is a warning sign for GDX investors, and a further decline in the metal could easily result in a 30% decline in the ETF.
The GDX ETF
The GDX is the largest gold mining ETF, tracking the performance of the NYSE Arca Gold Mining Index. Newmont (NEM) has the largest weighting on the index which has risen to 13.2% from 10.2% in June despite its underperformance since then as share issuance has risen. Barrick Gold (GOLD), the second-largest stock, has seen its weighting remain broadly unchanged at 8.8%. GDX's main competitor in the large-cap gold space is the iShares MSCI Global Gold Miners ETF (RING), with the main difference being the latter's higher concentration of NEM and GOLD, which make up a combined 32% of the index vs. 23 for GDX. This comes at the expense of a slightly higher expense fee, which is 0.51% for the GDX versus 0.39% for RING. It also results in the GDX having a lower dividend yield of 1.8% versus 2.3% as NEM offers a significantly higher yield than the other stocks in the index, with a 4.8% yield. As explained below, dividend payouts look set to fall significantly over the coming months.
Price Declines Reflect Ongoing Fundamental Deterioration
After continuing to decline despite robust gold prices, one might expect the GDX to be trading at discounted valuations, but the sector still cannot seem to translate high gold prices into sales, earnings and free cash flows. The chart below shows the gold price alongside various sales and earnings estimates rebased to three years ago. The most concerning is the ongoing decline in free cash flows, which have fallen over 80% over this period. As a result, the GDX trades at 58x forward free cash flow estimates.
Chart
Gold Price Vs GDX Sales And Earnings (Bloomberg)
Forward free cash flows are now below trailing dividend payments, which makes further dividend cuts all but certain. They have already declined by 14% on a per-share basis since their peak in early 2022, and it would not be surprising to see a repeat of the aggressive cuts seen during the 2013-2016 period as management looks to shore up balance sheets once again in response to declining net cash positions. The index's net cash position has been in decline since 2021, with debt once again rising and cash and short-term investments in decline.
Chart
GDX Dividends Per Share And FCF Per Share (Bloomberg)
A Fall To Book Value Would Require A 30% Decline
If gold miners have performed poorly in a gold bull market, it is worth thinking about what could be in store if gold prices undergo a meaningful correction. The increasingly precarious cash positions in the gold mining sector could cause panic selling in the GDX in response to a drop in gold, as we have seen on previous occasions, most notably in 2008 and 2013. During these gold price declines, the GDX price to book value briefly traded below 1x as investor focus shifted from return on capital to return on capital. From 1.4x at present, a decline in book value would result in a loss of almost 30%.
Chart
GDX PB Ratio Vs Free Cash Flows (Bloomberg)
Upside Risks Cannot Be Ignored, But Gold Would Need To Move Much Higher
The main risk to my bearish thesis comes from renewed upside momentum in gold. Despite the GDX's long-term underperformance, it still has a track record of outperforming gold during periods of strong gold price gains. If gold were to rise by 10% and this translated directly into a 10% increase in sales, at current margins, free cash flows would triple, bringing the free cash flow yield back up to 6%, which is where it was at the 2021 peak. That said, such a move in gold prices at current high real interest rates is highly unlikely, and even if it were to occur we would also likely see mining sector costs rise. On balance, the risks remain heavily skewed to the downside.
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