SBSW - DRDGold: Strong Upside Potential Awaits Bullish Gold

2023-11-15 22:37:11 ET

Summary

• DRDGOLD Limited stock is re-assigned a Buy rating, with retail investors well positioned to benefit from the expected recovery in the price of gold.
• The correlation between the gold price and DRD's share price is positive, and DRD shareholders will be happy again as sentiment towards gold is on its way to turning strongly.
• The Company offers retail investors the opportunity to benefit from the increase in the price of gold without having to invest directly in the physical metal.

A Buy Rating for DRDGOLD Limited

The stock of DRDGOLD Limited (DRD), a Johannesburg-based processor of surface gold tailings in South Africa, is once again assigned a Buy rating.

Previous analysis suggested that this stock, whose revenue and profitability are very sensitive to the gold price, had its retail investors well positioned to benefit from yellow metal's bull market in the form of a higher share price for DRD. The article also recommended waiting to implement the Buy recommendation, as it was believed that there was a good chance of lower valuations relative to the growth prospects. The Federal Reserve's continued hawkish stance would have created sufficient downward pressure on gold and DRD as increased interest rates do not bode well for investments in precious metals. In fact, the Fed's "higher-for-longer" stance on rates has made DRD's stock price more attractive now than it was a few months ago.

Gold Price Outlook

Meanwhile, conditions developed more in favor of bullish sentiment around gold: Persistently increased interest rates coupled with still-high core inflation have given further impetus to the start of the bullish catalyst for the price of gold and gold-backed securities, including DRD shares. Both household and corporate spending are slowing due to expensive shopping at stores and the costly procurement of raw materials. Taking out a loan is also very difficult because the costs are becoming increasingly prohibitive. These factors weaken key components of the Gross Domestic Product ((GDP)), consumption and business investment, paving the way for an economic recession. For the economists mentioned in this article , the US economy will experience a recession as early as 2024. Gold could well serve as a safe haven against the negative consequences of the recession. As investors realize they can take advantage of these special properties of gold, demand for hedging purposes is likely to be robust, which could result in strong upward pressure on the price of the precious metal and, in turn, higher prices for DRD shares.

DRDGOLD Limited Appears to Offer Good Exposure to Gold

This analysis still assumes that the retail investor could make a good profit if the price of gold rises in line with forecasters' predictions.

As the yellow area in the bottom section of the chart below shows, there is a strong positive correlation between gold prices - here measured by gold futures - and DRD's share price. This means that DRD stock will most likely behave in line with gold, not to mention what could happen to this stock if sentiment towards gold turns completely bullish.

The correlation is positive and strong as in the past 5 years the yellow area was almost always in the positive part of the chart. Readers may be confused as there is a difference in growth rate between DRD+276.4% and gold futures+38.4% over the past five years, leading to doubts about the relationship between the two assets. There is no need for confusion here: the positive correlation does not mean that the two securities have equal or similar returns, but that they tend to move in the same direction. With analysts at Trading Economics forecasting an increase in the physical gold price from the current $1,955.9 per ounce to $2,023.95 per ounce in 12 months, we will most likely see DRD shares rise from current levels and gain in value. The stark difference in performance likely has to do with the fact that DRD was able to recover faster than gold futures in a bullish mood for the commodity or fell less than gold in a bearish mood.

This analysis directly correlated DRD stock price with the price of futures contracts to get an idea of how much DRD stock could rise if the price of an ounce of gold were to increase as expected. From a linear model that combines the last 52 weekly returns of gold futures as input with the last 52 weekly returns of the DRD stock price as the output, the average change in the DRD stock price is 2.7 times greater than the change in gold prices, which is certainly tempting given the rosy expectations for the gold price. The model also says that 44% of the stock price change is driven by gold futures, which is therefore an acceptable representation of the possible cause-and-effect relationship between the two securities.

The relationship has been examined over the last 52 weeks and no longer before, as macroeconomic and geopolitical factors that have influenced the markets over the past year will in most cases continue to determine the good and bad weather in the markets in the near term.

The Risk of Investing in DRDGOLD Limited

Many would argue at this point in the article why one should not invest directly in the physical metal instead of participating in the uptrend through DRD shares. The most immediate reason for retail investors not to invest directly in the commodity is that there is usually not enough capital available to cover the costs of such an investment. The retail investor is not a large investor or an institutional investor who, on the contrary, has the ability to handle disproportionately large amounts of money.

Therefore, DRD shares offer retail investors the opportunity to participate in the gold market without holding gold, but rather shares of US-listed stocks of gold exploration and mining companies. Perhaps the downside to pursuing this goal through DRD is that due to the small volumes of shares traded in the market, the retail investor must be careful not to take too large a position if he does not plan to be a shareholder for a long time. Too many shares in the portfolio coupled with low trading volume creates the risk of loss if the position needs to be liquidated or reduced quickly.

DRD has 86.07 million shares outstanding, of which there are approximately 413.79 million shares outstanding in float and 14.68% of the float is owned by institutions. If the reader scrolls down this page of Seeking Alpha, he will notice that the average volume over the past three months has been low, with only 224,110 shares traded on the NYSE market.

The major shareholders of DRDGOLD include Sibanye Stillwater Limited ( SBSW ) with a 50.1% stake and The Bank of New York Mellon Corporation ( BK ) with a 27.3% stake.

DRDGOLD Limited for the Buy-and-Hold Approach

However, apart from the next projected sharp rise in the price of gold, which, as already explained, could be exploited by the DRD stock, this stock has performed very well in the portfolios of retail investors under the implementation of a "Buy-and-Hold" strategy.

In fact, the DRD stock price has risen more than 275% over the past five years, while the S&P 500 Index ( SPX ), the benchmark for the entire US stock market, has gained significantly less, returning a margin of 64%, as of this writing.

The stock has been able to mimic physical bullion's sharp rise over the past five years from $1,200/ounce 5 years ago to just under $2,000/ounce currently.

Similar to gold, which does not produce any income, the return from investing in DRD stock consists primarily of the share price appreciation over time.

The stock pays a dividend in two semi-annual installments, which in 2023 were $0.341 per share on September 28 and $0.110 per share on March 23, leading to a forward dividend yield of 5.45% as of this writing.

Typically, the investor does not hold the stock for the dividend; Although the payout can currently benefit from a solid balance sheet, it remains exposed to the volatility of the gold price and is therefore extremely variable in its amount.

DRD stock has been paying dividends since 2006, but not continuously as there have been significant interruptions over time.

Among other things, the amounts do not even come close to the amounts paid by regular dividend payers on the market whose mature businesses have been around for decades.

In order for retail investors to continue to benefit from a long position in DRD shares, they essentially need two things: 1) that the price of gold continues to rise over time, including cyclical fluctuations that are normal in the volatile precious metals market, but nevertheless continues to increase in value. 2) that the company can continue its activity as a gold producer and specialist in the recovery of metal residues from tailings reprocessing, thereby providing investors with a viable solution to benefit from changes in gold prices.

Based on the inputs from the current global macroeconomic and geopolitical situation, one could also conclude that gold prices have a very promising future. In an environment that appears to be increasingly turbulent, with monetary and government policies trying to offset the consequences of risky geopolitical decisions, financial markets are where such events typically lead to increased volatility.

For investors interested in the certainty of the returns that a portfolio of assets can generate over time, volatility is a hindrance. To brace for the challenges of the uncertain environment, investors will increasingly rely on the hedging properties of physical gold. The strong demand for gold for investment purposes will create a very favorable ecosystem in which the price per ounce can flourish.

DRDGOLD: Many Years of Gold Production Ahead

DRDGOLD Limited's operations are located in the Gauteng Province of South Africa and are divided into two main business segments: the Far West Gold Recoveries [FWGR] segment and the Ergo segment.

DRD recovers gold from the reprocessing of waste materials from previous metal production activities. These mineral activities have an estimated operational life until 2042 for FWGR and 2041 for Ergo.

At FWGR, workers are engaged in recovering the yellow metal from the treatment of old slime dams in the West Rand goldfields near the town of Carletonville. The asset is estimated to have 2.46 million ounces of gold stored in surface gold reprocessing operations and classified as Mineral Reserves. Two facilities (Driefontein Plant 2 and Driefontein Plant 4) process 1.1 million tons of material per month.

From the reclamation site or landfill, the recycled slurry is milled and then leached, removing 9 tons of gold-bearing carbon daily and sending it in packages to the next phase of elution, electrowinning, and smelting.

At Ergo Business, workers are processing old slime dams and sand dumps south of Johannesburg's central business district and the East and Central Rand goldfields. The asset is estimated to have 3.58 million ounces of gold stored in surface gold reprocessing operations and classified as Mineral Reserves. Two processing plants (the Ergo and Knights processing plants) process 1.8 million tons of material per month. The slurry is worked using sieving, cyclones, grinding, and CIL technology.

Although the two segments sold less gold in FY2023 (ended June 30, 2023), volumes fell 15% year-on-year to 1,337 kg for FWGR and 5% year-on-year to 3,936 kg for ERG, a higher gold price solved the problems for DRDGOLD Limited. As a result of a 16% increase in the price of gold in South African Rand terms, the company reported a 7% increase in revenue to 5,496.3 million South African Rand (approximately US$293.34 million).

Despite inflationary pressures, the activities generated a strong operating cash flow. This enabled the company to find resources for 1,172.2 million South African Rand (or US$62.6 million) in Capex financing 90% of the continued development of the projects in line with growth plans, including: 1) the replacement of the Driefontein 5 reclamation site (as it is close to reaching the end of its lifespan) with 9-year lifespan Driefontein 3 dump at FWGR. 2) the expansion of the waste storage capacity (TSF) at both Ergo and FWGR and the modernization of the electricity infrastructure. 3) the construction of the 60 MW solar project at Ergo, which is nearing completion, including the installation of 160 MWh of power storage.

Recently, the company has given a significant boost to its future operations and also managed to find the means to pay dividends of 515.3 million South African Rand (approximately US$27.5 million) and maintain its financial stability, which is characterized as follows: The balance sheet was unencumbered by debt, while cash balances, including short-term investments, amounted to 2,471.4 million South African Rand as of June 30, 2023, up from 2,392.2 million South African Rand at the end of 2022.

In regard to cash and cash equivalents without short-term investments, the company provided an update in October in which it estimated that the item would amount to 1,498.3 million South African rands as of Q3 of 2023 .

The balance sheet has an Altman Z-Score of 5.44 (scroll down to the "Risk" section of this page on Seeking Alpha), meaning there is currently no likelihood that the company is at risk of bankruptcy in the next few years.

Regarding gold activity, in Q3-2023 production and sales volume were 1,284 kg and 1,267 kg, respectively. Supported by a continued positive trend in tonnage throughput, both production and sales volumes are on track to approach the fiscal 2023 quarterly average of approximately 1,318 to 1,321 kg.

As the Fed's hawkish stance continues to slow the rapid rise in prices of goods and services, the inflationary pressures that have been adding to cash operating costs will ease. This factor will overlap with encouraging trends in tonnage throughput and expectations of higher gold prices.

The combination should help release pent-up adjusted EBITDA (down 18% y-o-y to 365.8 million South African rand in Q3 2023), which would provide strong upside potential for DRD shares as profitability is one of the key drivers of the share price.

Stock Valuation: the Lower, the Better

Shares of DRDGOLD Limited were trading at $8.78 apiece as of this writing, giving it a market cap of $717.82 million and a 52-week range of $5.97 to $13.85.

Given the strong upside potential outlined in this analysis, DRD shares aren't expensive at all: They are trading below the 200 and 50-day moving averages of $9.78 and $8.84 respectively, providing the retail investor with the opportunity to earn a good margin of return if all catalysts work in his favor.

Stock prices are now trading above mid-March 2023 levels that preceded the gold bull market sparked by the metal as a safe-haven asset against the U.S. regional banking crisis. If shares of DRD could be purchased after a significant decline in price, the investor would be much better positioned and have a greater chance of benefiting from the expected gold price rally amid recessionary winds. But after Fed Chair Jerome Powell's speech in Washington last week on November 9, there is now solid potential for a decline to mid-March levels.

The Fed chairman did not rule out another rate hike, as it still cannot be assumed that the tightening has reached a sufficiently restrictive level to bring core inflation back to the 2% target as quickly as possible.

There could be another rate hike in early 2024 as the Fed may need to send another recession signal to accelerate the decline in inflation and offset the possible revival in consumption during the December shopping season.

The rate hike bodes ill for the gold price and could temporarily cause shares of DRD to pull back to lower levels, while the 14-day RSI of 50.29 indicates there is enough downside room if shares want to.

Thus, the retail investor may want to wait until more attractive entry points emerge before acting on a Buy recommendation.

Conclusion

DRDGOLD Limited recovers gold from the treatment of surface tailings in Gauteng Province, South Africa. The stock price will continue to benefit from its strong and positive correlation with gold prices as long as these are bullish.

In addition to the projected bull market in gold prices, DRDGOLD Limited should benefit from other catalysts for higher stock prices, such as positive trends in tonnage throughput and easing inflation pressures as the Fed's hawkish stance impacts the economy.

DRD is a Buy, but if the Fed raises rates again, shares could reach more attractive levels.

For further details see: