DRD - DRDGold: The Stock Has Upside Potential As Gold Is About To Rally

2023-08-23 07:12:45 ET

Summary

• DRDGOLD Limited stock is recommended as a Buy due to its positive correlation with the expected recovery of gold prices.
• The company's revenues and profitability are highly sensitive to the price of gold, making it well-positioned to benefit from a potential expansion in the price of gold.
• DRD's strong upside potential and current valuations make it an attractive investment opportunity.

A Buy Rating for DRDGOLD Limited

This analysis suggests a Buy rating for the stock in DRDGOLD Limited (DRD), as shares of this Johannesburg-based processor of surface gold tailings in South Africa allow retail investors to be well positioned to benefit from the expected gold price recovery.

DRDGOLD Limited's revenues and profitability are very sensitive to the price of gold, so the South African operator's shares are positively and very strongly correlated to movements in the price of the precious metal.

And that should most likely be reflected in a significant increase in the market value of the stock should gold futures rally, as suggested in this analysis.

Although the share price is off its lows, an investment in DRDGOLD Limited still has the potential to provide the retail investor with a good return provided the precious metal exhibits the expansion that analysts project and this analysis supports.

Gold Price Outlook

Two 25 basis point rate hikes in the May and July sessions, an overall resilient economy despite initial concerns about monetary tightening, and significant progress in the ongoing disinflation process have seen gold retain much of its safe-haven prestige accumulated during the March 2023 regional banking crisis.

From an intraday high of $2,085.40 an ounce on May 4, 2023, following a sharp rise amid concerns over the US banking system, gold futures have given back 7.6% of the gains and are currently trading at $1,926.95 an ounce.

Potentially, another rate hike, as forecast by Minneapolis Federal Reserve Bank President Neel Kashkari last week and Federal Reserve Governor Michelle Bowman earlier this month , could result in further negative pressure on gold prices in the very near term as the inflation is still considered too high by the officials.

After this further possible period of decline due to the increased cost of borrowing, gold should then go through a period of expansion.

For gold prices to bounce back from their downtrend, it will require a greater aversion to riskier assets like US-listed equities, prompting investors to seek the precious metal as a safe haven from headwinds fueling the distrust in the stock market.

There should be a trigger for the dynamics just suggested, and this can be identified in a recession in the business cycle, which many currently believe is out of the question, but which this analysis finds very likely given some of the macroeconomic issues presented here.

First of all, it appears that for some time the economy will continue with the handbrake as the high cost of money, which constrains demand for loan capital, will not abate until the Fed is convinced that there will be no risk of a flare-up of inflation. Minutes from the mid-August meeting show that all participants still view the inflation risk as very high, Trading Economics reports , lending a strong sense that a change in monetary policy will not happen overnight.

Higher interest rates do not bode well for gold, as the precious metal would bear a higher opportunity cost of not holding interest-bearing securities such as bonds in a favorable yield environment. But higher interest rates also increase the likelihood of a recession, because the longer the cost of borrowing remains high, the more growth prospects can be affected. Should a recession wipe out expectations of a soft landing like a bolt from the blue, gold would have an ideal environment that would support its safe-haven qualities far more than the dampening effect that further rate hikes would bring.

However, it should also be noted that gold has developed remarkable resilience against increasingly high-yielding assets as the price per ounce remained well above its 5-year average of $1,695.4/oz. (see the chart from TradingEconomics.com below) for most of the time since the US Fed started raising rates in March 2022.

However, a further rise in interest rates could still result in lower gold price levels (though hardly a significant drop based on the statistics just described), perhaps linked to the possibility of lower spending for the investment in DRDGOLD Limited’s stock.

Keeping the interest rate high for an extended period will dampen consumption.

Consumption accounts for nearly 70% of the US GDP, whose progress has undoubtedly benefited from US household excess savings, but the latter cannot finance consumer spending indefinitely.

According to Reuters.com , U.S. household excess savings totaled $500 billion compared to before the Covid-19 virus pandemic a few months ago. However, it appears that the estimates offer no certainty as to whether US households' excess savings can truly support consumer spending into 2024. In addition to these excess savings that are about to run out, the following three things highlighted by Yahoo Finance also weigh on the outlook for US household spending today: a) the pressure to meet short-term financial commitments, along with rising prices of goods and services, is now becoming an impelling reason for many families to draw on their retirement savings; b) the rapid rise in Medicare drug costs could prompt many US households to make draconian budget allocation decisions; c) Americans' record high credit card debt is a concern for banks given the very uncertain outlook, with banks not ruling out another credit crunch.

The last factor in particular raises concerns about the quality of the US credit rating. According to cnn.com , Fitch has recently downgraded the long-term outlook for US debt, and, reports cnbc.com , appears poised to downgrade the credit ratings of some major US lenders.

The deterioration in the quality of US credit could be a strong signal of a slowdown in the US business cycle, which will not be able to count on support from the Eurozone or China, the two largest trading partners of the US. The Eurozone is struggling with the consequences of the very aggressive monetary policy of the European Central Bank. While China is grappling with the crisis in the real estate sector, reducing hopes of recovery for an economy that was already struggling to gain momentum.

About China's real estate woes, China Evergrande Group ( EGRNF ) — saddled with more than $300 billion in debt — filed for bankruptcy protection in Manhattan's New York court last week, according to Reuters.com .

These are conditions that seem more suited to an economic downturn than a soft landing. Likely, in response to the current situation, analysts at Trading Economics expect the price of gold to increase in the upcoming months and to be around $1,981.33 within a year. At the time of writing, the price was $1,926.95 per ounce.

How DRDGOLD Limited Is Performing

DRDGOLD Limited specializes in the re-treatment of surface gold and its operations are located in the Gauteng province of South Africa.

The company will benefit from the anticipated rise in gold prices by supplying the market with the metal it will produce through its Ergo business segment and the Far West Gold Recoveries [FWGR] business segment.

DRDGOLD Limited is not a pure gold exploration and mining company as its production consists mainly of the recovery of gold from the reprocessing of waste materials from previous metal production activities.

Within the Far West Gold Recoveries [FWGR] business segment, this includes the surface gold reprocessing operation for the treatment of old slime dams in the West Rand goldfields, located near Carletonville in the Gauteng province of South Africa.

The FWGR comprises a 600,000 tons per month processing facility referred to as Driefontein Plant 2 and a 500,000 tons per month tailings storage facility referred to as Driefontein Plant 4. The FWGR is estimated to have approximately 2.46 million ounces of gold in mineral reserves.

This is how FWGR works with its assets. Process water is pumped to the Driefontein 5 reclamation site (which is being replaced by the Driefontein 3 dump with a lifespan of 9 years as Driefontein 5 reaches the end of its lifespan) to form a slurry which is recycled and then flows to a sump where a pumping system pumps the waste [tailings] to the receiving tank at Driefontein Plant 2.

Then the slurry must be classified as slurry going to the mills or thickeners and processed through a cyclone system.

After the slurry has been processed by milling, it is pumped into the carbon-in-leach [CIL] circuit. The slurry is then processed in the CIL circuit, from which 9 tons a day of gold-bearing carbon is removed and packaged for shipment to a facility called Driefontein 1, where the material goes through the stages of elution, electrowinning, and smelting.

Instead, the tailings from the CIL circuit are pumped to a tailings tank and then transferred to the Driefontein 4 tailings storage facility, where a cyclone dam is located and the water from the dam can be reused for recycling activities.

For the year ended June 30, 2023 (the 2023 fiscal year), FWGR's operations benefited only partially from the 16% increase in the price of gold in South African Rand terms. This was due to the fact that the volume sold was significantly lower compared to the previous year (around 15% lower year over year to 1,337 kg) and the combination with the price obtained resulted in a 6% year-on-year decrease in sales to 387.7 million South African rands.

Ergo Business is a surface gold reprocessing operation for the treatment of old slime dams and sand dumps south of Johannesburg's central business district and the East and Central Rand goldfields.

The business segment includes the following assets: the Ergo and Knights processing plants, which have a combined capacity of approximately 1.8 million tons per month. These are fed by The City Deep facility, which acts as a pumping/grinding station, and two reclamation sites. Then there is a tailings storage facility called Brakpan/Withok with a total capacity of 2 million tons per month. Here the treated material that has undergone treatment using sieves, cyclones, milling, and CIL technology is deposited and shared with the Ergo plant. It is estimated that Ergo has mineral reserves of 3.58 million ounces of gold.

Knight's mineral reserves are running out, so the company is evaluating other opportunities to recover materials targeting remnants of historical mining and wetlands.

In fiscal 2023, Ergo reported a 57.3% yoy increase in revenue to 4,108.6 million South African Rand, reflecting a 16% yoy increase in the Rand gold price and a 21% yoy increase in yield to 0.227 grams of gold per ton of material re-processed. However, sales volumes fell 5% year-on-year to 3,936 kg, due to significantly lower throughput as new reclamation sites came online behind schedule.

As such, DRDGOLD Limited reported sales of 5,496.3 million South African Rand (approximately US$293.34 million) for the full fiscal year 2023, up 7% year-on-year, while cash operating expenses increased 6% year-on-year to 3,688.1 million South African Rand (approximately US$196.83 million) due to inflationary pressures.

DRDGOLD estimates that earnings per share will be in the range of 142.5 to 155.7 cents (approximately US$7.61 – US$8.31 cents) per share, up 9% to 19% year-on-year, and headline earnings per share will be in the range of 141.7 to 154.7 cents (approximately US$7.56 – US$ 8.26 cents), which represents an increase of 8 to 18% compared to the previous fiscal year.

As of June 30, 2023, DRDGOLD had 2,471.4 million South African Rand (approximately US$131.9 million) in cash and cash equivalents. In fiscal 2023, the free cash flow generated by operating activities was 468.9 million South African Rand (approximately US$25.03 million) after investing 1,172.2 million South African Rand (approximately US$62.6 million) and paying dividends in the amount of 515.3 million South African rands (approx. US$27.5 million). The balance sheet is not burdened with debt.

On March 23, the company paid a semi-annual dividend of $0.11 per common share, which translates to a forward dividend yield of 2.33% as of this writing.

A Highly Gold Correlated DRDGOLD Stock

Thanks to a business through which DRDGOLD Limited manages to successfully extract gold by processing waste material from previous mineral activities, its stock is strongly identified by the market with the precious metal.

The graph below from Seeking Alpha shows that the yellow area representing the correlation coefficient [“CC”] between DRD and gold futures is almost always above zero, indicating a positive correlation between the two assets, in a very strong way.

Therefore, it can be reasonably expected that the price of DRD shares will move in line with that of gold should the metal see an increase as expected and described in this analysis.

This analysis has also estimated how much the share price could rise if the price of gold rises. A linear model using weekly gold futures returns as input and weekly DRD stock returns as output yields a gold beta of 2.8, and the model was run over the past 52 weeks of returns. This means that the DRD stock price tends to triple the gold price gain and the model has a 50% coefficient of determination, which means that 50% of the change in the DRD stock price could be due to the change in the gold futures price.

The Stock Valuation

Shares of DRDGOLD Limited were trading at $9.56 apiece as of this writing, giving it a market cap of $800.44 million and a 52-week range of $4.66 to $13.85.

Given the strong upside potential already highlighted in this analysis, shares are not expensive at all, trading well below the 100-day and 50-day simple moving averages of $11.02 and $10.72, respectively, while trading close to the 200-day simple moving average of $9.23.

Shares are slightly above the 52-week range median of $9.255.

The current valuations present an interesting opportunity to take a position in this stock and participate in the expected gold price rally.

According to the 14-day relative strength indicator of 39.13, the stock is slowly recovering from an oversold situation, which implies great potential for generating significant returns in the coming months.

As mentioned earlier in this analysis, it is possible that the US Federal Reserve will raise interest rates again in the coming weeks. As higher interest rates do not bode well for the gold price, the dynamics could somewhat hamper the DRD recovery in the very near term.

If the retail investor deems it necessary, he may want to wait for the Fed's interest rate decision first, as there is the opportunity to invest in the DRD's strong upside potential but with a smaller amount of cash.

Conclusion

DRDGOLD Limited operates surface tailings operations in South Africa and recovers gold from surface tailings in Gauteng Province. The company's stock price has a strong and positive correlation with gold. At this point, retail investors might consider gaining exposure to the metal through DRD as there are strong signs that gold prices could rally significantly.

DRDGOLD Limited is increasing its sales and profitability thanks to the gold price, which is expected to remain high for a long time to come. A higher gold price helps to strengthen the financial position of the company, which has no debt and can support the dividend. A sound financial position improves the ability to continue the gold recovery portfolio for a long time and in areas that have been depleted by previous mining as there is also an interest in these areas to reclaim the territory.

DRD is recovering slightly from oversold levels, but if the Fed hikes the rate one more time, shares could hit lower levels again.

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