RING - GDX: Dividends Could Be At Risk

Summary

• Despite a 15% decline from its January peak, the GDX is by no means cheap, with a PE ratio of 28x and a price-to-free cash flow ratio of 38x.
• Even at current gold prices, miners are barely able to generate enough free cash flow to raise their dividends, and recent gold price declines suggest dividends will likely be cut.
• Furthermore, based on the historical correlation between inflation-adjusted gold prices and 10-year US TIPS yields, gold should be trading below $1,500, which could pose a major risk to the GDX.

The VanEck Vectors Gold Miners ETF ( GDX ) is by no means cheap despite a 15% decline from its January peak when I shifted to a bearish stance on the sector (see ' GDX: Don't Get Greedy ' and ' RING: A Risky Bet Despite High Gold Prices '). In fact, the fall in gold prices seen over the past few weeks has left the GDX as overvalued as it was at its recent peak as earnings are likely to decline over the coming months. The price-to-earnings ratio on the underlying NYSE Arca Gold Mining Index is a lofty 28x, while the price-to-free cash flow ratio is 38x. In the absence of a surge in gold prices miners are unlikely to be able to generate enough free cash flow to grow dividends over the coming years in my view, which may even be set to contract.

The GDX ETF

VanEck Vectors Gold Miners ETF is the oldest, largest, and most liquid gold mining ETF which tracks the performance of the NYSE Arca Gold Mining Index. Newmont ( NEM ) has the largest weighting on the index at 13%, followed by Barrick Gold ( GOLD ) which has a 10% weighting. The GDX is more diversified than the iShares MSCI Global Gold Miners ETF ( RING ) where these two stocks comprise 19% and 15% respectively. This comes at the expense of a slightly higher expense ratio of 0.52% versus RING's 0.39%. Despite rising dividend payments across the sector, the GDX only offers a 1.7% dividend yield, compared to 2.4% on the underlying index.

Earnings And Free Cash Flow Weakness Point To Dividend Cuts

Despite gold prices remaining just 10% from their all-time highs, gold mining companies still cannot generate significant earnings. On a per share basis, adjusted earnings are still a shocking 65% lower than their 2012 peak. Furthermore, when we add in the impact of so-called one-off losses, EPS falls further, putting the true price-to-earnings ratio at almost 28x.

The weak earnings performance is also reflected in free cash flows. Free cash flows over the past 12 months have been even lower than unadjusted earnings and as a result the price-to-free cash flow ratio sits at 38x. Mining companies are now paying out the same amount in dividends as they generate in free cash flows even at near record gold prices. In the absence of a surge in gold prices, I believe miners are likely to be forced to pare back their aggressive dividend increases seen over the past five years. The current dividend yield on the NYSE Arca Gold Mining Index of 2.4% faces significant downside risks, and is already far below the yield on US Treasuries.

Gold Prices Face Further Downside

The prospect of an upside reversal in gold prices that would be needed to justify the current price of the GDX are bleak. As I argued recently in ' Gold's Bearish Reversal Maybe Just Beginning ', gold prices continue to look expensive relative to the picture painted by US inflation-linked bond yields. As the chart below shows, based on the historical correlation between inflation-adjusted gold prices and 10-year US TIPS yields, gold should be trading below $1,500.

This is not to say that gold is heading down a further 20%, but it is a key risk to keep in mind and suggests we would likely need to see a dramatic downside reversal in US real bond yields in order for gold prices to rise and support the GDX. I actually see such a reversal as likely over the next 12 months, but much prefer to be invested in inflation-linked bonds themselves, which offer a much more favorable risk-reward profile.

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