Russian Gold Producers - A Spot to Hide In

The risk of pronounced global economic weakness extending beyond 1Q20, due, of course, to the coronavirus, along with global central banks' policy easing and vows to respond as needed, has sent the gold price above $1,670/oz. For now, we do not think that investors will be in any rush to sell Russian gold stocks, which continue to benefit from both strong gold prices and a weak ruble and thus look set to outperform the market for some time to come. We have re-run our scenario-based valuation and upgraded our target prices for both stocks by around 30%, to $78.00 per GDR for Polyus and $20.23 per share for Polymetal. As our target prices imply 12-month ETRs of more than 20%, we upgrade both stocks from HOLD to BUY.> The continued spread of the coronavirus beyond China has increased the risks of pronounced global economic weakness, which could potentially extend well beyond 1Q20. The transportation restrictions and quarantines have substantially reduced business activity and have disrupted supply chains, putting production at risk in a number of industries. The Fed's aggressive 50 bp emergency rate cut has seen a mixed reaction. While it has become clear that global policymakers are willing to deliver strong measures to head off an economic downturn, the Fed's aggressive stance also highlights that the scale of the epidemic and its potential consequences could be far worse than might be expected based purely on the new case and death rate statistics. > The yield on the US 10y Treasury continues to fall and has now reached around 0.70%, while the spread between the 2y and 10y notes narrowed 4 bps to 31 bps after having widened significantly over the last two weeks. The market is increasingly pricing in another 50 bp cut at the Fed meeting on March 17-18. The S&P 500 is down 9% since January 20, when the virus was first officially acknowledged by China. The Shanghai Composite is off 2%. Copper (a bellwether for the global economy) is trading 9% lower, while the ruble has weakened to above 68 against the dollar. Last but certainly not least, the gold price has now broken through $1,670/oz. > As the uncertainty over the scale and speed of the spread of the virus persists and whether more monetary stimulus may follow, we think Russian gold producers should continue to benefit from both strong gold prices and a weak ruble, thus making them a safe place to hide. We note that during the 2008 crisis, gold and gold stocks followed stock indexes on the way down. Gold prices fell 25% from peak to trough and Polyus dropped 81% (versus declines of 78% for the RTS and 51% for the S&P 500) as investors liquidated positions and moved into cash. However, gold stocks were among the first to rebound when monetary stimulus was announced in late 2008. Polyus surged more than 60% in January-February 2009, while benchmark equity indexes only really began to recover in March. > As we noted in our recent report, Polyus's investment program for 2020-23 is focused mainly on smaller brownfield projects (increasing BIOX capacity at Olimpiada, mill expansion at Verninskoye, a new mill at Blagodatnoye, etc.) and aims to offset grade declines at key assets and sustain annual production at close to the current 2.8 moz. Meanwhile, Polymetal should deliver decent production growth over 2020-23 thanks to the launch of Nezhda and POX-2 in 2021-23. It guides production to grow at a 5% CAGR over the period and reach 1.85 moz GE in 2023. However, Polyus has a much better long-term growth profile thanks to the planned launch of Sukhoi Log in 2027. We project a 2020E-27E production CAGR of 8% versus just 2% for Polymetal, even including its potential growth projects, Veduga and Prognoz.> We have updated our capex projections for both companies. Polyus recently increased its 2020 guidance by 25-35% to account for newly approved projects and capex rolled over from 2019, when it spent 15% less than initially guided. Polymetal, on the other hand, spent 15% more than guided in 2019 and has increased its 2020 guidance by around 18% from the level voiced at the beginning of last year. Polymetal's growing capex has been driven by higher pre-stripping expenses at Nezhda. Total capex at Nezhda over 2019-21 is now guided to be 42% higher than initially planned in 2018. Polymetal's current investment program does not yet include the development of Tomtor, a rare earth project controlled by Polymetal's largest shareholder, ICT Group. Polymetal is going to acquire a small stake in this project in 1H20 in a cash-in deal to fund the pre-feasibility study. At this point, we think that it could require some three years to bring the project to the investment decision. On the recent earnings call, the very preliminary startup date was guided as 2026. > As for potential share placements, Polyus still plans to increase its free float from the current 20.6% to 25-30%, though the timing is unclear. For Polymetal, Alexander and Nikolai Mamut sold significant portions of their stakes last year and have both fallen below 3% ownership (from a combined 9.5% stake as of end-2018), which is below the reporting threshold. PPF sold half of its stake in Polymetal last year and now holds a 6.5% stake. It has decided not to nominate a candidate for the BoD this year. We think this suggests that the stake may be for sale. Otkritie holds a 6.9% stake in Polymetal and has never had a BoD seat (though it nominated a candidate last year who was not elected).> In our story in the January 28 equity daily, we pointed out that gold stocks may tactically outperform other metals anlezd mining stocks during the coronavirus outbreak and stated our preference for Polyus over Polymetal on asset quality and valuation grounds. Since then, Polyus has outperformed our non-gold coverage by 14-34 pp and Polymetal by around 9-25 pp, which has closed the valuation gap between Polyus and Polymetal. At spot commodity prices and the current USD/RUB rate, Polyus and Polymetal are trading at an undemanding 2020E EV/EBITDA of 6.4, versus an average of around 7.5 for senior gold miners according to the Bloomberg consensus. > While incorporating the gold price forecast of our commodities team (a $1,560/oz average for 2020), we continue using a target 2020E EV/EBITDA multiple and a scenario-based approach to value the gold stocks we cover. We assign a combined 60% probability to our spot and base cases, while assigning a 35% probability to our bull case and a just 5% likelihood to our bear case. This gives us a target market cap of $21.0 bln for Polyus and $9.5 bln for Polymetal. We increase our target prices to $78.00 per GDR for Polyus and $20.23 per share for Polymetal. As our new target prices imply respective 25% and 22% expected total returns, we upgrade our recommendations for both stocks from HOLD to BUY.