Polyus - Upgrade to BUY and TP to $112/GDR

Polyus has reported a strong 2Q20 trading update and confirmed that there is no risk to its early 2020 production guidance despite the Covid-19 outbreak at its key assets in May. We expect 2Q20 EBITDA to come in at $855 mln for a 74% margin. Meanwhile, safe-haven buying and expectations of more stimulus boosted investment demand for gold. Having added gold stocks to our top pick list in the recent strategy report, we increase our target price for Polyus to $112 per GDR and upgrade the stock to BUY. > Polyus confirmed today that the Covid-19 outbreak at its Krasnoyarsk assets in 2Q20 didn't impact either 2Q20 production or the 2020 full-year target of 2.8 mln oz (which was highlighted as a risk during the 1Q20 earnings call). Dore gold output in 2Q20 came in at 712 koz, flat y-o-y and up 8% Q-o-Q, thanks to the seasonal launch of alluvial deposits. Polyus's total saleable gold output (refined and in concentrate) was flat y-o-y at 690 koz and up 16% Q-o-Q, as more gold was sent to refineries. Gold sales volumes were almost flat y-o-y at 672 koz, up 24% Q-o-Q. Gold revenues jumped 33% Q-o-Q to $1,148 mln thanks to higher sales volumes and an 8% increase in the realized price.> The flagship Olimpiada asset showed a positive performance. Following a weak 1Q20, the processing grade increased 8% Q-o-Q to 3.5 g/t and the recovery rate increased a further 0.6 pp Q-o-Q to 85.4% on the back of the launch of a Jameson Cell flash flotation unit. Dore gold output at Olimpiada decreased 6% Q-o-Q due to a planned increase in unfinished production, which should be processed in 2H20. > We expect Polyus to post a good cost performance in 2Q20, thanks to the weaker ruble. We expect its TCC to decline 10% Q-o-Q to $350/oz, which we think coupled with higher sales volumes and a higher gold price should boost EBITDA 45% Q-o-Q to $855 mln for a strong 74% margin. According to the company, Covid-19-related expenses will be recorded below the EBITDA line, meaning they will not affect the dividend calculation. Based on the reported net debt of $2.5 bln (including derivatives), we calculate headline 2Q20 FCF at a solid $440 mln for a 1.8% quarterly yield. The bulk of one-off costs related to Covid-19 will be recorded in 2Q20; Polyus guided them to total $97 mln in 2020.> Polyus reiterated that it is on track with the realization of its several brownfield projects. The one already in the construction stage is the mill expansion at Verninskoe, which is slated to increase mill capacity by 17% to 3.5 mtpa of ore. We model it to start next year and to reach full capacity in 2022. We model the project's contribution to annual EBITDA at around $55 mln in 2022 at the spot gold price, while the total project's capex is just $60 mln.> There are two new projects, for which investment decisions have yet to be made this year. First, Polyus is considering constructing a new 6 mtpa mill that would allow for throughput of Blagodatnoye ore to be increased. The final details should be forthcoming and the investment decision made by the end of this year. We preliminarily estimate that the new mill may increase production at Blagodatnoye from around 450 koz this year to almost 600 koz per year by 2024. Second, Polyus may build one more bio-oxidation unit at Olimpiada. This, together with the ongoing modernization of two out of four existing bio units, should convert half of the company's concentrate sales volumes (150-200 koz per year) into refined gold sales, thus increasing the average realized price and profitability. At the spot gold price, we preliminarily model that these two projects may contribute around $340 mln to Polyus's 2024E EBITDA.> Overall, taking into account the gradual grade decline at the flagship Olimpiada asset, realization of the brownfield projects and small-scale efficiency improvements (such as the above-mentioned flash flotation), we model that Polyus's production could come in line with the 2.8 moz target this year, edge down slightly toward 2.7 moz next year before starting to recover, reaching over 2.9 moz by 2024. This projected increase will be on the back of the launch of new brownfield projects.> Today, Polyus reiterated that it will announce in 2H20 the results of the Sukhoi Log pre-feasibility study and initial reserve estimate. As of now, we model the project using the production targets outlined in the scoping study, the results of which were unveiled in 2018. We assumed the first gold would be produced in 2026 and that capex would total $2.5-3.0 bln, above the guided $2.0-2.5 bln. We do not include Sukhoi Log in our valuation yet, but note that depending on the long-term gold price assumptions and WACC, it may provide a material upside to our estimate (see our valuation sensitivity below). > We added both Polyus and Polymetal to our top-picks list last week in the quarterly Russian Eagle strategy report. Since our downgrade of Polyus to HOLD in June, infection rates have surged in a number of US states and some lockdown measures have been re-imposed, which has cast doubt over the chances for a quick economic recovery. The prospect of further stimulus from the government has come into focus. Although so far inflation has remained below pre-pandemic levels, further stimulus amid a partially closed economy could boost inflation expectations - and hence further pressure real yields. Moreover, the ongoing standoff between the US and China may further boost demand for gold as a safe haven. Using our scenario-based valuation, we increase our target price for Polyus to $112 per GDR and upgrade our recommendation to BUY (see the valuation table below).> In terms of risks to our view, the successful development and widespread deployment of a Covid-19 vaccine may facilitate a V-shaped global economic recovery. This could encourage the rolling back of stimulus in key world economies and reduce the appetite for safe-haven assets such as gold. We would also note the risk of a more pronounced decline than expected in Olimpiada grades.