Shining despite operational difficulties

Lihir Gold (LHG, NASDAQ) is a substantial gold producer with operations in Papua New Guinea in the South Pacific. The core operation is the massive gold mine located on Lihir Island. The current mining plan consists of some 26Moz of gold reserves and a resource of 40Moz, for a mine life of over 20 years. After a number of production setbacks over the years, Lihir is now poised to increase production substantially. Following a hedge book restructure last year, the company has significant exposure to the spot gold price.

Lihir has performed solidly since last November, posting gains of more than 30 percent despite unforeseen production difficulties during October that negatively impacted production. In our view the share price re-rating in recent months reflects Lihir's enhanced status as a highly leveraged, quality gold stock.

The company has regained the market's confidence through a dramatic improvement in operational performance during 2005, with higher gold output and lower operating costs. Also boosting sentiment has been a substantial reduction in the size of Lihir's hedge book, which has increased the overall leverage of the stock to the gold price.

Lihir has announced what we consider to be a solid operating report for the December 2005 quarter. Amongst the positives was record gold production of 94,000 ounces during the month of December, a record gold grade of 8.54 grams per tonne (g/t) for the quarter and higher revenues during the second-half of $156.1 million compared to $130.7 million during the same period in 2004. The company also achieved full-year gold production of 596,000 ounces which was slightly below the previously revised guidance.

Investor sentiment toward Lihir remains very positive, with the solid rally of the past 10 months lifting the shares to $38.01 in January. This is the stock's highest level in almost eight years and is clearly associated with the 25 year highs recently seen in the physical gold market. The most noteworthy development on the charts has been an upward breakout from a triangle pattern in late December. A triangle is easily identified by narrowing boundaries and is often viewed as a consolidation phase ahead of a significant advance in prices.

As seen on the weekly chart, Lihir is heading toward the all-time high of November 1996 at $40.75. Considering the speed of the recent advance, we believe some consolidation is possible prior to this level being successfully challenged. However with investor sentiment remaining buoyant and firm support around $30, we believe that any pullback should attract firm buying interest.

Lihir was able to achieve near record gold production despite interruptions, with mining operations effectively back to normal by the end of the quarter. Furthermore the new era of independent management implemented during the quarter should help sustain the improved operational performance.

A total of 171,695 ounces of gold were produced during the quarter (193,031 ounces during the September quarter) at a total cash operating cost of $246 an ounce ($217 during the September quarter) and a total production cost of $298 an ounce ($259 during the September quarter). The operation was impacted by the unforeseen interruption related to a landslide on October 9th that blocked road access to the mine-site. The landslide also destroyed a portion of the pipeline that supplied water to the plant, in turn halting gold production for a month. Tragically, two workers were killed in the incident.

The production result was nevertheless a strong one, helped by the increase in gold head grade to a record 8.54 g/t, up 74 percent on a full-year basis compared to 2004.

For the full-year to December 2005, Lihir produced 596,000 ounces of gold, which was marginally below the revised full-year guidance of 600,000 ounces issued in October and just short of the 2004 production result. As a result full-year cash costs for 2005 increased by 4 percent to $282 an ounce, while production costs rose by 10 percent to $331 an ounce.

Production however increased strongly as the year progressed, with 231,000 ounces of gold produced during the first half of 2005, rising to 365,000 ounces during the second. This boosted revenue sharply from $68.8 million in the first half to $156.1 million in the second, based on stronger production and a firmer gold price.

It is clear from our view point that there is now a significant downward trend in the company's operating costs, best demonstrated by a comparison of the first and second halves of 2005. Total operating cash costs fell by 36 percent from $363 to $231 an ounce from the first to the second half of 2005, whilst there was a 33 percent fall in total production costs from $415 to $278 an ounce between the first and second halves of the year. A full year's operation of the recently commissioned geothermal power station will help maintain operating costs at low levels, with total cash costs for 2006 anticipated to be around $230 an ounce.

In terms of the production outlook, equipment shortages have meant that the rate of mining has unfortunately been below expectations. This situation is anticipated to continue during 2006, which will delay the development of the Leinitz orebody and hence impact on full-year production forecasts. We have revised our 2006 gold production target down from 700,000 ounces to 650,000 ounces, which is below the company's revised forecast of 670,000 ounces.

We feel more comfortable with the lower figure given the potential for ongoing equipment shortages. This still represents a production record for Lihir and the company is on track to achieve the full benefits of the production expansion from 2007 and beyond, with output of 800,000 ounces projected in 2007 and 900,000 ounces in 2008.

The major plank of this expansion is the flotation project, which will enable the treatment of lower-grade ore that would otherwise not have been suitable as mill feed. Further advances have been made on the flotation expansion, with engineering work now 25 percent complete and construction expected to be completed by the end of 2006. Annual production is expected to be boosted by around 140,000 ounces (over seven years) when construction is completed in 2007. The flotation project also has the potential to increase the gold resource base and a revised statement is expected in early 2007.

The flotation project is being funded by a gold loan, which in turn has necessitated a restructuring of the company's hedge book. What this hedge book restructuring has done is substantially increase Lihir's leverage to the gold price - a traditional attraction of the company that had been lost in recent years as the total hedge position grew. Following the hedge book restructure, Lihir's committed gold deliveries as a percentage of gold reserves and resources has fallen to less than 6.5 percent and 3.1 percent respectively.

Lihir currently has 1.047 million ounces forward sold at prices between $330 and $371 an ounce, deliverable by 2011. The current delivery schedule will see the hedge book fall to around 1 million ounces by 2008. Lihir intends to continue delivering into hedge commitments throughout 2006 and although 206,500 ounces are to be delivered into hedge contracts this year, the majority will be sold at spot prices.

The resolution of the management situation at Lihir has been a long time coming, with the company now achieving full managerial independence from Rio Tinto following the disposal of their 14.6 percent stake. Lihir now has a fully independent management team, with Arthur Hood as Managing Director. Mr Hood comes with considerable high-level executive experience from global diversified resource giant, Placer Dome, where he spent 16 years.

From a financial perspective, full-year 2005 revenues were down by 4 percent to $224.9 million compared with the previous year. This primarily was a result of lower gold production during the first half as mining operations transitioned from the original Minifie pit to the new Lienitz pit. As we have indicated, operational performance improved significantly during the second half, which augurs well for 2006. Despite the production loss due to the landslide, Lihir reported a net profit of $30.6 million for the second half, taking full year profit to $9.8 million.

In terms of profit outlook, we have revised downwards our 2006 forecasts in line with anticipated lower gold production to around $80 million, but maintain our 2007 net profit forecast of $160 million.

Lihir remains our preferred heavyweight gold exposure. The company's primary attractions in our opinion are its highly leveraged exposure to gold, along with a significant reserve base of more than 20 million ounces. The re-emergence of corporate activity in the gold sector is an added bonus, with Lihir offering a unique, long-life mining operation for a potential suitor.

Notwithstanding the possibility of some near term consolidation and volatility, we believe Lihir continues to possess considerable longer term upside potential. Accordingly the shares remain held in the Fat Prophets Portfolio. For those Members with no exposure, we recommend Lihir ADRs (LIHRY) as a long term buy up to $33.50.

Disclosure: Interests associated with Fat Prophets declare a holding in LHG.