This is a case where one plus one is greater than two
In the past the Fat Prophets Mining Portfolio has considered Newcrest fully valued. However, the proposed merger with Lihir changes our view and the merged group will offer good value. The combined group will have a market capitalisation of nearly A$26 billion, which is equivalent to nearly 2% of the ASX All Ordinaries. The combined group will be one of Australia’s largest companies and it will be on the radar of all institutional investors that invest in Australian equities.
The troubles of Greece and the probability of contagion spreading to Spain, Portugal and Italy has pounded markets with only gold and the dollar winners, at least in the short term in the case of the dollar. Investors have fled high risk investments and fearing the worst economic outlook for Europe, metal prices have all but collapsed and now there is fear of China slowing faster than expected.
Gold is in its element and increasingly investors are questioning the value of paper currency and the financial structure of the West that is built on borrowing to fund current consumption. The day of reckoning is close at hand as major economies teeter on the edge of the abyss.
Over recent times Newcrest’s share price has outperformed the ASX 200 index. However, the company remains well below the most recent peak of over $A39 in early December 2009.
We are taking advantage of the current lull in the share price to add Newcrest to the Fat Prophets Australian Mining Portfolio. After the merger is completed we expect that there will be a significant re-rating of Newcrest’s share price.
SHARE PRICE CHARTS AND COMMENTS:
Looking at the weekly chart of Newcrest Mining we can see that the share price has pulled back from a December 2009 high of AU$39.75 finding support at the AU$30 level. The recent low of AU$29.73 saw a brief penetration of this support level before significant buying on higher volume drove the share price above this level once more.
The weekly MACD has turned lower but is currently hovering around the signal line and is not giving a definitive signal, confirming the fact that the share price is currently consolidating sideways in what looks to be a large descending triangle pattern.
The daily chart highlights the downtrend that is in effect. At present the share price is testing both the 50 day and 200 day moving averages as resistance. If it can break above this level it is likely that it will gather enough momentum to break the intermediate term downtrend. Such a development would be very positive and would generate an upside target of c.AU$40.
STATE OF PLAY
The capital intensive nature of the mining industry can make for a frustrating investment experience in many cases. Positive cash flow from a successful development can disappear into expensive exploration programs before investors get their hands on it. Investors hold those miners whose operating cash flow is sufficiently strong to support a dividend in higher regard than those that don’t.
Newcrest bolstered their image in this respect. Management unveiled an interim $0.05 dividend (paid on 16 April 2010, unfranked) in amongst last week’s first half to 31 December 2009 earnings report. The miner has not paid an interim dividend since 1994 and the news was certainly a pleasant surprise.
Newcrest reported underlying first half profit of $266.6 million, representing 10% growth on the previous year’s $241.6 million. This was a particularly robust result, given that sales declined from $1.294 billion to $1.187 billion.
Although Newcrest benefited from higher gold prices, gold sales volumes fell 14%. The benefit of by-product copper payments was also less, with both the price of copper and volume of sales down 4% and 7% respectively.
Nevertheless, Newcrest’s profitability improved through a significant reduction in costs. Mine production costs came in at $527.9 million, compared to $555.6 million in 2008. While we would like to slap management on the back for this, the savings were in part due to the good fortune of lower energy prices. Indeed, costs associated to “fuel and lubes” decreased 35.1% to $43.2 million.
The cost savings were not passively achieved in their entirety though. Management’s various cost saving initiatives have borne fruit, with lower costs for both maintenance and contract mining. Reduced maintenance costs can often be the forbearer of bad news. This is not the case for Newcrest, with cost savings derived from improved planning of scheduled maintenance, rather than cut corners.
The company’s free cash flow has been positive for each of the 3 years following Mr Smith’s appointment. This includes last year in which Newcrest’s capital expenditure (excluding exploration and the Harmony JV acquisition) of $785 million set a record high for the company.
Newcrest is getting closer to realising a return on this expenditure. Ridgeway deeps, the Gosowong expansion and Hidden Valley will all become operational in the second half. Encouragingly, Ridgeway Deeps and Gosowong are both on time and budget. In fact, Ridgeway Deeps is on track to come in $40 million below its budget at $505 million. Hidden Valley is however around 3 months behind schedule.
These projects, in addition to Cadia East, will provide the foundation for management’s ambitious aim of expanding Newcrest’s gold production over 5 years. If achieved, this will take Newcrest’s gold production to 2.3 million ounces by 2014. Management also expect to deliver a 30% boost to copper production over the same timeframe, thereby assisting on the cost front.
It doesn’t stop there either. Management is currently assessing the next wave of development projects. These include O’Callaghans in the vicinity of the core Telfer project, Wafi-Golpu and Namosi, which are all progressing towards pre-feasibility. We will provide more detail on these projects as they near execution.
Suffice to say, Newcrest has a high quality asset base that has the potential to support longer-term production growth. Meanwhile, the quality of Newcrest’s assets is matched by its balance sheet. The company’s net debt to equity stood at just 3% as at 31 December 2009. Given its recently negotiated 3-year $600 million credit facility, Newcrest certainly has the financial capacity to drive its projects forward and take advantage of opportunities that may arise.
Turning now to the proposed merger with Lihir Gold we believe that the merger makes such excellent sense that we would have been surprised if the companies’ respective management teams did not make it happen. The sticking point as always was price, but that has since been removed. Newcrest sweetened its offer slightly to win Lihir’s approval and the merger looks to be well on its way to fruition.
Under the revised offer terms, Newcrest will issue 1 share and $0.225 in cash for every 8.43 Lihir shares. The cash component remains unchanged, with Newcrest simply improving the scrip terms from its original offer of 1 share for every 9 Lihir shares.
Lihir is in contact with other parties and Newcrest has allowed this to continue until June 8. Lihir is however currently trading marginally below the $3.98 value of the revised offer, which suggests that the market views the prospect of a higher bid as unlikely. The fact that Newcrest did not attempt to sew up exclusivity immediately certainly suggests that it is confident that a higher offer is not going to come in over the top.
The merger will create a gold mining behemoth, ranked number four in the world with gold reserves of 100 million ounces. There is ample scope for further reserve growth, with combined gold resources of 212 million ounces.
Both miners already have strong growth profiles, which will combine to lift their merged production to around 3.75 million ounces in 2014. Ridgeway Deeps, the Gosowong expansion, Hidden Valley and Cadia East will provide the foundation this growth from the Newcrest camp. Newcrest expects to lift its production to 2.3 million ounces by 2014.
Newcrest also has plenty of longer term development potential. The miner’s options on this front include O’Callaghans in the vicinity of the Telfer project, Wafi-Golpu and Namosi, which are all progressing towards pre-feasibility.
The merger also makes sense from a cost perspective. Newcrest’s copper production provides by-product credits that serve to reduce gold’s cash costs of production. The rising balance of copper in Newcrest’s portfolio was beginning to threaten its position as a gold miner. The merger removes any such concerns in one fell swoop, but that copper hasn’t gone away and will serve to keep costs low for the merged business.
The revised offer has received the approval of Lihir’s directors and now must receive shareholder approval through a vote that is to be held in July. Lihir shareholders will receive the merger documentation prior to the vote in late June. Assuming that no higher offer is forthcoming and that Lihir’s shareholders approve the deal, both of which we expect to be the case, the merger will complete in August 2010.
The bottom line for all gold miners is that their share price movement is ultimately determined by the price of gold. We expect to see further record highs in the months and years ahead.
Miners with favourable cost and production profiles based on world-class assets, such as Newcrest, are positioned to capitalise on the rise of the yellow metal.
Accordingly, we are recommending Newcrest Mining as a BUY for all members at around $A32.60 per share.
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