Australia | Mar 04 2013
– Newcrest result included ambitious guidance
– Lihir offers significant risks
– CIMB reduces its target price
By Greg Peel
Major resource sector developments take time, are costly, and are very risky. While the manufacture and sale of widgets, for example, is not without its business risk, such risks pale into comparison compared to those inherent in the production of metals, minerals, oil and gas.
Miners’ resource and reserve estimates are based on testing, as is the grade and consistency of those reserves. A resource will often surprise, either positively or negatively, with regard to grades and access. Building a mining operation is a complex process that takes a good deal of time to get from initial construction to production “ramp-up”, from ramp-up to “nameplate” capacity, and from nameplate capacity to targeted production. Over that time, many things can go wrong.
There will inevitably be delays and cost overruns for whatever reason. Either during or after development, mining operations can suffer from unscheduled shutdowns, accidents, the weather, industrial disputes, and be beholden to cost inflation, falling commodity prices, a rising currency, rising costs of input materials, and disappointment on grades, mine life estimates and the ease or otherwise of final product extraction. Mining is far from a straightforward business.
To that end, mining stock analysts always apply risk discounts to projects when assembling their valuation models. Risks are highest during construction, reduce as projects edge close to and then reach production milestones, and while waning thereafter they never actually dissipate altogether. All of the above is further true for expansion plans for existing projects.
While stock analysts spend a lot of time talking to mining company representatives, going on site tours and formulating in-depth commodity price forecast models, the starting point for any valuation is the company’s own guidance — timing schedules, production forecasts, earnings forecasts, capex expectations and so forth. Analysts look over the numbers themselves, visit mines themselves, and apply their own knowledge and experience before making their own judgements, but still they will apply risk discounts, if for no other reason than to err on the conservative side rather than the optimistic side.
It is in the interest of companies to also err on the side of conservatism when setting targets and guidance. Conservative guidance followed by over-delivery will always be rewarded by investors, while ambitious guidance followed by under-delivery will be punished, often severely. Over-guiding leads to wariness, which is often hard for investors to shake. If guidance is downgraded again and again, investors may simply walk away together, having lost trust.
Having said that, the complexities and risks of mining ensure that even the most conservative of guidance can be undermined by that which was completely out of a company’s control and could not be readily foreseen. In this case resultant downgrades just leave everyone disappointed, rather than angry. All of the above nevertheless is evident in the fact mining company valuations from a range of stockbrokers are usually spread across a wide range – far more so than would be the case for your common or garden widget maker. It doesn’t mean analysts are clueless, it just means that by the time one inputs all the different variables impacting on a mining operation, and then adds a subjective risk discount, simple chaos theory suggests that the final share price valuations that come out the other end are often wildly different.
Take gold miner Newcrest Mining ((NCM)) for example. As it stands today, the eight major brokers in the FNArena database are split four/four on Buy and Hold (or equivalent) recommendations. At least in this case there are no Sell ratings, because all of the eight brokers’ share price targets have been set above the current trading price. They range, nevertheless, from Deutsche Bank (Hold) at $24.50, or 10% upside over 12 months, to BA-Merrill Lynch (Buy) at $32.00, or 44% upside.
The extent of the range is not that surprising if we consider the size, complexity and geographical spread of Newcrest’s operations, but it’s slightly more surprising given there was much agreement among analysts with regard to their reports on the company’s earnings result release and project update early in February.
All analysts agreed it was a poor result, although all analysts expected a poor result. All analysts acknowledged that Newcrest is at a point in FY13 when a lot of money is being spent as major development/expansion projects reach ramp-up, meeting lower than expected gold prices. Production was also lower than expected, due to a couple of issues from the realms of the aforementioned. There’s not a lot the company can do about the gold price (outside of hedging, but gold miners closed their hedge books many years ago given gold’s rampant run) but capex from here should wane and production should increase significantly. All analysts acknowledged that Newcrest is at an important stage and is offering a deal of upside risk. Otherwise database ratings would not all be Buy or Hold. But all analysts were a little concerned that management is just a little too optimistic.
Newcrest has a long history of under-delivering on guidance. The company’s poor share price performance over a period of time in which the gold price rallied to its highs is testament. It is perhaps no surprise that management’s updated guidance at the result release came with caveats.
One of the caveats relates to accessing higher grade ore at one project, while analysts warn that to achieve guidance Newcrest will need to see improved production just about everywhere, from previously downgraded levels. Newcrest’s two “big ticket” developments are the Cadia East ramp-up in NSW and the expansion of operations on Lihir Island in PNG through the Million Ounce Production Upgrade (MOPU). At the time of the result release, Cadia was ahead of schedule, which is welcome news, and the MOPU had achieved ramp-up, albeit only one week prior. The Lihir operation and its various feeder mines and expansion projects were acquired by the company in 2010 with the takeover of listed company Lihir Gold, making Newcrest one of the world’s major gold miners. Lihir Island proved a problem child for Lihir Gold, and has remained a problem child for Newcrest. Much upside is on offer at Lihir, but it is a destination offering all sorts of complexities and risks.
The bottom line is that after Newcrest’s earnings release and update, analysts were prepared to take management’s revised guidance on face value but with a sensible pinch of salt. Basically, consensus is that Newcrest will miss guidance, but given guidance is seen as ambitious this won’t detract from the value of the company’s projects. The problem is that Newcrest investors have been so beaten down with guidance misses and downgrades over the years, another miss at this critical stage may just send them packing, irrespective of inherent risks and upside potential. Share price upside may thus never reflect this potential – not in the near term anyway.
CIMB is one broker that looked at Newcrest’s earnings result and guidance update last month and decided, while maintaining an Outperform rating, that a lot would have to go right for Newcrest for targets to be met. The analysts have taken a closer look at the Lihir operations and numbers in the interim, and decided that it is indeed unlikely the low end of management’s guidance range can be met in FY13. CIMB is thus anticipating another downgrade before end-June, and as a result on Friday cut its price target (report out today).
The extent of the cut is not enormous, at 1.4%, but the implications may be more significant. CIMB has taken its target down to $27.50 from $27.90 which still implies 23% upside, hence the broker’s Outperform rating remains in place. The significance is that CIMB is the first of the FNArena data brokers to actually translate concerns into forecast changes. Will CIMB be the last, before the fiscal year is out?
Lihir Island accounts for 42% of CIMB’s valuation on Newcrest, and has disappointed with poor operational performance for the past 18 months (in particular, albeit Lihir has proven difficult all its mining life). On this basis, the analysts felt it a good idea to review the operational risks inherent in the Lihir project.
Lihir Island is an active geothermal region, CIMB notes, with a small land footprint available (ie it is a dot on the map). Conditions are harsh, and mined rock can reach temperatures up to 200C. The gold is present in sulphide ore, and the grades balances of gold and sulphur vary greatly across the orebody.
The MOPU may now have ramped up, but as the above suggests it is not without its risks. Ongoing expansion is reliant on new mining areas on the island, but these depend on the construction of a “cofferdam”. A cofferdam is a large but temporary construction which is a little like a dry dock. It is built in the water and then the water inside is pumped out, allowing for dry access to the surface below. Such a tricky and expensive construction provides risks for further resource exploitation, particularly that of the Kapit deposit, while another potentially valuable deposit lies near to the Alaia Rock, but this is culturally significant for the local people.
On the other hand, it could all go well, and furthermore, technological advances in floatation and pre-concentration methods for gold expansion provide the potential for Newcrest to upgrade its stockpiles of lower grade ores. Yet CIMB’s conclusion is that, “unfortunately, due to complexities at Lihir, we also see the potential for downside risk to our forecast”.
CIMB’s reduced target takes the FNArena database consensus target for Newcrest down to $27.73, or 25% upside. CIMB retains Buy (Outperfrom) joining three other Buys and four Holds. The Hold ratings are not simply one of upside-to-target consideration but also one of lost investor confidence if another guidance downgrade is forthcoming, given the NCM share price staged a rally up to the result release.
Consensus forecasts suggest that Newcrest can deliver 59.6% earnings growth in FY14, reflecting the impact of expansion, but not before FY13 brings forth a forecast 19.5% fall in earnings.
And then there’s the gold price, to which the fortunes of the Newcrest share price are inevitably linked.
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