Australia | Oct 25 2012
This story features NEWCREST MINING LIMITED, and other companies. For more info SHARE ANALYSIS: NCM
By Rudi Filapek-Vandyck, Editor FNArena
Years ago, when Lihir Gold was still independent and the second largest gold producer listed on the ASX, analysts from Credit Suisse returned from a site trip with nothing but admiration in their suitcase. They decided to dedicate a whole research note to explaining exactly how challenging the gold mining operation on Papua New Guinea's Lihir Island turned out to be. They'd never seen anything like it. Apart from being on a tropical island, which has its challenges for transporting people and equipment, the Lihir mine is located inside a cooling volcano. Rocks mined and crushed can be up to 70 degrees Celcius at the source.
CS's adventure story made for interesting reading, but it also proved prescient for what shareholders in Lihir Gold were yet to discover: mining gold on Lihir Island is a big challenge, best not to be underestimated, and there's no other mining operation elsewhere that compares to it. Needless to say, by the time Newcrest Mining ((NCM)) launched its $9.5bn takeover bid for Lihir in 2010, most shareholders were all too happy to accept as the share price had effectively gone nowhere for years on the back of (predominantly) continuous disappointments from the company's key operation on Lihir Island.
The Lihir Gold experience at the time provided investors with one important message: seeking leverage to the price of gold via the share market is seldom a straightforward exercise (if it is, it usually doesn't last long). One has to also appreciate the specific risks that come with buying equity in a gold producer.
One producer whose share price had done well since the turn of the millennium was Newcrest. This facilitated the acquisition of Lihir Gold. Since the absorption of the Lihir mine, however, Newcrest shareholders have not experienced much joy. The share price tumbled from above $40 a few months after the "merger" to near $21 earlier this year -at a time when gold went from US$1300/oz to US$1700/oz- and the reasons are partially related to the tough operating environment on Lihir Island which to date has proved too unreliable and too unpredictable just as it had for the previous owners.
At the same time, Newcrest management embarked on a multi-billion dollars production expansion strategy and, similar to what has happened to oil and gas producers with comparable heavy investment programs (see: Santos ((STO)), Origin ((ORG)), Woodside ((WPL))), the delays, funding requirements, technical issues and cost overruns tend to exert downward pressure on the share price as not every shareholder is patient enough to stick around while management builds on its vision for the future.
Equally important, the gold sector has gone through some key changes in years past and both miners and investors have been slow in catching up. Gold miners' equity used to trade at a premium to other miners, but that changed about two years ago when investors woke up to the fact that the industry, worldwide, had developed a habit of paying little attention to costs and shareholder value, probably thinking that a continuously appreciating gold price would overpower everything else. That was a serious error of judgment and it has taken this long, and a sector-wide de-rating along the way, but gold miners are finally changing their focus. This is why some of the overseas producers have turned themselves into high yielding dividend payers today.
For loyal Newcrest shareholders, the combination of all three factors has proved quite devastating. From the peak of $42.66 in April 2011 the share price tanked to $21.15 by July this year (less than half) and it has now settled around $27-28.
While it is likely that the chequered share price legacy since April last year might deter many an investor to jump back onto Newcrest Mining's share price anytime soon, the odds now seem to have turned towards a much more favourable environment for the company in the years ahead. One reason is because Newcrest has by now spent the bulk of $3.6bn spread over two investment programs to start producing at Cadia East (total capex $1.9bn) and to increase and improve production on Lihir Island (total capex $1.7bn). Production at the first project is expected to start within weeks from today, with further ramp up throughout calendar 2013, while production at the Lihir mine should reach 1 million ounces (annualised capacity) by June next year.
If everything goes according to plan, Newcrest's annual gold production volume should increase by up to 50% over the next five years. As things stand right now, production and profits should make a step-jump higher in FY14 and then again in FY16. Taking guidance from the old Wall Street saying "as go profits, so goes the share price" this should lead to a much higher share price.
Note that Newcrest also produces some 800,000 tonnes of copper each year, but current projections are for a stable production outlook.
It goes without saying that as FY14 draws closer and closer, investors will seek to increasingly start pricing in the favourable prospects for that year. As a matter of fact, one could argue this process has already begun. Newcrest's Price Earnings Ratio (PE) for FY13 is currently above 20 and management will likely have little to show for it in August next year (reporting season in Australia) with market consensus anticipating yet another year of negative earnings growth. On current estimates, earnings per share could jump by some 55% in FY14 which offers the potential for a much higher share price, in particular if the price of gold and/or copper were to positively surprise in the year ahead.
PE ratios are not necessarily the best way to value resources companies. Most analysts at stockbrokerages prefer to calculate the Net Present Value (NPV) which takes into account long term pricing and production volumes for operational assets. Right now, most NPVs for Newcrest shares are situated between $23-$30, with more value to be added as production at Cadia East and Lihir increases.
A lot of the future potential is aligned with how successful management can execute production plans at the two key expansions. For example, the Lihir gold mine currently represents close to half of Newcrest's total NPV, again highlighting the importance of making production on the island more reliable and predictable (so that forecasts can be met). Given the long legacy of disappointments at the mine, investors and analysts are rightly sceptical. However, earlier this month Newcrest organised site trips to both Cadia East (near Orange in NSW) and to Lihir Island and most analysts have returned with more confidence and optimism.
Feedback from both trips is the operational crew at Newcrest has a lot of experience with difficult mining conditions. Not only does it appear Cadia East will come on-line on schedule, but analysts are confident Newcrest is doing a better job at Lihir than the previous owners, leading some to suggest production at Lihir already is more reliable than in the past and it only will become more reliable as the $1.3bn expansion and the $400m upgrade of old facilities will be put into place.
Investors should note that investing in resources companies comes with higher risks attached than your standard industrial company. No matter how much expertise is present at the various operations, there's always some chance for unforeseen obstacles lurking around the corner; just ask former shareholders of Lihir Gold. Above all, management at Newcrest has no control over the price for its two key products and not everyone is equally convinced today that prices for gold and copper will be higher in two years' time, let alone in five years from today.
Offsetting any concerns about future price weakness is Newcrest's strong production growth outlook, in particular for FY14 and FY16, but can the Newcrest team deliver on its promise?
Investors should never judge an investment opportunity solely on its past performances, but I do believe there are always valuable lessons to be drawn from the past. This is why I believe taking a peak at the past is never time lost. Below I have lined up the financial performance of Newcrest in the eight years prior. Note that two consecutive years of negative growth is rather rare for Newcrest. The second table shows consensus estimates for the present year and in FY14. As things stand right now, FY15 is shaping up as a negative year for Newcrest, but then FY16 should see another step-up. This could mean that investors won't fully price in the big jumps in profitability during the run ups to FY14 and FY16, but they may also not let the share price drop too low in between.
Probably best not to expect to see the share price back at $21 anytime soon, unless the gold price collapses.
Finally, I advocate investors always find out about both the strengths and the weaknesses of any potential investment opportunity. In the case of Newcrest, I believe these are:
Potential weaknesses: – likely start up problems at Cadia East and Lihir (especially Lihir has proved a tough challenge in the past) – no control over future prices for copper and gold – strong Aussie dollar is a negative as customers pay in USD and most costs are in AUD – company poised to announce further expansion plans in coming years which will require funding and bring along additional risks – takeover appeal has virtually disappeared as the traditional discount vis-a-vis North American peers has vanished
Potential strengths: – current plans should see gold production volumes increase by up to 50% over the next five years – more quantitative easing by central banks is widely seen as positive for the price of gold – commodity analysts have turned positive again on price outlook for copper – Newcrest management prides itself for in-house expertise to deal with difficult mining conditions
Keep in mind though that if you are seeking gold exposure because you believe the world is going to hell in a handcart at some point in the not too distant future, then direct exposure is your only logical option as the end of the world will impact on financial markets and thus also on the Newcrest share price.
Trivia: UBS analysts estimate every member of the adult workforce on Lihir Island is working for the Lihir mine, either directly or via a contractor
Recent research updates post the company's September quarter production update confirm most analysts have now positioned themselves on the cautious side, while acknowledging that if Newcrest manages to execute its plans successfully, the shares are likely to be re-rated. The next six to nine months will be crucial.
Bottom line: for patient investors with a higher risk profile.
This story was published earlier in the Switzer Super Report.
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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