ST. LOUIS (MineFund.com) -- Newcrest [ASX:NCM] and Lihir [ASX:LGL] are consummating their merger this week. It has been an interesting, if initially fraught, affair since it first came to light over 140 days ago.
By contrast, the Rodney Dangerfield of gold mergers, the friendly Kinross [TSX:K] offer for Red Back [TSX:RBI], promises even more drama as it continues to leak value at an alarming rate.
Lihir owners from the opening bid will walk away with an annualized rate of return approaching 90% at least. That's one for the memories in the turbulent wake of a global credit crisis. What's more, they're going to get nearly 10% of the deal in cold hard cash. For Australian owners it's a little sweeter still thanks to a 3% decline in the value of the Aussie dollar.
That's more firepower to diversify into other miners, especially offshore or to buy bullion, which rose US$114 per ounce over the course of the bid.
Therein also lies considerable unhappiness.
Anchors Away
Gold has gained 10% since the Newcrest bid started, but the pro-forma market value of the new Newcrest has fallen an equivalent amount. That leaves a net under-performance relative to gold of 20%. Ouch.
So Lihir investors have something to be apprehensive about as they become minority partners in the enlarged enterprise.
At least they can blame some of that under-performance on Newcrest's exposure to the copper market. Newcrest has a hefty copper component by reserves and production, the extent of which tarnishes the "gold premium" that investors assign and which differentiates gold stocks from all other mining equities. Even though copper has come back, it remains in backwardation which is certainly not the case for gold.
What can Red Back investors blame for their stock's flabby performance since Kinross came a-courting? Nothing but Kinross.
Kinross has no copper anchor dragging on its high grade shares (2 grams of gold reserves per share compared with just 1 gram per share for Red Back). As an aggravating factor, there is very little likelihood of an improved offer. At least Lihir stock owners got a sweetener with an improved ratio of shares and more cash, as well as a mix and match option.
Red Back investors cannot look forward to a similar boost simply because Kinross cannot afford it. The disparity in valuations is so wide that any attempt by Kinross to up the ante raises the risk of immediate suicide by merger. As it is the stakes are already high. Besides, Kinross has nothing in the kitty to offer unless it can sell some assets double-quick. And only vultures will be putting bids in for those assets given the smell of a margin call.
Valuations (see detailed valuation data on each of the bids here)
Both acquisitions see the bidder giving up around one-third of itself to the target. Both arrangements also share the unusual distinction of involving long reserve lives. New Kinross will have a pro forma reserve life of 20 years; new Newcrest 27 years. They will also both boast annual production of 2.7-3 million ounces per year at very low cash costs of US$468/oz and US$401/oz respectively. That's where the similarities end though; don't get us started on Kinross' underwater hedge book.
Newcrest is paying an all-in price of US$935 per ounce (bid price per reserve ounce, plus cash cost) for Lihir. That makes available to Newcrest shareholders an implied margin of US$316 per ounce of acquired Lihir reserves, or US$9 billion in total (based on the gold futures chain average). Clearly it's not cheap, but it's a buffer.
Then there's Kinross paying a whopping all-in price of US$1,310 per Red Back reserve ounce leaving a negative margin of US$58/oz. There's a word for that - gambling.
Let's be generous and say that Red Back's Tasiast deposit in Mauritania drills out sufficient new proven and probable reserves to make it a 15 million ounce super project. Just to clarify how generous that is, consider that it would rank Tasiast as the 17th or 18th largest deposit in the world. Gold investors are generally better off when they curb such enthusiasm. But back to the speculative valuation, adding 10 million ounces to Tasiast creates an all-in purchase price of US$843/oz leaving a margin of US$408/oz.
That looks pretty handsome compared with Newcrest, no? No. Newcrest has bought much more scale. Make no mistake though, $408/oz in margin would provide a handsome amount of total new value almost equal to the price being paid for all of Red Back.
However, let's not forget that the additional 10 million ounces are not in the bag - there is a lot of risk between now and the extraction of those presumed reserves. It also makes Kinross very dependent for its valuation on one asset in a jurisdiction without a track record. Investors must also expect a rise in cash costs which would further blunt the gains.
If you back off the juice and only give Tasiast another 5 million ounces for a total of 10 Moz (still a world class project), it creates an all-in reserve acquisition cost of US$1,260/oz. That's way under water on spot prices and even the contangoed gold futures market. To break even on the acquisition at current prices, Kinross will have to take a hatchet to Red Back's cash costs, or add at least 7 million reserve ounces at its projects.
Hurdle after Hurdle
We'll give our due to net asset value calculations, but let's track reality in the simple terms most gold investors do - accretion and dilution can be readily assessed using mineral reserve valuations. They tend to be sound indicators for success, and it's usually a bad omen when the acquirer sports a lower reserve valuation than the target.
In the case of Newcrest, its stock was trading at an implied reserve value (IRV) of 0.48x compared with Lihir at 0.33x. That premium of 0.15x augers well for the merged entity.
Kinross came into its deal on a stretcher. Its stock was trading at just 0.35x its implied reserve valuation. That was massively discounted compared with Red Back which traded at a heady 1.19x its IRV. That's a discount of 0.84x IRV which will need a miracle to make good.
Even if you front Red Back an additional 10 million reserve ounces, the IRV discrepancy does not reverse and remains a high hurdle. And then you need to factor in every other multiple that is out of whack. Kinross is buying high with weak paper; very very high.
Investors have digested a variety of institutional opinions warning about the Kinross deal, and it looks like the market is acting on the message as evidenced in further comparisons with the Newcrest-Lihir deal.
The charts below track both bids by days from announcement. The first chart is indexed to show the pro forma US dollar market capitalizations for each company divided by the gold price. An indexed gold price is provided for additional comparison. The second chart subtracts the indexed gold price from the indexed market caps to provide an additional view of the leverage to gold.
Comparisons
As expected, the charts show professionals hammering the acquirers out of the gate after each announcement as they worked the arbitrage potential (sell bidders shares short and go long the target). Newcrest came under additional pressure as the market drilled it once it became obvious that a higher price was needed. Once it did make the improved offer, the leak was plugged except for damage done by weaker copper prices.
Kinross-Red Back has been dealt with much more harshly. To date it has underperformed the gold price by 15% despite the gold premium carried by both stocks involved. That's a lot of additional suffering for Kinross shareholders, while Red Back owners must wonder where the love went after a stellar year.
Kinross shareholders may yet decide that C$250 million break fee is the cheapest metric in this merger. The size of the break fees is more suggestive of a dysfunctional pre-nup agreement: "If you don't marry me I'll make sure no-one else will want either of us."
Of course, we can be, and would like to be, wrong. The gold industry needs accretive deals. But it all looks far too risky absent a gold price that suddenly vaults to $2,000/oz and holds.
But let's not forget that Kinross stock has been crying into its handkerchief outside the gold gala ball for a while now. The problem is not the deal...
