Digging down into the Newcrest cave-in

No company has been a bigger disappointment this year than Newcrest Mining, with its shares down by 50%, management under investigation, and a $6 billion asset-value write-down looming. So this begs a question: why is it still on several big broker buy lists?

The answer is that some analysts believe that the news could not possibly get worse, and that Newcrest remains a fundamentally sound goldmining business.

On balance, but only just, that view is probably correct, and while it does not make Newcrest a buy for most investors it is possible to see the company climb out of the hole it has dug for itself. But it will take a long time to restore a bruised reputation, and even longer if the gold price falls further.

Ironically, I wrote a similar-sounding warning about Newcrest in early April (True believers stick by hapless Newcrest, April 10), cautioning then that: “If the gold price continues to slide, Newcrest will find itself under fresh pressure along with every other goldminer”).

A key question also asked back then was whether Newcrest  was “oversold, or just an accident-prone business doomed to lurch from crisis to crisis”.

Today, we know the answer because April 10 was the last day this year that Newcrest traded above $20 (opening at $20.10 and closing at $19.75), and yet another crisis has shattered whatever confidence remained in the company.

What’s happened over the past two weeks has been well reported, but essentially boils down to someone in management committing the unpardonable corporate sin of selectively briefing an analyst. Whether it was one or more is a matter being investigated by the Australian Securities and Investments Commission.

The key data released prematurely was that Newcrest expects next financial year’s gold production to fall to around 2.3 million ounces from a market consensus projection of 2.6 million ounces – an exercise known as “hosing down the street”, or preparing investors for bad news in much the same way politicians hose down voters.

Most of the bad news relates to ongoing problems at the Lihir Island mine in Papua New Guinea, which Newcrest acquired in 2010 at an inflated price near the all-time peak in the gold price.

Writing down the cost of Lihir, just as Rio Tinto was forced to write down the cost of its infamous 2008 takeover of the aluminium business, Alcan, will take up the bulk of the forecast $6 billion asset-value write-off.

To prepare for what is likely to be a bottom-line loss of $5.4 billion for the year, which ends next week, Newcrest is slashing head-office and regional office costs, sharply reducing its exploration budget, switching production so that more stockpiled material is processed, which reduces mining costs, and closing all high cost mines.

While that level of detail was only available in the formal announcement, the market was well prepared by the early selective briefing that the company was preparing for a big shift to cater for a tougher gold-price environment.

Unfortunately for Newcrest’s besieged management, the company’s shares started to fall before the official release of the news on June 7.

Over two pre-announcement trading days, Newcrest shares dropped by 15%, from as high as $15.68 on June 4 to $13.36 on June 6 – and then down to $11.40 after the company released its statement under the vague heading: “Newcrest completes business review – update on outcomes, impacts and outlook”.

By the time the official version reached the market the damage had been done, and today Newcrest is trading at close to a 10-year low of $11.15, a result of investors forming the view that the company cannot be trusted.

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For anyone thinking about investing in Newcrest they must first consider whether the stock is a “falling knife”, an old stockmarket warning about the risk of buying simply because a company looks cheap without recognising that there’s a valid reason for the cheap look.

That’s when the views of professional analysts become interesting because it might reasonably be expected that few would be able to say anything positive about a stock under an ASIC investigation.

The consensus, however, seems to be that Newcrest has fallen as far as is likely, with a sample of nine investment banks and stockbroking firms showing a bias towards buying.

Three brokers, Citi, Credit Suisse and UBS, have uncompromising sell tips against Newcrest with all seeing no reason to buy a stock that is unlikely to pay a dividend in the foreseeable future, while also carrying the risk of exposure to a further fall in the gold price.

Three other brokers, Deutsche, Goldman Sachs and Merrill Lynch, are more hopeful, recommending Newcrest as a “hold” after discounting the selective briefing allegation and seeing the prospect of a big asset value write-down as a case of “clearing the decks”, in Goldman’s words.

Three others, JP Morgan, Macquarie and CIMB, have put Newcrest on their “outperform” or “overweight” lists, with both words broker code for buy.

The views of those nine broking firms (three sell, and six hold or buy) have all been released after the premature briefing incident of earlier this month and indicates that while not forgiven there is a degree of forgetting under way because of the underlying appeal of the stock.

Macquarie is not convinced that all of Newcrest’s operational difficulties are in the open, yet, but is confident that management is making the right decisions and preparing the company for a more stable future. It has cut its 12-month price target from $19 to $15.70, which is 29% higher than the current $11.15.

JP Morgan believes Newcrest’s production outlook is relatively optimistic as it switches focus to mining higher-grade ore, and likes the prospect of generating cash rather than simply churning out ounces. It has cut its 12-month price target from $18 to $16.

CIMB is the most positive of all, retaining a target price of $20.40 because the bad news about asset-value write-downs does not significantly affect future cash flow.

If the optimists are correct in tipping that the worst is over for Newcrest, then the stock should start to recover over the next few months, though my April 10 warning about the company being accident prone remains valid, and will stick until there is a change in the company’s overconfident management style.

The issue of management leads to the question of ownership and introduces the blue-sky factor, which few analysts are yet talking about – the potential for a takeover from a bigger goldminer unafraid of trying to catch what could be a falling knife.

What the other big miners crave is Newcrest’s world-class resource of gold and copper in the ground, which was measured in December (the last official assessment) at 161.1 million ounces of gold and 20.98 million tonnes of copper.

The crash in Newcrest shares means those resources are valued on the stockmarket today at the bargain-basement price of $8.5 billion, an almost irresistible prize for the world’s biggest goldminers keen to quickly boost their own declining resources.

Whether Newmont of the US, Barrick from Canada, or AngloGold Ashanti from London and South Africa is prepared to make a grab for Newcrest is unknown, but it is worth considering by investors with a higher-than-average risk tolerance.

In a way, an injection of new management via a takeover (hostile or friendly) could be the best thing for the gold and copper assets inside the Newcrest corporate shell, because it is hard to imagine anyone else making a bigger mess of some of the world’s great goldmines.