Taking a second look at a Newcrest inquisition

One of the curious aspects of the response to Newcrest Mining’s recent announcement of some massive writedowns of asset values has been the call for blood to be shed as a result.

The market backlash to the foreshadowed $5-$6 billion of writedowns is separate to the controversy surrounding the "coincidental" flurry of downgrades by brokers in the days leading up to Newcrest’s announcement which are now being investigated by the Australian Securities and Investment Commission.

The larger part of those writedowns – about $3.6 billion – relates to the write-off of goodwill associated with Newcrest’s 2010 takeover of Lihir Gold.

There have been calls for the head of Newcrest chairman, Don Mercer, as well as some focus on chief executive Greg Robinson. Mercer has been chairman of Newcrest since 2006 while Robinson was chief financial officer for about five years before becoming chief executive in 2011, succeeding Ian Smith, now chief executive of Orica.

It would appear self-evident from those foreshadowed writedowns of Lihir that the takeover was a bad mistake, and that case could be argued. It isn’t, however, quite that simple and therefore the criticism of the company’s board and management isn’t quite as well directed or informed as it could be.

Newcrest acquired Lihir after a wrestle of wills with its board and management that pushed the price up in a deal that settled in September 2010 – two months before the Newcrest share price peaked in November that year at more than $43 a share. Today the Newcrest share price was below $9.60.

Newcrest, however, isn’t alone. The world’s biggest gold producer, Barrick Gold, had a share price approaching $US60 around the same time the Newcrest price was peaking. Today it trades below $US17 a share, a fall of more than 70 per cent. Bloomberg recently reported that the 14 largest gold miners had written down the value of their assets by about $US17 billion in less than 18 months and had lost about $US165 billion of market capitalisation since the gold price peaked in September 2011.

It is, in some respects, no surprise that the gold companies have seen their share prices – and asset values – decimated and that Australian producers have been particularly hard hit. The gold price has plummeted nearly 33 per cent from its highs and is down 30 per cent since late last year and the weak US dollar has, for miners with Australian cost bases inflated by the resources investment boom, compounded the damage.

The writedowns across the sector, however, have been compounded by one of the peculiarities of the sectors – its merger and acquisition activity has been almost exclusively scrip-based. That presumably relates both to the volatility of the gold price and the fact that the price includes an element of premium for its financial as opposed to industrial value.

In an era of massive consolidation of the sector in search of the particular scale and liquidity premium attributed to the big gold companies there has been a lot of scrip issued by gold companies.

Newcrest’s Lihir bid was financed about 95 per cent by the issuance of its own scrip and about 5 per cent by cash which was effectively financed by Lihir’s own cash reserves.

At the time Newcrest shares, perhaps because of its status as one of the world’s larger gold producers but also because it was a multi-mine group with fast-growing resources of gold and copper, had been significantly outperforming Lihir’s, so issuing scrip made even more sense.

Given that the Newcrest share price peak shortly afterwards and that share prices across the entire sector began tumbling around the same time, the price it paid for Lihir ought to be seen in context – it issued scrip at almost the historic high point of its market value to acquire more lowly-rated scrip.

Another way to look at that would be to say that when Newcrest acquired Lihir the target company shareholders ended up with about 36 per cent of the merged group. Even after the foreshadowed writedowns, however, Lihir’s book value would be around 50 per cent of Newcrest’s enterprise value, which suggests that Newcrest actually struck a pretty good deal back in 2010 and that even with its written down value it is worth meaningfully more than Newcrest paid for it.

It could be argued (as has been argued in analogous circumstances like Wesfarmers’ acquisition of Coles, Target and Kmart using scrip priced at an historic high) that there has been an opportunity cost to Newcrest shareholders – that the stratospheric share price could have been deployed in a "better" acquisition.

Given that there has traditionally been a meaningful "gold premium" associated with the larger gold companies, that’s a difficult argument to make – it would have made no sense to use the scrip to acquire anything other than a gold producer and the acquisition of any big gold producer would, as the entire sector demonstrates, have led to a very similar outcome.

The ASIC investigation of Newcrest’s compliance with the continuous disclosure regime will run its course and may or may not have some repercussions for the company, its board and/or its management.

The criticism of the Lihir deal, however, is too simplistic and lacks the context of Newcrest and Lihir’s own circumstances at the time of the acquisition, including the relative contributions of each of the companies’ shareholders, as well as the circumstances of the sector and what has subsequently transpired within it.