The dark truth to Newcrest's reverse alchemy

It is tempting for Newcrest to blames its woes on factors like the falling gold price and high Australian dollar, but the miner has made mistakes.

The $5 billion to $6 billion of write-downs that Newcrest Mining shocked the market with today could be said to flow from a confluence of factors for which it is largely, but not entirely, to blame.

In flagging a write-off of all the goodwill associated with the Lihir and Bonikro mines acquired via the 2010 $9.5 billion takeover of Lihir Gold – about $3.8 billion of write-offs) Newcrest is effectively conceding that it badly overpaid for Lihir.

The strategic logic of that merger, which brought together the two biggest regional gold miners and a mix of established and prospective projects in first and third world geographies, has never been questioned. The price paid, however, was regarded as full at the time.

The merger did, however, come as the gold price was starting a surge that within 18 months would see it above $US1900 an ounce. At the time the merger was agreed it was below $US1200 a tonne.

That run-up in the gold price, driven by fears of inflation being generated by the unprecedented easy money policies being pursued in the US and Europe, didn’t, however, do much for Newcrest.

Its share price peaked at about $40 six months after the deal was agreed and about a year before the gold price began to fall back. It should be noted that, at about $US1415 an ounce, the price is still higher than it was when the merger was agreed.

If the fall in its share price was due to factors beyond its control, like the gold price or exchange rates, the market probably wouldn’t be as hostile towards the group as it has become.

Newcrest has been plagued by operational issues and production cut-backs, as well as the general escalation of costs that has afflicted all Australian miners.

An ambitious and expensive ($1 billion-plus) program to increase production at Lihir Island in Papua New Guinea – the major asset acquired via the merger – is seen by some analysts as a failure, although Newcrest did say today that production and earnings from the expanded Lihir and from its new Cadia East mine would continue to grow in the coming years.

It hasn’t helped the group that the Australian dollar has, until very recently, held up at historically high levels but the market’s criticism relates more to management failings than external influences.

Newcrest’s response to its current circumstances, apart from the write-offs, is in tune with what’s happening in the resources sector generally. It’s cutting discretionary spending, halving exploration spending, suspending higher-cost production and generally cracking down hard on costs, where it is targeting a 20 per cent reduction next financial year.

With its free cash flow expected to be neutral and current metal prices and exchange rates, and its gearing post-write-downs pushing up towards 30 per cent compared with the 15 per cent objective it has in order to withstand prolonged adverse movements in the gold and copper prices, the group has said it doesn’t expect to pay a final dividend this year.

The outlook for the group will obviously be coloured by what happens to the gold price and the Australian dollar.

The absence of any sign of a rekindling of inflation in the major economies, despite the enormous amounts of cheap liquidity being pumped into the global financial system and the shift by investors from a defensive stance to a search for positive returns, has produced a lot of volatility in financial markets but gold has continued its steep slide.

The Australian dollar has, of course, fallen markedly in recent weeks but the extreme volatility in the value of the dollar as it is being buffeted by the US and Japanese monetary policies and shifting market expectations about the way those policies will play out makes its future course unpredictable.

The extent of the impairments unveiled today suggests that Newcrest believes that there isn’t going to be a significant reversal of the trend in the gold price, at least, in the near to medium term and that it isn’t prepared to bet on a continuing and substantial fall in the dollar.