Mining for Gold Mergers

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 |  Includes: ABX, AU, EGO, GDX, GDXJ, GFI, HMY, IAG, KGC, LIHR, NCMGY
by: Morningstar
By Joung Park

As gold prices have scaled new heights in recent years, acquisition activity has begun to heat up in the gold mining space. In this article, we will conduct a case study of recent major transactions in the gold mining space to identify characteristics of attractive takeover candidates. We will then apply these lessons to spot likely takeover targets within our coverage universe.

Profile of the Perfect Target

The primary reason a gold miner would acquire one of its peers is to expand its reserve base. As a gold miner depletes its existing reserves by extracting its below-ground ore, the firm must replenish those reserves to ensure continued production. This need is particularly acute for large majors, who typically deplete reserves at prodigious rates. While miners can expand their reserves by using either their shovels or their checkbooks, many prefer to purchase reserves on the market given the significant capital and time requirements, as well as the highly uncertain prospects surrounding exploration.

One of the largest deals in the gold mining space in recent years was initiated by Australian major Newcrest Mining (OTCPK:NCMGY), which extended a takeover bid for Lihir Gold (LIHR) in May 2010, valued at $8.8 billion at the time of the offer. We believe the deal will almost certainly close this fall. There are several reasons why Lihir represented such an attractive takeover target for Newcrest. The firm controls the world-class Lihir Island mine, which houses 31 million ounces of gold reserves. Lihir is also a low-cost producer, ensuring that the combined Newcrest-Lihir entity will remain in the bottom quartile of the industry cost curve. More specifically for Newcrest, most of Lihir's reserves are situated in Papua New Guinea, a country where Newcrest also enjoys a significant mining presence. This close geographic proximity of Lihir's assets undoubtedly increased its appeal to Newcrest, as the firm can leverage its existing infrastructure and experience working in Papua New Guinea to better service the acquired assets.

Another recent sizable acquisition was Eldorado Gold's (NYSE:EGO) takeover of Sino Gold, which closed in December 2009 at a value of $1.9 billion. At the time, the acquisition nearly doubled Eldorado's gold reserves, and also helped to consolidate the firm's operations in China, as the acquisition added two operating mines in the country to complement Eldorado's existing Tanjianshan mine. In this regard, Eldorado was motivated by similar reasons as Newcrest.

One noteworthy aspect of the Sino acquisition was that the company already owned roughly 20% of Sino's common shares before it launched its bid. Similar patterns also emerge when we examine many other recent deals in the gold mining space. That is, larger miners will often assume a minority equity stake in a target company, or partner with them to operate mines and development projects, as a precursor to launching an outright bid for the firm. This tactic allows the potential suitor to better gauge its target's business, which ultimately aids in the decision on whether or not to buy it. The strategy also facilitates the actual purchasing process since the suitor has already committed capital to buy a minority interest in either the target's assets or its equity, and just has to purchase the remaining stake. In other words, the buyer can pay for the target company in installments rather than in a lump sum, significantly reducing its financial burden.

Who is on the Hot Seat?

From our analysis of recent deals among gold miners, we concluded that miners with sizable, low-cost reserves situated close to the potential suitor's existing assets tend to make attractive targets. We have also seen that larger miners taking either a minority equity stake in or a joint venture partnership with a smaller miner can often be a harbinger to a pending acquisition. Using these criteria, we have identified three potential takeover candidates within our coverage universe. (Click to enlarge)

Click to enlarge

Kinross Gold (NYSE:KGC), a large miner in its own right, shares ownership of many of its operations with industry behemoths--none of which is bigger than Barrick Gold (NYSE:ABX). Kinross and Barrick have enjoyed cozy ties in recent years, cooperating to develop the massive Cerro Casale gold-copper deposit. We believe Kinross' vast reserves and below-average production costs make it an appealing acquisition target for any miner large enough to swallow it. And therein lies the catch: purchasing Kinross would be no easy chore, even for an industry giant like Barrick. With Barrick needing to commit substantial capital to develop its own mega-projects such as Pueblo Viejo and Pascua-Lama, we do not believe it is likely that the company will additionally launch a bid for Kinross. A more likely scenario may be an asset purchase. Barrick gained an additional 25% stake in the Cerro Casale project from Kinross in February 2010 for more than $470 million, and we would not be surprised if Kinross cashes out of the project completely.

Perhaps a more likely takeover candidate is IAMGold (NYSE:IAG), which shares ownership of several West African gold mines with both AngloGold Ashanti (NYSE:AU) and Gold Fields (NYSE:GFI). IAMGold also has several mining operations in Latin America and Canada, and is situated roughly in the middle of the industry cost curve. Nevertheless, the company boasts a much more favorable cost profile than either AngloGold or Gold Fields, which are weighed down by their high-cost South African mines. Both miners have stated their intentions to diversify their operations away from South Africa, and purchasing IAMGold's assets could be a good start. Further enhancing IAMGold's appeal is its lucrative niobium mining operation. Mining niobium, which is primarily used in super-alloys, is highly profitable given that most of global production is controlled by just three companies--with IAMGold claiming an approximate 13% market share in 2009.

We believe IAMGold might be a particularly good fit for AngloGold given that the company already owns assets in Mali and Ghana, two countries where IAMGold also has a significant presence. Complicating matters, however, AngloGold must commit some of its cash to eliminate its sizable gold hedge book, which stood at more than 3.5 million ounces at the end of March 2010. The firm also wants to maintain its investment grade credit rating, rendering large debt issuances unlikely. As a result, we believe that if AngloGold was to make an offer for IAMGold, the bid would mostly be financed through an equity issuance, which could dilute existing shareholders depending on the bid price.

One final takeover candidate is Harmony Gold (NYSE:HMY), which owns an eclectic portfolio of mostly high-cost South African mines as well as some assets in Papua New Guinea through its Morobe JV (joint venture), which it shares with Newcrest. While Harmony's production costs are well above the industry average due to its skew toward South Africa, its Morobe JV is a highly attractive asset given its low production costs and excellent growth potential. Considering Newcrest's past interest in Papua New Guinea assets (such as its Lihir acquisition), we would not be surprised to see the large miner eventually buys out Harmony's stake in the joint venture. However, an outright bid for the company seems unlikely given that Harmony's assets outside of Papua New Guinea are not very attractive, and that Newcrest is about to close its Lihir acquisition. Using Newcrest's offer price for Lihir as a guide (which valued Lihir's gold reserves at approximately $280 per ounce), we think Harmony's 50% stake in the Morobe JV is worth roughly $300 million. The final purchase price, however, could be much higher given the likelihood of additional reserve growth from continued exploration.

While the recent trend of consolidation within the gold mining space has proved a boon for some investors, we believe the possibility of acquisitions should not serve as the primary rationale for investing in gold miners. Instead, we think that investors in this space should focus on producers with relatively low production costs--which will help them remain profitable even if gold prices retreat significantly from current high levels--and a healthy gold reserve base, which will ensure sustained mining over the long run. Any upside from potential takeover offers should be viewed as icing on the cake.

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