Stand By For Gold Sector Consolidation

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            [3] => ((AND))
            [4] => ((MML))
            [5] => ((SBM))
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This story features KINGSGATE CONSOLIDATED LIMITED, and other companies.
For more info SHARE ANALYSIS: KCN
The company is included in ASX300 and ALL-ORDS

By Greg Peel

Having absorbed Australia's number two gold miner Lihir Gold, Australia's number one gold miner Newcrest Mining ((NCM)) is now 25 times larger by market cap than the next non-foreign owned gold miner, being Kingsgate Consolidated ((KCN)), and 10 times larger by production than the next being OceanaGold ((OGC)).

There is no separate precious metals sector index on the ASX, but if there were, Citi calculates Newcrest would represent 80%. The only other company with that sort of dominance in a sector is Telstra, before we slip down to 40% weighting to find CSL in the healthcare sector and Westfield in the REIT sector.

Westfield is a case in point. Given the size, quality and diversity of its assets, there's little doubting Westfield is a fabulous company. But fabulous companies aren't necessarily the best risk/reward bet for the more active stock market investor. As Citi notes, active investors tend to use Westfield more as a source of, or as protection for, funds, rather than a vehicle for capital returns.

This is manifested in Westfield's defensive nature. When the market is running scared, such as in the GFC, fund managers pile into “safe” Westfield and bail out of smaller, more risky REITs. But when the market is strong and confident, boringly “safe” Westfield is underweighted and riskier REITs with more upside leverage are sought. In this way, the market uses Westfield as a “safe haven” as if it were a government bond, protecting funds until such time as they can be “put to work” once more seeking higher risk/reward capital return.

Citi sees Newcrest as now becoming the Westfield of the gold sector. It is undoubtedly a fabulous company, with good management and a promising growth and exploration pipeline, as Citi suggests, but it has such a large production base that improvements in grades, costs and production volumes are unlikely to ever cause much of a ripple price-wise. And it is so big, not even the biggest foreign gold miners are ever likely to try to take it over.

Two years ago, notes Citi, the Australian gold sector was really only Newcrest and Lihir. Given Newcrest's copper diversity and Lihir's pure-play status, Lihir was the “go-to” stock when the market saw upside for the gold price. Fund managers would underweight Newcrest and overweight Lihir in such cases, or vice versa otherwise. If Newcrest had taken over Lihir two years ago, then Newcrest would have been the Australian gold index.

In the ensuing period however, Australia has watched gold juniors spring up like mushrooms. But they are all just asteroids to the Jupiter that is Newcrest, and there is no one available to fill the void left by Lihir. With Andean Resources ((AND)) looking like it will be taken out of the equation, no one junior can boast gold reserves offering the sort of organic growth potential that could make that company the new Lihir.

There are, nevertheless, several producers in the 100-200koz per year production range that offer valuable gold price leverage, Citi notes. Medusa Mining ((MML)) should produce 100koz from its Co-O mine in 2011 at a cash cost of under US$200/oz, making it “one of the most profitable gold mines in the world”. At the other end of the scale is St Barbara ((SBM)), whose high cost of production makes it most highly leveraged to the gold price.

In between is Kingsgate, which should reach 200koz production from its Chatree mine at a cost of US$450/oz and offers loads of exploration upside potential.

But none of these, alone, comes close to the lumbering Newcrest, which produces 3moz per year. Trading at 2.1x Citi's net present value, the broker notes that not only is Newcrest the most expensive of Australian gold stocks it is also one of the most expensive in the world. It's quality asset base and low production cost do justify a premium, notes Citi, but at current levels pricing is fair.

In other words, Newcrest doesn't really offer much for the active investor.

The door is thus open for Australian juniors to move into the space left by Lihir and become the market's new “go-to” gold stock. Realistically it can only be done through mergers and acquisitions. And it would have to be done before the big international miners come in to cherry pick the quality tidbits, as they are already clearly doing.

So if you want a low risk but low reward investment in a gold stock, go Newcrest. But if you want some riskier but potentially far more rewarding exposure to gold, exposure to one or more of the juniors is the way to go, suggests Citi, with consolidation a likely driver of those potentially significant rewards before you even talk about a positive view on the gold price.

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