Downgrades And Consolidation In The Copper-Gold Space

This story features PANORAMIC RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: PAN

By Greg Peel

Other than a European crisis blip, the copper price has risen steadily since January 2009 back towards all-time highs. Despite its outperformance, analysts are more keen on copper than any other base metal. The simple truth is that world-class copper finds are very thin on the ground these days, and very thin under the ground as well.

Which is leading analysts to assume the world will see a copper supply deficit in the next couple of years, with consumption to wire homes and offices and railway stations in China in particular driving an unquenchable demand side with limited global production growth driving a restrained supply side.

It is for this reason shares in junior copper producer PanAust ((PAN)) have doubled in price since June, including a 55% jump since August. Not a bad little earner. All bar one of the seven brokers in the FNArena database have had a Buy rating on the stock. At least until today.

Yesterday PanAust announced the expansion of the plant at its flagship copper-gold Phu Kham mine in Laos. At a cost of $110m the plant will see its throughput increased from 12mtpa to 16mtpa. With the copper price heading north, this should be good news.

But the reason for the plant expansion is the expected decline in copper grades at Phu Kham from 2012, hence the plant expansion will merely serve to maintain copper production levels, not increase them. Analysts have been anticipating such an expansion announcement, but for BA-Merrill Lynch it seems less copper will be produced beyond 2012 than the analysts had factored in and at a higher cost than forecast. This is not so great news.

Given PanAust's recent outperformance, Merrills has gone the whole double-whammy and downgraded its rating on PanAust directly from Buy to Underperform. Similarly, Credit Suisse has taken its rating from Outperform to Underperform. Merrills and CS are the only FNArena database brokers to respond to the expansion announcement to date, so it remains to be seen whether further downgrades will follow.

Having risen 68% since July, OZ Minerals' ((OZL)) share price performance has been almost as spectacular as that of PanAust. But then this particular copper-gold producer, with its sole mine at Prominent Hill, has a problem.

Some may wonder why having $1.4bn in cash sitting in the bank is a problem, but in listed stock land idle cash is a no-no. There is a case to be made for cash reserves if everything's going wrong in the world and metals prices fall below costs, but the opposite is true at present for the copper price and particularly the gold price.

OZ's cash represents 46% of its assets. Thus, as analysts note, the market is overlooking the fact that no matter how good OZ's copper and gold production is, the share price is only really half-leveraged to metal price movements.

OZ's production results have nevertheless been no less than spectacular. The results of last quarter's production, released on Tuesday, showed copper production was in line with forecasts but that gold production yet again beat forecasts, and by a long way. Every time OZ has released a production report lately gold production has exceeded forecasts. Now the company has increased gold production guidance in 2010 from 160-170koz to north of 185koz.

OZ even has the embarrassing problem of having a bit to much gold in its copper, meaning copper buyers have to credit back the gold content, but they seem to now be resigned to that. Despite the great news on gold, and a soaring gold price, analysts are beginning to suggest the share price rally is overdone unless OZ can find something constructive to do with its excess cash.

An acquisition is the obvious choice, and believe me, OZ have been furiously shopping around. But as noted above, copper supply is expected to be constrained in coming years and that means the market is putting a very high price on copper miners, OZ and PanAust included. It is a lot cheaper to develop a new site from scratch, and so OZ has also been furiously turning over all the rocks around Prominent Hill. The signs are positive, but until OZ announces another new mother lode discovery its share price is still looking a bit steep.

The other alternative is to simply buy back shares. But following a 68% share price rally, that's also an overly expensive option. OZ may simply be forced to pay a special dividend to shareholders in order to stop earnings per share eroding. Special dividends are nice, but then they are a bit defeatist. Stock markets prefer growth.

It is for that reason three FNArena database brokers took the opportunity of the production report release to downgrade their ratings from Hold, which had already reflected full value, to Sell, which suggests the market has driven OZ too far.

Merrills is a voice for the three brokers hanging onto Buy ratings, which are largely based on expectations copper and gold prices still have comfortable upside. A couple of brokers have suggested they prefer the upside leverage in Equinox Minerals ((EQN)).

If new copper finds are rare, the same is very much true for gold.

Before this year, the Australian gold sector (not including foreign-owned mines) consisted of one major miner in Newcrest ((NCM)), one mid-tier miner in Lihir Gold and then daylight ahead of a smattering of promising junior miners. Now that Newcrest has swallowed up Lihir, we're left with one mega-miner and then a huge vacuum before we reach the biggest of the juniors.

There is thus an incentive for those juniors to talk to each other about consolidation and in so doing become “the new Lihir”. It is not just about a matter of scale – if a mining company is big enough to make it into the ASX 200 index it will automatically have to be included in index-tracking funds and will fly into the radar of most other local and offshore equity funds. For those around the world focusing on gold alone, or even commodities alone, funds will not consider inclusion of a stock until it satisfies specific market capitalisation and production criteria.

Thus if you can become the new Lihir you're basically guaranteed of a share price boost irrespective of your gold production or the gold price.

Kingsgate Consolidated ((KCN)) is one gold miner which has been eying the vacant spot and was candid about its goals yesterday when it announced a friendly agreement to merge with Dominion Mining ((DOM)) on a scrip-exchange basis.

The merger is effectively costing Kingsgate $375m with a 33% control premium over Dominion's last price and will cost existing Kingsgate shareholders around 10% of dilution. Aside from increasing its gold production scale via Dominion's Challenger mine in South Australia, Kingsgate management yesterday cited its desires to be the new Lihir as a reason for the deal. The other major reason is based on the current global shortage of skilled mining professionals and workers.

Dominion boasts extensive experience in underground mining, and Kingsgate intends ultimately to increase production at its flagship Chatree mine in Thailand via underground development. This is important because analysts agree that Dominion's Challenger mine is aptly named, so a simple scale increase via Dominion is not in itself enough to justify the dilution factor. And there will be no cost synergies.

Analysts all agree, however, that “the new Lihir” is a valuable goal and the acquisition of underground expertise worthy of the price paid from a strategic point of view. Dominion also has a prospective site in PNG, which makes the Lihir comparisons almost spooky.

Given Dominion's board has approved the merger, and that Kingsgate has suggested it could still pay a bit more if forced, no one is assuming another suitor will gazump Kingsgate. However Citi throws up the possibility that deal might suddenly move Kingsgate into play.

Alone, Kingsgate is a quality target for another player looking to become the new Lihir, or for any global gold company looking for some more scale. Once merged with Dominion however, Citi suggests the entity would be a bit too big to attract interest. So we might possibly end up with one of those three-way battles that have proven popular in the coal sector of late.

There have been no ratings changes as a result of the Kingsgate announcement so far, but only one broker (Citi) rates the stock a Buy with the rest suggesting the stock is already well-priced given the risks surrounding the Chatree project.

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