GOLD V GOLD SHARES – HISTORIC DISJOINT OFFERS OPPORTUNITY

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One of the most remarkable features of equity markets right now is the valuations being attributed to gold mining shares. With the price of gold having strengthened considerably over recent years, margins and profits within gold mining industry have been soaring yet share prices have exhibited significant weakness.

Whether it is fears of resource nationalisation, political instability in gold producing regions, the expectation of further operational disruptions or doubts over the long term gold price, investors are giving the gold sector a wide berth.  As we have stated previously, a potential catalyst for the long overdue re rating of the sector (in which stocks large and small cap are severely undervalued) is takeover activity.  

Australian gold miner St Barbara Limited has become aware of the opportunity and has gone bargain hunting while the discount prevails.  The company launched a bid for Allied Gold Mining – listed in the UK, Australia and Canada – which would create a company with a more diverse and stronger financial position worth around A$1bn. 

The combined group will have largest gold reserves and resources portfolio of any mid-tier ASX listed peer company.  In any event Allied Gold should see good progress this year on reducing costs and increasing output (cash costs for 2013 are expected to be around US$850).  This is as the gold price looks to be showing strength once more. 

The terms of the deal are that Allied Gold shareholders receive A$1.025 in cash and 0.8 St Barbara consideration shares.  Using the St Barbara share price of A$2.12 before the announcement the value for Allied through the deal was given as £360m or 176p per share.  Allied has seen had operational hiccups recently and as such the terms are not as favourable as they would be otherwise.  A more detailed analysis is offered below. 

St Barbara is clearly striking at a time when valuations are depressed and sentiment towards Allied is weak – an opportunistic move.  Should we begin to see other companies follow St Barbara’s lead and invest the fruits of their highly cash generative operational activities, valuations will re-rate and that is irrespective of any moves the Fed makes over the coming weeks and months.   

Bid for Allied Gold; cash meets opportunity

Allied Gold has received a bid from Australian gold miner St Barbara Limited which is part in cash and part in shares.  This is as the group has stumbled since returning to production at its second mine in March 11 with high cash costs depressing profits despite the high gold price. 

The stretch of islands off the East coast of Australia holds significant gold exploration potential.  This is as the so-called Pacific Rim of Fire are in a region of “multi-million ounce deposit”.  The remoteness also means high costs and potential mine development issues. 

Allied Gold Mining focuses on two projects which are the Simberi mine on the Simberi Island in Papua New Guinea and the Gold Ridge Mine in the Solomon Islands.  Gold production in 2010 was 69,000 ounces which increased to 108,000 ounces in 2011 and is expected to come in at a rate of 200,000 oz per annum this year.

The increase in 2011 came as the Gold Ridge mine commenced production in March and produced 51,054 ounces during the year.  Gold Ridge was acquired in late 2009 with a targeted run rate of 110,000 oz pa and with A$150m spent on refurbishing the project.  Total cash costs for the group in 2011 were US$1,021 which compares to an average realized gold price of US$1,571.

In looking further out Allied Gold notes that it is looking to move to a run rate of 300,000 oz pa with a key driver being moving Simberi to over 200,000 oz pa.  Allied was listed on the main market of the London Stock Exchange on 30th June 2011.

The first quarter for the group saw some progress although the production target for 2012 is now at 180,000 oz pa.  The group is aiming for a cash cost of US$850/oz run rate by the end of the year which compares to the US$1,099 seen in Q1.

Looking further back and despite seeing an 81% increase in revenue in 2011 to US$146.4m the cost of sales rose by 87% which meant that gross profit came in at only US$16.3m.  After overheads the profit seen in 2010 of US$5.8m turned into a loss of US$6m in 2011.

Cashflow was US$22m which compares to an outflow last year of US$4m.  At the year-end the first quarter (31st March) the group had US$28.2m cash at bank and US$9.6m gold in hand.  In early January a US$80m gold loan was used to repay US$55m of borrowings.

Against this backdrop the Australian gold miner St Barbara has launched a bid for Allied Gold which would create a company worth around A$1bn.  This as the St Barbara group has strong cashflows and is looking to boost its gold exploration and growth potential.

The terms of the deal are that Allied Gold shareholders receive A$1.025 in cash and 0.8 St Barbara consideration shares.  Using the St Barbara share price of A$2.12 before the announcement the value for Allied through the deal was given as £360m or 176p a share. 

However, the stock price of St Barbara has since fallen off sharply to trade at around A$1.525 which puts a lower value on the transaction and makes it less acceptable to Allied stockholders.  It also suggests that St Barbara stockholders do not view the deal favourably which is a further stumbling block.

The deal is recommended by the boards of the two companies, however, which helps and stockholders may yet be persuaded of the rationale.  The argument put forward for the deal is that it is “value enhancing” as St Barbara’s strong cash flow generation supports the combined group’s development profile.

The fact that Allied has accepted the deal despite the company’s stock being weak suggests that the group may have meaningful cash needs to meet development goals.  If the transaction closes the combined group will have gearing of around 20% given that St Barbara had a closing cash balance on 31stMarch 2012 of A$137m.

The deal looks likely to go through given the common stockholder base and the undertakings received from Allied stockholders so far.  Around 20.1% of Allied shareholders have made irrevocable undertakings to support the deal while 14.6% have given letters of intent – 75% approval is needed from Allied stockholders.

We advise Allied stockholders to support the deal as the combined group will be more diversified and with a stronger financial position.  It is frustrating that Allied has seen had operational hiccups leading up to the transaction as it means that the terms are not as favourable as they would be otherwise.

Meanwhile an all cash takeover appears more attractive in the short-term given weakness in St Barbara shares.  Nevertheless, Allied stockholders are able to retain a position in the new entity which is muted as having: “the largest gold reserves and resources portfolio of any mid-tier ASX listed peer company.”

A counterbid looks unlikely but cannot be dismissed and as such holding the position for the moment is the most appropriate course of action.  St Barbara believes it can improve the operational performance of Allied’s mines and if this is the case then the takeover will benefit both parties. 

Summary

Gold miners seemingly have a habit of overpromising and under delivering.  In the case of Allied this has allowed a predator to make an offer for the group at an attractive price.  Some commentators also see St Barbara’s bid as too generous and potentially making the company a target for a rival group.

In any event Allied Gold should see good progress this year on reducing costs and increasing output (cash costs for 2013 are expected to be around US$850). This is as the gold price looks to be showing strength once more.  


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