Consolidation does not always lead to a gold mine

Consolidation is the name of the game underway in Australian gold mining today, and while it can be a stockbroker’s picnic it can also create more losers than winners.

The current focus of speculation about a rush of gold sector merger and acquisition (M&A) activity is the historic Western Australian mining centre of Leonora – the site of some fabulously rich mines, but also a place where a lot of money has gone to die, and where I lived briefly during the nickel boom of decades ago.

For investors with a high-risk tolerance and a willingness to trade quickly the consolidation game can be handsomely profitable if they can get in and get out, and that’s not always easy with some of the potential Leonora players going untraded for days.

Thin volume

Thin volume is the first warning sign that not every company mentioned in some of the more excitable tip sheets and websites are worth a second look, because they are not so much small caps as microscopic with a market capitalisation less than the value of my home.

Buying a stake in a mining minnow might be possible, just don’t expect to be able to sell easily.

In theory, the gold assets around Leonora are ready to be consolidated because the major player in the region, St Barbara (ASX: SBM), is under pressure, not so much because of its prime asset, the super-deep Gwalia mine, more because of problems elsewhere.

An overpriced 2019 acquisition in Canada (Atlantic Gold) has stalled while waiting for government permits.

The Simberi mine in Papua New Guinea has underperformed, leaving the 125-year-old Gwalia mine to do the heavy lifting – and that’s another clue to the overall Leonora problem because lifting ore out of a 1.6-kilometre-deep mine is expensive and will get more costly the deeper it goes.

Rising costs

Costs are another clue to risks in the consolidation game and while it is argued that a merger can cut operating costs it doesn’t always work because dramatic cost rises such as a 42% increase in diesel and 68% in contractor load and haul rates quickly consumes revenue and efficiency gains.

Then there is the question of who will drive Leonora consolidation. Management at St Barbara argues that it should be the company in charge because it is the biggest gold producer in the region, complete with substantial ore processing capacity and an extensive tenement position.

St Barbara, however, is being challenged by a highly successful team of mining professionals using Genesis Minerals (ASX: GMD) as their Leonora consolidation vehicle with a deal being a bid earlier this month for financially stretched Leonora player Dacian Gold (ASX: DCN).

Genesis is led by Raleigh Finlayson who previously headed the highly successful Saracen Minerals which merged with Northern Star (ASX: NST) to create a world-class goldminer which has the Kalgoorlie Superpit as its prime asset.

Other potential M&A players

After the two leading Leonora players there is a cricket team of hopefuls, all with their feet on a patch of ground, an old mine or two (the area has been worked since the 1890s), exploration plans, a bit of cash in the bank and a claim to be part of the game.

The smaller potential beneficiaries of Leonora consolidated include Kin Mining (ASX: KIN), Saturn Metals (ASX: STN), Red5 (ASX: RED), and Mt Malcolm Mines (ASX: M2M) – all have lower share prices today than when the first deal (St Barbara and Bardoc) was finalised in April.

St Barbara and Genesis have one Leonora takeover/merger under their belts and confirmed earlier this month (4 July) that there is a bigger game afoot as they look to “unlock operating and development synergies in the region”.

The management team at St Barbara’s would like to be on top of the action but, investor momentum is behind Genesis, especially given Finlayson’s track record.

If a St Barbara/Genesis merger emerges from their talks the guiding investment principle will kick into action, sell the bidder and buy the target because in most mergers the buyer overpays in the belief that value can be created from cost savings and growth potential.

Leonora consolidation starts with Bardoc takeover

The first phase of Leonora consolidation started late last year with St Barbara’s share-swap acquisition of Bardoc Gold, a deal which valued Bardoc at $157 million, but which has done nothing for St Barbara shareholders as their company’s share price slides away.

Completed in mid-April this year St Barbara’s share price has fallen by 37% from $1.47 at that time to last sales at $0.92.

Genesis, the other would-be Leonora consolidator, hasn’t done much better with its share price down 34% over the same time from $1.82 to $1.19 – a fall influenced by a share issue to raise fresh capital and its Dacian deal.

If the Leonora consolidation game was as attractive as some of its promoters are claiming, it’s unlikely that the prospective leaders would both have fallen so sharply.

What seems to be happening is that investors recognise the twin challenge of a falling gold price and rising costs – a devilish pincer squeeze on profits.

Rather than being seen as a way of achieving growth the consolidation story is more about survival in a hostile environment, ready to win when the gold price rises, which it will, just don’t ask when.

Commodity prices drop as costs rise

Former Rio Tinto (ASX: RIO) chief executive Jean-Sebastien Jacques warned last week about what he called “a nightmare scenario of a price/cost squeeze”, with commodity prices dropping as costs rise.

The Australian newspaper’s mining reporter, Nick Evans, was on the same wavelength as Jacques in a story published earlier this month, which warned that gold mining costs, as reported, were sometimes misleading.

His opening paragraph says all you need to know about the question of all-in sustaining costs (AISC) – they are, according to Evans: “largely bollocks, and retail investors who rely on them are fooling themselves”.

As an eye-catching comment for potential investors, it doesn’t get much better than that and while verging on exaggeration, there is a case to argue that AISC cost estimates are not as accurate as they should be given the failure to include interest costs on debt and the ability of a company to treat some operating costs as growth capital.

Aside from rising costs there is the problem of falling gold, the metal at the centre of the Leonora consolidation push.

Gold is down 12.5% from US$1,976 an ounce from when the Bardoc merger was finalised to the latest price of US$1,727/oz.

Locally, a falling Australian dollar (or rising US dollar to be more accurate) has seen the Aussie gold price lose just 5% from A$2,666/oz to A$2,553/oz – a modest move, which reflects an exchange rate which has moved from US75 cents to US67c.

‘Confession season’ imminent

Costs are absolutely critical to what happens next in the game of Leonora consolidation and while they can’t be seen as clearly as the falling gold price, they are doing their corrosive work on profits with “confession season” soon to arrive in the form of annual result statements from companies with a 30 June balance date.

St Barbara, despite being more than twice the size of Genesis by stock market ($734 million versus $298 million), reported encouraging production numbers for last financial year – lifting group gold output by 40% to 280,746oz with the lion’s share from Gwalia.

Unknown, until the results statement is released on 27 July, is St Barbara’s profitability, though Macquarie Bank in an 8 July research note tipped a loss for the last 12-months. However, the analyst did upgrade its advice from hold to buy with a 12-month share price target of $1.10.

A lot more will be reported over the next few months about gold sector consolidation, but investors would be wise to see the process as a trading opportunity because it’s not so much about making money it’s more about avoiding losses and achieving economies of scale to ride out a difficult and inflation impaired commodity market.