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Morningstar | Small Upgrade to FVE to AUD 24 per share but Newcrest Shares Now Slightly Overvalued. See Updated Analyst Note from 05 Jun 2019

No-moat-rated Newcrest shares have rallied strongly, particularly in the last couple of months. In October 2018, the shares were below AUD 20 but now sit around AUD 28, a more than 40% gain in eight months. We’ve liked Newcrest qualitatively for some time. This positive view is based on the upside we see from Cadia and Lihir driven by low-cost, incremental expansions, and productivity gains. The long reserve and resource life, which is superior to global gold mining peers, is also a key differentiator. The large reserve and resource base brings the ability to make long-term investment decisions and explore options to add value such as expansions.

However, the long list of positive factors for Newcrest are now largely reflected in the share price. Around AUD 28 per share, Newcrest screens as modestly overvalued. We’ve increased our fair value estimate to AUD 24 per share from AUD 23.50 previously due to the time value of money and the slightly lower AUD/USD exchange rate below 0.70. Despite the upgrade, shares are about 17% above fair value.

We’ve reviewed our assumptions for any obvious material upside to our fair value estimate. Using a lower discount rate would significantly increase our valuation, however, we feel the current cost of capital assumption of 8.2% is appropriate. This includes a sovereign risk premium of 1% to account for earnings from Papua New Guinea and Indonesia. Removing the risk premium would see our fair value estimate rise to AUD 28 per share, and the shares fairly valued. The exercise demonstrates the sensitivity of Newcrest’s valuation to a lower discount rate. However, if expectations for lower interest rates and discount rates was a key share price driver, we’d expect the share prices of other global gold miners to have risen as a group. That hasn’t happened, with Newcrest’s share price outperforming over three months, six months, one year, and five years. Using a 1% sovereign risk premium still seems appropriate.

Perhaps the market is more positive on recent acquisitions, particularly Red Chris in Canada. The USD 810 million deal is expected to close before Newcrest reports earnings in mid-August. It could bring 70% of another mine with low operating costs but grades are relatively low and significant capital expenditure is needed to get the mine up to scale. Given the size of recent acquisitions relative to the value of the existing assets, it’s hard to see those materially moving the share price in the near term.

The gold miner mega merger of Goldcorp and Newmont may have some investors excited about the prospect for Newcrest to be acquired. While we think Newcrest would make an attractive target, given its low costs and long life, acquisitions are hard to predict. Making money from speculation is a tough game. Newcrest may benefit from potential asset disposals from the combined Newmont/Goldcorp. However, if that happens, it would be into a positive environment for gold miners. We would expect competitive bidding for any divested assets, making it difficult to get a bargain.

Technology could be a longer-term source of upside. Telfer is underperforming at the moment and is only marginally profitable, but the 6.4-million-ounce resource is sizable and represents optionality. If management improves Telfer through a combination of ore sorting, low-cost mining such as block caving or enhanced processing technology, it could represent an important contributor alongside Lihir and Cadia and incremental upside to our fair value estimate. We already assume direct mining and processing costs decline by 2% a year in nominal terms to fiscal 2023 midcycle. A doubling of that decline in costs would add AUD 0.70 per share to our fair value estimate. It would move the valuation dial a bit, but to reduce the cost base that much will be a stretch.

Our thesis when the shares were undervalued was that operations would recover, Newcrest would build reliability, and the increased market confidence would reflect in the share price. At times, the market has been concerned about tailings management and seismic activity at Cadia. At Lihir, there have been lingering worries around plant reliability and throughput. Basically, whether gains from increased production and lower costs are sustainable. The operations are now doing well, and we think that reflects investor confidence. Management under managing director Sandeep Biswas’ leadership has done a great job of extracting more from the assets it has without the need for large capital investment.

Recently, renewed concerns around geopolitical stability, trade wars and the likelihood for interest rates to decline again have seen the gold price do well. It is now back above USD 1,300 per ounce. The depreciation of the Australian dollar is a positive for Newcrest with the price now touching AUD 1,900 per ounce. The Australian dollar gold price is now at record highs, which again seems to support our view that Newcrest’s shares are likely somewhat overvalued.