As the memory of colorful eggs and chocolate rabbits is now ebbing, the market is resuming its pre-Easter strides with a fury. Nowhere has it been more evident this week than in Sydney. Prior to the long weekend break, Newcrest’s management announced the long-anticipated takeout offer for Lihir. The target jumped over 30% on the impact, and the prospective acquirer closed up on the day as well. Back from the fattening Easter spell, the investors shifted gears, dropping Lihir by 6%, but buying even more of Newcrest, pushing up the latter by 3%. Importantly, the volumes of Lihir’s stock were three times Newcrest’s. This pattern has been sustained ever since.

Waking up to the announcement (and Lihir’s instant rejection) of the deal on April 1 one could not shake off the disbelief. The pair touted for consolidation for the better part of the last decade, and often arbitraged against each other is finally taking the vows… Or is it? Indeed, in order to understand where Australia’s two largest gold producers are today, it is necessary to step back a couple of years.

Lihir was incorporated in 1995, after the discovery of the large deposit on a remote and geothermally endowed island of New Ireland archipelago. Initially staffed by Rio Tinto’s management, the company was never destined to shake off the blessing – and the burden – of the difficult, unique project which gave it its name and 700koz of gold p.a. The company was eventually weaned of Rio’s involvement as investor and operator in 2005, when new CEO Alan Hood took over. Understandably, he drove the process of risk diversification for what was perceived as a value company over-exposed to a very long life mine located in a poorly understood environment. Listed in Australia and US, the management was keen to reduce investor resistance and closed its hedgebook in April 2007, but at a price of A$1.2bn equity raising. The management also commenced to talk about “growth”.

This was, however, easier said than done. “Corporitization” boosted the size of Brisbane office. The first attempt at corporate activity was the unfortunate purchase of Ballarat in early 2007, a company based in a historic gold district of Victoria. The eventual sale of the mine, for mere A$4.5m, was announced earlier this year.

When I met Lihir’s CEO in 2008, the management was still willing to talk up M&A, yet it was the flagship operation that suffered from recurrent issues with the oxygen plant, crusher accidents, heavy fuel oil pricing and low grade sulphide ore. The company continued to target prospective 200koz p.a. and soon enough it announced a A$1 merger with Equigold. The combination of Queensland and Cote d’Ivoire assets has fulfilled the initial criteria, and allows Lihir to flag creditable production growth from 2011 onwards. However, unable to digest the Ballarat glitch, the company was effectively without the CEO since January this year. When the newly appointed CEO, former BHP metallurgist Graeme Hunt walked into the office on April 1, he found his new house under a takeover offer from Newcrest.

This is Newcrest’s maiden voyage. The company is unique in the gold mining universe as it has always generated its growth internally. Indeed, it is perfectly possible that its management is serious stating that the deal costing 9/1 scrip + Ac22.5 is “not vital”. This could partly explain the relative share price fluctuation between the two companies this week (Lihir’s short interest ratio on the North American market is only 1.5). Still, one could argue that, given Lihir’s five year long independence, it could have happened before. However, Newcrest’s combined Telfer and hedgebook problems at reduced the probability of the takeover between 2005 and 2007. The embedded premium began to grow again in 2008, but by then the name of the game was cash conservation, especially in the copper-heavy NCM.

The company has always been regionally focused and controls some 17% of Australia’s proven and probable gold reserves. Its entry into Papua New Guinea is fairly recent. In August 2008, Newcrest entered into a 50/50 joint venture with strategically challenged Harmony Gold to gain access to a highly prospective area in PNG’s Morobe province. It included Wafi/Golpu area, which I remember being discussed at length among geologists during my trips to this wonderfully mysterious country. Wafi/Golpu represents today hidden value embedded in Newcrest, with copper-rich intercepts shown repeatedly in the results.

If there is a risk to Newcrest, it lies in its overdependence on the success of Cadia East porphyry – a huge panel-caving underground mine, which will soon represent over 30% of company’s earnings. Newcrest has a track record of overhyping otherwise promising projects to the market (e.g. Telfer) and too much focus on Cadia East could be detrimental in future, its relative merits and contribution to ca 15% annual cash flow growth notwithstanding. This alone could explain the sudden willingness to pounce on Lihir, regardless of the lackluster market response to Newcrest’s stellar results recently.

Lihir is now clearly at play. Indeed, with U$470m in cash at the end of 2009 and rudderless for months, the company was “asking” for it. But it is also worth remembering that every single mining company and her Easter Bunny had done the numbers on Lihir’s assets many times over. If it had not happened before, it is because of the unique mining, power, community and environmental challenges on the remote, volcanic island. The ultimate decision is now down to Blackrock, Fidelity, Commonwealth and First State, which hold together between 21% and 39% of either company.

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Tags: ASX gold stock arbitrage, Cadia East overdependence, Lihir's growth programme, Lihir's shareholders, Newcrest's offer for Lihir