November 26, 2001 – Newmont Mining has made a bid to become the world’s #1 gold mining company as measured by annual production and reserves. It is a brilliant strategic move.
Newmont has announced its intention to acquire Normandy Mining and Franco-Nevada. If this proposed acquisition is approved by shareholders of the different companies as well as the various regulatory agencies so that in the end it is completed as planned, the new Newmont will have an interest in over 20 mines on five continents, one of the largest land positions among gold mining companies, and a much improved balance sheet.
Newmont and Franco are stocks in my recommended gold portfolio, as was Normandy until recently. Consequently, I want to discuss this acquisition more fully, and the impact it will have on our recommended portfolio. Also, I would like to explain why this proposal clears up for me some uncertainty relating to Normandy.
Anglogold has an outstanding bid for Normandy, but it failed to lock up a commitment by Franco-Nevada to sell its shares under the proposed deal. Given that Franco owns 20% of Normandy, I found this loose-end to be curious. Did Anglogold think that it could get approval from 50.1% of Normandy’s shareholders without Franco? Or did it try to lock-up Franco’s shares in its proposed acquisition of Normandy but without success?
I did not know the answer to these questions, but it seemed to me that Franco had other intentions for Normandy. My sense was that there was more to Franco’s investment in Normandy than that which immediately met the eye. In other words, it seemed to me that its investment in Normandy was serving some long-term strategic purpose for Franco. I think we now definitely know that indeed it was.
It is now clear that Franco had no intention of letting Normandy be swallowed up by Anglogold. This new deal has Franco written all over it. Newmont does not in my view have either the strategic vision or the balance sheet to pull off an acquisition the size of Normandy, let alone gobbling-up both Franco and Normandy together. Clearly, as I see it Franco provided both the vision and the balance sheet (i.e., Franco’s $650 million cash position).
So what was Franco’s thinking about the Anglogold proposal and its own stake in Normandy? Why did Franco, with Newmont, put together this new deal? The answer I think has to do with hedging.
Anglogold is a hedger, and for this reason, it is not in my recommended portfolio. Newmont basically is not a hedger, though it did some limited hedging in the past that was not in my view successful, i.e., worth the risks taken. Normandy is a hedger, but over the past few years has been unwinding its hedge position in two ways.
First, Normandy has been delivering production into its forward sales. Its overall hedge position, though still relatively large at 11.2 million ounces, was reduced by a substantial 1.5 million ounces in the twelve months ending June 30th.
Second, Normandy has been changing the mix of hedging instruments that is uses, reducing forwards and changing them into puts. Both of the above steps have slowly increased Normandy’s leverage to the gold price.
I very much like Normandy. That’s why it was on my recommended list of mining stocks. They have some good mines, an attractive land position, well-run operations and a reasonable balance sheet. And it has been paying a healthy dividend that at times while we owned it topped 5%, an excellent return given low interest rates around the world. But Normandy also still has a relatively big hedge book, which is under water largely because of the decline in the Australian dollar.
Consequently, recently I recommended selling Normandy from my portfolio of recommended gold stocks. Because I was looking for gold to rally above $300, my thinking was that Normandy’s hedge problems would become even worse as the gold price rose. But as we all know now, that rally failed, and Normandy continues to work down its hedge book.
In any case, there was one other factor on my mind when I recommended the sale of Normandy. It was not clear to me what Franco thought of Normandy’s hedge book.
Franco has repeatedly made clear its view that it does not favor hedging. Further, Franco has stated that hedging has hurt the gold price. Franco is a member of the ‘gold is money’ school, and recently denigrated an effort led by hedgers Barrick Gold and Anglogold to raise $200 million to promote gold as jewelry.
You will recall that Franco bought 20% of Normandy earlier this year. Obviously, it must have analyzed the Normandy hedge book before it made this investment, but one thing bothered me. Even though the size of Normandy’s hedge book was declining, the marked-to-market loss on its hedge book was getting bigger, not smaller as the year wore on.
In the quarter from Mar’01 to Jun’01 the negative marked-to-market value of Normandy’s hedge book climbed A$171 million from a negative $258 million to a negative $429 million. It seemed to me that Normandy was digging itself into a hole, which is very easy to do by hedging.
I therefore began to wonder. Did Franco misjudge the problems of Normandy’s hedge book? And what would those problems be if the gold price did rise above $300 per ounce? Those questions, which remained unanswered, led to my recent decision to sell Normandy from my recommended portfolio of gold mining stocks.
Well, I guess we now know the answer to those questions. Franco obviously feels comfortable with the size and composition of Normandy’s hedge book. If it didn’t, Franco could have just accepted the Anglogold deal, which would have absorbed the Normandy hedges within its own big hedge book. Then over time Franco could have reduced its position in the much more liquid stock of Anglogold that it would have received in exchange for its Normandy shares.
It therefore seems to me that Franco is looking beyond the problems of Normandy’s hedge book, which confirms my own analysis of Normandy – it is a very good company. I only sold it because of my concerns about its hedge book, and those concerns have now been mitigated given Franco’s action to keep Normandy away from Anglogold and out of the grips of a big hedger. Franco sees something it likes, so we too should be looking across the valley, ignoring Normandy’s hedge book.
In statements after the announcement of the proposed acquisition, Newmont was asked about its new hedging policy. Newmont forthrightly stated that it “does not intend to enter into new gold hedging positions”. When asked about the Normandy hedge book, Newmont said that it “will seek to unwind the positions when economically attractive”. This last statement explains a lot about the risks of hedging.
What does “economically attractive” mean? It’s a soft way of explaining that the hedges have a big negative marked-to-market value. If these hedges were covered, the paper loss on the hedge would be turned into a real loss, meaning that cash is necessary to cover the loss.
It’s hard enough psychologically and emotionally to take a loss. It becomes even harder when those losses draw down a company’s cash position.
Therefore, the temptation is to let the losses remain in the hope that they become “economically attractive” by the A$ gaining in value and/or the gold price falling and/or volatilities going up and/or interest rates going up, etc. These are just some of the factors that can affect the value of a hedge book.
These numerous factors also provide I think the reason why the gold companies that hedge should be avoided. There are just too many risks with owning their stocks. Look what happened to Long Term Capital Management. Look what is now happening to Enron. These so-called ‘masters of the universe’ have had their head handed to them.
Cambior and Ashanti are gold mining companies that have already had hedging disasters. Newcrest and Sons of Gwalia seem to be close behind. And others no doubt will follow.
Given Franco’s aggressive stance toward Normandy, it seems safe to assume that Normandy will not be on that list of hedging disasters. Clearly, I hold Franco management in very high regard. I assume that they are in control – that they understand Normandy’s hedge book and have a strategy to work it off without it blowing up.
Consequently, I wholeheartedly endorse this proposal that brings Newmont, Normandy and Franco under one roof. The new Newmont is definitely a company that you want to own. It will be the world’s largest gold mining company, and I expect that Franco management will over time turn it into the world’s premier gold mining company as well.