And, in fact, for the 2008 year? Well, I've been running some...

And, in fact, for the 2008 year? Well, I've been running some numbers.

Lihir has been a pretty consistent underpeformer, in recent years. However, when you place that label on them, you always have to be careful.

Until recently, they have been a one mine company. And, there aren't too many mines in the world which produce +600,000oz almost every year, yet still get labelled as "underperformers". Consider LGL's past production. For the years from 1998 to 2002, each year was over 600koz of production. However, there was always an expectation that some lower grade ore would need to be accessed, in order to get to the next layer of good stuff. That happened, starting in 2003, with that year to 2007 going as follows: 550koz
599koz
596koz
651koz
701koz

With the exception of 2005, each year has seen about 50koz p.a. increased production. Pretty tidy, for any company, hey? Well, apparently not for LGL.

Their main problem has been perennial over-promising, rather than actually under-delivering. Consider what they estimated they would produce in presentations for the above years, starting in 2003:
+600koz
600koz
700koz
670koz
+800koz

The other big problem has been their hedge book. Let me give you an example, from their June 2003 quarterly, of what (in hindsight) appears to be an insane hedge book:-
2004 - deliver 218koz @ $US325/oz
2005 - 180koz @ $335
2006 - 222koz @ $322
2007 - 330koz @ $324
2008 - 375koz @ $332
2009 - 243koz @ $351
2010 - 10koz @ $327

So, their hedge book insanity only ended in 2010 and, in all likelihood, only because it was hard to hedge so far forward, back in 2003. Look at the prices, though - when they placed those hedges, they thought $320 - $350 would hold true for 7 years! In fact, at the time I took these numbers from (June 2003), the spot price was already $US345/oz and the hedge book was underwater to the tune of $56m. The following June, it had tripled to $166m on a spot price of $396/oz. You can see where this is going, can't you?

Of course, that was just the start. When all was said and done, LGL finally closed out its hedge book in 2007, via a $1.2bn capital raising, when the gold price had reached over $600/oz.

However, this little foray into the past, while interesting, is not without meaning. There is a little trick to do with hedge loss accounting, which means that LGL continues to suffer write-offs, even though it paid off its hedge book, using freshly-issued capital, back in 2007. I won't bore you with the "why". All you need to know is the "how much". Accounting standards require LGL to write off the following non-cash items: 2008 - $77m; 2009 - $102m; 2010 - $82m; 2011 - $44m.

Now, let's look at what LGL had to say in their Q308 quarterly report. Apparently, we're looking for 850koz of production for 2008, @$420/oz cash costs. Assuming an average gold price for 2008 of about $850/oz for the year, you would expect a gross margin of about $365m. Now, an operation like LGL (especially now that it's a multi-mine company) costs a lot to run. Then, you have exploration, development and depreciation write-offs. Costs a lot! So, at the end of the day, the first thing you can take off their net $365m profit is $77m of hedging write-offs. Nasty!

So, what did they report for the first 6 months? $36m of net profit. What can we expect for the 2nd half? A bit more, I would think. Why? Well, the achieved gold price in the first half was higher (at about $910/oz) than it will be in the second half (at about $820/oz). However, production should be higher in the second half, such that overall production should be split 40% first half, 60% second half. I would expect a net profit in the order of $50m (before tax, but after hedge write-offs).

However, here is the key for LGL. It now has two, big non-cash items cropping up in each report. They both reduce the company's dividend-paying ability, however they don't reduce its cashflow. The first is the hedging items, mentioned above; the second is depreciation and amortization charges. To give you an example of how large an effect they have on LGL, in the first half, EBIT before DA and hedging was $190m. Add in hedging losses, depreciation and amortization, and you get your $36m net profit.

So, you can see that LGL generates an awful lot of cash each year. Each year, it choses to spend some on keeping its existing operations running, but after that, it still has hundreds of millions per annum, which cannot be distributed as dividends to sharholders, because the effect of hedging and depreciation accounting, results in declared profits being reduced (and dividends can only be declared out of accumulated profits).

Consequently, we see the 1moz p.a. Lihir upgrade. However, that won't use up all of the free cash which the operation is throwing off at present gold prices, so Ballarat is purchased. Still not enough, so Equigold is gobbled up.

Given that LGL knew that they would be accounting earnings-constrained (and therefore dividend-constrained) for the next couple of years, I guess it was to be expected that they would be acquisitive. It gives them something (apart from Lihir Island) to spend their hundreds of millions of free cashflow on developing. They can't pay it out in divvies, so they may as well put it to use creating future earnings potential.