The Ugly Duckling

Australian based, Papua New Guinea gold producer Lihir Gold (US:LIHRY) listed on the Nasdaq at US$24.37 in October 1995. The stock quickly became a market favourite and within a year had soared to an all-time-high of US$40.75. However, the euphoria surrounding the record high was soon replaced with despair as the stock embarked on a deep bear market, largely in line with the falling gold price. In the four years that followed, LIHRY lost more than 86 percent of its value.

Since bottoming out at US$5.40 in April 2001, which coincided with a low in the gold price, LIHRY has recovered some lost ground. However given the context of current bullion prices we believe Lihir Gold offers excellent value.

In recent months, LIHRY has been held hostage within a tight trading range. This could be attributable to a directionless gold price, and/or investors awaiting confirmation of an improved operating performance at the company's PNG gold mine. A number of recent initiatives undertaken to lower production costs and increase output are not expected to positively impact on profitability until the second half of 2005.

Lihir recently announced first quarter production to 31 March 2005. Gold production of 101,370 ounces was down slightly on guidance issued by the company in January of 110,000 ounces. Production was lower largely as a result of the planned annual maintenance shutdown and reduced gold grades as detailed in last year's revised mine plan. Total cash costs were US$341 per ounce, which was in line with expectations due to the lower gold production.

Going forward, the commissioning of the 30 mega watt (MW) geothermal power plant this month will substantially reduce Lihir's energy expense and lower total cash costs. The Board has estimated that the new plant will generate savings of around US$14 million, which equates to around US$20 per ounce out of the production base. A further 20MW of geothermal capacity has also been approved at a cost of around US$37 million with construction to commence in July, and commissioning by second quarter next year. Management reaffirmed 2005 full-year total cash cost guidance of US$260 per ounce.

Production is forecast to increase throughout the year as higher grades of the Lienetz ore body are mined. Management confirmed the full-year production target remains 700,000 ounces. As production for the second quarter is forecast at 130,000 ounces, this indicates LIHRY anticipates a significant ramp-up over the second half of the year. The company intends to mine recently accessed small (6 metre), high grade benches (each containing between 50,000 and 100,000 ounces of gold) in Lienetz.

Over the medium to longer term, production will be further bolstered with the establishment of a flotation plant. Following a successful bankable feasibility study, the Board of Directors have approved progression to final engineering, and establishment of a financing facility for a 3 million tonne per annum flotation plant. Lihir will spend an estimated US$142 million on the flotation expansion that will generate an additional 140,000 ounces of production in the early years and give an investment payback of less than five years. By our estimates, Lihir currently has a positive net cash position of around US$50 million, leaving ample room to fund the flotation plant.

Lihir's hedge book is presently in the red by US$202 million on a marked-to-market basis, down from US$232 million in the December quarter. The company remains committed to delivering at least 160,000 ounces into outstanding forward sales contracts over 2005, with 48,500 ounces delivered in the first quarter. Given our bullish outlook for bullion, we were encouraged by management's statement that no new hedging will be undertaken in 2005. Total outstanding hedge commitments account for less than 9 percent of reserves and fewer than 5 percent of resources. We therefore do not view the negative value of hedge contracts as a major issue.

Over the past year, Lihir has been beset with operational issues, high production costs and generally poor sentiment towards the stock. However, we believe a much stronger year is in store for the company, driven by cost savings, increased production from higher grade ore, and a firm gold price.

Just as investors were overly optimistic at the all time high in 1996, we believe they have become excessively negative now that the stock is trading near historically low levels. In our opinion a lasting low is now in place, and we anticipate an enduring recovery to develop over the coming months. While sustained upward momentum may take time to develop, we believe that downside risk is relatively low at current levels. A break above trendline resistance at US$18 would be a clear sign that a turnaround was underway.

Having significantly under-performed the broader gold sector, we believe Lihir will play catch-up at some point in the not too distant future. We note that the market is currently valuing Lihir's reserves at around US$65 an ounce, which is substantially below the industry average of US$150 per ounce. In our opinion, Lihir is cheaply priced and holds excellent turnaround potential. Accordingly, we recommend LIHRY to all Members as a buy up to US$16.20. Members are advised to purchase the shares via their listing on the Nasdaq in the US.

COMPANY BACKGROUND

Lihir Island is about 900 kilometres north east of Papua New Guinea's capital, Port Moresby. Lihir Island is a volcanic seamount that rises steeply from sea level to approximately 600 metres above sea level. Gold was first identified in 1982, and exploration started the following year. In 1995 construction commenced in conjunction with the initial public offering. The first gold pour was in 1997. The Luise Caldera, in which all of the known ore deposits are located, is on the east coast of Lihir Island. Exploration identified several mineral deposits in the Luise Caldera, the principal ones being Lienetz, Minifie, Coastal and Kapit. The bulk of the known gold is located in Minifie and Lienetz.

Lihir Gold's world-class resource of 421.8 million tonnes averages 2.95 grams of gold per tonne for 40.0 million ounces of contained gold. It includes proved and probable reserves of 188.0 million tonnes, averaging 3.48 grams of gold per tonne for 21.0 million ounces of contained gold at a long-term price assumption of US$380 per ounce. With current reserves it is anticipated that open pit mining will continue until 2020, during which time the high-grade ore will be processed. The lower-grade ore that is currently being stockpiled will be recovered and processed over the subsequent 28 years.

Disclosure: Interests associated with Fat Prophets declare a holding in Lihir Gold