Historically, private equity houses have taken little interest in the mining sector, with few transactions of note in an industry that has been perceived as inappropriate for financial purchasers. With the ever-increasing buying power available to private equity and the rapidly changing metrics of the mining sector, perhaps it is time for the mining sector to be reconsidered.
So, Why Has The Mining Sector Not Been A Private Equity Target In The Past?
The reasons include the following:
- Empirical evidence suggests it is a cyclical industry
- Mining companies have been price takers, not price makers
- Cash flows have historically been unpredictable
- Capex is significant on assets that are depleting
- Concerns over environmental and other reputational risks
- It requires specialist knowledge to succeed
- Concerns over political and social risks in emerging markets
- Lack of possible exit options
But, the mining industry clearly perceives things differently. Transactions have seen a sharp pick-up since 2005, with global M&A deals spiking from US$16 billion in 2004 to US$54 billion and US$68 billion in 2005 and 2006 respectively.
A Cyclical Industry? This Time It Is Different.
The last metal price slump in the late 1990s was significantly impacted by the exceptional de-stocking of inventories built up during the cold war by the former Soviet Union. The impact of this was to greatly exaggerate the perception of mining being a cyclical industry.
The current higher metal prices are reflecting a very fundamental supply/demand imbalance – the industry cycle may now be out of sync with the macro economic cycle causing a step change in metal pricing.
Demand
World demand for metals is closely related to global GDP, although rapidly expanding economies tend to have a higher intensity of use of some metals, particularly steels, than advanced countries. Current levels of demand strength were not expected nor anticipated. Whilst the Western economies grow steadily, the growth of the Chinese and Indian economies continues to surprise, with no sign of abating.
Supply
Supply is constrained in ways that cannot easily be corrected and projected growth in demand already discounts substitution, recycling, and thrifting. Reasons for this include the following:
- It can take 10 years to develop a large mine, with current metals prices already taking into account existing projects coming onstream.
- Outside of existing projects, there is a lack of new mineral discoveries because:
- The most easy-to-find deposits are already known
- Exploration has been cut back as the long timescales for projects
- to come onstream make investment too risky
- Political risk has eliminated many prospective areas
- High-tech and biotech are competing for the same risk capital
- There has been a lack of new exploration technology
- There is a major skills shortage: mining engineers and geologists.
- There is a major materials shortage globally: tires and equipment often have three-year lead times.
Impact
The mining industry may not have the same nature of cycles as typically perceived by investors. The current level of high metals prices appears to be holding up and the predicted peak keeps on moving. There is a significant supply/demand imbalance in many metals which will take several years of higher prices to be resolved, possibly beyond a private equity exit period.
As inventories have fallen, nickel prices have risen to record highs, a steady progression which can be seen over the last 10 years.
Similarly, copper prices are at record highs as inventories have fallen over the last five years.
The Goose Is Getting Fat.
Metal prices have increased substantially over the last three years, with nickel and lead hitting record highs in early 2007 and tin enjoying a 22-year high. Copper, has been heavily shorted since its high in May 2006, but it is now holding at high price levels, and aluminum is experiencing a physical squeeze.
Symptomatic Of A Period Of Sustained Higher Metal Prices
The knock-on effect of this is that mining companies have become highly cash-generative, with predictable and secure cash flows. We are seeing the major mining companies with low gearing and a diminishing pipeline of capital projects despite acceleration of capital expenditure. Many mining companies are now aggressively returning cash to shareholders. Several of these organizations have unused credit capacity, are consciously "unhedged", and are aggressively consolidating to find growth opportunities through M&A activities. If metals prices remain high, we expect that these characteristics will only become more pronounced.
Major mining companies are running out of capital projects and are aggressively returning cash to shareholders.
Mining Companies Are Becoming Price Makers.
Continued consolidation amongst the major players is leading to an element of greater pricing power by the producers, after decades during which a fragmented mining industry had little control over its products' pricing. Management is behaving more astutely in limiting capacity expansion and future overproduction. As a result, normal supply/demand economics are being established.
As analysts predict lower commodity prices, Enterprise Value/EBITDA multiples have fallen over the last five years because EBITDA has outperformed expectations whilst commodity prices remain strong.
Impact
As many mining companies have large amounts of cash, lazy balance sheets, more pricing power, and are controlling the amount of new supply hitting the market, there are good grounds to believe that, while they are not controlling the cycle, mining companies can influence the length and strength of the cycle. Therefore they themselves are pursuing under-valued opportunities within their sector.
The chart below demonstrates that mining companies which have taken this bullish view over the last 16 years have significantly outperformed those that have bought into the "peak of cycle" view.
Where's The Exit, And How Important Is It?
a barrier to investment in the mining sector. The changing fundamentals in the industry mean that there are more exit opportunities, whilst the importance to the overall investment return is diminishing.
Given the changing fundamentals, a significant element of the required return on investment may be achieved prior to exit.
- Dividend capacity – Most of the producing mining companies have substantial retained earnings and the ability to pay significant dividends.
- Hedging capacity – The terminal metal markets (e.g., the LME, Tokom, Comex) permit extensive use of derivative instruments to accelerate future cashflows and lock in current higher prices. Many companies have not been able to use these facilities due to shareholder pressure for an unhedged investment vehicle.
- Unbundling – Several companies have divisions and units that can be separated and sold, or spun off. Many of the operating assets (mines and smelters) are independent stand-alone units. The other mining companies would be ready buyers of many of these operating assets, and can additionally realize operational synergies.
- Effiiencies – Many mining companies carry staff and cost structures from a different era, providing opportunities for cost savings.
- Financing – Most of the mining companies have attractive credit ratings, but unused capacity which is available for more efficient use of the balance sheet by issue of corporate bonds or project finance.
IPO Has Become A New Exit Route
Historically, public offerings have not been an option for mining companies in emerging markets because of the perceived political risks in crossborder transactions. Recently, however, there have been many successful offerings from previously unappreciated geographies, such as the most recent primary offering on London Stock Exchange of Kazakhmys plc (Kazakhstan), Hothschilds plc (Peru) and GEM Diamonds plc (Africa).
Impact
Short-term cash returns are potentially higher than acquisition prices would suggest, making the exit a less critical part of the overall return to private equity investors. Coupled with the availability of IPO, the opportunity for private equity to make a target return on mining investments is greater than ever before.
Global Mining & Metals Center.
Ernst & Young's Global Mining & Metals Center connects teams around the globe which share information on current and emerging trends in the sector to help clients manage risk, optimize performance, and increase operational effectiveness. The Center is where people and ideas come together to help mining and metals companies meet the issues of today and anticipate those of tomorrow.
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