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In mining, bulk is great. But then what?
DEREK DeCLOET, from the Globe and Mail
May 15, 2008 at 6:00 AM EDT
A fellow who has spent time in the mining business was talking about the twists of fate and fortune in digging up rocks. “Look at Newmont,” he said, referring to the largest U.S. gold company. Investors are looking at Newmont – with disdain.
Gold has gone from about $350 (U.S.) an ounce to $860 in five years, a rise of nearly 150 per cent. Newmont's gains have been less than half that (about 60 per cent). What? It's supposed to work the other way around: the commodity price goes up, profits (and share prices) go up even more. That's why people own mining stocks, 'cause it sure isn't for the skimpy dividends.
In misery, Newmont has company. Barrick, too, has been outperformed by gold – over three years, five years, 10 years. But the phenomenon is not restricted to gold bugs. Aluminum prices have more than doubled in five years, but Alcoa's returns haven't kept pace. Anglo American, one of the largest diversified miners, got big price increases in 2007 for some of its most important products, like nickel and iron ore. But in the end, operating profit was up just 3 per cent and Anglo underperformed the FTSE mining index by a mile.
Size does not guarantee success. Size brings its own headaches. EnCana discovered this, which is why it said this week it's splitting into two smaller energy concerns. Some big miners could be next.
At the moment, that may be hard to believe. Haven't we just gone through a massive round of mining mergers? Barrick bought Placer Dome, Xstrata bought Falconbridge, Brazil's Vale nabbed Inco, Rio Tinto got Alcan. Now even the acquirers could be acquired: Vale made a play for Xstrata (unsuccessfully) and BHP Billiton has been in pursuit of Rio for six months.
In every case, the buyers were (and are) in search of the holy grail: big reserves, monster market capitalizations, lots of trading liquidity in their stock, blue-chip investors. For Vale and Xstrata, the deals for Inco and Falco were transformative, as CEOs like to say; they turned those companies into legitimate, top-tier players.
But here's what mining mergers don't accomplish: They don't guarantee a torrent of free cash flow for their owners. Consider, once again, Newmont, which at the end of 2005 boasted that it had 93 million ounces of gold reserves.
Over the subsequent two years, it produced nearly $2-billion (U.S.) in cash flow and plowed $4.5-billion into exploration, developing mines, and making acquisitions to replace what it's taking out of the ground. And at the end of those two years, it had 87 million ounces of gold reserves. By any measure, that's an awful business. The cash flow picture is better at Barrick but the struggle to find gold is similar.
It's nice to be the biggest, but what then? Mining companies don't pay large dividends to their owners because they need the cash to build new mines and explore. But when you're already huge, and most (if not all) of the money is consumed in the struggle to stay even, what value are you building? All the sizzle goes out of the story. Your profit growth becomes entirely dependent on a rising commodity price. Your company stagnates. Eric Sprott, resources investor extraordinaire, figured this out, which is why he avoids mega-cap oil and mining stocks.
For diversified miners, the problems are a bit different. As with any conglomerate, they can be confusing. It's easy for them to trade for less than the sum of their parts. (Teck Cominco is so concerned with this that it recently sent analysts 126 PowerPoint slides – 126! – on how to forecast Teck's profits and cash flow.) The cost savings in building a global mining enterprise are dubious, too. Each mine is essentially an autonomous unit. If there aren't many “synergies” between EnCana's oil sands assets and its natural gas fields, there can't be many between a Peruvian copper play and a zinc mine in Alaska.
But if that's the case, why merge in the first place? Because up to a point, size does matter; a decent 11-figure market cap helps attract the big institutional investors and reduces the company's cost of capital. It's useful in fending off takeovers, too.
But as much as anything, mining CEOs do mergers because they're slaves to fashion. When the market wants big companies, they'll create them. When the market wants pure (or purer) plays, they'll slim down. Scratch the surface and you can find small bits of evidence that this process is beginning: Anglo spinning out assets to become more “focused,” Rio Tinto selling its piece of the Cortez gold mine.
Shrink, so that you can grow again. As EnCana found out, getting big is a lot more fun than being big.