Against the backdrop of current macroeconomic trends—European sovereign debt, the continued monetization of U.S. obligations, the prospect of a hard landing in China—another phenomenon is quietly playing out here in Canada: a continued strengthening of merger-and-acquisition activity in our mining sector, which could boost what are now severely compressed equity valuations.
We’re not talking about the large deals for senior producers that characterized the past decade. Recent attempts at mega-mergers, like BHP and Potash or Xtrata and Anglo, have been found wanting by investors who viewed them as unwieldy and destructive to per-share value, and by governments and regulators who found them detrimental to competition (or politically unpopular).
Instead, we’ll see more smaller deals, in the range of a few hundred million dollars to $1 billion, for several converging reasons.
For one, there has not been the increase in metals supply you would expect with sustained high commodity prices, because it simply takes so long to discover new deposits and then to permit, finance and develop new mines. Meanwhile, production at many senior companies is shrinking, as their older operations become more grade-challenged and difficult to mine, and workers agitate for larger shares of expanding profit margins.
Starved for growth and cash-rich, these seniors are increasingly putting that cash to work on earlier-stage opportunities, and acquiring good-quality, single-asset juniors with advanced projects. You can see that dynamic, and how competitive it has become, in the current tug-of-war between Cameco and Rio Tinto over junior uranium company Hathor Exploration, and the continued litigation between Barrick and Goldcorp over the undeveloped El Morro project in Chile.
Investors, meanwhile, are increasingly demanding that companies either use their cash on hand or give it back to shareholders. And while the industry is seeing some dividend increases, cash is increasingly the currency of choice for acquisitions, as equity multiples have been crushed by global macroeconomic trends.
This is important for another reason: there are more opportunities than ever before for investors to get commodity exposure, through ETFs, futures or other instruments. The only way to attract these investors to mining companies, then, is to be able to offer them leverage to the commodity price by growing mineral resources, and ultimately production, on a per-share basis.
Two other factors give us confidence that the M&A trend will continue: China’s aspirations, and the re-emergence of private equity as a player.
The Chinese have been active recently in both the mining and the broader Canadian resource sector, and they will continue to be, trying to cycle their vast sums of capital into hard assets as fast as they can. Though Barrick outbid Minmetals for copper producer Equinox last spring, Minmetals’ bid was hostile—a first for a Chinese state agency. Given China’s need to secure direct access to mineral deposits to support their enormous industrial complex, they will likely become even more aggressive.
On the private equity side, we are seeing increasing signs that PE firms are taking a hard look at junior and intermediate miners—for good reason. Given that many quality companies are trading at compressed multiples, current high metal prices and historically low interest rates have the leveraged-buyout model looking very attractive for the mining sector. A private-equity outfit could in theory take out an established producer at a reasonably modest premium, lock in metal prices at current levels through hedges, and realize a very good return on their equity investment, juiced by a substantial proportion of low-cost debt.
That adds up to private equity, China and established senior producers competing for the same scarce assets—making the months and years to come very interesting in the mining arena.
David Garofalo is President and CEO, HudBay Minerals Inc.