Coming out of the recessionary cost-cutting and post-recessionary restocking, US and European stocks offered a slew of expectation-busting results in the second quarter. But the positive earnings surprises (for the former) and revenues surprises (for the latter) did little to avert the outflow of funds from the equity market. A theory of ageing baby boomers caring less about return on capital and more on capital preservation (the popular pun refers to return OF capital) is gaining traction, keeping pace with the inflow of funds into the seemingly bottomless bond market. Safe heaven bonds are selling like hot cakes and only the Japanese Ministry of Finance is allowing more products to mature than to be sold. This week again, the yields on the Japanese, German and US government bonds have dredged record depths.
The stock market apathy is now being countered by feverish M&A activity. The last two weeks have seen an unprecedented onslaught of announcements targeting a variety of companies: Potash, McAfee, NedBank, 3Par Inc, International Power, Cairn India, Dana Petroleum, New Alliance and Sphere Minerals (which controls attractive iron ore assets in Mauretania). With the exception of Kinross’s advances in West Africa (and the earlier Newcrest-Lihir tie-up), the gold mining industry has been remarkably quiet on this front. This relative inertia continues despite the much higher level of fragmentation than in the case of more M&A-prone potash or iron ore industry. Why has the gold industry been so quiet? The answer is threefold.
The first part of the answer lies in the structure of the gold mining industry. Three out of top 10 gold mining companies are domiciled in South Africa. After Pretoria’s initial green light to Anglo American, Billiton and several others to establish Plc structures in the UK, the process of internationalization of South African resource companies stalled. The last significant acquisitions made overseas by SA gold mining firms were executed in 2001. The liquidity and fungibility of their shares made it extremely difficult to compete for Australian assets and practically impossible to enter a contest for North American assets. The legislation favoring ownership by historically disadvantaged South Africans, first leaked in 2002, further depressed any interest in South African producers as potential targets of corporate activity. Several years later, the botched approach by Harmony to take out Gold Fields offered the final nail in the coffin. Short of resuscitating the idea of intra-South African consolidation (or rather asset rationalization), there is little chance of the three giants to play a decisive role in the global consolidation of the industry.
The second part of the answer has to be sought in the relative valuation of gold mining stocks. The CEO of Yamana has recently complained that the undervaluation of large mining stocks vis-à-vis their smaller competitors lies behind the slow pace of consolidation. It is true that when a tier I company does venture out, the allegations of ‘overpayment’ abound. Kinross’s CEO is still facing a tough battle with many reluctant shareholders over the purchase of Red Back. Both gentlemen have investment banking background and Yamana’s boss seems to be correct in his assessment. Currently North America’s large gold stocks trade at around 13x next year’s cash flow, 21x forward earnings, 7x EV/Ebitda and around 1.4x NAV. By comparison, the 2nd tier producers, where most growth is expected, trade at 16x cash flow, 23x PE, 9x EV/Ebitda and around 1.7x NAV. And that despite the largest companies having the free cash flow yield twice the size of the second group’s. Essentially, that would mean that large companies – many of which were built on successful acquisitions in the past – are bound to destroy value if they embark on costly acquisitions among the 2nd tier producers. But that does not rule out some activity on the part of 2nd tier producers targeting small and emerging gold miners.
Here lies the third reason behind the slow progress in consolidation. Even if we put aside the Chinese and Russian producers, the universe of potential takeout targets runs close to three digits. Monitoring this universe requires dedicated teams for both desktop overview and on-site due diligence. Many of the 2nd tier producers lack the adequate corporate structure to focus on any targets that are not known already – through geography, personal contact or other privileged leads. Investment bankers will not find a $150m-$300m deal attractive enough to dish out a detailed proposal. Essentially, the industry lacks vehicles facilitating the deal flow beyond the most obvious targets (Lihir was one of them). Canadian banks may have the best information about their actual and prospective clients, but it is the prospective acquirer which will eventually have to do all the time-consuming homework. The signature of confidentiality and standstill agreements with the target will invariably divert resources from the key development work that 2nd tier miners depend on. Those which may potentially have such resources at their disposal (ElDorado? Agnico-Eagle?) possess plenty of in-house growth projects in the near term, or are busy integrating recently acquired assets. In addition, while tier 1 companies may more easily deploy resources from other operations to increase efficiency gains from the target’s assets, smaller acquirers usually find the post-merger acquisition just as challenging as the ongoing process of monitoring the available universe of potentially attractive targets.
The occasionally optimistic pronouncements about the overdue nature of gold mining consolidation are destined to remain just that – optimistic. The fragmentation of gold’s primary supply is a combination of historical legacy and the comparatively high-value, yet low tonnage nature of the majority of the relatively isolated deposits with few operational synergies. This does not mean that interesting targets are not there – in West Africa, in the Andes, in North America’s northeast or in Southwestern Pacific. But the process will be as slow as it has been in the past – regardless of the bouts of M&A fever in other sectors.
Tags: asset rationalization, consolidation, corrpoare activity, fragmentation of gold mining industry, gold mining M&A
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