Recent Mining Company Write-Downs
I was asked yesterday, based on my business valuation consulting background, for my views on mining company writedowns following recent announcements by:
- Barrick Gold Corp. on February 14 that it was taking a writedown of U.S.$4.2 billion, mostly related to its Zambian Lumwana copper mine which it acquired pursuant to the acquisition of Equinox Minerals Ltd. in 2011;
- Cliffs Natural Resources Inc. which announced on January 24 that it was taking a goodwill writedown of U.S.$1 billion pursuant to the acquisition of Consolidated Thompson Iron Mines Ltd in early 2011;
- Kinross Gold Corporation on February 13 that it was taking a writedown of $3.2 billion, mostly related to its Tasiast gold mine (located in Mauritania) which it acquired pursuant to the acquisition of Red Back Mining Inc. in 2010; and,
- Rio Tinto on January 17 that it was taking a writedown of about U.S.$14 billion. Of the U.S.$14 billion about U.S.$11 billion was attributed to its aluminum assets, and about U.S.$3 billion that was attributed to a coal 'deal' in Mozambique.
The questions asked of me were;
- what do these writedowns mean to the mining industry?;
- do these sorts of announcements worry investors?; and,
- are all writedowns created equal, or are some more worrisome than others?
I have read 'journalist write-ups' of each of the four referenced transactions (see article links). I have not analyzed any of the referenced transactions either before or after they closed. Subject to those caveats, my overview observations are:
- first, as best I can determine, all the referenced transactions were made between arm's length parties, where no party was under any compulsion to transact. At least one of the transactions (Barrick's purchase of Equinox) is said to have been subject to 'a heated takeover battle involving five different companies';
- second, I have seen no suggestion of transaction related wrong-doing on the part of the Boards or Managements of any of the companies that were parties to the referenced transactions;
- third, all of the acquiring companies are large measured by market capitalization. One can reasonably assume those companies to have a high level of business experience and sophistication at both the Board of Directors and Management levels;
- fourth, value as perceived by buyers and sellers relates to specific points in time. Sophisticated Boards of Directors in reliance on detailed due diligence and acquisitions analysis - which typically includes extensive 'price and cost sensitivity' analysis) - do not approve acquisitions of any size lightly - let alone material acquisitions in the context of size relative to existing business operations. To do otherwise would be contrary to both good Corporate Governance and the fiduciary obligations of those Directors. Simply put, Management recommendations and Board approvals are based on the best information available to Boards and Managements at the time of the transaction;
- fifth, it is all too easy to be critical of transaction prices and terms after the fact. Simply put, unless there is transaction-related wrongdoing typically hindsight is just that. It typically might be fair to say "based on hindsight evidence it appears Company Y paid too high a price for X". It typically would not be fair to imply "the Directors of Company Y approved a price they ought to have known was too high when they did that"; and,
- sixth, it is interesting to observe the market prices of the shares of each of the aforementioned companies on the day of their announced write-downs, and for the following four trading days. The share prices of two of the companies (Cliffs and Rio Tinto) went up, and the share prices of the other two (Barrick and Kinross) went down - but in no case by a price difference that was clearly material (i.e. significant). This can be taken to mean that the analysts and the financial markets had already 'priced in' the writedowns before they were announced - or at the very least none of the writedowns came as any great surprise. In theory, the analysts and financial markets
generally should anticipate significant writedowns for large and well followed companies - and in the four referenced cases they seem to have done that.
Question: What do these writedowns mean to the mining industry?
The things the referenced writedowns ought to (and I will be surprised if they don't) increasingly focus Mining Companies (and more particularly their Boards of Directors and Management) on include:
- the uncertainty and volatility that currently exists in the macro-economy, specific country economies, what appears to be escalating country risk, and the inflationary capital and operating cost environment faced by the mining industry on both the revenue side of profitability - where world commodity prices dictate revenue - and on the cost side of things;
- the current and prospective financial and capital markets attitudes toward mining company stocks generally;
- continuing escalating mine project capital costs and operating costs;
- depending on country, increasing energy and water scarcities; and,
- depending on country, increasing country risk measured by (among other things) government (at all levels) project approvals and interjections, government taxation, local population interventions, royalty, income and other tax increases, energy and water scarcities, and environmentalist interventions.
Mining Company Directors and Management are 'people also', who learn, respond and adapt like everyone else. So, of course, the writedowns that have been taken (and perhaps will be taken from here) broadly ought to attract their attention, and ought to cause them to reflect and focus on them when making their own business decisions going forward.
Do (or perhaps better said, should) these sorts of announcements worry investors?
The things the referenced writedowns ought to increasingly focus investors on include:
- at a high level investors should not be overly concerned about announcements of writedowns resulting from unpredictable changes in circumstances and events (such as unexpected downward metals prices, unexpected capital or operating cost escalations, or unpredicted changes in tax regimes in the context of the quality of the Boards of Directors and Managements of the companies they hold shares in;
- that said, investors should worry if a writedown taken does or could materially negatively impact the company's financial position, or negatively impact its ability to finance its day/day operations, growth plans, or ability to raise new capital;
- investors should worry that metals prices, possible cost escalations and possible country risk issues are extremely volatile in today's macro-economic conditions. Recall that it was only about one month ago the CEO of BMW said 'it is no longer possible to approve a corporate five-year plan in the belief the company will actually achieve that forecast' - see World Economy - The only certainty is uncertainty; and,
- investors should distinguish between transactions that appear to have resulted in over-payments due to unpredictable events that occur subsequent to the transaction, and over-payments that occur from poor post-transaction management of the transaction. Investors should worry if the latter is the case. Unfortunately, there is almost never enough public information to properly quantify this.
Are all writedowns created equal, or are some more worrisome than others?
My answer to this is quite straight-forward:
- no, not all writedowns 'are created equal'. They are all dictated by their own facts and circumstances. Importantly, writedowns should not 'immediately assumed in hindsight' to be mistakes based on bad analysis at the time of the transaction;
- writedowns in theory are unexpected permanent post-transaction downward changes in the present value of a company's after-tax discretionary free cash flow forecast for a given project. Such changes can result from post-transaction revised pricing forecasts, revised production forecasts, revised capital costs, revised operating costs, revised tax regimes, poor posttransaction management, etc. These changes don't always 'go the same way' - i.e. some of these might be revised downward but not upward. Such changes also can result because a changed economic and financial markets climate dictates a changed 'rate of return on investment' target at a different (i.e. post-transaction) point in time; and,
- in a sense, all writedowns are worrisome, because they bring attention to the fact that not everything always goes up, and therein lies risk in any commercial transaction - or for that matter any human endeavor.
- to some degree, 'writedown size' may matter;
- writedowns may dictate management change. In a perfect world, this occurs only where a writedown results from post-transaction mis-management; and,
- writedowns may prove to be more material to smaller companies than to larger companies. For example, if a writedown affected a company's credit rating or access to new capital, that could have a material affect on prospective company risk and hence on a company's share price.
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