Merges and acquisitions in the mining & metal sector
Introspection and inertia characterized a year of subdued M&A activity in the mining and metals sector. During the last 12 months, there was a distinct shift away from external investing for growth toward internal capital optimization. Traditional buyers concentrated on capital discipline, improving balance sheet strength and maximizing return on capital. The majors continued to pursue divestment of non-core assets, while cash-strapped juniors struggled to raise finance. Such a climate presents deal opportunities. However, the sense of urgency to make them happen was missing. These are the main conclusions of Ernst & Young experts, which prepared an annual global review of mergers & acquisitions in the mining and metals sector.
The year 2013 marked the third consecutive year of declining M&A deal values and volume in the mining and metals sector. Deal volume dropped 25% y-o-y, while total deal value increased by 20% to $124.7b. However, this increase was misleading as it was primarily due to the completion of the merger between Glencore International and Xstrata. Excluding this, overall deal value decreased 16% to $87.3b, prolonging the downward trend of recent years.
The mining and metals industry continued to be plagued by volatility in commodity markets and the macroeconomic uncertainty that characterized the last five years. With margins squeezed and returns from previous investments under scrutiny, companies are hesitant to part with capital. Faith has been shaken and investment sentiment in the industry is at an all-time low. But, for the large cap producers at least, there is very little distress and balance sheets are looking increasingly healthy. As diversified mining and metals companies seek to optimize portfolios with a focus on increasing overall margins, many of the industry’s majors have announced high-value divestment programs. During 2013, the industry’s top five diversified mining majors completed $6.3b (including Vale’s $1.8b sale of its Norsk Hydro shares, which falls outside of the M&A data within this report) of divestitures, while $5.5b of deals have been agreed and are expected to complete during 2014. Еxamples of divestments made in 2013 include the following:
• BHP Billiton divested its Pinto Valley mining operation and associated San Manuel Arizona Railroad Company ($650m), interests in the EKATI Diamond Mine and Diamonds Marketing operations ($553m), and the East and West Browse joint venture ($1.63b).
• Vale sold its shares in Norsk Hydro for $1.82b, and announced the sale of its Araucaria fertilizer plant for $234m and its stake in the Brazilian BM-ES-22A oil and gas concession for $40m.
• Rio Tinto sold its 80% interest in Northparkes ($820m); agreed the sale of its Eagle project to Lundin (c.$325m); and completed the sale of its 57.7% effective interest in Palabora Mining Company ($373m);the North American portion of its Alcan Cable business ($151m) in 2012; and 50% stake in the Clermont mine ($1b).
Additionally, most of the majors focused their strength on achieving cost saving targets and scaling back capital expenditure while pursuing only the top tier projects and doing so incrementally. For instance:
• Rio Tinto reduced operating costs by $2b by the end of 2013 and is scaling back capital expenditure 20% y-o-y for the next two years.
• Anglo American will deliver about $1.3b annually by cutting overhead costs, reducing its project pipeline and generating more value from product sales.
• AngloGold Ashanti plans cuts of $460m from corporate and exploration costs and $500m from operating cost savings.
This activity, together with other rationalization measures and an uptick in iron ore prices during the back end of 2013, has strengthened cash flows and balance sheets and eased the pressure to divest non-core or underperforming assets.
As such, investing activities remained subdued in 2013 and any expectation of rock-bottom asset sales seems off the mark. These conditions collectively point toward deal inertia. With buyers looking for bargains and sellers in no mood to let assets go cheaply, it’s a stalemate.
Valuation gap – increasingly difficult to bridge
However, the gap between buyers’ and sellers’ valuation expectations is not only the preserve of the large cap producers. A total of 74% of the respondents to EY’s Capital Confidence Barometer Survey for Mining and Metals, released in October 2013, believe that a valuation gap of 10%-30% currently exists. Further, the expectation of the majority of respondents is that the gap is going to remain or even increase.
A disparity in analysts’ forecast for metal prices, fueled by differing expectations for world economic growth, is producing a broad range of asset valuations. This is only serving to widen the gap between buyer and seller expectations on price and hinder deal completion. While some believe that current equity valuations are wildly undervalued, others consider this to be a much-needed market correction. From any vantage point, it is a challenging backdrop against which to make investment decisions. With price volatility expected to continue for a few more years as the supply and demand balance struggles to achieve equilibrium, both buyers and sellers will need to be innovative in their approach to valuations.
Financial investors embrace opportunities
Despite challenging market conditions, the sector’s new entrants appear to be finding a way to successfully navigate the M&A landscape. During the last 12 months, financial investors increased their share of total M&A undertaken by value from 5% in 2012 to 19% in 2013. This stands to reason given that many financial investors are countercyclical, attracted by the prospect of potentially strong returns driven by low asset valuations.
In 2013, 5 of the 19 megadeals (>$1b) were undertaken by financial investors:
1. The $3.6b joint investment by Lizarazu and Receza in Polyus Gold International
2. Onexim Group’s $3.5b investment in Uralkali
3. Chengdong Investment Corp’s $2b (12.5%) stake in Uralkali
4. Samruk-Kazyna’s $1.7b investment in Kazzinc
5. Crispian Investments’ $1.5b investment in Norilsk Nickel
These deals highlight the disparity between market valuations and the underlying value that a strategic and more patient investor can attribute. In most part, these megadeals demonstrated a belief by the financial investor that the market was being too risk averse.
This investor group has typically sought to acquire minority stakes, evidenced by the fact that 64% of their 2013 deals were for a stake of less than 50% in the company and 88% were valued below $50m.
Emerging financial investors include Former Xstrata CEO Mick Davis, who recently set up X2 Resources, Former Barrick CEO Aaron Regent who established Magris Resources, and former Vale CEO Roger Agnelli, together with fund company Grupo BTG Pactual SA, established B&A Mineração.
This is a trend that Nicky Crabtree, Assistant Director, Transaction Advisory Services, Mining & Metals, E&Y expects to continue. He also anticipates further interest from specialist funds and individuals over the next 12 months, led by a number of former mining leaders lending their expertise to privately held capital.
There is potential for ongoing activity in the year ahead, driven by these former mining leaders with in-house technical and operational expertise and a keen eye for strategic assets in the sector. The current capital-raising environment will present a window of opportunity for well-capitalized fund companies and a much-needed injection of capital for mining and metals companies. These specialist financial investors are likely to become mainstream investors in the years ahead, filling the gap until traditional acquirers and equity market confidence return.
Preference for smaller bolt-on deals
Given that 2013 was characterized by senior management changes and strong rhetoric to display capital discipline, it is not surprising that high profile megadeals were largely abandoned and leaders instead chose to undertake lower risk bolt-on deals.
There was just 1 deal undertaken with a value in excess of $10b – the Glencore Xstrata merger – and only 19 deals that fetched more than $1b a piece, compared with 26 such deals in 2012. These megadeals comprised 72% of the total value of M&A deals closed during the year but represented only 2.7% of total deal volume.
Many large deals that did occur were one-off, unique in nature and not reflective of the market sentiment as a whole. For example, the merger of Dubai Aluminium (DUBAL) with Emirates Aluminium (EMAL) to create a new entity, Emirates Global Aluminium – the only reported deal out of the UAE – was driven by a nationalistic desire by Dubai and Abu Dhabi to consolidate their state aluminium producers and strengthen their position globally.
The two major oil and gas acquisitions by Freeport-McMoRan Copper & Gold accounted for 7% of total deal value (10% when excluding the Glencore Xstrata merger) and were driven by a desire to diversify out of the mining and metals space.
The remaining megadeals were largely low risk, fueled by a desire to increase an existing stake, achieve domestic consolidation or a strategic attempt to secure future supply. For as long as the majors remain heavily focused on strengthening their bottom lines, simplifying portfolios and riding out volatility, any increase in high-value acquisitions is unlikely in the near future, short of these unique or highly synergistic opportunities.
Cross-border activity – declining popularity
The year 2013 saw the first fall in the proportion of cross-border deal activity since the global financial crisis (GFC) in 2008. Outbound activity, as a proportion of the total M&A volume, fell from 52% to 42% y-o-y, with only 18% of the total deal value for the year targeting cross-border assets.
The flow-on effect was a significant increase in the value of domestic deal activity, which rose from $43.3b in 2012 to $65.1b in 2013 (excluding the Glencore Xstrata merger), accounting for 75% of the entire deal value for the year. All of the top 10 deals were domestic targets, while two of the largest deals – the merger of DUBAL with EMAL and the merger of Sterlite Industries into Sesa Goa – were driven by nationalistic consolidation. The remaining megadeals were largely low risk, fueled by a desire to increase an existing stake, achieve domestic consolidation or a strategic attempt to secure supply.
Regional M&A trends
In 2013, Europe was both the most targeted and the most acquisitive region by deal value due to the Glencore Xstrata deal. Excluding this deal, North America was the most targeted region with 31% of deal value, narrowly leading Asia Pacific (29%). North America and the Asia-Pacific region tied as the most acquisitive regions by deal value, each with 33%.
At a country level, excluding Switzerland’s Glencore Xstrata merger, the US was the most targeted by value ($18b or 21%) and Canada was the most targeted by volume (153 or 22%). Similarly, the US was the most acquisitive country by value (21%) and Canada by volume (30%). The value of US domestic deals rose from $2b in 2012 to $16.6b in 2013, and Canada from $2.2b to $6.8b. Within these countries, buyers mostly targeted assets within their existing commodity focus and looked to strategically create growth and efficiencies locally.
The unusually high deal value targeting the Middle East is attributable exclusively to the DUBAL-EMAL merger completed in 2013, rather than an overall surge in activity from this region. Similarly, the CIS more than trebled its value of deal investment on a flurry of large domestic private investor activity in the gold and coal sectors plus the $5.5b worth of investment into potash producer, Uralkali, by Onexim Group and Chengdong Investment Group.
Activity in emerging and frontier regions slowed during 2013, with the value of deals targeting Latin America and Africa dropping 80% and 85% y-o-y, respectively. The drop-off is not surprising during a period of cautious capital deployment; there is a tendency instead to invest in mature, developed and stable jurisdictions. It is likely that investment capital is being prioritized to projects that do not have the added burden of significant infrastructure capital that often accompanies large-scale emerging market projects. Encouragingly, this is likely to be a short-term phenomenon.
The drop in China’s outbound and domestic deal value (a fall of 42% and 22%, respectively, in 2013) can be attributed to new leadership and major structural reforms as it switches from a growth-based economy to a consumption-based one. In particular, stricter rules around environmental protection and public backlash against health and safety standards have impacted the Chinese mining and metals industry. Overcapacity of supply in coal, steel and iron ore has impacted short-term pricing, making investments into anything other than high margin projects difficult to justify at this point in time.
Although China is still dependent on commodity imports to supply its large-scale capital expansion, the post-GFC strategy to secure supply through large-scale acquisitions slowed during 2013. Many of the recent deals have been subject to greater scrutiny, in particular over prices paid, which is driving a more cautious approach to M&A.
Consequently, buyers have increasingly been exploring alternative routes, such as off-take agreements and providing pre-export finance as an alternative method of securing supply over outright acquisition. For example, Yunnan TCT Yong-Zhe Company signed an agreement with Sirius Minerals for off-take (initially fixed price) and an ongoing collaboration arrangement instead of taking an equity stake in the polyhalite developer.
Gold surpassed steel this year as the most sought-after commodity: it was the target of 34% (237) of deals and $12b of investment.
A total of 47% of gold buyers came from outside the gold sector, of which financial investors represented 22%. This is a trend likely to continue as gold prices remain under pressure, costs look set to increase and the dwindling share prices of junior players make them attractive targets for those willing to see out volatile short-term prices. Additionally, financial investors will be an increasing source of finance as the flow of debt and equity into gold juniors/explorers remains elusive. As margins increasingly look to be under pressure and the specter of devastating impairments in recent years remains, gold players that are able to rationalize operations, share risk through joint ventures, achieve cost savings and improved cash flows by pursuing divestitures will enjoy the greatest returns.
In 2013, aluminium deal value was uncharacteristically high due to the $7.5b merger between Dubai Aluminium (DUBAL) and Emirates Aluminium (EMAL). This deal was driven by integration, merging the smelting capabilities of Dubai and Abu Dhabi to form the world’s fifth largest aluminium company and to further develop the UAE’s non-oil based economy.
Oil and gas figures were also high on the back of Freeport-McMoRan Copper & Gold’s $8.6b acquisitions of Plains Exploration and Production and McMoRan Exploration, which comprised 94% of the entire value of oil and gas interests by the mining sector. FreeportMcMoRan Copper & Gold, which has previously held assets in this space, was attracted by strong fundamentals in the oil and gas sector and the opportunity to reduce its exposure to fluctuating metal prices.
While 2013 deal activity was down on 2012, copper was still one of the most-sought after commodities, evidenced by a couple of big value deals during the year. Stand-out copper transactions included Capstone Mining’s $650m acquisition of BHP Billiton’s Pinto Valley copper mine, First Quantum Minerals’ $5.1b takeover of Inmet Mining and China Molybdenum’s purchase of Northparkes mines from Rio Tinto for $820m. As with gold, strong, long-term demand prospects and depressed valuations provide a good opportunity for financial investors to invest in copper.
The value and volume of deals involving energy commodities were among the worst hit in 2013 due to continuing market weakness and the threat of alternate energy sources. Deal value for the acquisition of coal assets dropped 56% y-o-y, while the value of deals targeting uranium fell 51%. In addition, we witnessed a 55% fall in y-o-y deal value targeting iron ore assets, where an uncertain price environment challenged deal execution.
We do expect this to change, however, as coal and iron ore assets are increasingly being targeted by commodity traders, with several large deals on the horizon.
For example, Rio Tinto looks likely to sells its stake in the Clermont coal mine in Australia to Glencore Xstrata and Sumitomo, while BHP Billiton has also announced the sale of stakes in its Jimblebar iron ore assets to Itochu Corp and Mitsui & Co. In addition, in 2013, Noble Group concluded minority stake acquisitions in coal miners, Resource Generation and Pan Asia Corp, and recently announced a 21% stake purchase in Cockatoo Coal. Commodity traders are also looking to secure long-term future supply of these commodities through off-take agreements, loan facilities and investment in low-cost assets on expected future delivery to high-demand growth markets, such as China and India. Stable supply available out of Australia makes this region particularly attractive for this kind of arrangement.
Outlook - long term health in the balance
The mining and metals sector is entering 2014 with a more positive outlook: confidence in the global economy is improving, companies have taken action to deleverage balance sheets and the industry-wide focus on productivity and efficiency should begin to yield results. As a result, we expect the gradual strengthening of mining and metals equity valuations to continue and the increased availability of capital.
However, continued economic volatility is also expected in 2014 due to Eurozone economics, Chinese economic rebalancing and US Federal Reserve policies regarding the tapering of quantitative easing. As supply and demand struggle to return to post-supercycle equilibrium, we expect further price volatility to occur for at least the next two years. This will see caution prevail: any uplift in M&A activity and improvement of capital raising conditions will be gradual and will require innovation in pricing to tame volatility.
There is an expectation that growth in M&A activity during the first half of the year to be driven by financial investors and equity-backed alternative capital providers as outlined in our Spotlight section: Alternative financing. This growth will not only be driven by anticipated longer term commodity price recovery but also by the application of in-house technical experience to drive operational, technical and financial influence. This has the potential to be the most exciting story of 2014. Will we see the deployment of capital so feverishly raised during 2013? And, if so, will it begin to drive new investment activity across producers?
With low levels of new capital and new investment, the mining sector may well be sowing the seeds for the next boom as supply falls short of demand. Will financial investors, private capital and other counter-cyclical investors be able to fill this capital shortfall in 2014? It is EY’s view that a more patient form of capital creation is essential for the sector’s long-term health. This capital will be required to both replace the “hot money” that has been leaving the sector, as short-term returns fall from their record level, and provide capital for the next projects required to restore extinguishing supply or meet future demand growth.