Global Merger and Acquisition Activity
Mining stocks began to recover earlier this year, but the recovery fizzled in the face of on-going concerns in the euro-zone and continued fears of a global economic slowdown. Investors continue to shun risky investments, and commodity companies are seen as high risk.
Some people are wondering if we will ever see a recovery in the mining industry.
Most people recognize the emergence of the developing world and the huge, long-term impact on the metals markets as 3 billion people enter the modern era. We are still in the early stages of a long-term super-cycle in metals.
The important question in this moment is: What is going to happen to share prices over the coming weeks or months?
At these price levels, the mining industry represents an extraordinary investment opportunity. But, will the prices get even better before they rebound?
To understand what is going to happen in the near term, we need to step back and look at the big picture. Also, it is vital to understand some of the critical changes that have occurred in the mining industry in recent years.
People get so caught up in what is happening in the moment that they often lose track of the bigger picture. The longer term trends are ignored and very few people take the time to anticipate what is coming in the future. The global picture is often completely lacking in the media. Investor thinking is often driven by the day’s headlines.
Last year saw an endless stream of bad news that kept investors in a state of terror for most of the year. The biggest story was the crisis in Europe, with the media predicting the complete collapse of the euro.
By now most people have forgotten the dire forecasts regarding the consequences of a US government debt downgrade. US debt WAS downgraded, and those dire forecasts were shown to be meaningless and have been forgotten.
Upheaval in the Middle East and North Africa threatened to set off a chain reaction of collapsing governments that would de-stabilize the entire region.
Japan was hit by a devastating earthquake and tsunami that created a nuclear disaster. The country is still struggling to clean up the mess and restore full power.
Throughout last year, there was fear of a global recession.
By now, for most people, the fear of a complete collapse of the global financial system is easing, but that fear still persists in minds of some people.
With seemingly a new crisis every week, in is not surprising that investors fled from everything that had a hint of risk. Gold fulfilled its role as a safe haven last year, as panicked investors pushed the gold price to an all-time record high.
Even after falling sharply from that record, gold closed the year up 10%. But, with the gold price reaching record territory and gaining 10% on the year, gold equities were down as much as 40%. There is still an unprecedented disconnect between the bullion price and the equity prices.
People are obsessed with the short term blips in metal prices. It is far more important to see the longer term trends. Gold is up 6-fold in a decade.
Gold was about the only metal that was a winner last year: Silver was down 9% on the year. Last year, base metal prices were down 20% or more across-the-board.
Again, the focus for most people is on the short-term blips. Note that the copper price is also up 6-fold in a decade.
Equity prices in the mining industry were down a multiple of the declines in the commodity prices. Investors abandoned the mining industry, driving share prices down to irrational lows.
However, not everybody was negative on the outlook for mining. Even with the world seeming to collapse around them and with metal prices falling, the major players in the mining industry maintained an optimistic long-term outlook.
That optimism was reflected in a near record for global mergers and acquisitions (M & A) in the mining industry. The value of mining M & A activity last year totalled $149 billion, nearly twice the level of 2 years before. Importantly, that buying frenzy took place as the metal prices were declining.
Canada was the biggest player in the acquisition scene, accounting for fully 25% of the total global M&A activity. The US and Australia made up another quarter, with the balance spread around the world.
To demonstrate how out-of-line equity prices have become, the takeover bids in the copper and gold sector averaged a 46% premium to the market prices of the target companies before the bids.
In a moment, I will touch on some of the reasons why the mining companies were making huge long-term commitments even with the world in turmoil and metal prices declining.
First, let’s look quickly at the present situation. This week, Spain joined Greece as the crisis of the week. Growth in Germany is being offset by recessions in the peripheral countries, with the net effect that the euro zone is unlikely to show any growth this year. The US is recovering, but ever so slowly. China, which was the big driver of global growth last year, is slowing down.
That all sounds dismal. But, let’s look just a little closer. Europe, with little or no growth, will use the same amount of metal this year as last year. The US, in slow-motion recovery mode, will use slightly more metal than last year.
China is on track to grow at 7.5% this year, slower than the 9 or 10% growth rate over the past several years. That is still a very substantial level of growth for the second largest economy in the world.
China is by far the largest consumer of metals and that 7.5% growth rate ensures that the country will use substantially more metal this year than last year.
In spite of the various fears, demand for metals is continuing to grow and will continue to grow for many years into the future. Consider this: the urban population of China, India, and the rest of the developing world will continue to grow at about 35 million people per year for several decades. Urbanization is an intensive user of metals. Imagine building the equivalent of every city and town in Canada every year; or, re-building all of California every year.
It is very clear that demand for metals will continue to increase – in the near-term, the medium-term and the longer-term.
The demand story for metals is pretty clear. But, the supply side of the metals industry is less well understood and perhaps even more important in understanding the outlook for the industry.
It is getting harder and harder to find new metal deposits. For that reason, and a whole host of other reasons, it has become much more difficult for the mining industry to expand production.
Basic economic theory tells us that when the price of a commodity increases in the face of growing demand, the industry will add new capacity.
Yet, look at what has happened in the gold market over the past decade. The gold price is up six-fold, yet production is barely ahead of where it was a decade ago. In fact, if it was not for the spectacular growth in Chinese gold mining, gold production would be much lower than a decade ago.
Here is one factor in explaining that anomaly.
In the 1960s, the average grade of a gold mine was 12 grams per tonne. Today, it is 1.3 grams per tonne. That means that nearly 10 times as much rock has to be processed to get the same amount of gold.
These changes have a profound effect on the industry, yet only a small number of people really appreciate the extent of the changes.
Here is an example of the rapid pace of change: 2 years ago, people thought that a gold deposit had to be well over a gram per tonne to have any value. Last year, a mid-tier producer paid a half billion dollars to buy a sub-1-gram per tonne gold deposit in British Columbia. That takeover price was 10 times the amount the company traded at just a year before.
The situation for other metals is not quite so dramatic as for gold, but in general, it follows that pattern: grades are declining, new deposits are harder to find and the industry is struggling to replace depleted mines and keep up with growing demand.
Many deposits that were found in the 1960s, 1970s and 1980s had little value at that time because the industry had a surplus of good quality deposits. Well, those good quality deposits were developed and are now largely mined out.
Today, those previously cast-off deposits are the best available to the mining industry. Just look again at the gold grade chart to understand how a deposit would have little value in the past, but would now be extremely valuable.
Junior companies now control many of the best development prospects available to the mining industry. The well-managed among those companies are continuing to add value to the deposits they hold.
Without getting into detail here, let me remind you that a metal deposit that has already been drilled off as a resource can appreciate in value by 10-, 20- or even 30-times as that deposit advances toward production.
As those deposits advance, there will be more takeovers. And, as was the case last year, the takeovers will come at substantial premiums to the present share prices.
It is very clear that mining companies will continue to seek out new acquisition targets: the miners need to replace depleted mines. In addition, demand for metals is continuing to expand.
The producing companies are well financed to continue the acquisition binge. The mining industry has been extremely profitable over the past few years, amassing an enormous amount of cash. At this time, the top 40 largest mining companies are sitting on $105 billion of cash. The mining industry has never, ever before had anywhere near that sort of cash in the bank.
The takeover activity this year is likely to be far more competitive than it was last year. There is more money available and there will be more bidders: A number of new players are entering the mining space and will be competing against the established mining companies.
For example, users of metals are becoming increasingly concerned about security of supply. The steelmakers are buying iron ore mines. The Japanese and Korean base metal smelter companies are investing in mining deals to secure off-take agreements.
Non-mining investors are also taking a greater interest in the mining industry. For example, sovereign wealth funds and private equity firms are becoming more active in mining deals.
Perhaps most importantly, mining companies in the emerging countries are getting bigger and they are getting more aggressive. Large mining companies in China, India, Kazakhstan, Indonesia, Philippines, Mexico, Brazil and other emerging economies were big players in the merger and acquisition scene last year. Buoyed by their successes, those companies and many others will be competing aggressively to buy metal deposits this year and in years to come.
Okay, that all sounds very good, but where’s the action in share prices?
We started to see a recovery in the mining industry earlier this year, but that recovery fizzled. Part of the reason is that there is still a great deal of fear in the minds of many investors. With the diminished prospects of a financial collapse, interest in gold has faded, lessening the appeal of gold equities.
In this moment, the financial problems seem to have gone away. Soon enough, there will be reminders of the ongoing uncertainty throughout the financial world and gold will resume its decade-long uptrend.
Nearly everybody who thinks about investing in mining believes that there has to be gains in the metal price to make money. That is simply not true. Companies can add enormous value even with flat or declining metal prices as they advance projects toward production.
Very few people understand the supply/demand picture. They don’t appreciate the on-going need for new mines. They don’t recognize that the mining industry is sitting on more than $100 billion of cash and they are looking to deploy that cash to grow their businesses.
So, back to the important question: Is this the right time to invest in mining?
Absolutely, yes. The downside risk from the current price levels in minimal. The upside is huge. Just remember that there is enormous diversity in the quality of companies in this sector.
Investors must be selective. The objective should be to own companies with high quality projects that will become takeover targets. Management is critically important. Companies that have cash are in a much stronger position than companies that will have to raise cash in a bad market.
Areas with low perceived risk will be more popular in the near term: Canada, parts of US, parts of Latin America. For example, the recent coup and pending civil war in Mali has further impacted the value of companies throughout Africa.
There are good projects in risky areas: you just have to weigh the risks against the potential rewards.
Importantly, you should diversify and you should get some professional input in evaluating companies. There is still further downside risk. In the meantime, high quality companies are adding value and the takeover binge continues. Another of the companies that we follow received a takeover bid last week, again at a substantial premium to the market price. There will be many more such offers, regardless of whether investors come back to mining.
About Lawrence Roulston
Lawrence Roulston Archive
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