Why Capital Structure of Mining Companies Matters

by: Daniel Moser

Mining companies represent a compelling opportunity for investors with very long time horizons. Everything I have written about so far has been centered on this point. However, not all mining companies are created equally. Some companies didn’t manage themselves financially as well as others throughout the gangbuster times and are now facing harder times relative to their peers. If you are considering investing in the mining industry, it is a very good idea to consider how the company of interest has been managing their finances over the last several years.

Last year should have made just about every CFO in the world take out their old text books to review the Modigliani-Miller theorem in order to review proper capital structures. Most Business models that relied extensively on debt financing were destroyed in 2008 and those not officially destroyed in 2008 are going to be struggling for the foreseeable future. I am not sure that debt driven business models will ever come back, let alone come back in the next 10-15 years.

In an article by The Economist titled “Digging Deep” published on Feb 5th, the author points out that several mining companies are rushing to raise equity. Companies specifically mentioned in the article are Rio Tinto (RTP), Freeport-McMoRan (NYSE:FCX), and Xstrata (OTC:XSRAF). According to the article, these firms together are aiming to raise as much as 17 billion dollars which will result in “lopping a fair chunk from their combined net debt of $62 billion dollars”.

Not all companies are in the predicament of raising equity to pay down debt. For instance Vale (NYSE:RIO), after an 11 billion dollar equity raising in mid-2008 (according to The Economist), has actually been buying assets from some companies such as Rio Tinto. Other companies such as Pan American Silver (NASDAQ:PAAS) have issued secondary equity offerings, but since they have no real long term debt, the influx of equity can be used for capital investments and operations–hardly a bad thing. Pan American Silver raised approximately $100 million with an average price of $16.25. Since closing the secondary offering, the stock is up a little over $17 per share. Freeport-McMoRan actually just finished its stock offering which raised $740-$750 million in cash with an average price of $28 per share. The stock was up a little over $29 when this article was being written.

I couldn’t possibly recommend purchasing Rio Tinto. They didn’t manage themselves very well over the last several years and as such they are paying the consequences of their actions by being forced to sell assets and may even sell a large stake to China. Other companies like Vale, Southern Copper (PCU), and Pan American Silver are better positioning themselves despite the downturn. Freeport-McMoRan is hopefully included in this group as they have taken a nice amount of medicine and has hopefully learned their lesson. In conclusion, even though I am a long term buyer of this sector, I do not believe all companies are created equally. Thus, I believe investors need to use a fine tooth comb in their examination of how these companies have conducted themselves in the good times as well as bad.

Disclosure: I remain long RIO, PCU, PAAS, and GLD