There are fashions in investing just as there are fashions in clothing, and just as the cycle can turn from short skirts to long skirts, so too can the cycle turn in investing. Rarely does one have the opportunity to observe multiple visions compete against each other over a long period of time, and when one does, it is usually between two vastly different industries where it can be argued that the assets involved demand a different management style. However, just such a process has occurred over the past decade in the extractive industry. Oil & gas companies have hedged their costs and revenues through a variety of means. This has "de-risked" their cash flows by cutting operational leverage. They have then "re-risked" the cash flows" by using debt in the capital structure - they have employed financial leverage. Gold miners have done the exact opposite. They have "de-risked" their cash flows by paying off debt and cutting financial leverage. The absence of debt allowed them to then "re-risk" themselves by discontinuing their hedging programs, so that they could become a "Pure Gold Play." In other words they have hitched their fortunes to their underlying commodity by employing operational leverage. The first company to do this was Goldcorp. It started winding down its hedging program in Q4 1999, when it reduced its hedging book by 50% from 18.8 million ounces of gold, to 9.9 million ounces. Many others followed. Eldorado effectively paid off its debt in June 2002 so that its lenders would allow it to discontinue its hedging program. Barrick finally threw in the towel and stopped hedging its production on September 8, 2009.
One can argue about which strategy has been better for shareholders, but I believe that it is more important to look forward. As Table 1 shows, the market currently gives a higher valuation to oil and gas companies, despite their higher riskiness as measured by Beta, and the fact that gold companies on average have a much lower Beta (0.53) than the market as a whole. Why might this be the case? Both types of companies involve sinking large sums of capital into complex engineering projects (often in politically risky jurisdictions) in return for a payoff that stretches over decades. Both benefit from global growth and the urbanization of emerging market countries. Both have an element of environmental risk (less for mining companies than oil companies), and both produce commodities. One obvious answer might be that the outlook for oil and gas companies is more favorable than the outlook for gold miners. However, as Table 2 shows, gold is currently in contango (the future price is higher than the spot price) while the reverse is true for oil. It's hard to argue that the outlook for oil is better than it is for gold. Moreover, given that energy costs form a large percentage of a mine's costs, one can see that the outlook for miners is even more favorable. The market is forecasting both higher revenues and lower energy costs for miners. Some might argue that the reason futures prices exhibit these patterns is because of the difference in storage costs for both commodities, but neither a mining company nor a oil and gas company have to pay storage costs for commodities that are currently in the ground.
OIL & GAS COMPANIES vs. GOLD MINING COMPANIES1
Ent. Value /EBITDA2
Total Debt /Equity3
AVERAGE OIL & GAS
AVERAGE GOLD CO
1 Data Supplied by Capital IQ except where noted, and based on closing prices of Oct. 16, 2013
2 Based on trailing 12 months
3 Based on most recent quarter
4 Data Supplied by Thomson Reuters
Closing CME Futures Prices, October 16, 2013
I believe that at least part of the reason for this valuation gap lies in the different views the two types of companies have concerning risk management. A recent report by the McKinsey Global Institute shows that the volatility of resource prices has more than doubled over the past 13 years when compared to what was experienced in the years 1980 - 2000. Oil, at 46.6% (versus 39.5% for Metals) has been the most volatile of all commodities. If you think about a typical mine, there are huge sunk costs incurred when it is built. The expected payoff is a long stream of positive cash flows, but those cash flows will only be positive if the price of the commodity in question behaves as forecast and doesn't fall. If it doesn't behave as expected, then the mine must be shut down either temporarily (not only is this costly, but revenue is forgone) or maybe even permanently closed. Permission to operate a mine is often contingent upon the land being returned to its pre-mine condition within a certain time frame. It's hard to imagine future governments granting extensions for environmental remediation stretching years or decades because of a fall in commodity prices. In many ways, the mine can be thought of as a Knock Out Option, an option that expires worthless if a certain price is touched. Investors pay a big upfront cost (an option premium) in return for a positive payout over time. However, if the price of the commodity decreases materially, the mine is closed, and the upfront cost (the option premium) is forfeited. As any options trader will tell you, increased volatility (and Gamma) can cut both ways. In such a situation, hedging your downside has a lot of appeal. Oil and Gas companies choose to do this, gold miners don't. What might have been an appropriate strategy in 1999 when Goldcorp started winding down its hedge book might not work as well today when volatility has doubled.
What does all of this have to do with private equity? In general private equity funds are attracted to relatively low risk assets with stable cash flows and low degrees of financial leverage. The private equity playbook is relatively well established;
1) Find an industry with undervalued companies and low levels of debt. One can argue that mining companies fit the bill, see Table 1.
2) Look for a company within that industry that is a conglomerate, or a "grab bag" full of different businesses or assets. The stock market will often assign a low value to these assets because it believes that either; a) Existing management doesn't have the time or resources to focus on the business or asset in question, or, b) The full potential of the business or asset isn't being realized because it is being used to subsidize other non-related businesses, perhaps as a cash cow. Buy the desired asset, or buy the entire company and spin out the assets you don't want. The sum of the parts will be worth more than the whole. There are plenty of mining companies that have a producing mine for mineral A in say North America, that is acting as a cash cow to subsidize exploration properties in South America, Africa and Asia of minerals B, C and D. The skills needed by management to run a mine are very different than those needed by an exploration company and both sets of expertise may not present in the target company. Given the riskiness of the exploration properties, the amount of debt used by the corporation is often much less than could be used if the producing mine was in a stand-alone company.
3) Once you own the company or asset, hire an experienced manager and give him or her equity so that he or she makes decisions in the best interests of the owners, and not the employees. One would think there are plenty of mid level managers at the BHPs of the world who love such an opportunity.
4) Cut costs! Sell the company jet, decrease advertising and R&D, break the unions, downsize the work force, and if possible, raid the employees' pension fund.
5) Lock in revenues and costs with long dated supply and labor contracts, futures, forwards, and swaps. For gold mines, one can easily hedge both inputs (energy costs) and outputs for relatively long periods of time, for example gold swaps can be transacted out to ten years.
6) Leverage the company to the hilt, take advantage of the tax shield offered by interest payments to transfer value from the government to debt and equity holders. Note, often the same tax free pension funds that invest in Private Equity Funds are big buyers of corporate debt. To give a simplified example, they go from controlling an asset by owning 100% of the equity of a company with no debt, to controlling that asset by owning 100% the equity of a highly leveraged company, and also owning 100% of the company's debt at the same time. If the company goes bankrupt, they foreclose on themselves and retain control of its assets. The only loser is the government that now collects less tax. See the low levels of debt at certain of the companies in Table 1.
7) After a few years, sell the company for a profit and move on to the next opportunity.
As the above analysis shows, it would appear that the gold mining sector, and perhaps the mining sector in general, is ripe for the entrance of private equity funds as buyers. Assets appear to be undervalued. Value can be created through more stringent risk management, something private equity funds have experience with. Not only is it possible to lock in a positive cash flow for a lengthy period of time, it is also possible to lock in higher revenues and lower costs with a counterparty (the futures exchange) that is relatively risk free. One would think that gearing up these assets would be feasible.
"Why," you might ask, "hasn't someone already done this?" Historically private equity has tended to avoid commodity firms for a variety of reasons (volatile cash flows, environmental risk), but according to an article published in Canada's National Post on October 16, 2013, six percent of all mining deals (as measured by deal value) in 2011 and 2012 involved private equity. To date their role has been limited to participating in syndicates but this may be set to change. Several weeks ago, the Hong Kong based trading house Noble Group, and the Private Equity Group TPG, each announced that they have invested $500 million into X2 Partners, a fund launched by Mick Davis, that is dedicated to becoming a mid tier mining and metals group. The strategic rationale for Noble is clear; it will be the preferred partner for the sales of any production from the assets of X2 Partners. TPG on the other hand manages $55 Billion of capital that has been invested in 275 different companies in a number of industries, none of which have anything to do with commodities or mining.
Mr. Davis was recently the CEO of Xstrata plc, an Anglo-Swiss multinational mining company that had a market cap of $44 Billion when it was taken over by Glencore. Xstrata was a well-run company with low leverage, a diversified asset base, and relatively low cost of operations. A good question to ask is why did Glencore think that they could extract more value from Xstrata's assets than Xstrata itself was able to? While by no means a comprehensive review, reading the 2012 annual reports for the two companies offers some insights. Glencore devotes 12 pages to explaining how they mitigate the risks inherent in their business. The comparable section in Xstrata's report is four pages long. The following excerpts are illuminating;
We maintain a diversified portfolio of commodities to reduce the impact of price movement in any one commodity. We do not typically implement large-scale hedging of price movement initiatives. (Xstrata 2012 Annual Report, Page 16)
The Group has a policy, at any given time, of hedging substantially all of its marketing inventory not already contracted for sale at predetermined prices through futures and swap commodity derivative contracts, either on commodities' exchanges or in the over the counter market. (Glencore 2012 Annual Report, Page 26)
The Group uses, among other techniques, Value at Risk, or VaR, as a key market risk measurement technique for its marketing activities. (Glencore 2012 Annual Report, Page 27)
While X2 Partners' strategy hasn't been made public, I would think that it's a good bet that Mr. Davis has learned a few lessons from Glencore, and that he is looking to do one better by following the private equity playbook. Don't be surprised if others follow, reports have it that Blackstone, Apollo and the Carlyle Group have all established mining desks.
There are a number of ways to play this emerging trend. The first step is to determine likely targets for a takeover. To do this, first look at gold mining companies (and miners in general) that have positioned themselves as pure plays on the underlying commodity that they mine by paying off debt and discontinuing hedging. Several have already been mentioned in this article. A good filter to use is the credit ratings assigned by Moody's and S&P. The higher the credit rating, the greater the chance that a company will be taken over. To help further choose which companies are the best bet to be taken over, and which would command the greatest takeover premium (i.e. the ones where hedging can add the most value) think like an option trader. Choose companies that have options (mines) with the greatest chance of being knocked out. These will be companies with assets (producing mines) that have a high cost of production near to the current price of the commodity being mined. If the asset/mine in question forms a high percentage of the company's market cap, and has similarly high decommissioning costs, it will derive the greatest benefit from hedging its downside, and from locking in positive future cash flows that can be geared up with debt. If you are a long only equity investor, go long the targets that you have identified. If you are a long-short fund, go long the targets and short other miners that didn't make the cut. If you are a credit trader, go long Credit Default Swaps (go short the credit risk) either outright, or hedged by a short CDS position (long the credit risk) in a non-target company. There is a lot of event risk that is not yet being priced in.
One word of caution. Don't expect a wave of takeovers to start tomorrow. It takes time to raise capital, identify targets, and consummate a deal. That said, markets are forward looking and price in potential events well in advance of when they actually happen, and, the time between Glencore's takeover of Xstrata (May 2, 2013) and the announcement by Noble Group and TPG that they were investing in X2 Partners (September 30, 2013) was less than five months - barely the length of time to complete a standard gardening leave.