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Why does resource size matter on junior projects?
Major companies invest in major properties. The colloquial phrase, “Does the project move the needle?” is very apt at explaining why resource size matters on junior projects.
Large projects should have multiple the valuations of smaller projects. It sounds like common sense, but it is worth looking at closely. Here we will use the zinc sector as an example.
The total zinc market is 11 million tons annually. A large mine produces half a million tons and $1 billion in revenue per year. BHP Billiton (ASX:BHP) is not interested in zinc and for good reasons. BHP produced $53 billion in revenue in 2010 (BHP Billiton Annual Report 2010). For a project to be material, BHP must get 5% of its annual revenue from it. Thus, for BHP to be interested in any project, it needs to produce about $3 billion in annual revenue. To generate $3 billion in revenue, a zinc project would need to produce about 1.5 million tons per year.
Selwyn Resources (TSX-V:SWN) owns one of the best zinc deposits in the world, but even the Selwyn Project will not produce 1.5 million tons per year. Thus, there is no junior zinc company that BHP would acquire to enter the zinc business. The only zinc assets large enough belong to Hindustan Zinc (NSE:HINDZINC), a subsidiary of Vedanta (LSE:VED).
The zinc business is going to go into supply deficit in the next three years. Major mining companies including Anglo American (LSE:AAL) exited the business because there was no money to be made. Our view is this persistent underinvestment is going to result in the strongest zinc market in 30 years over the next 10 years.
Even with an upcoming supply deficit, BHP needs one to three million tons of annual production to go into the zinc business. That is not going to happen unless they cobble together six or seven junior companies, which is probably not worth their management time.
When looking at a junior, take the resource size in tons, divide it by 20, and multiply by the market price. Then compare the result, the annual revenue generated, to the annual revenue of major companies within a sector. Most juniors just aren’t large enough and never will be.
Junior mining companies work themselves towards an exit. Traditionally they have three exit options: die, build the project themselves, or sell it. If the project is not large enough, the option to sell is significantly reduced. There is a rational pool of bidders for zinc assets. If a zinc project cannot move HudBay (TSX:HBM), Teck (TSX:TCK.A, TCK.B), or Hindustan Zinc’s respective needles, then the valuation goes down significantly.
If projects can only ship 30,000 tons of zinc per year, very few bidders will be interested. If a project can ship 300,000 tons of zinc per year, many will be interested. However, whenever we see retail investors drop major names like BHP for niche businesses like Canadian Zinc Corp. (TSX: CZN) in niche sectors, the market has lost sight of the size principle mattering.
Vale should not become Anglo American
Vale is a world-class mining company. It holds a dominant stake in the iron ore business. With the cash flow from its iron ore stake, what should Vale do next? Should it diversify downstream in Brazil or continue to build what could become the world’s greatest mining company?
The Brazilian government clearly feels it can claim some of the cash flow from Vale’s mining operations and redirect it to local development. The government feels Vale should be building up Brazil first and the global empire second.
Vale, however, will be limited by two factors: corporate attention span and, if the government gets its way, low returns from domestic tolling operations. Vale currently has a pipeline of extraordinary projects that will generate extraordinary returns. It is impossible for management of a major company to manage non-material projects. When you are building the world’s largest iron ore mine, world-class copper mines, and global coking coal assets, do you really want to waste valuable boardroom time and energy on a shipyard or a steel mill?
Vale should stay firm and stay out of building steel mills, shipyards, and other random businesses. If it must, it should fund startups and other companies that build local infrastructure. Nevertheless, it should remain a minority in these companies and use its balance sheet to get these companies going, but not provide any corporate guarantee.
Steelmaking is a tolling operation. Steelmaking companies charge a toll to convert iron ore into steel. That markup is used to pay for everything from coking coal to salaries. The problem with the steel mill is if steel is not continually produced at full production capacity, it is impossible to recover the lost production. In good times, steel mills make money. In bad times, governments keep them operating to keep employment up, even though they turn horrible profits. This is not where Vale should be focusing.
The Brazilian government does not want to create the Anglo American of Brazil. It might think a conglomerate is the way to go, but before it forces Vale down that path, it had better spend some time with retired Anglo executives. Vale is the world’s best iron ore company and a national treasure of Brazil. With the addition of lots of non-mining related companies, however, Vale will go from being the world’s sleek, impressive miner to a tired old barge of a company in less than 20 years.