Speaking at a mining conference in Florida nearly two years ago, David Garofalo said the words nobody wanted to hear, and most simply chose not to say.
In the midst of a wave of mergers and takeovers, the chief executive officer of HudBay Minerals Inc. fired a warning shot for the whole industry. Taking the microphone in front of his peers, he reminded them that growth for growth’s sake was “very value destructive.” And he took aim at the popular notion that commodity prices were in a “supercycle,” less vulnerable to slowing economic growth.
“We are not in a supercycle. This is a cycle and when the central banks find religion on inflation again, the cycle will be over,” the 23-year industry veteran told peers, including top brass at the world’s largest mining firms.
Mr. Garofalo may as well have been the prophet of doom, his words heralding the start of a downturn in the global mining sector that has seen a litany of multibillion-dollar losses at top companies.
In the ensuing fallout, chief executives have been fired and project financing has dried up. Acquisitions that were hailed as game-changers are now derided as dumb mistakes. A once-robust pipeline of new projects is all of a sudden looking emaciated, one mining company after another puts its ambitious growth plans on hold.
The implications for Canada, home to more mining dollars than anywhere else in the world, are profound. The resource sector faces the threat of a culling of junior companies, the lifeblood of the industry and a key source of financial activity in Toronto, Vancouver and elsewhere.
The sudden turn of fortune is particularly shocking for mining, an industry where resources are constantly depleted. Typically, large mining companies scoop up smaller ones to replenish their reserves and enhance the growth story they tell investors. But recent takeover mistakes have made traditional buyers gun-shy.
This week two of Canada’s largest gold companies, Barrick Gold Corp. and Kinross Gold Corp. , announced a combined $7-billion worth of writedowns related to takeovers of gold and copper companies since the start of the decade.
That’s just the tip of the iceberg. In the past year, global mining companies have erased billions of dollars from the value of acquisitions they once announced to shareholders as “transformational” deals, certain to create new wealth for investors. Most striking was Rio Tinto PLC’s decision to slash $14-billion of value, mostly from aluminum assets acquired with the takeover of Montreal-based Alcan in 2007 in this country’s largest-ever takeover deal. And the list goes on.
“I’ve never seen anything like this,” Mr. Garofalo, said in an interview that revisited his comments this week.
WHAT WENT WRONG
The merger mania that began in the middle of the past decade was hardly surprising, considering the tantalizing numbers. Global commodities prices were in the midst of a long upward trajectory, powered by such strong growth in China that not even the global financial crisis could stop the rise for long.
Barrick, like so many other giants, jumped at the bait, and the story of its missteps demonstrates what happened to so many others.
“Barrick would have been immensely better off if they hadn’t done any of their acquisitions and had just stuck with mining Goldstrike and building out their operations in Nevada,” said Michael Farrant, former Barrick corporate controller and now the chief executive officer of Commonwealth Silver and Gold Mining Inc., referring to his former employer’s leading North American assets.
Instead of focusing on projects it already owned, Barrick opted for growth: Its management believed metal prices would soar on the back of Chinese demand..
The decision to buy Equinox Minerals Ltd. boiled down to a simple opinion: “We were bullish on copper prices,” Barrick CEO Jaime Sokalsky said of the $7.3-billion acquisition. While copper prices still hover around $3.74 (U.S.) a pound, they are below the record prices at the time of the deal.
More importantly, costs have soared and analysts now argue that the acquisition, like so many others, was simply mismanaged.
Management teams will “blame it on labour inflation and cost inflation and ‘how could they have known?’ but I think in this market we’ve been in an inflationary environment for [capital expenditures] and [operating expenditures] for some time now,” said Jorge Beristain, managing director for metals and mining research at Deutsche Bank Securities Inc. in New York.
“They go out and buy the asset and then they plead ignorance when the costs go against them, and I think that if you are in the business of mining, you should know the environment,” he added.
Now Barrick is paying the price for its recklessness. In the past year, the stock has plummeted 34 per cent and Aaron Regent, the CEO who struck the Equinox deal, has been replaced by Mr. Sokalsky. A similar shuffle took place at a slew of other mining firms who have replaced their acquisition-hungry chiefs with conservative executives who can focus on costs and organic growth.
Kinross Gold Corp. is another example. But the fallout from a mistake by previous CEO Tye Burt is still being felt. The gold producer paid $7.1-billion to acquire the Tasiast gold mine in west Africa in 2010. This week, the country’s third-largest gold producer erased another $3.2-billion from the mine’s value, bringing its total project writeoff to $5.5-billion.
DEAL MAKING TO SUFFER
Ultimately, the writedowns have hurt investor confidence, wreaking havoc on an industry already suffering from disillusioned shareholders.
Historically, major gold miners financed their projects by selling new shares, but burned investors are less willing to pony up now for equity, forcing miners to resort to alternatives such as the bond market. Last year, mining companies raised $49-billion (U.S.) in debt, up from just $19-billion in 2010, according to CIBC World Markets.
Acquisitions for junior mining firms are also rare these days, hurting the smaller players who depended on being bought out by a bigger miner. “One of the messages that we’ve had is that in this challenging environment, we’re not building any new mines,” Mr. Sokalsky said, meaning he’s focusing on projects he’s already got, rather than buying new resources.
The transition won’t be easy. Juniors must often finance on their own, a tough task when few people are willing to put money into growth stocks.
Mr. Farrant, the former Barrick controller who now runs a junior mining company, tried to raise money last year but struggled. He travelled to meet with investors in Toronto, New York, Boston, Vancouver and London, but he didn’t get one bite. Mr. Farrant pulled the IPO and eventually had to settle with raising just over $2.5-million privately.
“It’s a pretty grim scene out there,” he said.
Mark Mahaffey, co-founder of Hinde Capital, a London-based investment management firm that advises the $50-million (U.S.) Hinde Gold fund, figures a significant number of the roughly 800 to 900 precious metals companies listed on Canadian indexes need to disappear, either by going out of business, selling out or merging. “You can’t have 20 different companies with single mines in close proximity to each other” chasing the same investor dollars, he said.
But wary CEOs could mean a further slowdown in M&A in a mining industry already suffering from a financing drought that has persisted almost without respite since the global economic crisis. That means fewer new projects will not make it to production.
There are also big question marks around intermediate-sized miners, many of which were once takeover darlings. Case in point: Osisko Mining Corp., which operates the Canadian Malartic mine in Quebec. Last year, the largest completed mining takeover in Canada topped out at $1.5-billion, so the likelihood of a bid for a company like Osisko, with a market value of $2.5-billion, is now much lower.
But Osisko is also getting squeezed in the equity markets because it was recently stung by higher development costs and lower-grade ore. Shareholders have punished the stock, sending it plummeting 45 per cent in the past twelve months, making selling new shares a more difficult proposition.
CIRCLE OF LIFE
The good news is that eventually the same challenges afflicting the industry today will drive it upward tomorrow.
If miners scale back on new projects, supply will suffer and metal prices will rise. Plus, the sweeping mismanagement across the industry can be fixed. The new cast of CEOs have already pledged greater transparency on costs and those who are the most zealous on this front are likely to be rewarded by shareholders for delivering more tantalizing profit margins.
“It’s starting to get interesting again, particularly [for] the senior golds,” said Keith Graham, president of Toronto-based Rondeau Capital, an independent investment management firm and a seasoned Canadian portfolio manager.
His take: Mining is an industry racked with poor capital allocation management and unrealistic cost and timing expectations. But there’s money to be made – he’s done it himself – and now could be the optimal moment to wade back in because so many of these miners are now out of favour.
Of course, there is one criterion that must absolutely be met, he argued. “If the price of gold stays where it is or goes up, there could be real value in the senior golds. But management has to be more cautious with their capital.”