As the pace of deal making picks up in the mining sector, some investors and analysts can't shake the sobering memory of the last bull run before the Great Recession.
That season of mega-deals proved that in mining, takeovers beget takeovers - even when valuations are soaring. And the last thing capital markets need right now is another bubble.
Yet the global recovery is boosting demand for resources, driving up both commodities prices and production. At the same time, stock markets are surging and shareholders are finally confident enough to look for growth rather than simply protecting valuations, which was a key focus during the financial crisis.
That means deal-making is on the rise in many sectors, and for mining companies in particular, combining with other companies may be a faster and more cost-effective way of achieving growth.
The very nature of mining means companies can't suddenly boast higher reserves or pump out more minerals. "From the time you start commercial production, you are depleting what's there," said Andre Hidi, head of mergers and acquisitions at BMO Nesbitt Burns. "It's not like you can just make another widget and sell it."
That puts miners on the prowl for new projects, which in turn bumps up exploration and development costs. There are only so many skilled engineers, service companies and mine mangers. Plus, mining is energy intensive and energy costs are creeping higher by the day. Mining giant Alcoa Inc. cited these problems in its fourth-quarter earnings earlier this month.
The companies that win the growth battle over the long term are those with the lowest costs of capital, which can come from the right merger or acquisition. "I don't think it's 'just because my neighbour did it, I'm going to do it too,'" said Rick McCreary, head of mining at CIBC World Markets, of the pickup in deal activity. "It's really founded on the capital requirements to grow."
When two companies merge, they suddenly have more assets to drive cash flow, which boosts equity valuations, and their merged balance sheet make them less risky, allowing them to borrow more cheaply.
Inmet Mining Corp. and Lundin Mining Corp. took a note from this playbook earlier in January by leveraging their existing European operations to develop burgeoning copper projects in Panama and the Democratic Republic of Congo. Plus, Lukas Lundin, the company's chairman, said leaning on each other was a better option than a trial-by-fire partnership with a sovereign entity.
Mr. McCreary said miners Quadra and FNX applied the same logic when merging early in 2010, except instead of using their combined balance sheets to fund existing projects, the two companies wanted more capital to make acquisitions.
The logic behind deal-making is much more straightforward when a huge size gap between two companies exists. With a market capitalization around $200-million, Baffinland Iron Mines Corp. had no way of paying the $4-billion development cost of its Mary River iron ore project in Canada's Far North. The company was already negotiating with a strategic partner when it received its first hostile bid from Nunavut Iron Ore Acquisition.
Plus, larger miners trade at better multiples to cash flows and net asset values than smaller firms that are still in the development phase, Mr. Hidi said. That discrepancy lures the bigger players because it means their takeover has a much higher chance of quickly becoming accretive.
Because the valuation gap is so appealing, companies like HudBay Minerals Inc., which just bid for copper producer Norsemont Mining Inc., feel the need to act now rather than risk losing out to a rival large-cap miner, or waiting until the smaller firm discovers more minerals and its valuation pops, Mr. McCreary said.
It is this sense of urgency that creates a sense of panic, convincing chief executive officers to bid aggressively for other firms. But both bankers agreed the Canadian market hasn't seen too many deals just yet, nor have deals come at prices that are too expensive. Mr. McCreary acknowledged that some investors think Kinross Gold Corp. paid too much for Red Back Mining and Goldcorp Inc. paid too much for Andean, but he said the acquirers did their due diligence and simply believe there are many more minerals in the ground than outlined in the resource estimates.
Still, the prices paid could jump if the big players start to move on deals. "I frankly believe it's a matter of time before we see a higher level of activity out of the major mining companies," Mr. Hidi said.