To buy or to build, that is the question

When escalating costs and a much-delayed construction schedule forced NovaGold Resources (NG-T, NG-X) and Teck Cominco (TCK.B-T, TCK-N) to pull the plug on building a mine at their Galore Creek copper-gold deposit in northwestern B.C. last year, their decision lent some credence to the view that sometimes it’s cheaper to pick up mining assets through mergers than it is to attempt to build a mine from scratch.

“The buy versus build argument in copper favors building, but only when there is clear ability to execute,” Citigroup Global Markets argues in a recent research report. “New projects (most starting post-2010) have a capex/production ratio of about US$4 per lb, versus about US$14 per lb to purchase. But if capex climbs by 50%, the cost of new projects lifts to US$10 per lb. Given modest arbitrage between projects and producers, plus development risks and project scarcity, we believe companies will continue to hunt for M&A.”

The popularity of mergers and acquisitions will continue due to “free cash flow yield premia”, mounting cash balances, fewer reinvestment opportunities, “frictional barriers” to new capacity and “aggressive forays” by sovereign investors.

“Whilst it is not a clear-cut argument that it is cheaper to buy rather than build, the risk factors surrounding capex [and] cost inflation, the near-term cash generation from existing assets, the acute lack of construction materials and labor and the lack of major Greenfield projects all indicate to us that companies could continue to look for M&A opportunities with their surplus cash generation,” Citigroup Global Markets argues.

Either way, if last year’s robust M&A activity is any guide, the wave of consolidation is likely to continue at least until the end of this year, some analysts believe.

Data from PricewaterhouseCoopers indicates that the volume of global mining deals climbed 69% to 1,732 in 2007, up from 1,026 in 2006. The value of transactions last year reached US$158.9 billion, a year-on-year increase of 18%.

Citigroup notes that the 34 companies it covers in the mining sector will generate about US$412 billion in operating cash flow through 2010. Of that amount, the investment bank says, about US$176 billion will go toward capex, US$87 billion to dividends, leaving US$149 billion in cash surpluses.

Given about US$150 billion in borrowings coupled with cash generation, Citigroup notes, about US$300 billion will be available for acquisitions.

“Despite capex more than quadrupling since 2001, capex as a percentage of operational cash flow has fallen from [an estimated] 70% to 44% in 2007 and we forecast it to drop even further to an estimated] 38% in 2010,” Citigroup writes. “Dividend spend has remained more constant, but has also slipped. The upshot of the falling capex and dividend ratios is an improvement in the companies’ balance sheets and a build-up in cash stockpiles.”

What’s more, strong balance sheets will mean that the current credit crunch will have less impact on the rate of “deal flow” Citigroup notes.

Citigroup has compiled a list of the companies it believes will be “hunters” and which will be “hunted”. Of the hunters, it lists Xstrata, Teck Cominco, Oxiana, Newcest, Vale, Kazakhmys, Peabody Energy, Consol Energy, Sally Malay, China Shenhua and Peter Hambro.

In the hunted category it lists: Anglo, Xstrata, First Quantum, Freeport, NovaGold, Steel Dynamics, Foundation Coal, Iluka, Alumina, Felix, Equigold, Oxiana and Lonmin.