The Wrath of the Writedown

VANCOUVER – The mining sector has seen more than its fair share of writedowns of late.

Many have been huge. Barrick Gold (ABX-T) wrote off $3.8 billion related to a copper mine in Zambia. Kinross Gold (K-T) has written off a total of $5.5 billion related to a gold mine in West Africa. Rio Tinto (RIO-N, RIO-L) slashed $14 billion from the value of the aluminum assets it acquired in its takeover of Alcan.

Taken as a group, global mining companies have erased $12 billion of value in the last year alone, slashing the valuations of acquisitions they had just recently described to shareholders as transformational. The vanishing billions stretch from copper to coal to iron ore to gold.

The writedown debacle is hurting the entire mining sector. Stung by a series of bad acquisitions, majors are now focusing on improving their existing operations and are denouncing new deals. That will help repair their balance sheets and, in time, bring renewed investor confidence.

But when majors stop buying, mid-tier producers and junior explorers feel the pain. Buyouts are the endgame for these players, their raison d’etre, and the potential for a takeout is the main reason investors come along for the ride. When that potential disappears investment dollars dry up and the entire sector grinds to a halt.

The wrath of the writedowns is widespread. Low-risk investors who banked on majors for their supposed stability have been hosed by share prices that fell alongside the value of these failed acquisitions. CEOs have been sacked, plans to build or expand mines have been shelved, and acquisition has become a dirty word.

Now the higher-risk investors who play the juniors game are also in dire straits. With buyout hopes dashed across the sector, junior share prices are struggling, compounded by a general lack of investment interest and debt availability.

Thankfully, the problem is also part of the solution. Majors overextended themselves with overpriced acquisitions; now they have to work to improve the assets they own and rebuild their cash reserves. Once that is done, buyouts will begin again.

Hopefully this time, cooler and more conservative heads will prevail.

Buy, Buy, Buy

The buying spree started in 2007, when the markets were hot, commodity prices were sky-high, and majors were flush with cash. That year Agnico-Eagle Mines (AEM-T) spent $710 million to buy Cumberland Resources, Newmont Mining (NMC-T, NEM-N) handed over $1.5 billion for the Hope Bay gold project in Nunavut, Anglo American (AAL-L) inked the first of two deal that together saw the major spend $5.2 billion on the Minas-Rio iron ore project in Brazil, and Rio Tinto closed the biggest takeout deal Canada had ever seen: US$38.1 billion to buy Alcan.

Then the recession hit. Suddenly, it became painfully apparent that these deals had all transpired at the top of the market, which means majors had shelled out top dollar for assets that soon were worth notably less.

You might have thought that reality would have tempered CEOs, that when they saw valuations slashed almost overnight they might have reigned in spending and kept a careful eye on returns. And they did, for a while. But when the markets started to heat up again in 2010 and 2011, CEOs seemed to get it in their collective heads that they had to buy something.

So, one after another, they did. First Kinross shelled out $7.9 billion for Red Back Mining to get its hands on the Tasiast mine in Mauritania. Cliffs Natural Resources (CLF-N) spent US$4.9 billion on Consolidated Thompson Iron Mines. Not to be left out of the buying spree, Barrick burned $7.3 billion to buy Equinox Minerals for its Lumwana copper mine in Zambia.

The prevailing thought pattern was that global commodity prices simply had to continue along the upward trajectory they had been tracking because Chinese demand was insatiable, backed by vociferous commodity thirst from places like Brazil and India. CEOs assumed that the more ounces of gold, pounds of copper, and tonnes of iron ore a major could sell to these markets, the better.

A race started amongst the world’s major miners to grow through acquisitions. But the mantra propelling the race – that bigger is better because demand will keep growing – turned out to be a trap.

Barrick Gold is a great example. In 2011 the gold major shocked the markets with a decision to diversify into copper with that $7.3-billion deal to buy Equinox. The logic was simple: Barrick was bullish on copper. It was great fun to be bullish on copper in mid-2011 – the metal was trading above US$4.50 a pound and demand seemed limitless.

Barrick’s CEO at the time, Aaron Regent, was fully subscribed to the copper mania. From the midst of that copper cloud, he argued that Barrick had to buy Equinox to get into copper because assets like the Lumwana mine were rarely available.

Regent was right that large, long-life copper mines are few and far between. However, $7.3-billion deals are also not that common, because big gambles create the potential for big losses. And a big loss it has been.

Copper prices remained relatively strong, but have fallen about 25% since Barrick bought Lumwana. At the same time, costs climbed. And so, in mid-February, Barrick wrote down the value of Lumwana by $3.8 billion. The company also shelved plans to expand the mine after expansion drilling revealed low-grade, deep mineralization that isn’t worth the stripping at current prices.

Kinross found itself caught in the trap as well. Barrick’s writedown news came just two days after Kinross acknowledged for the second time that it overpaid handily for its acquisition gamble. Kinross paid $7.9 billion for Red Back Mining, all aimed at the Tasiast mine in West Africa. Last year Kinross cut the value of that operation by $2.5 billion; in February it erased another $3.1 billion from Tasiast’s worth, bringing its total writedown to $5.6 billion. That’s 71% of what the company paid to buy it.

Cliffs also found itself holding an over-valued acquisition. The iron ore and coal major spent almost $5 billion on Consolidated Thompson Iron Mines, but recently wrote the value of those assets down by US$1.1 billion. Newmont joined the writedown party when it slashed $1.6 billion from the value of its Hope Bay project. Not to be left out, Agnico-Eagle erased $645 million from the value of its Meadowbank project. And Anglo American cut no less than $4 billion from the value of that Minas-Rio iron ore project, the one it spent $5.2 billion to buy.

The biggest writedown of them all came from Rio Tinto. After spending US$38 billion to buy Alcan at the top of the commodity cycle, Rio has cut the value of its Alcan assets several times. The latest $14-billion writedown brought its total charge against the purchase to $30 billion, or almost 80% of the purchase price.

Sector-wide struggles

Most majors with overvalued assets have now written them down, taking big share price hits along the way. CEOs also went under the axe – most of the corporate leaders responsible for these expensive blunders have been replaced. But the storm isn’t over.

In fact, the end of the writedowns marks the start of a new storm.

Every major miner that had to slash the valuation of an overpriced acquisition is now turning inwards. The plan has changed: rather than chasing acquisitions to grow for growth’s sake, majors are now publicly eschewing new purchases and instead focusing on increasing returns from their existing operations.

It’s the right plan, and in time it should improve majors’ balance sheets and share prices. But it doesn’t bode well for the rest of the sector.

The entire junior exploration sector is based on buyouts. Every time a major sweeps down and buys a project or a company, the rest of th
e sector is injected with renewed optimism. Buyouts are the junior sector’s endgame: they are the goal.

So when the mining sector’s majors announce loud and clear that they will not be buying any new projects anytime soon, the rest of the sector deflates. Junior explorers’ raison d’etre has disappeared, at least for the foreseeable future.

For a junior, as the odds of a takeout decline so too does the chance of securing the financing or debt needed to move projects forward. So when majors stop buying, juniors feel the pain. Projects get postponed, employees laid off.

It gets worse. The majors will come back around – they will need to restock their project pipelines at some point, so junior just need to survive until that point arrives. But there is no guarantee that the 1,800-odd junior explorers listed on the Toronto Venture Exchange can achieve that survival feat.

Juniors generally don’t have any incoming cash flows because their projects are all far from production As such, they have only a few ways to get cash: equity raises, assets sales, and project partners. The odds of achieving either of the latter two options – inking an asset sale or finding a project partner with deep pockets – have fallen off dramatically. The majors that would usually buy or earn into projects just aren’t spending money.

That leaves equity raises. Unfortunately, mining’s tough run has left many juniors trading near their 52-week or even three-year lows, which means issuing new equity is highly dilutive. And that’s if you can even find investors willing to buy shares, not an easy feat in today’s nervous investment environment.

Juniors aren’t alone in feeling the pain. Intermediate-sized miners are also facing significant uncertainty. They too would love to be taken out by a major, but that is very unlikely now that almost every major mining company has turned inwards.

Making matters worse, many development-stage mining projects are struggling with creeping capital costs, news of which often sends share prices plummeting.

That leaves mid-tier miners facing the same choice as the juniors. Should they try to raise funds through dilutive, thinly-subscribed equity raises? Or should they batten down the hatches and do as little as possible to save money until things improve?

There’s no single answer. Each company will have to figure out the path that provides the best odds of survival for its unique circumstances. In time – a year or two – the majors will have recalibrated their operations and restocked their banks accounts, and they will start seeking new projects to partner or companies to buy.

That’s just the cyclical nature of the mining sector. It’s just that the cycles get stretched – the peaks pulled too high and the troughs trenched too low – when an over-exuberant race for grow turns acquisitions into value-destroying traps.

Lesson learned? Hope so.