M&A: ‘The only certainty in an uncertain market’

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 favours 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 (mergers and acquisitions).”

The popularity of mergers and acquisitions will continue due to free cash flow yield premiums, growing cash balances, fewer reinvestment opportunities, “frictional barriers” to new capacity and increasing interest by sovereign investors, Citigroup says.

“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 con- materials and labour 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,” the Citigroup Global Markets report contends.

Indeed, if the popularity of M&A last year is any guide, the wave of consolidation is likely to continue at least until the end of this year. PricewaterhouseCoopers data 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 more than 30 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 an estimated US$150 billion in borrowings coupled with cash generation, Citigroup asserts, about US$300 billion will be available for acquisitions.

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

Even though capex has more than quadrupled since 2001, as a percentage of operational cash flow capex has actually dropped from an estimated 70% to 44%last year and Citigroup expects it will fall even more to about 38% in 2010. Spending on dividends has remained more flat, but has also dropped, Citigroup writes. The result: An improvement in balance sheets and a build-up in cash stockpiles.

Looking ahead, Citigroup has compiled a list of “hunters” and “hunted” it expects to see in M&A country. In the hunter category, it lists Xstrata (XSRAF-O, XTA-L), Teck Cominco, Oxiana (OXR-A), Newcest (NCM-A), Vale (RIO-N), Kazakhmys (KAZ-L), Peabody Energy (BTU-N), Consol Energy (CNX-N), Sally Malay Mining (SMY-A), China Shenhua and Peter Hambro (POG-L).

In the hunted category, it names Anglo American (AAUK-Q, AAL-L), Xstrata (XSRAF-O, XTA-L), First Quantum Minerals (FM-T, FQM-L), Freeport-McMoRan Copper & Gold (FCX-N), NovaGold, Steel Dynamics (STLD-Q), Foundation Coal Holdings(FCL-N), Iluka, Alumina (AWC-N, AWC-A), Felix, Equigold (EQI-A), Oxiana and Lonmin (LNMIF-O, LMI-L).