Ernst & Young: Strong growth expected for 2011

The following is an excerpt from Ernst & Young’s annual mining and metals transactions report, Ungeared for Growth. For the full report visit: www.ey.com.

Despite uncertainty over European debt, the pace of the U.S. recovery and the potential effect of future mining taxes, the industry enters 2011 in an extremely strong position. In fact, 2011 could see mining and metals companies return to earnings levels close to the 2007 peak.

As de-leveraged companies compete for shrinking resources, we expect merger and acquisition activity to continue to trend upward, characterized by larger deals and bolt-on acquisitions. While resource security continues to be a major force behind increased deal activity in the sector, several other factors will also help to fuel transactions – including improved cash flow and availability of capital to do deals; ongoing industry rationalization; the desire for greater vertical integration to manage costs; and product diversification to reduce risk and tap into new growth opportunities.

We expect capital raising among the majors to be increasingly allocated to growth rather than balance sheets – either directly though equity offerings and project finance, or indirectly through the finance of acquisitions. The large end of the sector is recapitalized and generating large cash flows, but there is increasing pressure to forego the planned megadeals and return capital to shareholders through dividends or buybacks. The use of some leveraged acquisitions may allow mining and metals companies to do both.

With companies still smarting from the global financial crisis, responsible capital management will remain at the core of most acquisitions. While interest rates remain low and cash flow remains strong, the majors will continue to finance project development through a combination of internal cash generation, corporate bonds and loans. 

For at least the first half of the year, large-scale bank lending is likely to remain the purview of those with the strongest balance sheets and lowest credit risk. The fully debt-funded aborted acquisition of Potash Corp. of Saskatchewan demonstrated that funds are available at the top end and, to the extent that available funding isn’t used, it is likely to find its way into funding other M&A deals.

Bond market conditions will depend on a supportive macroeconomic backdrop and positive investor sentiment. Faced with the prospect of tightening monetary policies bringing an end to the 2010 low pricing, companies with sizable funding requirements may be driven to access the markets sooner rather than later in 2011.

The initial public offering (IPO) pipeline is robust, and we expect an even stronger recovery in 2011. Driving this are the long list of postponed offerings; state privatization programs in a period of high fiscal deficits in many economies; emerging exchanges such as Hong Kong offering new opportunities and sources of finance; and the desire to benefit from, and provide shareholder exposure to strong commodity prices. Exchange consolidation and partnerships, such as those proposed between the Australian and Singapore, the London and Canadian, and the London and Mongolian exchanges, will further support financing opportunities for the resources sector. 

Global mining and metal companies with large exposures to higher risk destinations will consider spin-outs to rerate the residual projects, such as with African Barrick Gold. This will allow greater flexibility and transparency for investors.

We believe that equity will continue to flow into the juniors and mid-tiers through spin-out IPOs, strategic placements, streaming and offtake agreements. We also expect to see an increasing role for secondary listings, reflecting the growing globalization and cross-border interactions of producers and consumers, and investors’ appetite for exposure to emerging markets. 

We expect Chinese acquirers to quickly learn what it takes to generate greater deal success in a more competitive environment and, together with Indian companies, be more prominent in the successful completion of deals in 2011.

Emerging markets are also likely to play an increasing role in global financing of the industry, with many initiatives to improve their attractiveness to the sector – from competitive listing criteria and open investment frameworks to the broader development of robust domestic credit and share owning cultures.

This year promises to be an exciting year of growth, with the sector showing no sign of slowing. The year will see increasing competition for quality assets as companies gear up for M&A activity to meet their growth plans. The winners will be those who bring to a deal, not just cash, but strategic value.