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Does cutting debt have to mean reducing your ambitions? Volume 2: Satisfying investor demands
The better the question. The better the answer. The better the world works.
Executive summary
The sector has to search for long-term strategies to drive competitive and sustainable shareholder returns. Depending on strengths, there are options to grow production volumes and optimally reconfigure assets within their portfolios. A balanced approach to capital allocation, which considers not only the need to return cash to shareholders but also the need to grow, is necessary to enhance shareholder value creation.
In the first part of this series, released mid-2017, we analyzed the debt levels in the sector and concluded that the industry had significantly brought leverage under control, driven by a strong earnings momentum. We continue our analysis in this second part of the series, focusing on what this means for the sector in terms of capital structure, growth prospects and the industry’s ability to satisfy the returns demanded by its investors.
Using the top 50 global miners as a gauge on the industry’s health, we illustrate in this report that focus remains on reducing financial risk. However, there is a need to innovate strategies to satisfy shareholder return demands as shareholder value creation has consistently eroded since 2011. In essence:
• During 1H17, focus remained on reducing financial risk; and net debt continued to decline, falling by approximately 15% year-on-year
• Capital structure for the sector continues to change; gearing dropped to 32% at the end of 1H17 for the top 50 miners, two percentage points lower than that at the start of the year.
• Total Shareholder Returns (TSR) saw a positive rebound since 2016 as equity appreciated but in 2017, TSR will be driven by the return of dividends and share buybacks.
• However, economic value creation has consistently eroded across the industry since 2011, even in 2016 — despite the turnaround in TSR and significant restructuring of the sector.
Foreword: this analysis is based on the top 50 mining companies in the world by market capitalization as at 30 June 2017. This excludes aluminium and steel companies, along with backward integrated metals producers with significant mining assets. The analysis is also based on aggregated financial statements data from Capital IQ. For consistency, calendar years have been used across all companies. The definitions and treatment of the financial data are as per Capital IQ and may differ from other information sources. However, in this analysis, the overall trends are more important than the absolute numbers and any interpretation should be treated as such.
In the first part of our series, we focused on the mining industry’s capital agenda. We looked at debt levels across the sector and how leverage has been brought back under control. ey.com/DebtinMining
Does cutting debt have to mean reducing your ambitions?
Does cutting debt have to mean reducing your ambitions?2
01
Net debt/EBITDA
Net debt/EBITDANet debt
0.0
0.5
1.0
1.5
2.0
2.5
0
50,000
100,000
150,000
200,000
250,000
CY20
11
CY20
12
CY20
13
CY20
14
CY20
15
CY20
16
CY20
17
A sharp, and somewhat unexpected, rebound in market fundamentals has eased the pressure on mining companies generally. However, this has not stopped the relentless focus on margin improvement and reduction of financial risk through cost cutting, capex curtailment and divestments. A majority of this cash has been used to pay down debt or returned to shareholders through dividends and share buyback programs.
Net debt continued to decline during 1H17, although at a slower pace than seen in 2016, falling by approximately 15% year-on-year. Projecting forward, there is a real possibility that net debt/EBITDA falls below 1.0 for the first time in five years across our sample.
Solvency returns but is capital structure optimal?
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3Does cutting debt have to mean reducing your ambitions?
Despite the turnaround in fortunes and stronger financial position, shareholder expectations over value creation continue to put pressure on mining companies to seek other ways to unlock profit and not rely solely on commodity prices being maintained at current levels.
The return to growth is now driving the sector to determine optimal strategies for long-term value creation. Our view is that this can partly be achieved by reducing cost of capital through maintaining an optimal capital structure. Indeed, the capital structure for mining companies continued to change; gearing dropped to 32% at the end of 1H17 for the top 50 miners, two percentage points lower than that at the start of the year. While this offers flexibility, particularly as most miners continue to manage volatility and macroeconomic uncertainty, many players will now be assessing the efficiency of their capital structure given its implications on the overall cost of capital and shareholder value creation.
Gearing dropped to 32% at the end of 1H17 for the top 50 miners.
Does cutting debt have to mean reducing your ambitions?4
Net debt and gearing
Net debt Net debt/Equity
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
US$
b
0255075
100125150175200225250
CY2011 CY2012 CY2013 CY2014 CY2015 CY2016
Shareholder returns back on agenda. Mining stocks have typically been attractive to yield-seeking investors as the sector has historically paid dividends even through down cycles. However, in 2016, several players, including the majors, suspended dividends and adopted a flexible approach, reflective of circumstances.
Despite the cut in dividends in 2016, Total Shareholder Returns (TSR) — measured by capital appreciation and cash returns — saw a positive rebound as equity prices rallied hard toward the end of the year, despite earnings remaining relatively flat year-on-year. Investors were actually forward-looking, anticipating stronger earnings in 2017 on the back of a sustained commodity price recovery.
As highlighted above, the drop in dividends paid during 2016 was more than compensated by the appreciation in equity prices, turning the sector into positive TSR for the year after a sustained period of decline. Many companies have since then clarified their dividend policies and announced share buyback programs. The composition of TSR is likely to change again in 2017, with an increased proportion of dividends and share buybacks than seen in 2016.
Total shareholder returns
Market cap Share buybacks Dividends
–4,00,000
–3,00,000
–2,00,000
–1,00,000
0
1,00,000
2,00,000
3,00,000
2012 2013 2014 2015 2016 2017
The composition of TSR is likely to change again in 2017.
5Does cutting debt have to mean reducing your ambitions?
Shareholder value creation: return or grow?02
To sustain TSR, mining companies have to continue to add economic value. Beyond returning cash to shareholders in the short term, industry participants have to create portfolios that can sustain and satisfy shareholder demands in the long term. So far, shareholder value creation is being driven mostly by robust commodity price performance.
Commodity price changes, YTD Jan-Aug y-o-y
–4%0%
5%9%
19%23%23%
26%39%
41%44%
49%
–10% 0% 10% 20% 30% 40% 50% 60%
PlatinumGold
SilverNickel
AluminiumCopper
TinLead
PalladiumIron Ore
ZincCoal
As can be seen from the chart, Economic Value Added (EVA) has consistently eroded across the industry since 2011, even in 2016 — despite the turnaround in TSR and significant restructuring of the sector. This clearly is not sustainable, and the industry still has a long way to go to correct this trend in the long term. For those that are unable to do so, there will be an increasing intervention from activist shareholders and potential acquirers. It is no longer considered an option to sit through the cycle and return economic value only when commodity prices rally.
Mining companies’ weighted average cost of capital (WACC) is increasingly weighted toward the cost of equity as net debt falls. Reducing leverage has helped to restore balance sheet flexibility, but the bias toward equity funding, which is more expensive than debt, is increasing the overall cost of capital. There was not much optionality in recent years as the availability of traditional debt facilities dried up due to the sector’s poor credit outlook. In addition, there has been a need to lower the financial risk profile of the sector to re-attract investors.
–
Economic Value Added has consistently eroded across the industry since 2011, even in 2016.
Does cutting debt have to mean reducing your ambitions?6
However, turnaround in fundamentals and improved access to traditional financial instruments now means there is scope to re-engineer capital structures with a view to reduce the WACC. This is played out, in part, by an increasing prevalence of share buyback programs across the sector, with surplus cash being returned rather than put back on balance sheet to reduce debt.
While return on capital employed (ROCE) is trending in the right direction, the sustainability of earnings in the absence of commodity price gains will be a concern for shareholders. Indeed, with focus still on reducing capital intensity, the capital employed by mining companies continues to steadily decline due to reduced capex commitments. The reduction in capital employed
in recent years was also partially driven by asset impairments as commodity prices weakened.
Increasing profitability and return on capital will inevitably require volume growth over the short term as it is unlikely to see commodity prices rallying to the same extent as that of the last year or so. Volume growth has been worryingly off the table for most miners though. Poor performance post the super cycle forced the sector to reduce growth capex in a bid to optimize scarce cash requirements and also due to capital discipline. For five consecutive years, miners have been committing fewer resources to build future capacity to maintain operations and this has continued into 1H17.
Top 50 mining companies' EVA
–15.0%
–10.0%
–5.0%
0.0%
5.0%
10.0%
15.0%
2011 2012 2013 2014 2015 2016
ROCE WACCValue creation (ROCE — WACC)
–
Surplus cash is being returned rather than put back on balance sheet to reduce debt.
7Does cutting debt have to mean reducing your ambitions?
Capital expenditure
020406080
100120140160
CY2011 CY2012 CY2013 CY2014 CY2015 CY2016
US$
b
Exploration budgets by region by amount budgeted, 2011–16 (US$m)
Source: SNL metals & mining research
0
1,000
2,000
3,000
4,000
5,000
6,000
Australia Canada United States Africa Latin America Pacific/SE Asia
Rest of World
US$
m
2011 2012 2013 2014 2015 2016
Reduced capex has helped optimize cash allocation; but there are now increasing signs that the cutbacks will create future supply deficits for some commodities. The reduction in exploration budgets across the sector has been particularly conspicuous. This may ultimately drive M&A activity across the sector when pipeline replacement becomes an issue, which can be resolved only through the acquisition of an asset already in production.
M&A activity has improved in 2017, with some signs of a shift from largely divestment-led drivers to strategic-led deals focused on growth. The value of transactions increased by 68% year-on-year (y-o-y) over the first nine months of 2017 compared to the same period in 2016. Although there was a quarter-on-quarter (q-o-q) drop in deal value in 3Q17 (down 42% to US$9.4b), deal activity overall remains buoyant, with transactions involving Australia, Canada and China particularly strong.
M&A — value and volume (2010–3Q17)
0
200
400
600
800
1,000
1,200
020406080
100120140160180
2010
2011
2012
2013
2014
2015
2016
3Q16
3Q17
Volu
me
Valu
e (U
S$b)
<$200m Between $200m and $1b >$1b Volume
Glencore Xstrata merger
South32 spin-out
Alcoa spin-out
Does cutting debt have to mean reducing your ambitions?8
03
Capital appreciation
Drivers of TSR
Cash returns
Free cash flow (after capex, debt and acquisitions) Profit growthValuation multiple
Productiongrowth
Marginimprovement
Lowerfinancial risk
Better capitalallocationDividendsShare buybacksDebt repayments
TSR
The drivers of TSR are interrelated and it is always important to maintain focus on all aspects. Of course, some drivers carry more weight than others depending on stakeholders; clearly dividends matter more to income-seeking investors. A closer analysis of mining companies highlights that industry participants are currently placing limited attention on production growth, better capital allocation, and, therefore, the free cash flow generated after capex and acquisitions.
To sustain value creation and meet shareholder expectations on return, miners increasingly have to shift from a short-term focus on cash, to a long-term strategic plan for capital that delivers returns across the portfolio.
Strategies for sustaining shareholder value creation
9Does cutting debt have to mean reducing your ambitions?
Long-term drivers of shareholder value creation1. Production growth
Over and above maintaining or improving margins, companies can look to add production levels by expanding existing operations or bringing new mines on line. It is important, however, not to dilute performance by pursuing volumes for volumes’ sake. As such, quality of assets has to be extremely good for the volume growth to be effective. Acquisitive growth is also another avenue. However, challenge will be in identifying the best projects to invest in, from both a quality and a portfolio-fit point of view. This will particularly be important as the longer-term outlook for demand diverges for different commodities. Strategies may include investing in those commodities that are forecast to be in deficit in the medium term as well as in the quality assets resilient to price downturns due to their competitive and relative cost positions.
2. Portfolio optimization The divergence of commodity markets and increased volatility demands mining companies to maintain a balanced portfolio which is able to cushion against unexpected adverse price
movements. Clearly, there is no magic formula for companies to follow in order to de-risk a portfolio of assets, but greater consideration is likely to be placed on factors such as synergies across assets, relative optionality in projects, natural hedges from by-product credits, relative stage of asset capital intensity and many other factors that create a more resilient portfolio.
3. Balanced capital allocation Reducing capital intensity has been a critical and necessary value creation driver on the back of the need to instill confidence in the sector. However, as the market shifts to growth, measures for better capital allocation, which not only consider the need to reward shareholders but also the need for productivity growth (from both increased volumes and increased efficiency), will be crucial for future standout performers. While returning cash to shareholders is important in the short term, it is sustainable only if efforts are made to ensure that future production is delivered. It is important to balance returning cash (dividends, share buybacks and debt payments) with the growth agenda (capex and acquisitions).
Does cutting debt have to mean reducing your ambitions?10
Conclusion: what’s next for mining companies?For many years, the performance of the mining sector has lagged behind other sectors. Increasingly delivering shareholder returns and creating economic value for the future will remain at the core of investor expectations. The return to growth brings opportunities for future outperformers to restructure their portfolios and create unique value for shareholders.
11Does cutting debt have to mean reducing your ambitions?
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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.
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EY | Assurance | Tax | Transactions | AdvisoryHow EY’s Global Mining & Metals Network can help your businessThe sector is returning to growth but mining and metals (M&M) companies face a transformed competitive and operating landscape. The need to improve shareholder returns will drive bold strategies to accelerate productivity, improve margins and better allocate capital to achieve long-term growth. Digital innovation will be a key enabler but the industry must overcome a poor track record of technology implementations. If M&M companies are to survive and thrive in a new energy world, they must embrace digital to optimize productivity from market to mine.
EY takes a whole-of-value-chain approach to support each client to help seize the potential of digital to fast-track productivity, balance portfolios and set a clear roadmap for their new energy future.
EY Global Mining & Metals LeaderMiguel Zweig+55 11 2573 [email protected]
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Service line contactsEY Global Advisory Leader Paul Mitchell +61 2 9248 5110 [email protected]
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EY Global IFRS Leader Tracey Waring +61 3 9288 8638 [email protected]
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