May 2013


Enterprise value and new mining projects

By Mauro Chiesa

Boards of mining companies today are often perplexed by the loss of shareholder value under their watch. To address this issue, one must review the fundamental components of shareholder value, or enterprise value (EV): capital outlays, capital inflows and their relevant discount rate. Shareholders are well-armed with analysts and historical figures but seldom understand the changes that are occurring – often beyond management’s control. In order to protect shareholder value in the future, it will be essential to understand the following new drivers, as they appear to be medium-term, if not long-term.

Asset replacement costs

Financial statements generally reflect current metal market prices and historical fixed asset costs. These fixed assets may have been discounted due to past bear metal market prices (1995-2005) and the resulting asset sales, and then subsequently restated upwards because of the recent rise in metal prices.

Even restated, however, the development costs of older assets have remained attractive, relative to those of greenfield assets. Many older assets come with cost-sharing supports from the public sector on infrastructure, tax flow-throughs, and energy and training subsidies. Also, new projects have consistently lower mineral grades and are situated in more remote locations that require more infrastructure and have higher energy cost exposures. These projects may face a longer permitting process as well, thus compounding the inflationary impact on the capital budget outlay and the timing uncertainty of future cash inflows from a project. As new greenfield operations come on-stream, the perceived costs appear to climb, and the shareholder challenges management on its cost controls.

The new public sector

The industry is now profitable, while the public sector faces mounting deficits due to higher social financial obligations and weaker revenue bases. This is the reverse of a generation ago and it leads to less cost-sharing capacity from the public sector. As already noted, governments have more complex permitting processes and a need for increased taxes and/or royalties. The financing of restitution costs reduces the anticipated long-term cash inflows from a mining asset. Lastly, with many new projects being developed in emerging economies with evolving policies, governments will be demanding and securing back-in equity rights that may or may not come with capital infusions into the projects. The net effect is a higher up-front capital burden on companies and a lower cash inflow from the asset during the operating years.

The circular capital market

The capital markets are fragmented; they are pulled apart by quantitative easing policies, the American fiscal cliff and ongoing eurozone issues. In tandem with pension funds looking for lower-risk investments and income rather than value growth on returns and the cost of financing increases on two fronts.

First, as investors become risk-averse, the appetite for mining risk fades and the share prices fall, thus raising the cost of capital as the price-to-earnings ratio drops. Such risk-aversion also impacts the bank lenders who have been hit by the bailouts and are reducing commitments to riskier project financings. The second is the cost of the search for capital. What was once a two-stop shopping process (first securing aggressive equity and then the project-recourse bank debt for completion financing) now involves multiple continents and capital markets, including the traditional sources and the limited-scope capital such as joint venture capital, export credit agencies, supplier credit financing, international financial institutions and metal stream financiers. Each source has its own agenda and requires time to assemble and close. The net effects are delays and the resulting capex inflation, higher process costs and a higher cost of capital (and a higher discount rate applied to cash flows) for calculating EV. Given the circular nature of the relationship between cost of capital and shareholder value, even established mining companies must now consider financing themselves first – be it with cash from existing operations or from asset sales of non-strategic existing assets – before addressing the more difficult markets.

In summary, these higher cost uncertainties, public sector deficits and ambiguous capital markets translates to more upfront capital required, greater timing uncertainty, lower cash inflow streams and a higher discount rate applicable to those streams. Their aggregate effect will require operational and strategic adjustments by all companies to better manage their existing and prospective assets and their capital budgets. Many companies will have to overhaul their capital budgets and to reassess their asset risk management practices and personnel.

Mauro Chiesa has over 33 years of experience in financing and advising extractive and infrastructure projects around the world. He has worked with multinational banks, the World Bank Group and EDC. Chiesa will chair a panel discussing the shifting aspects of shareholder value at the 2013 CIM Convention in Toronto on May 7.

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