At the end of September, we got news of Barrick’s merger with Randgold Resources. The merger solidified Barrick’s status as the world’s largest gold producer and, at first glance, I thought the merger brought some financial and operational advantages. And, the market agreed: both companies’ stocks jumped on the news by around 5 percent.
Yet, as usual, there were naysayers. One, whose name I’ve lost somewhere (and isn’t worth looking for) described the merger as two drunks holding up each other, and other analysts cited in one report were dismissive of the whole industry. And, the industry has had a rough go since gold prices retreated from its recent highs in 2011-13. Stock prices have been beaten down and are selling at discounts to their net asset values (NAV). The sector is certainly an exception, and not a good one, to a stock market that is selling at premiums to their NAVs rather than discounts. (This is just an observation not a buy recommendation, although, in the interest of full disclosure, I do own a number of gold producers’ stocks indirectly through exchange traded funds.)
What we are observing with the Barrick merger is part of the normal consolidation that occurs during the downside of the industry cycle – or the business cycle if it is more widespread. A larger wave of consolidations occurred in the late 1990s after prices declined. We saw Newmont merge with Newcrest, Santa Fe, Euro-Nevada and other smaller companies. Barrick merged with Homestake and others, to name some more publicized cases. These mergers followed a sustained decline in gold prices of about 25 percent, from the mid-$300s to the $270 range.
Since 2011, when gold prices were in the $1,800 range, we’ve seen another, roughly, 25 percent decline in gold prices. Sure, prices are a lot higher today than in the 1990s, but so are costs and expectations, so the effect is the same. Companies make plans based on expected prices and cash flow margins. When these expectations aren’t met, and since 2012 we have seen a six-year run of sideways price movements – in a malaise there is a need to cut back and consolidate because cash flow rules.
Cash flow is king
We frequently hear that mining is a different kind of business, and this is true in a number of ways. But what is usually meant by this is that a mining company’s main asset, its orebody, is a “wasting asset.” That is, as the company mines the orebody it wastes, or destroys, its main unique asset. This reasoning leads to a number of tendencies that leaders in other businesses find curious.
One of these tendencies is to try to expand ore reserves beyond what can be mined within a reasonable time window, particularly at times when prices are rising (and some always expect prices to rise). And, the fastest (and sometimes the cheapest) way to increase reserves is to buy them through acquisitions and mergers, which tends to lead to taking on more debt. Exploration is the alternative to buying reserves but it takes more time (plus skill and luck) and takes resources away from generating cash flow through operations – cash needed to finance acquisitions.
If this sounds a bit like a game of musical chairs, that’s because it is. And like when the music stops in musical chairs, when prices fall in the mining industry it’s time to scramble. Scramble for cash and to dump debt.
Silicon Valley firms during the “dot-com” bubble of the late 1990s thought they were a different kind of business too, and they were. They were banking on expectations of innovations, and they sold stock and took on debt and “burned” through the cash. At the time, the financial press was publishing dot-com companies’ “burn rates” and how long it would take them to burn through it all.
The mining industry is nowhere near the state of the dot-coms in the 1990s, especially companies that can generate cash because cash flow is king and operations that generate that cash flow are more important than ever.
“[C]ompanies that can generate cash because cash flow is king and operations that generate that cash flow are more important than ever.” — John Dobra