Canadian Underwriter

Debt, earnings disconnect leaves mining companies vulnerable: EY

November 30, 2015   by Canadian Underwriter

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“Market conditions are not showing signs of imminent improvement, and if this doesn’t change, only the fittest will survive,” Lee Downham, Ernst & Young’s global mining & metals transactions leader, cautioned in a statement Friday.

Debt, earnings disconnect leaves mining companies vulnerable

Globally, mining companies are factoring in “‘lower for longer’ commodity prices as leverage levels across the sector stretch balance sheets and trigger a flood of asset sales,” Downham explains in response to the release of the EY report, Debt in the mining sector: Liquidity vs. solvency and maintaining financial flexibility report.

“Coal, steel, iron ore and potentially aluminum may experience future difficulties,” states the report, which includes an analysis of the historical financial performance of a cross-section of 88 large mining companies globally. The report notes the following:

  • Coal – this sector is struggling, particularly among U.S. coal miners, as producers elsewhere have typically benefited from favourable exchange (FX) movements in the cost base;
  • Iron Ore – There is a clear mismatch between large-scale, low cost producers in Australia and Brazil, relative to smaller-scale, higher-coast operations both in these countries and beyond;
  • Steel – Chinese overcapacity, combined with lower domestic demand, ahs seen rising exposures and sliding global prices, leading to antidumping measures in some countries; and
  • Aluminum – with metrics bordering a “3” rating, this may be exacerbated by growing Chinese capacity, potentially backed by subsidized power and falling LME premiums.

“Even for companies better-placed, stress-testing their adaptability to low prices may help guard against overambitious price curves directing strategy,” states the report. “Budgeting for downside price forecasts can help identify and prepare contingencies for potential liabilities,” it points out.

“One factor that is driving the short-term fortunes of individual operations is FX, where all other things held constant, we can estimate the impact from a U.S. dollar appreciation on input costs,” notes the report [click image below to enlarge].

Impact of favourable exchange

“Management’s focus on the risks of leverage across the sector has become significantly more acute in recent months, reflected in the large number of assets put on the market as companies try to raise capital and free up future cash commitments,” Downham explains in the statement from Ernst & Young Global Limited (EYGM). “With mining and metals companies looking at every measure possible to free up cash, three things should be top of mind: retaining financial flexibility, creating long-term shareholder value by releasing and conserving cash, and positioning today to capitalize on a future cyclical recovery,” he says.

“Continued deterioration in commodity prices has undermined cash flows, putting pressure on the serviceability of existing commitments,” notes the report, which includes an analysis of the historical financial performance of a cross-section of 88 large mining companies globally.

Net debt has continued to rise since 2010, despite earnings falling over the same period, notes the EYGM statement. “Critically, this is the first observable period of such a disconnect between debt and earnings progression. With net debt/EBITDA at levels exceeding those last seen in 2000, leverage is starting to increasingly stretch balance sheets and limit flexibility to absorb financial shocks,” the report adds.

“The analysis highlights that the fortunes of individual companies can vary widely,” Downham explains. “High-debt metrics may be sustainable in the short term in certain circumstances, and conversely, low leverage may disguise impending risks which, if triggered, could generate a possible liquidity crunch.”

Factors that may cause a liquidity crunch are outlined below [click image below to enlarge].

Factors that may cause a liquidity crunch

Citing results of EY’s recent Global Capital Confidence Barometer – a survey of more than 1,600 executives in 53 countries, including 68 respondents from the global mining and metals sector – found that the proportion of mining and metals companies confident in corporate earnings has slumped from 90% in Oct. 2014 to 58% in Oct. 2015.

Although 71% of the polled mining and metals companies are now focused on cost reduction and operational efficiency – almost double a year earlier – the percentage focused on growth has more than halved, from 43% to 19%.

That could leave the door open for private equity and private capital funds to snap up assets. “Deal activity feels like it could increase as we enter 2016, with a significant volume of assets coming to market. Private capital funds have been patiently looking for opportunities for some time, but until now sellers have not had the burning platform required to force through a deal.”

As companies “enter a period of ‘survival of the fittest,’ cash conservation may represent an opportunity to acquire de-risked, operating assets in the future,” notes the report. “Besides balance sheet strength, this may be reflected in above-peer share price performance, providing a basis to enter into acquisitions without unnecessary dilution.”