PAUL DUNNE: Mining’s $64bn question

Are today’s mining leaders ill-disciplined when it comes to capital allocation, playing loose and fast with the company balance sheet, and chasing favourite projects at the expense of dividends?

These are loaded questions and the answers can become emotive depending on your point of view. It is certainly a common theme at mining conferences and often gains traction in the mainstream media.

Shareholders and the financial community have long memories and will remember mining companies’ poor decision-making in previous commodity cycles — in particular during the last economic boom, which was driven then, as it is now, by Chinese demand.

There are well-known examples from that period of badly timed, expensive mining investments, combined with hefty debt funding arrangements. The collapse in commodity prices after the 2008 global financial crisis highlighted the nature of risk in mining businesses all too well, and significant pain was experienced by shareholders as equity values priced in worst-case outcomes.

Major surgery was scheduled to patch up severely damaged balance sheets, including more debt, asset sales at knockdown prices and rights issues. Some companies did not pull through, and shirts were lost in the laundry.

It means the survivors have deep scars and today’s mining companies have self-corrected quite dramatically. We are more conservative in nature and appreciation of risk is more nuanced. Board governance has been overhauled, and mining companies have changed for the better, and changed for good.

Today, mining companies present themselves in rude health and the fairly recent recovery in commodity prices has helped generate plenty of free cash. This is precisely why investors choose our equity counters; it’s quite exciting.

It means the allocation of capital under these circumstances is a "good problem" for boards to grapple with. But it implies very careful consideration nonetheless, taking into account the requirements of the company and the providers of capital (the shareholders and lenders), both today and in the future.

The long-term success of a mining business demands an optimal balance between sustainability of the operations, the option to grow, and the ability to return value to shareholders and debt funders.

The problem is that mining is a highly front-loaded capital-intensive industry with relatively long time horizons, and longer-dated cash returns. So we carry a higher-than-average business risk, in a complex environment. Mining is not just about digging holes in the ground.

The cyclicality of commodity markets requires management teams to be attuned to market conditions as they develop over time. A classic countercyclical investment strategy works well in this sector, but the timing needs to be impeccable. Unfortunately, this is not always possible and is rarely achieved in practice.

Still, investing through the cycle is a way for companies to average out their capex, mitigating some of the inherent market risk.

Crucially, not reinvesting sufficiently is a fatal flaw for a mining company. At best this is a standstill option; ultimately, however, not investing money into operations begins a process of terminal decline.

That’s because the underpin for sustainability for any mining company is the sustainability of the ore body and its ability to produce into the future. Continued and disciplined conversion of resources into reserves through the application of capital is the lifeblood of any mine and shareholders should always ask: "Are we spending enough?"

What’s more, as a primary industry, mining sits at the base of the economic triangle and we have a high economic multiplier. In developing countries we also have high dependency ratios per employee.

The industry is closely tied to societal outcomes and the politics of the countries where we operate. We are a powerful economic force which should be harnessed and driven hard to the benefit of all stakeholders. Governments need to create the conditions to attract and retain capital, providing security of tenure and long-term certainty for investors. Correct policy adoption plays an enormously important role here, and unfortunately some of SA’s policy decisions are antagonistic towards capital providers.

The shareholders are the first to provide the capital and the last in line for distribution, with no guarantees. Only once the requirements of the business and all other stakeholders have been satisfied, including employees, suppliers and the tax agency, might a dividend be received. This is why investment hurdles should be set high and project execution should be exacting.

Attraction and allocation of capital are two of the most important jobs for mining executives and their boards. When this is done well, shareholders will benefit.

Dunne is CEO of Northam Platinum and has been working in the SA mining industry since 1987