Mining stocks: A second scare

“It is breathtakingly obvious that a large part of the mining sector needs to re-equitise.”

In that single ugly word, “re-equitise”, used by an investment banker on the sidelines of a mining conference in London last week, lies the reason why investors would be wise to not see current low share prices as a reason to move back into resource stocks.

The expression itself, “re-equitise”, sums up the problem because it's banker-talk for “here come the share issues”, which can itself be translated into “why buy now when there will more, and cheaper, shares on the market tomorrow”.

The need to repair balance sheets damaged by falling commodity prices and excess investment in new projects during the China-driven boom was one of the dominant themes at London's annual Mines and Money conference.

Other themes from the event, which was roughly half the size of last year, included:

•    The end of mining stocks being treated as yield plays as dividends decline, or dry up altogether.

•    An expectation of rising defaults on corporate debt in its many forms, including bonds.

•    Concern that the widely-expected rise in U.S. interest rates will trigger a debt-servicing crisis across the mining industry which has been hit by falling commodity prices and is now likely to be whacked by rising rates, and

•    The creation of a perfect climate for private equity to pick through failed corporate structures, starting with the acquisition of distressed debt.

Always an important event in the mining calendar the London conference, this was the event which alerted me to the gold boom of several years ago, and the gold bust of two years ago. In both cases it demonstrated that London's historic grip on mining finance remains as tight as ever and views formed there flow quickly into mining centres such as Australia.

The fall from rock-star status of Glencore, a one-time local favourite with British investors, was seen as a proxy for the wider resources sector because of the way management initially denied there was a problem before caving in, forced to reveal a basket of asset sales, and a dilutive $US2.5 billion share issue.

Glencore was once seen as rival to sector leaders BHP Billiton and Rio Tinto, but is now struggling to survive in its current form after a 70 per cent fall in its share price and a debt burden which remains at around $US30b – alarmingly close to double the $18b value of company's equity on the London stock exchange.

By the end of next year Glencore is confident that it will have retired more than $US10b of debt, but it is highly likely that the effort will involve more asset sales and potentially another share issue.

The uncertainty about how much fresh equity companies like Glencore might need to compensate for falling revenue from commodity income to service boom-time debt levels has London investors deeply concerned.

Two other comments from the conference go to the heart of the problem:

•   “Mining company management will try everything before a plain vanilla share issue”, and

•   “Next year will see a wave of equity issuance”.

Older investors have seen the process before during periods of correction after a boom. It's a time when nobody is quite sure about the hidden side of a business, its debts.

Trading in opaque debt market, and the equally unclear market for corporate bonds, tells part of the story, and reinforces the problem for conventional equity investors who can quite rightly feel that they're not being shown the complete picture of a company's financial health.

Activity in the market for resource company bonds is an example of how the focus has shifted from equity to debt, and how ownership of debt could determine the future ownership of some high-quality mining assets.

Boiled down, this is the problem: it is generally easy to see what a business owns. It is never easy to see what it owes – and worse still companies often hide the true extent of their indebtedness with off-balance sheet financing and by using products with hybrid debt, in the form of certain types of bonds that are said to be half-debt and half-equity.

An emerging example of what's happening is the attempt by Perth-based Iluka Resources to merge with Irish-based Kenmare Resources, a proposal which was first made last year and officially ended yesterday – but which could easily continue behind the scenes tomorrow.

The bid for Kenmare, which is a titanium minerals miner like Iluka, was in the form of a proposed share swap but the real issue was Kenmare's debts.

On the London stock exchange Kenmare's equity is currently valued at $US24 million (£16m) while its debt load stands at $US317m.

Iluka's pursuit of Kenmare ended when the Irish company said it had secured a deal with the government of Oman to help restructure its balance sheet but where that leaves the holders of the debt is uncertain, nor is it clear whether Kenmare will also be required to raise fresh equity through a share issue which could be dilutive to existing shareholders.

Kenmare's desire to avoid Iluka's proposed merger has effectively turned it into a “falling knife”, very dangerous to try and catch on the way down.

Other companies active in the debt market in preference (at this stage) to the equity market include BHP Billiton which raised $US6.5b in October through an issue of hybrid bonds which ratings agencies agreed to treat as half-debt, half-equity.

The fresh funds were seen by some investors as a way of BHP Billiton retaining its generous dividend policy, a hope that was dashed by the Samarco iron ore tailings dam tragedy, which could end up costing BHP Billiton all of the funds raised in the October hybrids.

It's the prospect of taking on more debt to keep its dividend promise or, ironically, the more likely event of abandoning the promise of a progressive dividend, which is as much a cause of BHP Billiton's sharp share price fall of 35 per cent over the past six months (including 20 per cent over the past month) as is investor concern about commodity prices.

BHP Billiton is not alone in confronting the problem of low commodity prices, high debt levels and promises made in the past which cannot be kept.

Anglo American, another big London miner was a hot topic at last week's conference and became a hotter one yesterday when it announced a dramatic restructuring program that effectively cuts the business in half.

As well as closing 35 mines and sacking 85,000 workers, Anglo American has suspended its dividend and effectively said that everything it currently owns is for sale at the right price, a measure of how desperate the company has become in its battle to survive – with asset sales possibly including the crown jewels in the form of the De Beers diamond business.

The weakest of the big diversified miners, Anglo American had a value on the London Stock Exchange of $US7.3b before it revealed its makeover, only to see its shares fall by another 12 per cent to leave company capitalised at just $US5.1b, roughly half its debt burden of $US11.9b.

Another company active in the debt market rather than the equity market is Fortescue Metals Group, which has been busy buying back its own discounted debt at values as low as 75 cents in the dollar.

Fortescue can buy its own debt today because it has cash reserves left over from the time of high iron ore prices, and is enjoying the benefit of reducing its overall debt servicing commitment while also booking a profit on the transactions.

But, as the iron ore prices slides in to the $US30 per tonne range, and potentially below Fortescue's break-even level, the game will change. Buying back its own debt will no longer be an option – unless it falls even more steeply in value, or unless its super-cheap debt becomes attractive to an aggressive investor interested in Fortescue's best assets should they become available.

Buying debt today, especially the highest quality (of fulcrum) debt is a game being played by some of London's more entrepreneurial speculators and fund managers because ownership of the right debt will give them the best seat in an asset disposal process should a company fall into receivership.

It's the prospect of asset fire sales to raise quick cash, dilutive share issues to repair damaged balance sheets, and corporate insolvencies, which lie ahead for the mining and oil sectors.

Now is a time for plain vanilla equity investors to be observers rather than participants – ready to make a return when the dust settles – because a corporate crisis today will eventually become an opportunity tomorrow.