Australia mining: Desert stirrings

When EMR Capital closed its second mining fund above target at $860 million in November, the level of demand underlined a growing expectation that new momentum in global commodity prices would drive a surge in Australian resources investment. EMR, however, doesn’t play price cycles.

Instead, the Melbourne-based GP focuses on exploiting favorable long-term supply-demand dynamics by improving project competitiveness regardless of where metal valuations are at any given moment. Although the logic of this approach is firmly rooted in the traditional private equity model, it can elude investors as they consider the sector’s sometimes counterintuitive tendencies.

For example, operational streamlining in mining can actually require taking on additional expenses in the form of third-party contracts with a view to achieving economies of scale. As a result, EMR contributes to one of the cyclic business drivers for mining service providers in its home country.  

I get the feeling it’s early days and we’re only three or four months into an increase – Adrian Loader

“One of the big advantages of Australia versus other jurisdictions is that you can really tap into a labor force of best-practice mining services, technology and neighboring skillsets,” says Jason Chang, CEO and managing director of EMR. “Our thesis is increasing the volumes and operations, so by definition, we actually increase the number of people working for us.”

In this light, Australia’s well-respected mining services companies can be seen as both primed for growth and subject to an even more complex web of value drivers than the mines themselves. As enthusiasm for firmer commodity prices and the growth strategies of asset owners like EMR unfold in the near term, services investors will need to weigh case-specific circumstances with care.

On the rebound

The latest price rallies for iron, coal, gold and copper are restoring confidence to an Australian mining industry which has endured extensive setbacks since a sharp commodities market retreat in 2013. Miners have responded by writing more checks to services providers, but the priority is on furthering the efficiency programs of the downturn rather than mounting a rebound with new projects.

Heavyweight operators such as iron giant Rio Tinto offer the most telling indicators of industry sentiment in this context. Between 2013 and 2016, Rio’s annual capital expenditure dropped 77% to $3 billion, and it is forecast for only marginal growth across the next two years. The company has granted several large service contracts in recent months but its modest capital expenditure guidance suggests there are no robust greenfield plans on the horizon. 

“We may be at the bottom, but don’t expect this recovery to be like the cycle we saw with the China boom. There is no boom coming,” says Vivek Dhar, a mining and commodities economist at Commonwealth Bank of Australia. “The producers out there know that and have tried to position themselves for it.”

The basic arbitrage around mining services in this environment is related to the industry’s connection to commodity price cycles. Since third-party contractors tend to represent the first mine site expense that gets cut when times are tough – and the first to be re-integrated when budgets improve – their fortunes are closely linked to the moods of metal markets. The turnaround openings this relationship creates can be all the more inviting if a company has not been properly priced at the extreme ends of the macro undulation. 

In the early aftermath of the downturn, services companies facing cash crunches attracted special situations investors seeking to exploit opportunities based on the immediate shock to share prices and other valuation metrics. Notably, Centerbridge Partners supported a $352 million restructuring of equipment provider Boart Longyear and Apollo Global Management bought half of Leighton Holdings’ maintenance services business, generating cash proceeds of around $573 million.

The more recent appeal of this opportunity set is based on observations that tendering among service providers is trending upward in step with commodity prices. Transactions include Centerbridge putting another $20 million into Boart Longyear and Resource Capital Funds acquiring engineering company Ausenco at an enterprise value of about $113 million. Significantly, the latter deal represents the first services investment for Resource Capital Funds, a GP which previously backed only primary assets.

Meanwhile, Allegro has highlighted the quality available among post-boom survivors with an $11.5 million carve-out of JSW Australia – a company with a fleet of 18 drill rigs and a staff of 140 – from bankrupt parent Hughes Drilling. The collapse of a company with such a viable asset has been interpreted as an indicator that current market conditions are ideal for PE. This is because the physical equipment and talent is still intact; all that is lacking is a supplier of capital with the cyclical risk appetite Australia’s major banks rarely embrace.

“Our view is that mining is starting to come back again in Australia, and basically everyone we’ve spoken to has been positive about where we are in the cycle. I get the feeling it’s early days and we’re only three or four months into an increase,” says Adrian Loader, managing director at Allegro. “The hard thing to do is work out what’s going to happen in the future in terms of the macro story, if the company can actually add-value for its customers and if you can rely on forward contracts.”

Preserving value

Contract terms are notoriously fragile in mining services and often considered practically terminable at will. As such, it can be an advantage for service companies to aim for a diversified book of smaller contracts even if it seems to suggest a lower overall value than a relatively short roster of big-ticket agreements. 

Companies like JSW that are focused on the goldfields of Western Australia benefit from this effect since precious metal miners are typically smaller than bulk commodity players and therefore more dependent on wider range of outsourced services. The ability for service providers to be competitive in this regard is a key due diligence concern that, despite being largely related to intangibles such as personal relationships, can be quantified ahead of investment.  

“We try to get a sense of what mines might be coming on or where increases in production might be coming from,” says Greg Evans, mining M&A leader for KPMG Australia. “It’s all about how you build that pipeline of opportunity and essentially how you put a number around it to get a confidence level about what types of contracts you may or may not win.”

So far, holding on to existing customer relationships after a change of ownership has not proven to be a problem for GPs, as long as continuity of leadership is maintained. But attention to this risk factor must be prioritized going forward since bolt-ons that include an element of management reshuffling have emerged as the preferred growth strategy among investors consolidating the service sector’s undervalued companies.

Value-add strategies in services otherwise focus on familiar PE initiatives related to creating consistency in financial management and optimizing workflows. The overarching thesis is to maintain a presence in the bottom half of the industry operational cost curve, with an understanding that a range of erratic political and environmental factors inevitably causes raw material markets to squeeze out the weakest players.

After cost optimization, competitive differentiation is most effectively achieved through offering unique intellectual property or a niche technical proficiency. In the case of drilling, for example, this effort could include the keeping of a database on past experience in various geological settings in order to be able to claim expertise about situation-specific ground conditions.

“Mine owners know the conditions of their mines and have very particular needs, so they want to maximize efficiencies,” Allegro’s Loader explains. “It’s a mixture of offering a specialization and having relationships because ultimately it’s about the service to the end-customer and meeting their needs.”

The renewed ability of PE to engage these strategies of late is underpinned by ongoing efforts among diversified resource industry vendors to hive off non-core assets and a narrowing bid-ask spread for services companies. At the same time, LP pressure on international PE firms to increase their exposure to Australia and a steady stream of secondary mining exits are awakening a market that was comparatively dormant just 6-9 months ago.

Law firm Hogan Lovells is now seeing about one-third of its Australian M&A deal flow in private equity space in either mining or mining services, and this is expected to increase in coming months. However, in perhaps another example of the industry’s penchant for paradoxes, the heightened interest has not translated into an escalation of auctioning activity and company valuations.

“Interestingly, while mining services targets are attracting PE attention – and a number of firms are running the ruler over them – when it comes to execution of transactions, there is often a very small field of PE buyers per asset,” says Andrew Crook a partner at Hogan Lovells. “In our experience, there is often only one or two bidders, and competition has not been vigorous.”

Approach with caution

This sporadic participation exposes two main points about PE’s lingering hesitation in the mining services space. First, most investors are still continuing to focus their attention on primary assets that provide longer-term and more secure sources of income. Second, the vacuum of support from banks has obliged interested GPs to consider uncomfortably large equity checks and debt funding from alternative lenders on less attractive terms.

Caution is also being observed due to the delicate nature of the current commodities market bounce: price surges for the steelmaking ingredients iron ore and coking coal have been largely based on demand caused by fickle Chinese policy pivots. As a result, belt tightening continues to take priority over expansion in the industry overall, and restructuring specialists looking for 3-5x turnarounds on the services end could struggle to find feasible acquisition targets in the near term.

“There are definitely some green shoots, but I don’t think there’s enough momentum into the services space yet to be saying we’ve got a full blown recovery on our hands,” says KPMG’s Evans. “Services companies are still bidding for contracts at relatively low margins, and hence they’re going to be unlikely to attract strong multiples for a little while yet.”

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• Topics
• Australasia
• Industrials
• Support services
• Buyouts
• Restructuring
• Australia
• Allegro Funds
• EMR Capital
• Resource Capital Funds
• Commodities