Australia mining: Panning the value stream

With the announcement in December that Pacific Equity Partners (PEP) and Bain Capital had offered A$872 million ($731 million) for mining industry supplier Bradken, there was a distinct possibility that Australia would see its third mining services deal in as many months.

Only weeks earlier The Blackstone Group had agreed to buy the chemicals division of Orica, a supplier of explosives and blasting equipment to the mining industry, for A$750 million, while in October Centerbridge Partners threw its support behind a $352 million restructuring plan for Boart Longyear, which provides drilling services and equipment. Around the same time, it emerged that Apollo Global Management would buy half of maintenance services business of Leighton Holdings, another mining industry services provider.

But the transaction was not to be and by the end of last month PEP and Bain pulled the plug, unable to obtain financing on acceptable terms due to the turbulent market conditions. Bradken's board noted that the offer had come at a low point in the mining cycle, with continued price declines in iron ore and oil responsible for significant share price volatility in the services sector. It sees no immediate evidence of a turnaround.

The amount of activity in the past four months alone seems to suggest that mining services companies are in dire need of capital, particularly in Australia. However, the challenges that prevented the Bradken deal from going forward indicate how difficult it can for private equity firms to take advantage of these opportunities without assuming unacceptable levels of risk.

Conventional wisdom dictates that mining services offer better insulation from price volatility than exposure to the commodities themselves, but it is also a very diverse sector. As prices continue to bottom out, GPs are exploring how they can ride the wave of inevitable recovery. Not all agree that mining services will be the best point of entry.

Appealing proxy?

According to the Reserve Bank of Australia's commodities index, prices of non-agricultural commodities - which include base metals such as iron ore, copper and gold as well as bulk commodities such as coal - reached an all-time high in 2011 of 111.9 points while base metals peaked at 152 in 2007. As of late January, the index price of both non agricultural commodities and base metals have dropped to 70 and 94, respectively.

"Many mining services businesses have been hit hard by the change in the cycle but intrinsically these cycles are difficult to call because their underlying drivers of both demand and supply are so diverse, fragmented and global," says David Grayce, managing director with Pacific Equity Partners. "Public equity markets for mining services companies may have over-corrected."

However, simply targeting mining services for their lower valuations does not make for sustainable investment plan. Instead, Grayce stresses the importance of looking for companies with a strong business model, a good market position and the potential to grow profits through change in strategy, driving operational improvements independent of the commodity cycle.

"Lower valuations - as many businesses are on the downward slope or in the trough stages of the cycle - will certainly get the attention of private equity as well as other parties and we will continue to see opportunistic offers," adds Nicholas Harwood, a partner with Deloitte Australia who covers mining services. "That said, it doesn't change the fact that the underlying investment case and its associated returns still need to stack up."

The relative attractiveness of mining service companies also depends on where they enter the mining life cycle. Broadly speaking, this comprises four phases: exploration; construction; development, where a company will put in a tunnel or open the pit; and production, during which ore is taken out the ground. Those mining services firms worst hit typically serve the pre-production phases.

Boart Longyear, for example, provides drilling services required at the very early stages of the cycle and has therefore seen business dwindle as miners scale back exploration. Another company that falls into this category is The Anywhere Group (TAG), a provider of temporary accommodation for the mining sector. It went into administration in February of last year, owing Singapore-based Crest Capital Asia A$9.5 million ($8.4 million), less than a year after the pair entered into the strategic partnership.

On the other hand, assets focused on production activities rather than exploration or development are more likely to be able to weather the current storms. Arguably, the best way a GP can mitigate the impact of a downturn in prices is by targeting businesses that are exposed to commodity volumes as opposed to commodity prices. Ideally, a portfolio company will have either scale, a broad service offering, or occupy a position in a niche segment that cannot easily be replaced.

On top of this, a strong management team and customer relationships underpinned by long-term contracts are deemed essential if a potential target is to deliver the requisite returns for private equity over a 3-5 year period.

Value chain pressure

"You don't have to be a genius to see that, when the end-market pricing comes under pressure, the whole value chain comes under pressure, because everyone focuses on efficiency and needs to sharpen their pencil around their own costings," says Anthony Breuer, a managing director with Gresham Investment House.

As a result, many PE players pursue companies serving mines and infrastructure operated by the global majors - Anglo American, BHP Billiton, Rio Tinto and Xstrata. While other miners are closing capacity because they cannot afford to operate at current prices, there has been an opportunity for larger players to increase market share and so they are not scaling back production. The logic goes that is if capital is not committed yet then it makes sense to hold off until the market comes back; but if it is already in the ground and the operator has a low-cost position, increasing output can pay dividends.

Australian Securities Exchange-listed Energy Developments is a case in point. The company provides distributed power to large, low-cost mines run by the global majors. According to Grayce, earnings have increased by about 70% since PEP acquired the business in 2009, and by 15% in the past year. This is in part due to the company - supported by a capital expenditure program - consolidating its already strong market position.

"It's probably fair to say that if you are investing now - versus several years ago - you would probably be doing so in a business, and an industry, that has learnt a lot from its mistakes and has been forced to become much more efficient," adds Deloitte's Harwood. "Furthermore, those that are still around now are the stronger ones; the weaker players are falling away."

While mining services is a proxy, it is not always a complete one. In many instances, producers are moving more activities in-house, so mining services companies might be losing contracts and seeing fewer tender opportunities but this does not necessarily correlate to industry performance. Harwood notes that, over the last couple of years, Australian export volumes of coal and iron ore have continued to increase, but the Deloitte Australian Mining Services index for the fourth quarter of 2014 points to a continued decline in market sentiment. Meanwhile, the S&P/ASX 200 Index has improved.

Upstream opportunities

There are generalist GPs that are happy to participate in mining services but steadfastly refuse to invest earlier in the value chain. This territory is the preserve of specialists, for whom the pool of opportunities goes deeper.
"In the 25 years I have been doing this I have never seen private equity as active as it is now as it is mining, particularly in the later life cycles of mining companies," says Greg Evans, a partner and head of M&A at KPMG Australia.

According to AVCJ Research, private investment into Asian mining reached $1.32 billion across 22 deals in 2014. Australia accounted for over half the deals and $343 million of the capital committed. The headline number is heavily influenced by a couple of big-ticket deals and the inclusion of oil and gas extraction investments, notably Blackstone's $800 million commitment to Malaysia's Tamarind Energy.

In 2013, the Australian impact was more pronounced but activity was comparatively muted. Australia was responsible for eight of nine deals region-wide and $103 million out of $443 million invested. During the 2009-2012 period, there was an average of 37 deals per year in Asia and 14 per year in Australia.

Evans stresses that while there may be relative dearth of attractive opportunities in mining services, the same is not true of the mining sector as a whole. This past year alone has seen Perth-based GP Denham Capital close two significant investments within the space of six months.

The first deal, in May, saw the private equity firm commit $200 million to Pembroke Resources, a new platform formed by senior management from Gloucester Coal that will develop a portfolio of metallurgical coal assets across Australia, New Zealand and Indonesia. It is targeting small but potentially highly profitable projects that are undeveloped, under construction or have just started production. This was followed in November by another platform investment as Auctus Minerals received $130 million. Denham enlisted an experienced team from Karara Mining to take on stalled mining projects around Australia.

Meanwhile, resources-focused EMR Capital invested in Highfield Resources - a listed company that is currently developing three potash projects globally - in June, and more recently announced a $450 million final close on its latest fund.

Speaking to AVCJ earlier this month Bert Koth, managing director with Denham, said much of this activity was due a change in the whole money-making paradigm in metals and mining.

"Five or six years ago capital might go into advanced exploration, but now you can only create value by going into producing assets and at a late stage." he says. "So where you once had longer holding periods and higher risk, now you have shorter holding periods and lower risk. It is positive for the industry because a lot of these companies are not viable and the management teams are mediocre; they are just going to run out of cash and disappear from the market."

Jason Chang, CEO and managing director at EMR Capital, shares a similar view, noting that the rewards are there for those with patient capital. While falling commodities prices are sending shockwaves through the industry now, the longer-term outlook is brighter - especially when one factors in growing demand from Asia's emerging economies led by China and India.

"The medium- to long-term outlook for mining assets is very positive so long as you target the right commodities in the right projects, and in the right countries," says Chang. "We focus the quality of the asset, the commodity, the scale of the potential upside, stable jurisdictions, and cost structures. If you have those metrics right then we think things look good."

As for mining services, many in industry also sound a positive chord. With less attractive projects falling by the wayside, demand may exceed supply sooner than most people expect, which would help dig the likes of Bradken out of their hole. It may not happen tomorrow, but the groundwork it is underway for the next up-cycle.

"Eventually we will start to get increased activity, mining services companies will be required again," says KPMG's Evans. "And while it may not be boom from 2008 to 2012, the simple fact is the mining industry is very resilient - it is essential and necessary, not only for China but for a lot of emerging countries."

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• Topics
• Australasia
• Buyouts
• Australia
• Commodities
• Pacific Equity Partners
• Bain Capital Asia
• The Blackstone Group
• Gresham Private Equity
• buyout