Thank you to all those who responded to last week’s call for either a “yes” or “no” vote on the proposed acquisition of a $150 million gold mine for $200 million. First to the results: The split was around 80% voting no – and 20% voting yes. One lateral thinking colleague answered “neither” – which is exactly why he is in the process of undertaking a PhD – but for the sake of argument here we will constrain the solution space to simply yes or no. That said, the answers are never quite as simple as they first appear.
By way of reminder, a short-from version of the conundrum is as follows:
• You are a $150 million company seeking to become a gold producer. Your flagship asset is gold development at feasibility stage in Australia. You have sufficient cash reserves and to complete feasibility.
• A large gold company has decided to sell a number of gold mines. These mines have limited life and higher costs than their overall portfolio average. You consider acquiring one of the operating assets.
• You estimate the present value of future cash flow from one of the mines at $150 million. Due diligence is sound. The asset will generate cash immediately.
• You check the financial model and consider all assumptions appropriate. Bank finance is available and if the board recommends a deal it is anticipated that the equity component can be raised from existing shareholders.
• Now the conundrum. To win the bid you will need to pay $200 million, some $50 million above what you consider to be fair value.
• The conundrum is simple: Do you make a $200 million bid to acquire the operating gold mine?
The devil is always in the detail so the following information is critical: You can consider the discount rate correct (to reach the $150 million valuation), that real option value and exploration upside has been fully captured in the $150 million too, that the correct impact of the debt-equity mix, financial terms and advisory fees have been estimated, that the gold price assumption is correct, that sustaining capital is included and so on.
So what is the rationale for a yes vote? The case for no is simple of course. Buying something for $200 million that is correctly valued at $150 million makes no sense at face value, end of story. On that basis, especially as gold price upside and exploration upside had been ruled out, the majority response was a clear vote of no: The proposal is defeated.
The yes vote takes more explaining though – and is worthy of investigation. The logical flow for a yes vote goes something like this.
1. The yes vote relies on the assumption of a degree of market inefficiency relating to the transaction. That is, the first assumption for “yes” is that the markets will not immediately mark down the acquirer for paying $50 million too much – indeed may actually re-rate the company positively given it now has an operating cashflow.
2. The next assumption required to support a yes answer is to consider the ‘standard’ value accretion curve as a company progresses from discovery (an initial rise in value) through feasibility (declining value) to eventual production (re-rated value) at the company’s existing flagship asset . If this plays out to the standard stylised form so often seen in investment banking presentations, then the company may well lose $50 million (or more) in value in coming months as the feasibility progresses at the existing asset should the board choose not to make the acquisition. That is, those voting yes saw the acquisition of a cashflow as mitigating the potential value loss as the flagship asset continued to progress through the ‘feasibility malaise’.
3. Finally, one wag even suggested that the board of a company saying yes might then subsequently launch a takeover bid for any company saying no to the acquisition on the basis of the cashflow and larger market capitalisation. This bold move requires the assumption that an independent valuation would not reveal the value destruction of the acquisition. Of course if the board of a “yes” company is willing to pay another premium then the board of the “no” company may agree to the deal!
So there you have it. At a stretch buying a $150 million asset for $200 million can be rational in such circumstances.
What do you think the probabilities are that assumptions 1 and 2 – or even assumption 3 – might hold in a continuing bear market? Is the vote still 80:20 for no?
Of course the management of any company has a strong vested interest in a yes vote here. Why? Executives of larger companies are paid more! Academics call this agency theory, resulting from a disparity in pay-offs between the principals (shareholders) and the agents (executive team). The same agency issue holds true for ‘independent’ directors too – although the decision bias is less marked in terms of the absolute size of NED fees.
Further thoughts are welcome. Good hunting.
Allan Trench is professor (value and risk) at the Centre for Exploration Targeting, University of Western Australia, professor of energy and mineral economics at Curtin University Graduate School of Business, a non-executive director to several resources sector companies – and the Perth representative for CRU Strategies, a division of independent metals and mining advisory CRU Group (allan.trench@crugroup.com).
