Strictly Boardroom has spent the last few months coordinating a course with the grand title of the “strategic management of minerals and energy companies”. The class is now complete – so a sincere thanks to all those who helped make it a success*.
Of course strategic management is far easier to espouse in the lecture theatre than it is to execute within the boardroom. To close that gap between theory and practice – your scribe set up a conundrum during the course to which he expected opinion to be divided. It most certainly was.
The conundrum went something like this.
- You are an emerging $A150 million company by market capitalisation seeking to become a future Australian gold producer. At this stage however you are some years from first production. Your flagship asset is potential gold development at feasibility stage in Australia. To advance that gold asset you have sufficient cash reserves and no debt (other than trade creditors) to complete the feasibility study to a definitive standard.
- A large gold company has decided to sell out of a number of mines globally that no longer fit with its scale and mine life requirements. These mines have limited life and higher costs than the overall portfolio average for the large company. The divestment creates the possibility for you, as a would-be gold producer, to acquire one of the operating assets set to be divested by the large miner.
- Your CFO, working closely with a corporate advisor, estimates the present value of future cash flow from one of the mines that is for sale at $150 million. Your technical team has a solid track record of operating experience of similar gold assets. Technical due diligence has been satisfactorily completed. The asset is clearly not a lemon – and as an operating asset will generate cash from day one.
- You check the financial model – and consider all the assumptions to be appropriate. You have independent financiers and engineers check the model without issue. Bank finance is available on what the board considers satisfactory terms and if the board recommends a deal it is anticipated that the required equity component can be raised from existing large (and small) shareholders without seeking out new investors.
- Now here comes the conundrum. You determine that to win the bid for the asset 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?
At this point in the exercise a large number of questions quickly appear.
People ask for further detail on the asset, the valuation and the bid process for example. Specific questions include whether the right discount rate has been applied (to reach the $150 million valuation), whether the real option value and exploration upside has been fully captured, the correct impact of the financial terms and advisory fees used to fund the acquisition, what the gold price assumption was, if sustaining capital has been accounted for and so on.
All these questions point to uncertainties in reaching the ‘right’ answer of course – but let us for the purposes of the exercise assume that all the above factors have all been correctly estimated (albeit that it is very difficult to value several factors with certainty) in arriving at the $150 million present value of future cash flows.
Similarly let us assume that the answer of $150 million represents the board’s preference in terms of financing mix and any hedging contracts to be entered into. Whilst financial engineering could certainly change the answer, let us assume the financing terms and structure is considered the most appropriate and that the financiers are willing participants in the deal should it proceed.
Of course as noted here there is material uncertainty on any single point valuation number – so let’s again for the sake of argument here say that such uncertainty is understood. Let’s call it plus or minus $50 million in present value terms. So while the base case valuation is $150 million, the upside valuation case is $200 million (the price tag required to win the asset) and the downside $100 million.
So there you have it. It is a simple conundrum really. Would you in these circumstances buy a $150 million asset for $200 million?
All those in favour of buying please vote YES. Similarly, all those against please vote NO.
Unlike the Victorian state election, the poll to date is about even. So what do you think?
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).
* With thanks to guest speakers Erica Smyth (Toro Energy), Rich Krasnoff (CET), John Sykes (Greenfields Research and CET) and Sally-Anne Layman (Macquarie Bank) for delivering lectures into the course.
