The Hindu Business Line : `Current metal prices represent a return to sustainable price levels'

The key challenges for deals would be valuations becoming aggressive and cultural issues coming to the fore, pertaining to posttransaction integrations, in the case of crossborder deals. - MR Manoj Bothra, Associate vice-president, Ernst & Young.

According to a recent report by Ernst & Young, 2007 was a record year for M&A (merger and acquisition) transactions in the metal and mining sector. The value of M&A in this sector reached $210.8 billion in 2007, which represents an increase of 444 per cent from $38.8 billion in 2000.

"High commodity prices, resource security, economies of scale, infrastructure sharing and rising demand from emerging economies are driving local as well as crossborder M&A activities," says Mr Manoj Bothra, Associate Vice-President, Ernst & Young, in an email interaction with Business Line. He feels the ferrous segment in India, like iron ore and steel, is very fragmented and ripe for consolidation.

As a dealmaker, Mr Bothra says the key challenges for deals would be valuations becoming aggressive and cultural issues coming to the fore, pertaining to post-transaction integrations, in the case of crossborder deals.

"The competition authorities around the world are very unlikely to permit industry consolidation to happen without extensive analysis of the pricing effects. The mining industry may have discovered pricing power, but the buyers will not hesitate to bring the dangers to the attention of the authorities," he quips. Read on.

Excerpts from the interview:

Many analysts believe we are reaching the end of a commodity super-cycle.

It is our view that current metal prices actually represent a return to sustainable price levels following an extended period of artificially depressed prices. This is opposed to the conventional belief that the industry is near the top of the cycle. The fundamentals of the Chinese and Indian domestic economies remain strong. Therefore, the potential for significant demand growth also remains strong.

What are the key issues from the supply side perspective?

Underinvestment in exploration and development during the 1990s has resulted in severe supply constrains. As available reserves are more difficult and expensive to produce, this imbalance looks set to continue.

The increased cost is due to infrastructure access, inadequate supply of skilled workers, access to secure energy and the social cost of operating the mines.

In order to gain social permission to exploit natural resources, the mining sector must excel on the social dividends it provides to employee health and safety, the environment and the host community. Loss of that permission will result in loss of access to resources.

Do you see any signs of the heightened M&A activity in the metal and mining space abating?

We believe that the trend for more and bigger deals would continue and perhaps accelerate.

In the past there was commodity-wise consolidation, now we see consolidation across commodities - for example, a BHP making a bid for Rio Tinto.

Acquirers are taking a much longer-term strategic view on investments. They are beginning to invest in early stage exploration assets as well as in assets that still have project risk attached to them, particularly with regard to infrastructure access and political risks. There is increasing pressure on companies to grow and we believe that the inorganic growth route will be the preferred one.

How are acquirers supposed to fund large acquisitions, typical of the metal and mining space, with credit becoming dearer in the light of the global turmoil?

Global downturn appears to be having little impact on the sector. While the cost of debt has soared, we are yet to see delays in bankable transactions because of debt availability issues, as is starting to happen in other sectors.

The sector attracted the majority of debt raised through the second half of last year. On the other hand, tighter funding situations for mining development projects would accelerate the long-awaited consolidation of junior miners, particularly poor performers. The situation will clearly differentiate the hunters from the hunted.

Based on the transactions in the metals and mining space in the last 5-10 years, how successful have been the acquirers?

As key players compete for control of low-cost production across the globe, significant premiums have been paid over the market price. For example, Xstrata paid a 28 per cent premium for Jubilee, and Rio Tinto paid 66 per cent more for Alcan than its undisturbed market value.

Back home, Vedanta Group acquired Sesa Goa at about 50 per cent premium to the market price before the acquisition announcement. Today, Sesa Goa's market price of Rs 3,000 is 50 per cent higher than what Vedanta paid. Based on a study done by EY, companies with acquisition strategy have generated significantly higher shareholder returns (about 100 per cent higher), than those with non-acquisition strategy.

Where will we see more consolidation in the domestic metals and mining space?

The non-ferrous space in India is fairly consolidated. In the case of aluminium, copper and zinc, there are two or three large players in each segment. So, in the non-ferrous space, it would mainly be capacity ramp-up by these players which might also include overseas acquisitions.

On the contrary, if we look at the ferrous segment like iron ore or steel, the industry is very fragmented in India, and one would see some amount of consolidation happening in this ferrous metals space going forward.

What is the role of the Government in the M&A space in the metal and mining industry?

In the age of resource security we are likely to see a greater emergence of Sovereign Wealth Funds (SWFs) in the sector. The top 20 SWFs globally are estimated to have in excess of $3 trillion under management and are now looking at deals in the mining sector also. This is both from a straightforward investment perspective, and also with a view to securing supply of vital industrial inputs. The most notable example of this is the recent acquisition of a 9 per cent stake in Rio Tinto by state-owned Aluminum Corp of China (in a joint agreement with Alcoa).

For dealmakers, what are key challenges?

The key challenges would be valuations becoming aggressive and cultural issues pertaining to post-transaction integrations in the case of cross-border deals. Also, there is significant risk in terms of regulatory intervention by competition authorities. Competition authorities around the world are very unlikely to permit industry consolidation to happen without extensive analysis of the pricing effects. The mining industry may have discovered pricing power, but the buyers will not hesitate to bring the dangers to the attention of the authorities.

D. MURALI
KUMAR SHANKAR ROY

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