Why miners are diversifying

The mining industry has witnessed a spate of mergers and acquisitions in recent years. In India, Vedanta Resources-controlled Sterlite Industries and Sesa Goa intend to merge, creating a larger and more diversified conglomerate. So why has the diversified mining model become such a coveted one?

THE BIG PLAYERS

The big mining players include BHP Billiton, Rio Tinto and Xstrata. BHP Billiton today mines iron ore, uranium, copper, gold, crude oil and coal. Rio Tinto and Anglo American also have similarly broad portfolios. Diversified miners have several advantages. Having multiple product lines gives a hedge against weakness in any one commodity. Between 2008 and 2009, BHP Billiton managed to hold onto profits more effectively than concentrated players such as Xstrata and Freeport that were hit harder by the downturn. These large players can also invest their capital in the most lucrative segment and at the right time. This is in contrast to India's standalone dominant miners such as Coal India, NMDC, Nalco which currently operate in single segments. Despite high levels of cash holdings, the firms have struggled to deploy their cash.

ADVANTAGE SCALE

Operating across geographies and mining a variety of ore provides BHP Billiton a useful edge over the likes of Fortescue, Vale and Indian miners whose product mixes are dominated by a single product and operations are far more concentrated. The Australian Mining and Mineral Resources Tax (MMRT), which looks to impose a 30 per cent charge on profits of iron ore and coal miners, is the latest example. The sheer scale of fixed asset which large Australian miners hold, may work as an advantage here too.

Small and mid-sized miners allege that the allowances within the MMRT will reduce the tax outgo from the likes of BHP Billiton and Rio Tinto by virtue of the size of mining assets. Given the global stranglehold which these miners have on seaborne iron ore and coal, there were early jitters on higher global iron ore and coal prices. But depending on how big miners play the cards with allowances within the bill, the profits which are actually taxed could be lower. The disadvantage is even more acute in the case of smaller coal and iron ore mine operators whose margins are more slender than larger miners.

ADVANTAGES OF DIVERSIFYING

In 2009 (when commodity prices bottomed), both BHP Billiton and Rio Tinto managed to stem the profit de-growth far more effectively than standalone peers such as Potash, Vale and Xstrata, whose profits tumbled by 60-82 per cent. This ‘hedge' is a useful trait in markets where commodity prices are increasingly volatile. But single ‘product' based miners such as Vale, Freeport Mcrowan and Potash Corp tend to see profit margins expand more aggressively than diversified miners during good years for iron ore, copper and potash respectively.

Vedanta's own rejig will produce a conglomerate with operations in crude oil, zinc, iron ore, energy and copper. This is intended to better shield margins against the volatility inherent in individual commodities. The company also hopes to save on shared costs arising from administrative and financing requirements. This would, for example, enable Sesa to tap into or piggyback on Hindustan Zinc's massive cash coffers to raise funds for expanding in Liberia.

But the painful side of being a conglomerate is the willingness to pay a huge premium for the sake of diversification. Prime example is the 2007 acquisition of aluminium producer Alcan, by Rio Tinto, for $38 billion. The debt-laden acquisition hurt Rio Tinto's profitability for close to three years before surging iron ore and coal prices helped counter the losses from aluminium. The metal and mining space saw the most M&As over the last ten years. But the efforts at diversification have come at fairly high costs per deal. However, the additional pricing power brought in by size, has attracted the regulators attention.

REGULATORS STRIKE BACK

Early entrants or deals such as the BHP and Billiton merger (2001), Rio Tinto's Australian acquisitions gave the respective companies a strong grip over global iron ore trade. Soaring global prices over the last few years have resulted in two problems: One, the perception that entry of a big miner could result in higher prices of the commodity. The Canadian government blocked an attempt by BHP Billiton to acquire Potash Corp. Similarly, an effort by BHP and Rio to merge their Western Australian iron ore operations was also derailed by regulators.

Two,, the fat-margins enjoyed by miners have also sparked off a wave of tax increases by various governments. India is in the midst of introducing a new mining bill which will increase payments made by miners to the government. Several African countries and Indonesia are also in the process of introducing radical norms which mandate domestic ownership and higher taxes.

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