In recent months, prices for many mined commodities have hit record levels. While some prices have already declined, many industry commentators still talk of a new super cycle. Price increases seem reminiscent of events from a decade ago, when commodity prices remained elevated from 2009–11 following the global financial crisis. A subsequent flurry of M&A activity and project investment resulted in capital expenditure blowouts, bloated cost structures, and asset write-downs. The remainder of the decade was largely spent rebuilding balance sheets.
Based on current prices, cash flows from operations for a majority of mining companies are expected to remain strong in the near future. This presents the industry with a conundrum: How should companies invest for growth, exert capital discipline, and avoid missteps from the past?
An assessment of how the industry used cash in previous cycles points to a way forward for pursuing growth, optimizing balance sheets, and adjusting internal processes. As record cash flows provide an ability to grow after years of cash conservation, a refreshed expansion strategy could include organic growth and a rethink of allocation decisions to emphasize more greenfield investments and sustainable processes, which are better suited to today’s evolving regulatory backdrop. An M&A strategy built around a series of smaller deals could enhance growth prospects and avoid some of the pitfalls of past large acquisition moves done at high premiums. And more flexible processes to manage investment project leverage and create commodity pricing outlooks can even out some uncertainty in the next business cycle.
How cash drives mining value
As in other industries, the mining industry’s ability to generate and grow cash flows affects shareholder wealth. To better understand how the industry is generating cash and where it is being deployed, we analyzed cash flows over the past two decades and researched best practices on cash-flow management (Exhibit 1). Our findings show patterns in how cash was used during certain cycles. We also identified key pain points for the industry during sudden changes in cycles, as well as practices that can help ensure financial resilience.
What cash-flow management reveals about the industry
Starting in the early 2000s the mining industry experienced a significant improvement in cash flows, as commodity prices remained elevated through 2011 (excluding the 2008 financial crisis). Prices were largely driven by rapid economic growth in China. From 2007–12, companies invested back into their businesses, tapping strong operational cash flows along with debt and equity issuances. These investments supported growth both in the form of greenfield and brownfield projects as well as acquisitions, with the majority of capital spent at price peaks. Cash returned to shareholders generally moved in line with commodity prices.
Our analysis suggests that 2016 was the nadir for the mining industry. As commodity prices declined from 2012–16, most mining companies changed their focus to reducing capital expenditures, fixing balance sheets, and controlling costs.
Since 2016, though, the financial performance and health of the industry has improved. Our research reveals three trends from the past five-plus years that help explain the industry’s current position.
Cash flows from operations have improved significantly—and should continue to grow. Even through 2020—a challenging year due to the COVID-19 pandemic—cash flows from operations have continued to grow, as overall profitability improved with both top-line and margin increases. Cash flows from operations are expected to reach historical highs in 2021–22 given ongoing elevated commodity prices. A significant part of this improvement seems to be driven by increases in the top line. However, relative to revenues, cash-flow generation is below the highs of 2010–11. It appears that companies are now less efficient in converting revenues to cash flows. Our research also shows that cash-flow increases since 2016 have largely been driven by volume and/or price increases.
A slight increase in capital expenditures and M&A suggests a cautious approach by leadership. Absolute capital expenditures have increased since 2016. However relative to cash flows from operations, capital expenditure levels are still modest. This suggests caution among executive teams and boards with regard to growth fueled by large-scale capital projects. The same is true for M&A: while there have been several large transactions in the gold sector, for example, overall levels are significantly lower than they were during 2007–12.
Capital structure has emphasized low debt, while dividends have reached peak levels. Since 2016, the mining industry has focused on reducing leverage levels. Less than 10 percent of the companies in our research had a net debt-to-EBITDA1 ratio greater than 2.5 times, indicating that balance sheets have been relatively strong. The industry has also adjusted payouts to shareholders. Companies reduced dividends after 2011, when commodity prices started declining. Then, in 2017, when cash flows started improving with commodity prices, dividends and share buybacks started increasing again—and reached peak levels in 2019. This helped companies conserve cash at the time of shortfall and prioritize other uses of cash. This was in contrast to other industries such as oil and gas, which decided to maintain dividend levels despite a reduction in oil prices post-2014.
What to consider for the next cycle
Cash flows are expected to increase to unprecedented levels in the next two years, according to sell-side analysts (Exhibit 2). If the industry does see an uptick in cash, some leaders might see it as a “license to grow.” But based on recent history, how should companies approach growth in the future? What are effective ways to maintain healthy balance sheets, all while considering the potential for upcoming price swings?
To prepare for the next cycle, companies should consider adjusting their strategies, capabilities, and mindsets. Here are three key areas where companies may have to think about changing the status quo given the industry’s cash outlook.
Refreshing growth strategy
For most of the past decade, companies have focused on cash conservation, with the modest approach to capital expenditures and M&A and emphasis on low debt that we outlined above. However, if cash flows remain strong, growth is likely to be management’s top focus.
Any growth should be fully backed by strategy, as well as a plan for future commodity price changes. Our research into how companies have pursued both organic and inorganic growth reveals a few tactics to consider.
Pursuing organic growth. Some of the disciplined players in the commodity industry plan for organic growth using an internal outlook for long-term prices. This internal price analysis is often based on an organization’s demand–supply balances. Longer-term investment decisions are then made with these centralized assumptions in mind—not in reaction to the short-term volatility of market prices. Companies often factor market prices into their internal pricing outlook to some extent, though, such as to help account for inflation. This current upcycle has already brought some inflation in operating expenditures and capital expenditures, which also happened in past upcycles.
Some companies that focus on value over volume utilize a KPI that ensures assets are economically viable even when commodity prices are low. For example, an upstream oil and gas company developed a KPI focused on break-even costs. It not only evaluated new projects during investment decision making but also regularly reviewed the current portfolio’s performance against that KPI. The company also utilized the KPI to communicate decision making with external investors.
Going forward, some companies may also have to rethink their capital allocation policy between greenfield or brownfield projects. Given the low-risk mindset in recent years, the majority of companies have focused on brownfield expansion. With commodity prices increasing, however, this is likely to change. In fact, according to S&P Global Market Intelligence, nonferrous exploration budgets for 2021 are already above recent years’ levels and are closer to 2014 levels. Also, given that investors and financial markets are increasingly demanding an approach to growth that considers environmental, social, and governance (ESG) factors, it will be important to understand how potential changes in regulation might affect project attractiveness when deciding between greenfield or brownfield projects. This may require reviewing different technological options to develop mines, with a focus not just on one-time cost but also the impact on ESG scores.
Additionally, organizations should consider how new investments can provide flexibility—for example, being able to adjust production in case of sudden cycle changes.
Pursuing inorganic growth. M&A in mining has been largely cyclical. Many assets were bought at close to peak valuation through 2011–12, for example, when cash flows were high. When prices went down, the industry had to reassess the value of these new assets—which was often lower than the value paid. While M&A activity in mining has largely been down (barring a few subsectors), companies with more funds at hand might look to M&A again as a way to grow strategically. One potential benefit of M&A: derisking the uncertainties in developing a resource base compared with greenfield or brownfield projects.
Our research shows that programmatic M&A strategy, where companies do at least two small or midsize deals every year but no large, “big bang” deal, is most likely to create the best value for companies. In the gold industry, for example, companies that have regularly acquired smaller assets have generally done well compared with companies pursuing other M&A strategies.
Another lesson from the gold industry is the emergence of zero-premium deals. These are deals in which two companies agree to join hands through a stock deal and without any premium being paid. This helps mitigate downside risks in case the commodity prices change significantly.
Companies should also evaluate a potential M&A deal with different commodity price projections to prepare for a range of outcomes. And similar to the decision-making process for brownfield or greenfield projects, companies making M&A deals should consider factors such as production flexibility and ESG implications.
Optimizing the balance sheet
Some companies in our research have come up with effective ways of optimizing balance sheets for future price swings.
Keeping an optimum level of debt is ideal from a cost-of-capital perspective, and the majority of industry players have a comfortable leverage position right now. Still, it’s important to consider setting clear targets for leverage ratios going forward, to better prepare for price cyclicality and fluctuating cash flows.
Some companies will factor leverage into their decision-making process for project investments. Projects that potentially increase leverage will go through closer scrutiny. We have seen companies build and maintain stress-test models that ensure debt is easily serviceable during commodity price swings. These are flexible models in which companies can test cash-flow variability (or other KPIs) under different macroeconomic and commodity price outlooks.
When cash flows increase, companies will typically think about updating their long-term dividend policies. It is important to be judicious before announcing aggressive policies, such as having dividends that grow by a set rate in the future. Instead, companies may want to consider paying excess cash through a special, nonrecurring dividend. As mentioned earlier, cash usage will depend on an organization’s commodity price outlook. If management believes commodity prices are nearing the peak, companies may want to retain some cash in anticipation of the next downturn.
Adjusting process
Shifts in growth strategies and optimizing balance sheets could require a reimagining of certain organizational processes.
Earlier we mentioned that organizations can create commodity price outlooks based on internal demand–supply balances. Many large companies have internal “assumptions” teams that can develop custom outlooks, which can be used consistently across a company’s financial-planning processes on a through-cycle basis. Creating these price outlooks typically requires a comprehensive financial model—one that incorporates data at the project level—as well as an understanding of different macroeconomic scenarios.
Organizations can also look to streamline and improve the process around investment decisions. Our research shows that during periods when cash generation was constrained, committees tended to be conservative when considering investments in ongoing projects. By utilizing commodity price outlooks, these committees will potentially have better information to make faster decisions, and in certain cases can shift from a mindset of “Is this project still worth it?” to “How can this project be successful?” Investments shouldn’t happen in low-return projects, of course, but committees can consider putting an emphasis on criteria such as derisking and optionality, while relaxing criteria focused solely on cash conservation. Companies may also need to consider both the opportunities and risks associated with environmental regulations and the broader energy transition.
The mining industry faces an interesting challenge of utilizing excess cash, especially if commodity prices remain high. Leaders can consider different tactics for approaching growth, managing debt and dividends, and rethinking existing organizational practices. They should also develop a long-term view on prices that will help inform financial decisions going forward.
