Is Diversification a bad word in the Mining world by Aditya Mehra

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THE LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE
Is “Diversification” a bad word in the “Mining” world?
M. Sc. Finance (part-time)
2012-13
FM4T4: Cases in Corporate Finance
Exam Candidate Number:
Word Count: 6033 words
The copyright of this dissertation rests with the author and no quotation from it or
information derived from it may be published without prior written consent of the
author.
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TABLE OF CONTENTS
1. Introduction 2
2. Motivation behind diversification 4
3. Literature review 7
4. Data and Methodology 9
5. Performance comparison 14
6. Credit risk comparison 18
7. Value comparison 21
8. Functioning of internal capital markets 27
9. Stock market reaction to acquisitions/ divestments increasing/ decreasing
diversification 33
10.Conclusion and caveats 38
Annexure 40
Bibliography 81
Glossary 84
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1. INTRODUCTION
In this study, the author endeavours to determine if there are any benefits of
diversification in the mining industry over a business cycle (2007 to 2012). This has
been accomplished by comparing the diversified mining companies with their single
segment pure play counterparts, analyzing the performance of the internal capital
markets of diversified mining companies, and finally, by interpreting the reaction of
the stock market to transactions increasing or decreasing the level of diversification.
The top four global diversified mining companies on FTSE 100 were selected. These
companies are BHP Billiton (“BHP”), Rio Tinto (“Rio), Anglo America (“Anglo”) and
Xstrata (“Xstrata”) (collectively “Diversified miners”). A brief summary of these
companies is below:
Table #1.1 – Overview of Diversified miners
31 Dec 2012
Market
capitalisation
USD 184.1 billion USD 105.3 billion USD 42.8 billion USD 51.6 billion
31 Dec 2012
Enterprise
Value
2012
Revenues
2012
EBITDA
Segments
(based on
2012
EBITDA)
Listed in UK and Australia UK and Australia UK and South
Africa
UK and
Switzerland
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Each of these Diversified miners has reporting segments based on commodities
(and not geographies), which is the focus of this study. The benefits of diversification
have been analysed over three dimensions - operating performance, credit risk and
valuation. Commodity-wise pure plays have been selected and compared against
the Diversified miners on these three dimensions.
One of the major characteristics of diversified firms is the existence of an internal
capital market. This study analyses the capital allocation between segments to
determine the efficacy of the process. Finally, the stock market is an important
barometer of managerial decisions on increasing or decreasing the level of
diversification. The stock market reaction to such transactions is also included in this
study.
This study is structured as follows – Section 2 delves into the motivation behind
diversification, which is followed by a literature review in Section 3. Section 4
describes the methodology adopted for this study. Sections 5, 6 and 7 compare the
operating performance, credit risk and valuation respectively between the Diversified
miners and their pure play counterparts. Section 8 analyses the internal capital
market of the Diversified miner whereas Section 9 is an event study to understand
the market reaction to acquisitions or divestments that increase or decrease the
diversification of the Diversified miners. Finally, Section 10 draws inferences based
on the previous sections to answer the question “Is “Diversification” a bad word in
the “Mining” world?” This is followed by the Annexure, which is an integral part of this
study, a Bibliography and Glossary.
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2. MOTIVATION BEHIND DIVERSIFICATION
The motivation behind corporate diversification is a puzzle, and a generalised
conclusion on the motives behind a move to diversify could be misleading. In the
Modigliani-Miller world, diversification should not have any impact on firm value.
Investors have the freedom to diversify their risk by holding a portfolio of investments
and hence do not require a corporate to front-run them. However, the truth is that
firms still do diversify.
Some of the motivations that lead to diversification are:
a) Synergies
a) Related diversification
The benefits take the form of economies of scale and scope due to
market power, better resource utilisation, better coordination in
production and supply chain, product and service bundling etc.
b) Unrelated diversification
These benefits take the form of economies of scale. There could be
efficiency benefits between unrelated segments (better capital
allocation via internal capital markets, avoidance of duplication of
management, better managerial oversight etc).
b) Debt co-insurance
The cash flows of a diversified firm, by their very nature, depend on
numerous segments which may not be correlated to each other. The
risk of a lender reduces unless there is a systemic shock which impacts
all the segments significantly. Further, various segmental assets can
be used as a collateral. This added comfort to the lenders helps in
reducing financing costs wherein cash generated by other segments
provides an insurance against the borrowing segment. This also
enhances the debt capacity of the diversified firm which could lead to
higher interest tax shields.
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c) Internal capital markets
When external financing is expensive, diversified firms have the option
of allocating capital across segments to avoid the expensive external
source of financing. Further, the cash flows of under-performing
segments can be diverted for investing into a good segment, thereby
increasing the overall benefit to the firm.
The imperfections in the external capital markets also lead to
diversification wherein the firm can internally allocate resources more
efficiently. Moreover, the miniature internal capital market replicates the
discipline of external financial markets.
d) Agency problems between management and owners of the firm
a) Empire building
Managements aspire to enlarge their area of influence and power by
acquisitions. This leads to firms undertaking acquisitions that increase
the perimeter whether geographically or along the value chain or
sometimes event unrelated.
b) Increasing managerial compensation and perquisites
Larger organisations generally have higher compensation and
perquisite levels. This leads to managements undertaking acquisitions
so that their permit increases, thereby increasing their overall
compensation and prestige.
c) Safeguarding their jobs
Managements enter into acquisition transactions to create a niche
within the organisation for themselves. This leads to management
entrenchment wherein they become indispensible to the larger
organisation.
e) Response to industry prospects and growth opportunities
If the industry in which the firm is operating has poor growth
opportunities, the firm would have a higher propensity to diversify into
an industry with good growth opportunities.
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f) Value considerations
On numerous occasions, firms simply acquire a new business because
it is undervalued.
g) Hubris
Managements at times believe that they have a “Midas touch” which
can be used to build larger, well functioning businesses.
h) Risk reduction
Managements have the belief that diversification will help reduce the
risk of the firm and that the firm can diversify better than the
shareholders.
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3. LITERATURE REVIEW
There is a significant amount of literature available on corporate diversification.
Some of the literature relevant for this study is below.
Value:
Early studies like Lang and Stulz (1994), Berger and Ofek (1995) and Rajan,
Servaes and Zingales (2000) concluded that diversified firms trade at a discount to
their single segment comparables. However, literature by Campa and Kedia (2002)
and Villalonga (2004) alluded to the fact that the value implications of diversification
were not negative but depended on a case by case basis.
Motivation:
Studies by Jensen (1986) and Jensen and Murphy (1990) have mentioned that
managers take the diversification route to increase their power and compensation. A
study by Amihud and Lev (1981) concluded that diversification reduces individual
employment risk. Finally, Shleifer and Vishny (1989) concluded that diversification
helps managements to entrench themselves.
Internal capital markets:
Poor performance of internal capital markets was found by Scharfstein and Stein
(2000) and Lamont (1997). Glaser et al (2011) concluded that managerial power led
to frictions in internal capital markets as divisions under powerful and connected
managers are able to secure more resources in a financially constrained
environment.
Over the cycle:
Yan et al (2010) found that investment declines in single segment firms while it
remains the same for diversified firms during times of recession. Further, they
concluded that internal capital markets become more efficient during depressed
market conditions.
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Re-focussing spin offs:
Stock markets tend to appreciate re-focussing spins offs as per Comment and Jarrel
(1995), John and Ofek (1995) and Desai and Jain (1999). On the other hand, a study
by Morck el al (1990) shows that firms increasing diversification had negative
returns.
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4. DATA AND METHODOLOGY
a) The largest diversified mining companies of FTSE were identified:
– This selection included BHP, Rio, Anglo and Xstrata. These companies
have a global footprint and mine multiple minerals.
b) These four companies were researched:
– Annual Reports, Earnings Releases, Company presentations and Press
Releases available on the company website, Bloomberg and Thompson.
c) The reporting segments of these four companies were identified and the
corresponding financial information available was collected.
– In most cases, the reporting segments were not appropriate for the said
analysis as the management of the companies had aggregated commodities
into certain segments based on their organisational and management
structure and there were changes in the segment perimeter during the period
of this study.
– In order to perform a reasonable analysis, 12 segments were identified
based on the segmental information available for each of the four diversified
miners. These segments are as follows:
i. Petroleum upstream
ii. Iron ore
iii. Coal
iv. Copper
v. Other base metals (Gold, Silver, Uranium, Lead and Zinc)
vi. Nickel
vii. Platinum
viii. Diamond
ix. Aluminium
x. Manganese
xi. Speciality products
xii. Industrials and Technology
– Reporting segmental information of the four Diversified miners was then
classified under these 12 segments. Any material corporate overheads and
assets were apportioned over these 12 segments so that the aggregate of the
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segmental information would tie in with the reported consolidated financial
results of the four diversified miners.
d) Pure play comparables were identified for each of the commodity segments:
– The endeavour was to determine pure play/ single segment firms in each of
the commodities. There were not many ideal pure play comparables as
mineral companies endeavour to sell whatever they can extract from the
earth. As minerals seldom come in their pure form, by-products play a role in
the economics of each company. In order to overcome this issue, companies
which had a high turnover from the relevant commodity were selected as a
proxy of the pure play wherever necessary. The comparables comprised of
the big players in each segment as opposed to the fringe pure plays. The
various criteria that were used to select comparables were – pure play, size,
geographic locations, production history etc. The search was further limited to
only public companies, as reliable financial information of private companies
was not easily available.
– In total 86 companies were considered and 36 were selected under the 12
segments. Annexure 1 on page 41 presents a table with all the close
comparables that were considered.
– For each segment, there were more than one comparables which were
selected and averaged out to obtain representative metrics for operating
performance and valuation for that segment
e) The appropriateness of the pure play comparables was compared:
– Selection of the correct pure play comparables was critical for this study. In
order to confirm the appropriateness of the pure play comparables, the actual
asset beta of the Diversified miners was compared with their implied asset beta
based on the asset betas of the pure play comparables.
– The actual equity beta of the four diversified companies was determined by
regressing their excess stock returns against the FTSE index.
– The Diversified miners have a high beta and no alpha as can be seen from their
t-stat below. The detailed regression output is in Annexure 2 on page 43.
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Table #4.1 – Summary of regression output
– There were not adequate pure play companies on FTSE to determine the
segmental beta and hence the comparable pure plays across exchanges were
considered. The underlying assumption is that markets co-move and hence an
average of the betas with respect to different markets would be comparable with
the beta of the Diversified miners based on the FTSE index. The global market
for commodities ties in with this assumption. The various equity betas were de-
levered based on the capital structure of the respective company assuming a
debt beta of zero. Annexure 3 on page 45 provides the individual equity and
asset betas for all the companies.
– The implied asset beta of the four diversified companies was the weighted
average segmental asset betas using their segmental EBITDA as weights.
Ideally, the weights should have been the value of each segment but the EBITDA
of the respective segment was used as a proxy.
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Table #4.2 – Implied asset beta of Diversified miners
– As there is not a significant deviation between the actual asset beta of the
Diversified miners and their implied asset beta, the chosen comparables were
considered as appropriate for this study.
f) Data of the Diversified miners and their comparables was gathered
– Information was collected from Bloomberg and Thompson for the Diversified
miners and their segmental pure play counterparts across six-monthly periods
during 2007–2012. The period of study was dividend into sub-periods
corresponding to the business cycle (H1 2007 – H1 2008 -> growth; H2 2008 to
H2 2010 -> recession; 2011 – 2012 -> recovery) in order to draw conclusions of
the effect of diversification over the business cycle.
– Suitable performance (EBITDA margin, EBIT margin, Revenue growth, Return
on assets, Net Working Capital/ Revenue) leverage (Net Financial Debt/
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Enterprise Value, Net Financial Debt/ EBITDA) and valuation metrics (Enterprise
Value/ Sales, Enterprise Value/ EBITDA and Enterprise Value/ EBIT) were
identified for this study and calculated based on data available. The data was
reconciled with the consolidated financial statements of the four diversified firms
in order to ensure accuracy and similar accounting treatment of investments
accounted for under the equity method.
– The performance and valuation metrics, as mentioned above, were averaged
out for each pure play comparable to determine the segmental performance and
valuation metric. The averaging procedure ensured that a reasonable and
representative estimate of the actual performance and valuation of the segment
was determined, thereby minimising the effects of the lack of pure plays or fully
comparable companies in some segments.
– Any extraordinary impacts on performance (start up, accidents, windfall gains
or losses etc.) and valuation (takeover announcement, extraordinary dividends,
class action etc.) were not considered in the averaging process in order not to
distort the segmental results.
– For Diversified miners, information on major acquisitions or divestments
impacting the level of diversification was gathered from the respective company
press releases. Stock price information for conducting an event study around the
announcement period was taken from Bloomberg.
– Lastly, for Diversified miners, data was gathered on the Capital Expenditure
spent on individual segments to calculate metrics such as Capital Expenditure/
Depreciation and Capital Expenditure/ EBITDA. This segmental information was
used to analyse the function of internal capital markets at each of the Diversified
miners.
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5. PERFORMANCE COMPARISON
Objective:
To determine if diversification led to superior operating performance over the
business cycle as compared to segmental pure plays.
Methodology:
The segmental operating performance of the four diversified companies was
compared against their pure play counterparts.
Profitability (EBITDA and EBIT margin), growth (Sales growth) and asset returns
(EBIT/ TTM Assets) of each segment of the Diversified miners and their pure play
counterparts was determined and compared for the 12 six-monthly periods during
2007-12.
Further, as the segmental working capital information was not available for the
Diversified miners, the total working capital was considered and compared to the
average working capital metric of the segmental pure plays.
Outcome:
As can be seen from the chart set 5.1, Diversified miners have (in terms of
profitability):
a) significantly outperformed their pure play counterparts in
a. Iron ore
b. Coal
c. Manganese
b) significantly underperformed their pure play counterparts in
a. Nickel
b. Industrials and Technology
c) initially outperformed pure plays in Aluminium, Copper and Other Base
Metals; however, for the last few years, profitability has dropped below the
average of competitors
The revenue growth comparison between Diversified miners and their pure play
counterparts also shows recent underperformance by the former. In segments like
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Nickel, Diamond and Speciality Products, this underperformance has been
consistently significant over the business cycle.
On pre tax RoA, the Diversified miners have outperformed the pure play
counterparts due to the fact that the asset base of the former is much older than that
of the latter thereby increasing the returns.
Figure #5.1 – Segmental over/ (under) performance as compared to pure plays
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The graph below depicts the average net working capital to revenue ratio which
clearly shows the superior working capital management of the Diversified miners.
Figure #5.2 – NWC to Revenue ration of average Diversified miners and average
segmental pure plays
Conclusion:
As can be seen from the segment wise performance graph in Annexure 4a to 4d
starting on page 47, there is a high correlation between the direction of segmental
performance and the direction of corresponding pure plays performance. This is not
surprising on account of the global market for commodities and the presence of well
established commodity pricing indexes for most of the commodities.
Diversified miners have significant competitive advantage in Iron ore and Coal due to
their large integrated (mining + infrastructure) operation in Western Australia and
Queensland respectively. Further, Iron ore and Coal comprise on average 51%,
82%, 55% and 35% respectively of the total EBITDA of BHP, Rio, Anglo and Xstrata.
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Due to this very high percentage share of total profitability, these segments are given
special attention from the management. Besides, the large scale operations have led
to cost optimisation thereby increasing profitability.
The Diversified miners have underperformed the pure play in Copper, Nickel,
Platinum and Industrials and Technology. From this list, except for Copper, all the
other operations are of marginal size and hence adequate management attention
and focus has been perhaps lacking. Further, under performance has increased in
the recent past. There is a recent trend in the underperformance in segments where
the Diversified miners had a clear advantage in the past like Copper, Other Base
Metals, Nickel, Platinum, Diamond, Aluminium and Speciality products. This is a
potentially alarming situation where past competitive advantage has not been
sustained by Diversified miners.
The Diversified miners have outperformed the pure plays significantly in working
capital management. This is on account of the integration with infrastructure
networks which the pure plays have not been able to achieve due to their smaller
size.
It can be inferred that the fall out of diversification is that management focuses on
segments which will have a significant impact on the companies’ profitability at the
expense of marginalising the smaller segments thereby questioning the strategy of
diversification itself.
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6. CREDIT RISK COMPARISON
Objective:
To determine if diversification has any impact the credit risk of the diversified miners.
Methodology:
As the segment wise net debt is not disclosed by the Diversified miners, the total
debt of these companies was analysed and compared to that of the pure plays.
The CDS of the Diversified miners was compared with the CDS of pure plays and
the iTraxx Europe CDX index for the period of this study. Finally, the credit ratings of
the diversified miners were compared with the individual credit ratings of the pure
play firms (where available).
Outcome:
Figure #6.1 – Comparison of average leverage of the Diversified miners
with pure plays
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In general the leverage of pure plays is much lower than that of the average
Diversified miner. This is understandable considering the lower credit risk associated
with the Diversified miners and hence the higher availability of credit. The Diversified
miners also have a lower net debt to EBITDA ratio thereby providing additional
comfort to the lenders.
The CDS spread graph of all the miners and ITraxx are identical in their movement
except the Petroleum and Coal pure plays as can be seen in Annexure 5a and 5b
starting on page 55. The CDS spreads were low during the boom period of 2007 –
H1 2008 but then drastically rose as the recession set in. The CDS spreads peaked
in H1 2009 but then reduced in 2010 as recovery kicked in. However, spreads rose
again in H2 2012 but did not reach their peak of H1 2009. Some of this phenomenon
can perhaps be explained by correlation breakdown wherein the correlation between
businesses increases in a recessionary environment. This leads to businesses with
low correlation in ordinary business environment co-moving downward during a
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recession, thereby reducing the benefits of diversification when they are needed the
most.
The CDS band of the Diversified miners has been much more stable than most of
the pure plays. The difference in the CDS between the Diversified miners and their
pure plays is the least during the boom phase of H1 2007 to H1 2008 but the
difference increases during the recession.
The credit rating of pure plays is lower than the rating of the larger Diversified
miners. There is only one pure play with a credit rating similar to the one of the larger
Diversified miners. A few pure plays have a similar credit rating as the smaller
Diversified miner. Annexure 6 on page 60 corroborates these observations.
Conclusion:
Diversification has lowered the credit risk of the Diversified miners somewhat.
However, there are pure plays with similar CDS levels and ratings. Hence, credit risk
does reduce by diversification but it does so perhaps due to size as can be seen by
the ratings of the larger pure plays.
Diversified firms have the advantage of various streams of cash flows and also size.
This combination leads to the Diversified miners being able to provide better
collateral to the credit providers thereby improving the rating and reducing the CDS.
Segmental pure plays do not have this combination and hence typically have higher
credit risk.
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7. VALUE COMPARISON
Objective:
To understand the impact (if any) that diversification has had on the value of the
Diversified miners.
Methodology:
Compare the actual Enterprise value of the Diversified miners based on their market
capitalisation with the sum of the parts implied Enterprise value based on the
multiples of segmental pure plays.
Work steps:
The six-monthly segment-wise trailing Revenue, EBITDA and EBIT for the period
2007-12 for the Diversified miners and their segmental pure plays was assimilated.
As far as possible accounting differences (equity investments, classifications etc.)
were taken in consideration and data modified to facilitate comparison. The
segment-wise Revenue, EBITDA and EBIT of the Diversified miners was reconciled
with their consolidated income statement. Any differences were allocated to the
segments in order to reflect the consolidated performance.
The Enterprise Value/ Revenue, Enterprise Value/ EBITDA and Enterprise Value/
EBIT multiples of the segmental pure plays were derived and averaged out in order
to determine the multiple for the respective segments. While calculating the average
multiple, the impact of any extraordinary events (accounting changes, losses,
takeover announcement, class action lawsuit etc.) on the Enterprise Value,
Revenue, EBITDA and EBIT of the segmental pure plays were normalised.
The average segmental pure play multiples were multiplied with the corresponding
segment-wise Revenue, EBITDA and EBIT of the Diversified miners. If the EBITDA
or EBIT were negative for any six-monthly period, the Enterprise Value was
computed by averaging the Enterprise Value immediately prior to negative EBITDA
or EBIT with Enterprise Value immediately after the period of negative EBITDA or
EBIT. The implied segmental Enterprise Value was aggregated separately based on
Revenue, EBITDA and EBIT.
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The final implied Enterprise Value was calculated by the weighted average of the
implied Enterprise Value based on Revenue (50% weight), EBITDA (25% weight)
and EBIT (25% weight). This averaging ensured that equal weight was given to top
line (Revenue) and bottom line (EBITDA and EBIT) multiples. Annexure 7a to 7d
starting on page 62 provides the detailed calculations.
Finally, the implied six-monthly sum of the parts Enterprise Value during the period
2007-12 was compared to the actual Enterprise Value to determine if the Diversified
miners traded at any premium or discount.
Outcome:
While the top two Diversified miners (BHP and Rio) on average traded at a slight
premium (1-6%) to their segmental counterparts, the smaller Diversified miners
(Anglo and Xstrata) traded at a significant discount (11-26%) to their corresponding
segmental pure plays.
There were no trends in the quantum of the premium or discount that were observed
across the sub-period of the study. However, Anglo has constantly traded below its
implied Enterprise Value.
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Figure #7.1
(Average diversification premium/ (discount) and Actual EV to implied EV ratio)
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Conclusion:
Larger the size of the diversified miner, more is the premium or lower is its discount
to their sum of the parts. As the discount at which Anglo and Xstrata trade is
significant, it can be inferred that the benefits of diversification increase with size. If
critical mass is not achieved, diversification actually penalises value.
The exposure of the Diversified miners to different commodities is different. Some
segments like Iron ore, Coal and Copper have a high beta; segments like Nickel,
Platinum and Industrials and Technology have medium betas; segments like Other
Base Metals, Diamonds and Aluminium have a beta close to the market beta
whereas Petroleum, Manganese and Speciality Products have low beta. The
exposure of the Diversified miners to these four classes of beta is as follows:
Table #7.1 – Exposure to segments with different betas
Valuation
Discount/
Premium
High
beta
Medium
beta
Market
beta
Low
beta
BHP Premium 60% 6% 10% 24%
RIO Premium 77% 3% 15% 5%
Anglo
American
Discount 49% 37% 8% 6%
Xstrata Discount 70% 14% 12% 4%
As can be seen from the table above, there seems to be no correlation between the
discount or premium that can be attributed to the exposure to the different
commodities.
The leverage of the Diversified miners was also analysed but could not explain the
discount/ premium. Rio and Xstrata have had high leverage but the former has, on
average, traded at a premium to implied value whereas the latter at a discount. The
graph below depicts the leverage analysis.
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Figure #7.2 - - Leverage of the Diversified miners
The discount or premium could be on account of the growth opportunities of each of
the Diversified miners. Though all the Diversified miners have a healthy pipeline of
growth opportunities, the quality of these opportunities may vary, which could
perhaps explain some of the discount/ premium.
The corporate governance of the four diversified miners was analysed to understand
if they could explain the discount/ premium. A comparison of the provisions is below:
Table #7.2 – Corporate governance provisions of Diversified miners
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The provisions followed by the Diversified miners are almost the same. The
only exceptions are:
i) Rio does not have the ability to grant pre-emptive rights to existing
shareholders.
ii) BHP and Rio’s board has the authority to issue capital, which Anglo
and Xstrata’s board does not.
iii) BHP and Rio’s senior management do not have a golden parachute.
iv) BHP and Anglo shareholders do not have the right to call a special
meeting.
v) Rio does not have a staggered board
The value impact (if any) of these governance provisions is out of the scope of
this study.
Finally, the difference in valuation between the Diversified miners themselves and
with pure plays can perhaps be simply due to idiosyncratic factors like quality of the
existing production assets, management etc.
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8. FUNCTIONING OF INTERNAL CAPITAL MARKETS
Objective:
To infer whether the internal capital market of the Diversified miners was functioning
appropriately by analysing the segmental capital allocation.
Methodology:
The segmental organic capex and segmental returns on assets was analysed to
determine if capital had been allocated to segments based on returns.
The segmental capex to depreciation and segmental capex to EBITDA ratios were
determined to identify the segments that are favoured for growth. Further, the
historical performance of segments favoured for growth were analysed to see if there
was any justification for the preferential treatment.
Finally, prevalence of any cross subsidisation in allocation of capital between
segments was analysed by comparing the proportion of segmental capex to total
capex with the proportion of segmental EBITDA with total EBITDA.
Outcome:
Well functioning internal capital market was observed for BHP.
The company has been in a significant growth mode over the duration of the study
as can be seen by the capex-to-depreciation and capex-to-EBITDA ratios. The
internal capital allocation has been functioning well as most capital is allocated to the
most profitable segments like Iron ore, Petroleum and Coal. Aluminium, Nickel and
Coal seemed to be the favoured segments while Copper seemed to be out of favour
and actually cross subsidizing the favoured segments. Diamond and Manganese
segments have had good returns but a small proportion of EBITDA and capex,
perhaps due to limited growth opportunities. No glaring aberrations in capital
allocation over the cycle were noted. In general, capex reduced as a fall out of the
recession but picked up again during the recovery phase. Annexure 8a on page 66
has the graphs on the segmental share of capex with the segmental share of
EBITDA.
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Figure #8.1 – BHP segmental capex and profitability
Note: Y-axis range of Capex/ Depreciation graph has been shortened to facilitate interpretation
Well-to-average functioning internal capital market was observed in Rio.
Like BHP, Rio has also been in a significant growth mode over the duration of the
study. The internal capital market has functioned reasonably except that the
Aluminium segment has received significant capital allocation despite low returns.
This could be perhaps due to legacy under-investments in Alcan which was acquired
in 2007. The Iron ore segment seemed to be cross subsidizing the Aluminium capex.
The other favoured segment was Diamonds which received higher than
commensurate capital despite negative returns. The Uranium segment received a
low share of capital in spite of good returns, perhaps due to the limited investment
opportunities. Other than these exceptions, a high proportion of capital had been
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allocated to the Iron ore and Copper segments in sync with their good profitability.
No major aberrations were noticed across the sub-periods. Annexure 8b on page 67
EBITDA.
Figure #8.2 – Rio segmental capex and profitability
Average-to-below average performing internal capital market was observed in Anglo.
Like the others, Anglo has been in the growth mode over the last few years. Some
major evidence of cross subsidization has been noticed. The segments of Nickel and
Platinum have received significant capital allocation despite low returns. This bias
has been observed uniformly across the sub-periods of this study. Platinum received
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more capital allocation than Coal despite earning a fifth of the return from Coal.
Manganese and Speciality products have received low capital allocation in spite of
excellent returns due to limited investment opportunities. Annexure 8c on page 68
EBITDA.
Figure #8.3 – Anglo segmental capex and profitability
Note: Charts below exclude a) Diamond business which is accounted for as an equity investment during the
period of analysis b) analysis for the period H1 2007 to H1 2008 due to differences in accounting treatment and
disclosure of capex
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Average-to-below average performing internal capital market was observed in
Xstrata.
This is a growth oriented company like the other three Diversified miners. There was
significant evidence of cross subsidization wherein Nickel was favoured despite low
returns. Over the period of study, Nickel has been allocated the same share of total
capex as the Copper and Coal segments which have returns more than twice the
returns of Nickel. The Ferro alloys segment did not receive capital allocation
commensurate with its returns. The largest segments like Copper and Coal which
have high returns have been allocated a major proportion of capex but lower than
their respective share of total EBITDA, thereby effectively cross subsidizing the
investments in the Nickel segment. Annexure 8d on page 69 has the graphs on the
segmental share of capex with the segmental share of EBITDA.
Figure #8.4 – Xstrata segmental capex and profitability
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Conclusion:
No general conclusion can be drawn on the functioning of internal capital markets of
the diversified miners. As has been seen previously, the internal capital markets of
BHP and Rio function well as compared to their smaller counterparts wherein there
appears to be significant evidence of certain segments being favoured at the
expense of more profitable segments. While there could be certain non-financial
consideration or commitments which led to the cross subsidization but the same was
observed across the sub-periods.
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9. STOCK MARKET REACTIONS TO ACQUISITION/ DIVESTMENTS
INCREASING/ DECREASING DIVERSIFICATION
Objective:
To understand and interpret the market reaction to transactions that increased or
decreased the level of diversification of the Diversified miners.
Event study:
The share price movement and the cumulative abnormal returns in the run up to and
post announcement of an acquisition or divestment deal that increased or decreased
the level of diversification of the four Diversified miners were analysed.
Methodology:
Acquisition transactions that increased the number of segments or increased the
size of existing segments substantially over the period under study for each of the
four diversified miners were selected. Considering the size of these global Diversified
miners, only acquisitions with an Enterprise Value of above USD 1 billion were
considered as smaller acquisitions had minimal impact on the value of these large
diversified miners.
Similarly, divestments made by the Diversified miners over the period of this study
that reduced the number of segments or reduced the size of existing segments
substantially were considered. No value threshold was used to filter these
divestments.
The data on the acquisition and divestment deals was taken from the press releases
made by the Diversified miners during the period 2007-12. Their share price and the
FTSE 100 index values were obtained from Bloomberg.
Excess returns from the stock price movement (using the risk free rate from Bank of
England) of each of the four diversified miners and the FTSE 100 was calculated. A
regression was run to determine the α and ß of the individual diversified miners. The
details of the regression are in Annexure 2 on page 43. Using these estimates of α
and ß and the prevalent risk free rate at the time of the individual transaction
announcement, the expected return was calculated and compared to the actual daily
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return over the 60-day period surrounding the announcement of acquisition or
divestment (-30 to +30 days from deal announcement) to calculate the abnormal and
cumulative abnormal returns.
Further, the share price and the FTSE 100 index value during this 60-day period
surrounding the announcement date was scaled to the price on the date of
announcement to observe any major movements.
Outcome:
Over the period of 2007-12, 34 transactions fit the criteria on the level of
diversification of the Diversified miners. This comprised of 15 acquisitions, 2 JVs, 2
mergers, 14 divestments and 1 spin off. The category-wise sub-period-wise details
are below:
Table #9.1 -- Acquisitions (2007 – H1 2008)
Table #9.2 -- Acquisitions (H2 2008 – H2 2009)
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Table #9.3 -- Acquisitions (2010 – 2012)
Table #9.4 -- Divestments (2007 – H1 2008)
Table #9.5 -- Divestments (H2 2008 – H2 2009)
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Table #9.6 -- Divestments (2010 – 2012)
Table #9.7 -- JVs and Mergers (H2 2008 – H2 2009)
Table #9.8 -- JVs and Mergers (2010 – 2012)
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Table #9.9 -- Spin offs (2007 – H1 2008)
Annexure 9a to 9d starting on page 70 have the graphs of the share price movement
and the cumulative abnormal return for the individual transactions.
Conclusion:
The table below summarises the inferences:
Table #9.10 – Summary of transactions increasing/ decreasing the level of
diversification
It can be inferred that during the boom period, the market did not provide a clear
verdict on acquisitions. This was perhaps due to a combination of the strategic
nature of some of the acquisitions along with the possibility of over-payment.
However, the market reaction to divestments and spin-offs which reduced segments
was categorically positive during this period.
As expected during the recessionary environment of H2 2008 to H2 2009, the market
reaction to acquisitions was categorically negative. However, it was strongly positive
to divestments which helped firms to focus their business and get rid of non-core
businesses.
During the recovery of 2010 – 2012, the market was positive on divestments, which
led to refocusing the business and providing much needed cash. The market’s
verdict on acquisitions and JVs was mixed.
Overall, it can be said that during the period under analysis, the market preferred a
reduction in segments and complexities with a focus on low cost and competitive
segments.
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10. CONCLUSION AND CAVEATS:
Even within the Diversified miners, there was a clear differentiation on the impact of
diversification based on size. The results of the analysis led to two groups being
formed – larger Diversified miners (BHP and Rio) and the smaller Diversified miners
(Anglo and Xstrata). The table below summarises the impact of diversification on
each of these groups.
Table #10.1 – Impact of diversification on larger and smaller Diversified miners
Impact of diversification
on:
Larger Diversified miner
– BHP and Rio
Smaller Diversified miner
– Anglo and Xstrata
Operating performance
Credit risk
Valuation
Legend:
Strong advantage Some advantage Neutral Some disadvantage Strong disadvantage
On the operating performance front, the Diversified miners performed better than
their pure play counterparts in segments that were large and critical for the overall
profitability of the respective miner. Segments which were small and marginal did not
get the required attention of the management because their impact on overall
profitability was low.
On credit risk front, Diversified miners due to their very nature provided better
stability on account of numerous streams of cash flows and collateral. But it was
observed that large pure plays were at par with atleast the smaller Diversified
miners.
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Finally, on the valuation front, the large Diversified miners have traded at a slight
premium whereas the smaller Diversified miners have traded at a significant
discount.
All in all, diversification has been more beneficial for the larger Diversified miners as
compared to the smaller Diversified miners. Whether this is because of better
functioning internal capital markets or lower credit risk or larger and better operations
is a question that will need to be further studied.
In the context of diversified versus single segment firm, the conclusion from this
analysis is mixed. However, the stock market has been consistent in its appreciation
of transactions reducing the level of diversification.
Any conclusion must take into account the following caveat:
a) Finding exact comparables is always challenging and more so in the said
analysis due to the diverse segments and geographical footprint
b) Period of this study is limited to the last six years only. A longer duration over
a few business cycles would perhaps provide better results
c) Only the largest 4 diversified miners were considered. Though these are
representative of the mining industry, a few other non FTSE listed miners may
provide better clues (e.g. Vale etc.)
d) Reflecting the value of equity investments is always challenging.
e) Each company has its idiosyncratic variables and controlling these variables
even by increasing sample size may not completely remove their effect.
While early academic literature on diversification concluded that diversified firms
trade at a discount to their pure play counterparts, the recent literature has been
open ended, suggesting that conclusions have to be made on a case by case basis.
In the context of the mining sector, this study reinforces the view mentioned in recent
literature. The question that this study set out to answer unfortunately does not have
a straightforward response.
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ANNEXURE
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Annexure #1 – Pure play sample selection
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Annexure #2 – Regression outputs of Diversified miner
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Annexure #3 – Segmental pure play and Diversified miner betas
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Annexure #4a – EBITDA Margin comparison
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Annexure #4b – EBIT Margin comparison
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Annexure #4c – Revenue growth comparison
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Annexure #4d – Six monthly pretax Return on Assets comparison
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Annexure #5a – Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)
Diversified miners and iTraxx Europe
Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)
Diversified miners and iTraxx Europe
55
Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)
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Annexure #5b – Segmental pure play CDS (1 Jan 2007 to 31 Dec 2012)
Petroleum upstream comparables
Iron ore comparables
Coal comparables
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Copper comparable
Other Base Metals
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Platinum comparable
Diamond comparable
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Aluminium comparables
Industrials and Technology comparable
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Annexure #6 – Credit rating and CDS band
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Annexure #7a - Value comparison - BHP
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Annexure #7b - Value comparison - Rio
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Annexure #7c - Value comparison - Anglo
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Annexure #7d - Value comparison - Xstrata
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Annexure #8a – BHP’s segmental share of capex vs share of EBITDA
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Annexure #8b - Rio’s segmental share of capex vs share of EBITDA
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Annexure #8c - Anglo’s segmental share of capex vs share of EBITDA
Note: 2007 figures not considered due to change in accounting in 2008 and onwards
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Annexure #8d - Xstrata’s segmental share of capex vs share of EBITDA
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Annexure #9a – Share price performance near announcement of BHP’s acquisitions
and divestment:
12 Nov 2007 – BHP’s initial offer for the acquisition of Rio Tinto
6 Feb 2008 – BHP’s revised offer for the acquisition of Rio Tinto
25 Nov 2008 – BHP revokes its offer for the acquisition of Rio Tinto
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5 Jun 2009 – BHP’s offer for the Iron ore JV with Rio Tinto
18 Oct 2010 – BHP terminates its offer for the Iron ore JV with Rio Tinto
18 Aug 2010 – BHP’s offer for the acquisition of Potash
15 Nov 2010 – BHP terminates its offer for the acquisition of Potash
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17 Jul 2008 – BHP’s offer for the acquisition of New Hope-New Saraji Project
22 Feb 2011 – BHP’s offer for the acquisition of Chesapeake Energy Corp
14 Jul 2011 – BHP’s offer for the acquisition of Petrohawk Energy Corp
1 Feb 2012 – BHP’s offer for the divestment of Richards Bay Minerals
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27 Aug 2012 – BHP offer for the divestment of Yeelirrie Uranium deposit
13 Nov 2012 – BHP’s offer for the divestment of its Diamond business
12 Dec 2012 – BHP’s offer for the divestment of its stake in East West Browse
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Annexure #9b – Share price performance near announcement of RIO’s acquisitions
and divestment:
12 Jul 2007 – RIO’s offer for the acquisition of Alcan
18 Aug 2009 – Divestment of Alcan Packaging Europe business
30 Jan 2009 – Divestment of Potash business
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5 Jul 2009 – Divestment of Alcan Packaging Americas business
5 Aug 2010 – Divestment of Alcan Engineering
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Annexure #9c – Share price performance near announcement of Anglo’s
acquisitions and divestment:
1 Jun 2007 – Spin off of Mondi
1 Oct 2007 – Anglo divests it stake partly in Ashanti Gold
17 Jan 2008 – Anglo’s offer for the control of MMX
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16 Feb 2010 – Anglo divests Tarmac’s European (continental) business
10 May 2010 – Anglo divests its Zinc business
14 Nov 2010 – Anglo divests it stake in Moly-Cop and Alta Steel
18 Feb 2011 – Anglo mergers T armac with Lafarge
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4 Nov 2011 – Anglo’s offer for gaining control of De Beers
24 Apr 2012 – Anglo divests Scaw South Africa
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Annexure #9d – Share price performance near announcement of Xstrata’s
acquisitions and divestment:
11 Apr 2007 – Divestment of Aluminium business
7 Aug 2007 – Xstrata’s offer for the acquisition of Eland Platinum
29 Oct 2007– Xstrata’s offer for the acquisition of Jubilee Mines
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6 Aug 2008 – Xstrata’s offer for the acquisition of Lonmin
1 Oct 2008 – Xstrata’s offer for the acquisition of additional stake in Lonmin
7 Feb 2012 – Merger announcement with Glencore
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BIBLIOGRAPHY
1. Academic literature
a. Amihud, Y. and Lev, B., ‘Risk reduction as a managerial motive for
conglomerate mergers’ Bell Journal of Economics, 12(2), 605 – 617, 1981
b. Berger, P. G. and Ofek, E., ‘Diversification’s effect on firm value’, Journal
of Financial Economics, 37(1), 39 – 65, 1995
c. Campa, J. M. and Kedia, S., ‘Explaining the diversification discount’,
Journal of Finance, 57(4), 1731 – 1762, 2002
d. Comment, R. and Jarrell, G., ‘Corporate focus and stock returns’, Journal
of Financial Economics, 37(1), 67 – 87, 1995
e. Desai, H. and Jain, P. C., ‘Firm performance and focus: Long-run stock
market performance following spinoffs’, Journal of Financial Economics,
54(1), 75 – 101, 1999
f. Erdorf, S., Hartmann-Wendels, T., Heinrichs, N. and Matz, M., ‘Corporate
Diversification and Firm Value: A survey of recent literature, CGS Working
Paper, Cologne Graduate School, 2012
g. Glaser, M., Lopez de Silanes, F., and Sautner, Z., ‘Opening the black box:
Internal capital markets and managerial power’, Working Paper, University
Konstanz, EDHEC Business School, Duisenberg School of Finance, 2011
h. Jensen, M. C., ‘Agency costs of free cash flow, corporate finance, and
takeovers’, American Economic Review, 76(2), 323 – 329, 1986
i. Jensen, M. C. and Murphy, K. J., ‘Performance pay and top-management
incentives’, Journal of Political Economy, 98(2), 225 – 264, 1990
j. John, K. and Ofek, E., ‘Asset sales and increase in focus’, Journal of
Financial Economics, 37(1), 105 – 126, 1995
k. Lamont, O., ‘Cash flow and investment: Evidence from internal capital
markets’, Journal of Finance, 52(1), 83 – 109, 1997
l. Lang, L. H. and Stulz, R. M., ‘Tobin’s q, corporate diversification and firm
performance’ Journal of Political Economy, 102(6), 1248 – 1280, 1994
m. Morck, R., Shleifer, A., and Vishny, R. W., ‘Do managerial objectives drive
bad acquisitions?’, Journal of Finance, 45(1), 31 – 48, 1990
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n. Rajan, R., Servaes, H., and Zingales, L., ‘The cost of diversity: The
diversification discount and inefficient investment’, Journal of Finance,
55(1), 35 – 80, 2000
o. Scharfstein, D. S. and Stein, J. C., ‘The dark side of internal capital
markets: Divisional rent-seeking and inefficient investment’, Journal of
Finance, 55(6), 2537 – 2564, 2000
p. Shleifer, A. and Vishny, R. W., ‘Management entrenchment: The case of
manager - specific investments’, Journal of Financial Economics, 25(1),
123 – 139, 1989
q. Villalonga, B., ‘Diversification discount or premium? New evidence from
the business information tracking series’, Journal of Finance, 59(2), 479 –
506, 2004
r. Yan, A., Yang, Z., and Jiao, J., ‘Conglomerate investment under various
capital market Conditions’, Journal of Banking and Finance, 34(1), 103 –
115, 2010
2. Anglo
a. Annual Reports, Earnings Release and Company presentations for the
period 2007 -12, accessed during 18 Apr 2013 to 13 Jun 2013 on the
website http://www.angloamerican.com/investors/reports/2013rep
b. Website information, accessed during 18 Apr 2013 to 13 Jun 2013
http://www.angloamerican.com/
3. BHP
website
http://www.bhpbilliton.com/home/investors/reports/Pages/default.aspx
http://www.bhpbilliton.com/home/Pages/default.aspx
4. Bloomberg accessed during 1 Mar 2013 to 13 Jun 2013
5. Rio
website http://www.riotinto.com/investors/results-and-reports-2146.aspx
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http://www.riotinto.com/
6. Thompson ONE Corporate Development subscription with Thompson Reuters
accessed during 1 Mar 2013 to 2 Jun 2013
7. UK risk free rate from Bank of England website
http://www.bankofengland.co.uk/Pages/home.aspx
8. Xstrata
website
http://www.glencorexstrata.com/investors/reports-and-results/xstrata/2012/
http://www.glencorexstrata.com/
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GLOSSARY
Anglo – Anglo America
BHP – BHP Billiton Ltd and BHP Billiton Plc
Capex – Capital expenditure
CAR – Cumulative abnormal returns
CDS – Credit default swap
Diversified miners – Anglo, BHP, Rio and Xstrata
EBITDA – Earnings before interest, tax, depreciation and amortisation
EBIT – Earnings before interest and tax
EV – Enterprise Value
NFD – Net financial debt
NWC – Net working capital
Rio – Rio Tinto Ltd and Rio Tinto Plc
RoA – Return on Assets
Xstrata – Xstrata
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Is Diversification a bad word in the Mining world by Aditya Mehra

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