Capital management and resource companies (and a portfolio addition)
Your investment team has often been frustrated, and probably no more so than now, by the approach to capital management undertaken by the Boards and management teams of resource companies. Particularly the large ones.
What does capital management mean?
Capital management is the way a company uses its capital – be it debt or equity. Capital can be used for investment purposes or returned to shareholders (when it is in excess).
Debt is funds loaned to a company. The lender expects a rate of return, which is interest. Equity is funds given to a company. The shareholder expects a rate of return, which is dividends and share price appreciation.
Payments of interest by a company are tax deductible, payments of dividends are not tax The total cost of capital to a business is a blend of these.
Why is it important?
Capital management is important because inefficient use and allocation of capital impacts the returns that shareholders receive.
And we are not talking about tinkering around the edges. There can be a very substantial destruction of shareholder returns if capital decisions are poor. BHP’s acquisitions at the top of the resources cycle are a case in point (especially Petrohawk for US$12.1billion in 2011).
The right balance
Too much debt capital (and too little equity capital) increases the interest a company has to pay, reducing profit. It creates risk too.
Too little debt capacity (and a high portion of equity capital) can act as a constraint on a company’s ability to invest and grow. Debt capital is also usually cheaper than equity capital. Therefore, too little debt can dampen returns to shareholders.
The balance between debt and equity, along with the magnitude of each, is dependent on the individual characteristics of each company. Some companies should have very little debt - for example, those with no tangible assets (such as professional services companies). Some companies can sustain quite high debt levels, such as regulated utilities (there are some risks here, but not in scope for today’s edition).
Most companies sit somewhere in the middle.
Capital must be adaptive
Capital is not set and forget. Instead, it needs to respond to the opportunities and circumstances that a company faces, in order to maximise returns for shareholders.
For example, when investment opportunities are attractive, increasing the amount of debt and /or equity capital to take advantage of these is often appropriate (when returns exceed the cost of capital and other factors).
Conversely, at the top of cycles when asset prices are eye watering, debt should be paid down and equity returned to shareholders (e.g. via special dividends / distributions etc). Companies may even consider asset sales.
There are some market participants out there who are saying that now is one of the best times to add to positions in the large resource companies. Because they have little planned in the way of capital spending (combined with the partial recovery in the price of many commodities and the cash generation / cost of production focus), a large increase in dividends and buybacks is expected.
Sounds great right? Lots of free cash flow to reward investors via dividends. Bring it on.
However, we caution this is the view of a short term ‘investor’.
The time to pay big dividends…
The time to give over-the-odds dividends back to investors was at the peak of the commodities cycle - when commodity prices were excessive and asset prices were toppy. Then paying down debt and returning equity to shareholders was the way to go.
…and the time to invest
So this is where many resource companies frustrate your investment team. There really hasn’t been any meaningful capital investment in recent times, especially by the large resource companies.
We understand that BHP currently is attempting to make an investment in potash, and maybe other commodities too (including nickel, which is used in lithium-ion batteries). But we understand that the activist investor Elliot is attempting to scuttle at least the potash endeavour.
We strongly argue that now is the time for companies to sow the seeds for future investment returns for shareholders. Investing for the future is in the long term interest of shareholders – even if it means a more conservative level of dividends in the short term.
Although we aren’t seeing a lot of investment in the large cap space, we are seeing some activity from a number of the smaller miners.
This week there is a new addition to your equity portfolio, Moreton Resources (ASX Code: MRV).
Moreton has a number of opportunities. It has recently raised capital (which we participated in) to enable it to get a silver mine near Texas in Queensland operating. Although it has a relatively short term asset life (~11 years), it is expected to provide meaningful cash generation: cash generation that will provide the foundation for it to make investments in other opportunities it owns – such as drilling for copper within the Texas tenements and moving some coal assets into production.
This is a small investment in your equity portfolio. It has a strong management team who really do get the concept of being a custodian of capital. The company has a number of opportunities it can pursue, and it is actively investing to provide benefits to shareholders in the future.