Writing this letter occurred to me while listening to Simon Brown’s MoneywebNOW podcast this morning where he and his guests spoke around the current free cash flow most mines are making. What will the miners be doing with all this cash (flow)?
It is certainly a topic amongst our team (we are bullish on commodities and resource stocks). The key question is how will mines allocate these large cash flows?
Consider for a moment that how they allocate capital at this point in the cycle will both determine their respective prospects and how the cycle itself plays out. Hence, this is not just an important question to the mining sector and investors, but actually to South Africa as an entire country!
Therefore, allow me to suggest a simple hierarchy that any CEO in any mining group can follow in terms of capital allocation. Start with all your free cash flow at (1) and keep allocating until the end (4) with whatever is leftover from the previous step:
- Pay down debt: Mines and mining companies have so many risks (operational, resource, spot, regulatory, labour, and so on) that I–and most investors–do not want the added risk of debt. Use this cash flow to make a bulletproof balance sheet by paying down all discretionary debt. Use this period to build the balance sheet that will allow you to survive the next cycle. Simple. You cannot remove mining risk from a mine, but you can remove financial leverage.
- De-bottleneck, maintain & improve existing operations: Over the last decade of trouble, most mines and mine managers have probably (and correctly) skimped on preventative/discretionary maintenance. Now is the time to build some operational buffers into the production flow at mines, debottleneck key processes and improve what you already have in either volumes or efficiency (or both). Much like paying down debt, this is a very low-risk capital allocation that can generate a strong and long-tail IRR on your capital.
- Declare the remaining two-thirds to three-quarters as dividends: Return most of what is left to shareholders through dividends. Do not do this via a share buy-back due to the potential of future capital raising (see Step (4)). Shareholders who have sold their shares in a share buy-back will be unlikely to fund a capital raise (Why would they? They are no longer invested.) while shareholders that still hold your shares and have not received dividends will not necessarily have any cash to follow these future potential capital raises. Do not view these dividends as the Group losing the capital, but view it as buying shareholder loyalty that you can cash in at some future date with a capital raise. I.e. You will probably get those dividends back someday.
- Invest the remaining one-third to one-quarter as exploration spend: Mining exploration spend has collapsed over the last half-decade and this is one of the reasons the supply of commodities is currently so constrained. It takes years to find and build a new major mine, but you have to start with the finding. Allocate a small amount of your free cash flow (after dividends) to a structured mineral exploration programme. This will start to build your Group’s “optionality”. You cannot catch any fish if you do not have any lines in the water. Likewise, you cannot find the next great project if you are not looking for it. Most of this exploration spend will come to naught (that is the nature of exploration spending), but you only need one great resource to be found to potentially change the entire forward-production profile and valuation of your Group/share. And, indeed, if you have been returning dividends to shareholders, you can now cash this loyalty in for a project-specific capital raise. (As a side note, exploration spending is currently quite cheap given that no one is doing it and most of the rigs around the world are sitting idle. Be a first-mover here.)
- Nothing else: Do not do major mergers. Do not do major acquisitions. Do not blow capital on vanity projects or inflated remuneration schemes. Do nothing else, but stick to your knitting.
Many people may disagree with my (5), especially the bankers and corporate advisors that profit from originating, advising and broking such corporate actions. But, I think most people and most investors (and, hopefully, most Boards) will agree with my hierarchy and points (1) to (4).