Mining value in tough times: PwC assesses how mining companies can respond to the current economic reality

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For the mining industry, 2008 began with a boom. Demand was on the rise, prices soared to record highs, companies invested heavily in capital projects and shareholders enjoyed substantial returns. For the top 40 mining companies worldwide, cash flow from operations increased by 25 percent from 2007—exceeding $100 billion for the first time—and revenues increased by 23 percent year-on-year. Then, in the last quarter of 2008, this profitable picture began to fade fast.

PwC, which audits 32 percent of the world’s mining companies with more than $1 billion in revenues, recently reviewed the state of the industry, including potential ongoing risks and opportunities. Although global economic distress continues, managers can play an active role in maintaining long-term goals while tackling short-term challenges. Those who do can fend off margin erosion and build stronger, more nimble and ultimately more competitive businesses moving forward.

Leadership: managing a shift in priorities

As the economic crisis developed, commodity prices fell sharply. Shareholders lost confidence, refinancing options for short-term debt payments became scarce, and market capitalization of the top 40 global mining companies dropped 62 percent, compared with a 38 percent decline in the S&P 500. In the first quarter of 2009, 14 of these top 40 companies announced mine closures, cut production, or placed mines on care and maintenance programs, and $13 billion in capital expenditures was deferred or canceled. Some companies have fared better than others. Gold, for instance, has been the least impacted, thanks to the public perception of the commodity as a safe haven and wealth protector during a downturn. But no one has been spared from increased operating costs and a general uncertainty about when and how the economy will rebound.

During the industry boom, mining CEOs focused their energy on managing capital expenditure programs and ensuring they were delivered on time and on budget. Now, as the economic situation has changed, so have the CEOs’ priorities. Those who run strong companies must work on reducing operating costs to maintain margins in the face of lower commodity prices and demand. Those at the helm of companies with heavy debt burdens find themselves in a defensive position, fighting to secure financing to stay afloat in the short term.

All must take steps to operate at the lowest possible cost and repair the shaken confidence of shareholders. This will require decisive action and, in many cases, creative thinking. For example, the continued tightness in the credit markets and the leverage positions of many top mining companies will continue to make long-term financing difficult to obtain. To support current operations and future expansion, companies may need to seek alternative sources of non-bank funding, through strategic partnerships, share or rights issues, sales of non-core assets, and sales of royalty streams.

Talent: the most valuable commodity

Although CEOs must eliminate costs to ensure short-term viability, they must also take care not to cut too far and harm the company’s long-term agenda. Given the lengthy timeline of mining projects and associated capital commitments, reducing costs will require re-examining project feasibility and making some difficult decisions. To do this, CEOs need motivated and experienced management teams to support them—a requirement that presents its own challenges.

Bolstered by the boom, many seasoned senior managers cashed in their options and left the industry, leaving less-experienced managers to run what have become more complex businesses. CEOs must find ways to reward and retain talent while being sensitive to public perceptions of excessive executive compensation. To do this, they have several options for how to structure compensation packages.

For example, while companies recognize the motivating power of an annual performance bonus, it may be unpopular with shareholders. Deferring part of the increased bonus into shares over the long term could encourage sustainability of short-term performance. Equity-based long-term incentives may be more palatable to shareholders, but they tend to be complex and less valued by employees, and they don’t typically recognize average performance. Offering graduated, long-term incentive plan payments over a wider range of performance would reward more employees and still address shareholder concerns. Finally, for executives whose compensation is not disclosed to shareholders, there is a trend toward granting the more modest restricted-share awards that are subject to continued employment rather than complex performance conditions. The share award has value to the employee even if the share price has gone down, which enhances retention value and aligns with shareholder expectations.

Flexibility: the key to securing value

For mining executives managing multibillion dollar capital expenditure programs, the inconsistency between a long-term outlook and short-term uncertainty creates a particularly difficult challenge. Recent capital expenditure reductions and deferrals could help preserve cash in the short term. But, they could also leave companies vulnerable when demand increases and may limit their growth options as conditions improve in the medium and long term. If companies cut expenditures too far now, considerable investment will be required to fund capital pipelines when prices rebound.

With so many unknowns, flexibility is key. Companies must stress-test capital expenditure plans under different industry scenarios and be prepared to adjust in response to market changes. They should renegotiate contracts to insert flexible budgeting structures, allowing them to take advantage of lower prices of energy-related costs and materials now and limit increases in the future. And, organizations should adopt a broad approach—looking beyond the engineering mindset—to keep project options open once construction has begun. They can create and then integrate flexibility in a number of ways.

First, companies should explore different levels of scale and modular development options before projects begin so they can react seamlessly to any change in plans. Along the same lines, companies should consider designing multiple project paths so a project team is ready to increase speed or slow down in line with market developments. And, mining firms should negotiate flexible contracts with contractors and suppliers so prices, tariffs, volumes and scope of services are changeable within known rules and costs.

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