Undervalued Junior Miners: Targets for M&A in 2012

Depressed valuations for juniors alongside healthy metals prices and declining reserves are likely to translate into increased M&A activity in 2012 as companies become more open to alternatives to equity financing for advancing projects.

“With risk capital-dependent junior companies accounting for close to half of annual exploration spending in recent years, the state of equity markets plays a key role in shaping trends and strategies in the exploration industry from year to year,” said Metals Economics Group (MEG) in its World Exploration Trends report, which is issued each year at the PDAC convention’s opening.

In late 2010 and early 2011, many miners cashed in on rebounding share prices to fatten their exploration budgets. According to the World Exploration Trends report, after dropping to a low of $8.4 billion in 2009 following the 2008 crash, nonferrous exploration spending reached a record high of $18.2 billion in 2011.

MEG attributes the remarkable rebound to relatively strong metals prices over the last two years, which have helped make such projects economically feasible. “Despite periods of weakness and volatility, metals prices – the primary driver of exploration spending – have improved significantly since bottoming in early 2009 and have remained well above their long-term trends through 2010-11,” begins the report. “Almost all companies have responded by increasing their exploration budgets over the past two years.”

The catch is that although exploration budgets recovered (the industry had set a previous record high of $14.4 billion in 2008), share prices for many miners, especially precious metals miners, have not enjoyed the same rebound. Despite the underlying long-term optimism for many commodities markets, junior miners’ share prices have been left behind. Those with the most promising projects are now undervalued, a situation that offers opportunity for majors and investors alike.

M&A activity steadily rising

“Since most of the money a junior spends on exploration in a given year is typically raised between the fourth quarter of the previous year and the middle of the current year,” said MEG, “if equity markets fail to improve in the first half of 2012, many juniors may have trouble raising the necessary funds to sustain or increase exploration spending in 2012.”

For cash-strapped juniors who depend on equity financing to fund their exploration projects, continued volatility in the equity markets spells trouble. However, it presents opportunities for better-positioned players looking to increase their reserves and resource base.

Juniors who funded multi-year programs during the stronger market conditions between late 2010 and early 2011 will be less vulnerable to unfavorable M&A terms. However, “juniors with promising projects at current and long-term metals prices, but with insufficient access to equity funding to advance them in the short term, are more open to financing, joint venture, or acquisition discussions,” said MEG.

Prices for most metals should “remain above their long-term trends and comfortably above the nominal cost of production through 2012,” highlights the MEG report. Healthy demand levels from developing countries and supply deficits brought on by a lack of fresh production are expected to continue to support the prices of most nonferrous metals, prompting producers to “remain committed to exploration to replace mined reserves and strengthen and grow their pipelines.”

For producers, an alternative to funding continued property exploration is adding advanced-stage projects to their existing portfolio.

The strong desire on the part of metals producers to “secure raw materials supply is a now well-established M&A trend,” said a new report from PricewaterhouseCoopers (PwC), which shows that M&A activity in the mining sector reached a near-record high in 2011. The research firm’s consultants are already calling for the trend to continue strongly in 2012, breaking all previous records as cash-flush producers look to replace declining reserves.

“Despite a weak macro backdrop and falling commodity prices, 2011 marked the second busiest year in mining M&A activity in history,” said the report. “More than 2,600 M&A deals worth $149 billion were announced in the global mining sector.” The dollar figure is one third higher than the total value in 2010. The metals most targeted were gold, coal, copper, iron, and niobium, which represent 81 percent of total M&A value. Canada (25 percent), the US (15 percent), and Australia (eleven percent) were home to the majority of M&A sell-side volume.

Moving into 2012, the industry’s top 40 major and intermediary producers together have amassed a vast potential war chest. “With over $105 billion in cash, pent-up demand for new projects, rising production costs and declining developed world reserves, miners will seek out targets to build scale and achieve cost efficiencies,” said PwC. This year has already witnessed the single biggest M&A deal in mining history: the proposed US$90 billion merger of Glencore International plc (LSE:GLEN) and Xstrata plc (LSE:XTA).

Gold, copper, and zinc companies may be significant portion of future M&A activity

In 2012 and beyond, investors can expect to see a significant portion of M&A activity targeted at precious metal, copper, and zinc projects.

According to MEG, over the past ten years, new mines have produced about 440 tonnes of gold, while production at existing mines has fallen by approximately 600 tonnes. Speaking during PDAC’s keynote session, MEG CEO Michael Chender said future growth in mine supply for gold will be constrained as both discovery rates and available deposit quality fall.

Already these conditions are prompting gold producers to grow and replace their own reserve base through both exploration and M&A activity targeted at juniors with well-developed projects.

Copper is another metal facing supply constraints, said Scotiabank Vice President of Economics and Commodity Market Specialist Patricia Mohr, also speaking during the PDAC keynote session. Mohr believes the price of copper will continue to outperform the rest of the base metals complex in 2012 to average $3.90/lb and $3.80/lb in 2013.

Zinc is gaining a lot of analyst attention right now due to its supply-supportive fundamentals. In her PDAC presentation, Mohr said the price of the metal is likely to best copper and other base metals by 2013 or 2014, with prices reaching $1.45 or higher by mid-decade.

Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.