Mergers, acquisitions and capital raising in mining and metals - EY

Mergers, acquisitions and capital raising in mining and metals 2013 trends 2014 outlook Changing gear

About this study • The data is primarily sourced from ThomsonONE.com. • Unless otherwise stated, all values are in US dollars.

Notes on the data: Mergers and acquisitions (M&A)

Capital raising

• Only completed deals are included. Deals identified as incomplete, pending, partly incomplete, conditional or intended as of 31 December 2013 were excluded.

The primary source for this data is ThomsonONE. Certain details have been supplemented with information from company and stock exchange websites and major business press. Only completed transactions are included.

• The acquirer country is based on the ultimate owner’s geographic headquarters. The target country is determined by where the primary targeted asset or company is located. • Country-based refers to domestic and inbound deals. • A country’s acquisition refers to domestic and outbound deals. • Commodity analysis is based on the company’s primary commodity focus. • The value of M&A activity by commodity includes deals where the given commodity is the acquirer and/or target’s primary commodity. Commodity charts illustrate the value of deals where the given commodity is the target. • The data does not capture the value of transactions where this information is not publicly available. • “Megadeals” refer to all deals with a value equal to, or greater than, $1b.

• Only original Initial Public Offerings (IPOs) — the first time that a company issues equity to the public — are included in the IPO analysis. Proceeds are allocated to the primary exchange of listing. • Equity issues are geographically categorized by the primary exchange where the issuer’s stock trades, except where stated. Where a company offers Global Depositary Receipts or American Depositary Receipts, the issue is allocated to the destination market of those shares. • Loan data and proceeds include refinancing and amendments to existing debt, and are as per ThomsonONE intelligence. Proceeds are allocated to the geography of the borrower. • All credit rating references are to Standard & Poor’s long-term issuer ratings, unless otherwise stated.

Note: The data is primarily sourced from ThomsonONE, $ refers to US dollars.

Mergers, acquisitions and capital raising in mining and metals — 2013 trends, 2014 outlook This EY study examines transactions and financing in the mining and metals sector in 2013, and discusses the outlook for 2014. It provides an in-depth analysis of the major global mining and metals transactions, capital markets and resulting capital flows, by considering mergers and acquisitions (M&A), initial public offerings (IPOs), secondary equity offerings, bonds and loans. It also provides an analytical breakdown by commodity.

This report was authored by:

Lee Downham

Mike Elliott

Emily Colborne

Jodie Eldridge

Celeste van der Walt

Paul Murphy

Robert Stall

Kunihiko Taniyama

Global Mining & Metals Transactions Leader Tel: +44 20 7951 2178 [email protected]

Strategic Analyst, Mining & Metals Tel: +44 121 5352086 [email protected]

Senior Researcher, Mining & Metals Tel +27 11 772 3219 [email protected]

Americas Mining & Metals Transactions Leader Tel: +1 404 817 5474 [email protected]

Global Mining & Metals Leader Tel: +61 2 9248 4588 [email protected]

M&A Analyst, Mining & Metals Tel +61 2 9248 4423 [email protected]

Asia-Pacific Mining & Metals Transactions Leader Tel: +61 3 9288 8708 [email protected]

Japan Mining & Metals Transactions Leader Tel: +81 3 4582 6470 [email protected]

And thank you to the EY Global Mining & Metals team for their support.

Nicky Crabtree

Assistant Director, Mining & Metals Transactions Advisory Services Tel: +44 20 7951 5237 [email protected]

Contents

Themes Executive summary Spotlight: Alternative financing Q&A with Silver Wheaton Corp. Spotlight: The window of opportunity Mergers & acquisitions Capital raising Outlook

6 10 14 18 22 32 40

Commodity analysis Aluminium Coal Copper Gold Iron ore Nickel Potash/phosphate Silver/lead/zinc Steel Uranium

44 46 48 50 52 54 56 58 60 62

Executive summary

2013: A year of calibration and repositioning

which, excluding the all-share merger of Xstrata and Glencore International, were down 25% and 16% year-on-year (y-o-y) to 702 and $87.3b, respectively.

We look back at 2013 as an inflection point, a year when management and investors finally came to terms with a new investing paradigm.

Capital raising followed a similar trend, with only a 9% increase in total proceeds to $272b, largely due to some exceptional loan refinancings, and a 9% decrease in the total volume of issues to the lowest level seen since 2008. There were few new investments in the sector and the bulk of capital raised during 2013 is being used to refinance existing facilities.

The extreme price volatility and rapid changes to the global economy that defined 2012 persisted through 2013. Year-end reporting announcements were littered with headlines of impairments and recriminations that forced changes in strategy and senior management across many of the industry’s participants during 2013. As a result, we saw investing activity contract during 2013, where the risks were just too great given the moving base on which decisions needed to be made. Acquisition plans were not supportable and as a result, few deals were pursued. As the year progressed, even divestment plans were scaled back as it became clear that price expectations could not be met, and as balance sheets became less stressed due to refinancing and stronger cash generation in the second half of the year. 2013 marks the tipping point for the sector, with many investors calling it the bottom of the market. This investment “inertia” is clear in the underlying deal volumes and values for the year,

This pull-back in risk capital hit the junior sector hardest, with equity markets providing little support. Proceeds from secondary issues by juniors fell 43% y-o-y (from an already low base) with an inevitable tightening of global exploration spend. Investors are looking for low risk, near-term, high-yield opportunities, which the early-stage junior mining sector cannot offer at present. To bridge this gap, alternative capital raising options provided some reprieve but did not satisfy the level of capital being demanded across the sector. However, the continued rise of private capital in the sector, including the increased share of total M&A undertaken by financial investors (by value) from 5% in 2012 to 19% in 2013, supports the view that 2013 marks the tipping point for the sector, with many of the providers of such capital calling the bottom of the market.

Volume and value of deals (2003-2013)

Volume Value ($m)

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

475

596

564

701

903

919

1,047

1,123

1,008

941

2013* 702

46,182

26,350

65,430

175,713

210,848

126,884

60,035

113,706

162,439

104,014

87,309

Average value ($m)

97

44

116

251

233

138

57

101

161

111

124

Median value ($m)

4.4

3.1

4.8

6.2

7.2

6.0

3.2

5.2

5.6

5.0

3.8

*Excluding the merger between Glencore International and Xstrata (the “Glencore Xstrata merger”)

6

| Mergers, acquisitions and capital raising in mining and metals

“2013 was a year of calibration and repositioning. Those mining companies who had a change of leadership refreshed their strategies and focused on productivity and capital optimization rather than pursuing M&A. Across the sector we saw the capital raising environment tighten for those without an investment grade credit but, looking forward, we expect to see a steady improvement in market conditions.” Lee Downham Mining & Metals Global Transaction Advisory Services Partner UKI

Capital raising by asset class - proceeds $b (2007-2013) 2007

2008

2009

2010

2011

2012

2013

Change

IPOs

21,400

12,406

2,987

17,948

17,449

1,388

815

-41%

Follow ons

66,802

48,751

73,806

49,705

49,745

25,950

26,233

1%

Convertibles

12,865

12,238

14,431

5,477

2,365

3,537

7,738

119%

Bonds

36,358

38,146

61,016

72,502

83,804

112,539

87,890

-22%

Loans

110,787

171,691

62,420

183,875

187,059

105,981

148,881

40%

Total

248,212

283,232

214,660

329,507

340,422

249,394

271,557

9%

Deal inertia drives M&A activity down 2013 marked the third consecutive year of declining M&A activity in the mining and metals sector: deal volume dropped 25% y-o-y. While the value of deals increased by 20% to $124.7b, this increase was primarily due to the completion of the Glencore Xstrata merger. Excluding this deal, value decreased 16% to $87.3b, highlighting the contraction in investment spend across the sector during 2013. Although there were notable exceptions, such as First Quantum Minerals’ acquisition of Inmet Mining, the majority of deals that completed in 2013 were largely smaller, low-risk acquisitions fueled by a desire to increase an existing stake, achieve domestic or inter-regional consolidation, or a strategic attempt to secure future supply. As diversified mining companies seek to optimize portfolios, many of the industry’s large producers announced significant divestment progams. During 2013, the industry’s top five diversified mining majors completed $6.3b1 of divestments, while $5.5b of deals have been agreed and are expected to complete during 2014, with the Las Bambas divestment by Glencore Xstrata being the last major

divestment still in the process of finding a buyer. This activity, together with other rationalization measures and an upturn in iron ore prices toward the end of 2013, has taken the pressure off earnings and balance sheets, easing the pressure to divest. Although the successful exit of many divested assets suggests deals are there to be done, there is strong evidence that a gap remained between the valuation expectations of buyers and sellers during 2013. Intensified volatility in metals prices continues to drive a disparity in asset valuation expectations and, as a consequence, buyer and seller differing views on price remain a drag on M&A activity.

The opportunity for financial investors continues The year in review proved to be of great opportunity for financial investors who increased their share of total M&A value from 5% in 2012 to 19% in 2013. These investors can act counter-cyclically, attracted by the prospect of potentially strong returns driven by low asset valuations.

1. This includes the $1.8b sale of Vale’s Norsk Hydro shares, which falls outside of the M&A data within this report.

Mergers, acquisitions and capital raising in mining and metals |

7

A total of $74b of the refinancing completed in the year was largely refinancing on improved terms, which pushed out maturities and lowered yields to strengthen balance sheets. Average spreads on non-leveraged loans narrowed to 147bps in 2013 from 174bps in 2012. Intense competition among banks to secure relationships with industry heavy-weights meant that investment grade borrowers attracted greater flexibility and, in some cases, better pricing, than corporate bonds could offer.

Debt refinancing driving an improvement in balance sheet strength Although bank lending increased 40% y-o-y to $149b, this headline includes a large refinancing of $17.3b by Glencore Xstrata — reportedly the largest corporate loan refinancing in any sector in Europe for over five years. About half of the total loan proceeds were amendments, increases and extensions to existing credit agreements, with only $33b of lending coming in the form of new agreements for project financing, acquisitions and capital expenditure.

8


Proceeds

160 140 120 100 80 60 40 20 -

Number

Convertibles became increasingly popular in 2013 as investors could secure coupon rates comparable with those of vanilla high-yield bonds, thereby effectively receiving free options as an inducement. This bucked the historical trend of issuers paying lower coupons to compensate for the potential equity dilution. The average coupon paid in 2013 was 9%, with one issue offering 22.5%. This partly reflects the high proportion of early-stage,

Number

16 14 12 10 8 6 4 2 -

2013

So, while 2013 will be known as the year in which this capital was raised, the inflection we now see in the market is likely to mean that 2014 is the year when we start to see this capital being deployed.

Convertible bond raisings experienced a 32% increase in volume and a massive 119% increase in proceeds, albeit from a low base in 2012.

2012

Other smaller deals of this nature included B&A Mineração, a venture headed by the former CEO of Vale Roger Agnelli, and Grupo BTG Pactual’s joint purchase of Rio Verde Minerals Development Corp for $36m. In addition, Mick Davis (Former Xstrata CEO) announced his intention to establish X2 Resources, while Aaron Regent (former CEO of Barrick Gold Corp) formed investment company Magris Resources, demonstrating the growing relevance of mining-focused private capital.

Convertible loans providing a rare source of capital for exploration and development companies

2011

Financial investors (including sovereign wealth funds) undertook five of the 19 megadeals (>$1b) in 2013: Lizarazu’s and Receza’s joint $3.6b investment in Polyus Gold International; investments in Uralkali by Onexim Group ($3.5b) and Chengdong Investment Corp ($2b); Samruk-Kazyna’s $1.7b investment in Kazzinc; and Crispian Investments’ $1.5b investment in Norilsk Nickel.

2010

*Excluding the Glencore Xstrata merger

2009

Financial investors Commodity traders Undisclosed

Syndicated project finance that closed in 2013 reached $13.4b, up from $5b in 2012. The largest financings went to steel and aluminium projects in India and the Middle East, respectively. A small number of iron ore, gold and base metals mines in Africa, South America and Australia also attracted project finance on a smaller scale. Although this increase is well below 2011 levels, it is a move in the right direction. This positive indicator, coupled with greater competition from banks to fund the industry’s advanced and de-risked projects, supports a stronger appetite for lending going into 2014.

2008

100%

2007

80%

2006

Industry acquirers State-backed acquirers Other sectors

60%

2005

40%

2004

20%

2003

0%

2002

2011

2001

2012

2000

2013*

Proceeds ($b)

Share of deal value by acquirer type (2011-2013)

unrated and therefore higher risk companies that are issuing convertibles, and in some cases are prepared to accept the highly dilutive equity valuations in the absence of many alternatives. As a result, any lack of confidence in the upside potential of the share price is compensated for by the high yield that investors receive for the debt component.

Outlook - long term health in the balance The mining and metals sector is entering 2014 with a more positive outlook: confidence in the global economy is improving, companies have taken action to deleverage balance sheets and the industry-wide focus on productivity and efficiency should begin to yield results. As a result, we expect the gradual strengthening of mining and metals equity valuations to continue and the increased availability of capital. However, continued economic volatility is also expected in 2014 due to Eurozone economics, Chinese economic rebalancing and US Federal Reserve policies regarding the tapering of quantitative easing. As supply and demand struggle to return to post-supercycle equilibrium, we expect further price volatility to occur for at least the next two years. This will see caution prevail: any uplift in M&A activity and improvement of capital raising conditions will be gradual and will require innovation in pricing to tame volatility. Conditions in the bond markets are likely to tighten if global interest rates begin to rise should quantitative easing begin to taper. “We expect to see a greater proportion of the sector’s funding to come from equity through follow-on raisings, although a widespread return to equity will require a return of confidence at the top of the industry along with some high profile success stories among junior developers. If this occurs, it should translate into optimism and risktaking at the bottom,” said Lee Downham, Mining and Metals Global Transaction Advisory Services Partner, UKI. Similarly, we are seeing strong appetite from debt providers, with increased competition among banks likely to improve access to leveraged loans for quality mid-tier mining companies and developers. However, given the strict criteria applied by these investors, it is questionable if the availability of these funds will support industry needs in their entirety. We expect growth in M&A activity during the first half of the year to be driven by financial investors and equity-backed alternative capital providers as outlined in our Spotlight section: Alternative financing. This growth will not only be driven by anticipated longer term commodity price recovery but also by the application of in-house technical experience to drive operational, technical and

financial influence. This has the potential to be the most exciting story of 2014. Will we see the deployment of capital so feverishly raised during 2013? And, if so, will it begin to drive new investment activity across producers? With low levels of new capital and new investment, the mining sector may well be sowing the seeds for the next boom as supply falls short of demand. Will financial investors, private capital and other counter-cyclical investors be able to fill this capital shortfall in 2014? It is EY’s view that a more patient form of capital creation is essential for the sector’s long-term health. This capital will be required to both replace the “hot money” that has been leaving the sector, as short-term returns fall from their record level, and provide capital for the next projects required to restore extinguishing supply or meet future demand growth.

The Capital Agenda Based around four dimensions, the capital agenda helps mining and metals companies consider their issues and challenges and understand their options to make more informed capital decisions. 1. Preserving capital: reshaping the operational and capital base 2. Optimizing capital: driving cash and working capital and managing the portfolio of assets 3. Raising capital: assessing future capital requirements and assessing funding sources 4. Investing capital: strengthening investment appraisal and transaction execution How organizations manage their capital agenda today will define their competitive position tomorrow. EY works with clients to help them make better and more informed decisions about managing capital and transactions strategically in a changing world. Whether you are preserving, optimizing, raising or investing capital, EY’s Transaction Advisory Services brings together a unique combination of skills, insight and experience to deliver tailored advice attuned to your needs — helping you drive competitive advantage and increased shareholder returns.


9

Spotlight

Alternative financing The majors found little difficulty in securing funding through traditional means (primarily the debt markets) in 2013. But with equity markets increasingly taking a short-term view, juniors are necessarily looking for alternatives.

Lack of confidence in the industry’s ability to yield satisfactory nearterm returns has resulted in a dramatic pull back in public equity funding to the sector. Further, efforts by the majors to restore that confidence, including through a focus on optimizing existing assets, have resulted in a slowdown of buying or investing on their part, particularly in long-lead exploration. With much of the industry focused on optimization, it should be of little surprise that funding sources designed to achieve just that have seen an increase in demand. Streaming and royalty agreements aim to unlock incremental value through the monetization of non-core metals production; hence we are seeing the streaming model evolve and grow in tune with the current needs of the industry. Further, a lack of clear consensus over the near-term direction of commodity prices – and more importantly, whether the bottom of the latest cycle has been reached – continues to inhibit the wholesale return of both public equity and industry-led M&A. But equally, this impasse has created exceptional opportunities for

capital providers with confidence, patience and financial capacity to take a long-term view on the sector, whether from an investment returns or supply security perspective.

Known brands, new vehicles In the private sphere, where arguably greater freedom exists to take such a view, veteran industry expertise is combining with private equity to inject capital into the sector through strategic acquisitions. Some examples include: • X2 Resources, led by ex-Xstrata CEO Mick Davis and backed by TPG and Noble Group • B&A Mineração, the venture of Roger Agnelli (ex CEO of Vale) and BTG Pactual • QKR Corporation, the fund headed by ex-JP Morgan Chase banker Lloyd Pengilly, with Andre Liebenberg (former BHP Billiton), and backed by a consortium of investors including Qatar Holdings • Magris Resouces, the fund set up by Aaron Regent (ex CEO of Barrick Gold Corp)

10


“Alternative finance, while not a new phenomenon, has increasingly become mainstream in 2013. Unsupportive, “short-termist” equity markets have spawned a greater variety of funding structures and capital providers at a time of critical need among the industry’s advancing juniors.” Michael Elliott Global Mining & Metals Leader Australia

In addition, Resource Capital Funds, a mining-focused private equity (PE) firm, has $2.04b of committed capital in its latest fund to invest in the mining sector. This represents an estimated $4.6b of capital deployed – or waiting to be deployed - by this group alone. The traditional private equity model has historically played a relatively small role in the upstream mining sector, but depressed valuations have increased speculation that this trend may change. However, while there may be discrete deals of this nature, with traditional PE looking at specific deals, our view is that “private capital” funds, of the type described above, are the ones that will be most active in the sector. These investors are deploying patient capital, adopting a longer-term investment horizon and seeking to establish a robust operational structure that supports margin-led growth, rather than pursuing the strategy of “growth for growth’s sake” which characterized industry growth over the previous decade. For mainstream PE, it is about backing the right management and funding an asset with short-term exit potential; those types of opportunities are few and far between. Strategic offtakers, such as state-backed entities and commodity traders, typically have greater private visibility over their particular nearand long-term demand picture through their customer base. This gives them the confidence to invest now to secure future supply.

Exploration in crisis Early-stage exploration companies have historically relied on public equity markets for funding. However, challenging market conditions mean that few institutional investors are prepared to take a risk on early stage investment and few companies are keen to issue further shares at such low valuations. As a result, explorers are left with few options: cancel exploration programs to preserve precious cash resources; or seek “last resort” financing options that typically delay the dilution impact but of course come at a cost. Consequently, there has been both a dramatic decline in exploration expenditure over 2013,2 and an increase in the pursuit of equitylinked financing options, such as standby-equity agreements and convertible instruments. Risk capital is unlikely to be available on a large scale in 2014, but there is an increasingly large pool of family offices, private equity providers and venture capitalists that provide early-stage seed funding, often linked to certain conditions and achievement of project milestones. However, access to this group of investors can be challenging, given the private and highly selective nature of their investments.

2. “SNL Metals Economics Group’s 24th Corporate Exploration Strategies estimates worldwide exploration budgets to fall 29% to $15.2b in 2013,” SNL Metals Economics Group press release, 24 October 2013.


11

Evolving landscape Different financing options are suited to particular stages of the development cycle and critically to the individual needs of the asset, each with their own risks and costs attached. Companies today typically require non-dilutive, committed, flexible, value-accretive funding options where investor objectives are aligned with the long-term goals of management. Portfolio funding approaches are often adopted by advancing companies as a means of managing risks and costs. Importantly, funding options are becoming increasingly flexible and innovative in their structure, evolving to meet the changing demands of the industry. Streaming agreements form such an example: Vale’s landmark $1.9b agreement with Silver Wheaton Corp marked a step change in the scale and scope of streaming deals.3 For insights into Silver Wheaton Corp’s investment strategy, refer to the Q&A with Randy Smallwood, President & Chief Executive Officer, and Gary Brown, Senior Vice President & Chief Financial Officer, Silver Wheaton Corp. Streaming represents a non-dilutive, non-controlling means of securing upfront capital and unlocking value, typically from noncore production. However, no form of financing is without its costs and limitations. Streaming agreements limit the project owner’s future exposure to the streamed metal, and potentially impact a project’s margins once in production, through the loss of by-product credits. Further, Standard & Poor’s (S&P) has recently announced its decision to treat streaming agreements as debt (under prescribed circumstances), which may deter leveraged producers from undertaking streams. Other rating agencies, including Moody’s, have not followed suit, so the extent to which this move by S&P will inhibit the growth of streaming in 2014 remains to be seen. The focus of stream providers remains typically on producing and near-producing assets that present low political risk, and sufficient operating margins and earnings stability to deliver throughout cycles. However, earlier stage options, such as the “early deposit” structure agreed upon by Silver Wheaton and Sandspring Resources in November 2013,4 are also emerging.

3. “Silver Wheaton acquires gold streams from Vale’s Salobo and Sudbury Mines,” Silver Wheaton Corp press release, 2 May 2013. 4. “Silver Wheaton completes early deposit gold stream agreement with Sandspring Resources,” Silver Wheaton press release, 11 November 2013.

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Streams have arguably been the story of 2013, although their contribution to the overall sector funding remains small: we estimate that about $2.4b of upfront capital was injected into the sector via streams in 2013. However, this is not to downplay its importance. While relatively small compared with traditional bank lending, project finance and equity, streaming as a form of alternative finance has become significant, dwarfing the level of investment into the sector from standby equity distribution agreements (SEDAs) or royalties, for example.

Future of alternative financing Just as many of the structures described above have been around for a long time, so they are likely to remain an important component of mining industry funding, going forward. The return of equity markets for early exploration should limit the need for higher cost alternatives, but we believe this may be some way off. If we are adapting to a “new normal” of steadier demand growth and increasing supply complexities, there will be an ongoing need for countercyclical, long-term investment approaches that sustain industry growth through inevitable periods of volatility. Demand is only one side of the equation; supportive conditions would need to persist for finance providers to be able to secure and provide capital on attractive terms. Circumstances in 2013 have given rise to an environment of low confidence among the many and high confidence among the few – translating into the potential for opportunistic buying at depressed valuations. We expect these circumstances to persist through 2014: the window of opportunity for private capital investment is clearly now and capital is ready and waiting to be deployed, albeit only to the best projects and teams. There are signals that juniors are adapting and responding to the changing funding environment - from better management of expectations, scaling back of project plans, and careful cost management, to better “storytelling.” As a result, in 2014, we expect to see continued strong growth in alternative financing to the industry.

Alternative financing options The table below outlines some of the options that are being adopted by mining and metals companies in the current environment. These options are explored in more detail in EY’s contributions to Mining Journal’s “Global Mining Finance Guide 2014.” Alternative financing options utilized in 2013 Type

Typical structure

Benefits/drawbacks to company

Example providers

Standby equity agreements

Deferred equity and equity-backed loans. Option to issue shares to the provider over a multi-year period, at the issuer’s discretion.

Issuer is in control of timing Delayed dilution can adversely impact liquidity and share price

Earn-in agreements

Partner (often a major) funds exploration activities over a specified time period, thereby earning the right to a predetermined share of project ownership.

Ability to progress exploration projects Potential exit option Exit risk – earn-in partner can elect not to continue Potential dilution

Development finance

Loans, strategic equity and convertibles. Banks may offer ancillary services (e.g., community engagement strategies, environment and social risk management).

Strong vote of confidence in the project and management Stringent environmental and social requirements; extensive diligence required

• International Finance Corporation • China Development Bank • European Bank for Reconstruction and Development • International Development Corp of South Africa

Offtake

Terms vary but typically include exclusive right to percentage of future production. Can, but may not, include advance payment. Can be structured as take-or-pay.

Guaranteed source of demand Often a requirement for project finance Can include minimum stipulations – e.g., minimum price and volume, hedging

• • • • •

Strategic state buyers Private capital – e.g., Red Kite, Blackrock Banks Customers Traders

Equipment/EPCM

Equipment leasing agreements and project investment by equipment/service providers. Typically include operating leases, sale and lease-back, hire purchase, secured term loans, RCFs, asset-based inventory financing and equity investments.

Can reduce capital outlays at construction phase Supply chain default risk - financial and legal due diligence required

• • • • • •

Equipment suppliers or EPCM contractors – e.g., GE Capital Macquarie Bank Caterpillar Financial Services Standard Bank

Royalties

Upfront payment in return for a percentage of either future revenues or profits, or the value of the product produced

Long-term, passive investments – no dilution No interest costs Payments must be made – regardless of future profitability Reduces future cash flows

• • • • • • • •

Royal Gold Franco-Nevada Premier Royalty Anglo Pacific Group Callinan Royalties American Bullion Royalties Royalco Resources Gold Royalties Corp

Streams

Upfront payment plus ongoing payments in return for a right to a percentage of production from an identified asset (usually life-of-mine). Typically precious metals by-product.

No equity dilution or interest costs Retain operational control Monetization of non-core production Ongoing payments designed to cover cost of production S&P treats as debt (from November 2013) Terms need to be carefully negotiated Loss of by-product credits

• • • • •

Silver Wheaton Franco-Nevada Royal Gold Sandstorm Gold Sandstorm Metals + Energy

Stage E

D

C

P

• YA Global • Darwin Strategic • Dutchess Opportunity Cayman Fund

Note: Stages refer to exploration, development, construction, production.


13

Q&A Interview

With major producers under pressure from shareholders to pull back capital investment, combined with slow equity markets for developers, timing seems perfect for patient, counter cyclical investors such as Silver Wheaton. Do you agree, and how long do you see this “window of opportunity” being open for investors like Silver Wheaton? “I think we’ve proven that this model works across the cycle. The current state of the industry in terms of reduced capital spending, lack of equity support and a challenging debt environment has made this market about as good as it can be for us and created all sorts of investment opportunities for us. We always compete as a source of capital against debt and equity and in most markets we provide an attractive form of capital with one of the key characteristics being the unlocking of hidden value.

Randy Smallwood President & Chief Executive Officer

The feeling we get is that we are close to the bottom. We see fourth quartile producers hurting, and marginal projects cancelled or put on hold. In the precious metals space, we really feel that commodity prices cannot go down much further because it’s driving supply side pressure, so it’s only a matter of time before it starts moving up again. On the demand side of the equation, there is a continued appetite for metals out there, which will apply upward pressure on commodity prices, so I am hopeful that by the end of this year we will start seeing a move back up off the low price environment that we are in right now. I have been in the industry for close to 30 years now and it’s amazing how many times the experts can be wrong with respect to predicting commodity prices. You have to rely on your intuition to a certain extent, but more importantly, you need to focus on making good long term investments that are able to withstand the short term fluctuations in commodity prices.” Randy Smallwood Given the desire among many investors in major producers to reduce invested capital, do you see a greater opportunity for Silver Wheaton to come into some of these large assets through a streaming arrangement?

Gary Brown Senior Vice President & Chief Financial Officer

14


“I think that we have already touched upon the point that equity investors have definitely pulled back from this space, so the availability of capital from equity investors has definitely been reduced over the last 12 months. That in itself creates an opportunity for competing forms of capital like metal streaming. On the debt side, the companies that can attract debt are generally trying to reduce the financial risk in their capital structures and that combination does create a more favorable environmental for metal streaming.

with Silver Wheaton Corp. While there have been capital spending cuts, a lower commodity price environment results in less operating cash flow being generated by mining companies to fund capital projects that have not been cancelled. As a result, there is still significant demand for capital in this space.” Gary Brown And how about assets which are already in production, where a release of capital via a streaming agreement is being considered. Do you see an increase in those types of transactions? “I think there is a bit of a paradigm shift happening in the mining industry in general. Historically mining companies have focused on growth without necessarily focusing on return on invested capital. And now I see there being a higher focus on generating returns on invested capital. With streaming’s ability to unlock value and reduce the mining company’s equity exposure to a particular project, I think that does open up additional opportunities to us.” Gary Brown You have often been quoted as saying that a streaming arrangement creates shareholder value for both the streamer and the seller. Why do you think this is? “There are two principal areas that highlight that value for shareholders: Firstly, precious metal companies typically have a lower weighted average cost of capital than base metal companies and hence precious metals that are hidden within a base metal asset typically wind up getting valued with a higher weighted average cost of capital. So when you bring them into a precious metal company like Silver Wheaton, they have a lower weighted average cost of capital resulting in a higher net asset value. In addition, precious metal companies tend to trade at higher market multiples than base metal companies, so when you take silver from a base metal company and bring it into a precious metals company, there is a creation of value there. This arbitrage was really the founding principle when we created Silver Wheaton back in 2004. So those two characteristics haven’t changed through the commodity price cycles - precious metal companies continue to trade at better multiples and they have better access to capital than base metals companies.” Randy Smallwood What are the key characteristics of an investment for Silver Wheaton, and is there anything that is absolutely critical for you to consider investing? “In terms of us selecting a mine and making that investment into a mine, the key is the quality of the asset itself, specifically

the operating margins of the asset. We want mines that will deliver product to us through both the highs and the lows of the commodity price cycles. We have been in the industry long enough to know that commodity prices are cyclical and so the first criteria that we look at is where the mining operation is expected to fall relative to the respective cost curve for the primary metal being mined. We are very focused on making investments in operations that lie in the bottom half of their respective cost curves. To expand on that a little bit, if it is a copper mine that has silver or gold by-product production, we look at the copper cost curve and determine where this asset fits relative to all the other copper mines in the world, and we’ll be interested in the assets at the bottom half of the cost curve because those are the ones that will continue to operate and deliver through highs and more importantly through the lows of the commodity price cycle. It’s the fourth quartile and some third quartile producers that suffer and sometimes have to shut down during the lows of the commodity prices. When we look at our existing portfolio, about 90% of our production comes from assets in the bottom half in the respective cost curves. With a portfolio that is comprised of 24 different assets, 19 in operation and 5 at various stages of development, to have that high a concentration in the bottom half of the cost curve, we would argue, it is one of the highest quality portfolios in the mining industry.” Randy Smallwood And what about management, how important are good management teams to your investment decision? “We are very focused on making sure that we invest into good partners, but one of the things we always have be sensitive to, is the fact that we do not select the management. So although these mines may have expert management right now, we do not know who is going to be operating these mines five years from now. We do not have that control. Management is very important to us, and we work with strong partners but we also want assets that are able to withstand weak management and changes in management. And so, again, that’s one of the objectives of being down on the bottom half of the cost curve, it gives it some capacity to withstand whatever gets thrown at these assets including political risks, tax changes, low commodity prices and poor management - we want to make sure that they are strong enough to withstand the impact of all of those.” Randy Smallwood


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Risk aversion is driving many investors into safer, more developed mining districts. Do you see Silver Wheaton following this trend, or are emerging markets a key focus for you? “Yes, we have always been and continue to be focused on assessing all the risks inherent in a potential investment opportunity, including assessing political risk. When you look at our current portfolio, the majority of the assets are located in the Americas and Western Europe, which represent very safe jurisdictions from a political risk perspective, and we don’t see that changing. We don’t see ourselves expanding to areas that have a high level of political risk associated with them. We are a precious metals streaming company, but we are focused on the silver side of things and when you look at where silver naturally occurs in the earth’s crust, that’s primarily North and South America. There is significant amount of silver produced in China and Russia. However, those would be places that we would have a tough time consummating a silver stream transaction, unless we had a partner that could indemnify us against any of the political risks that we would be exposed to. And then you look at Africa which has pockets of high political risks and there is really very little silver produced out of Africa, so there is very little chance that we’ll consummate a silver stream transaction relative to one of those areas. The bottom line is that we continue to see a lot of opportunity in politically stable jurisdictions and those are the opportunities that are at the top of our list.” Gary Brown Silver Wheaton has 19 streams with operating assets and 5 with development assets. How does Silver Wheaton manage the increased risk associated with those in the development stage, where the ability to exercise operational control is limited? “We consider all of our agreements as partnerships and we do our best to work with our partners in terms of supporting these projects going forward and when it comes to development assets, our primary security comes from the completion tests and corporate guarantees that are put in place when we close a transaction. These not only ensure that we are protected in terms of these assets getting to market, but also have penalty clauses to compensate us and encourage the asset to be built on time and on budget. Typically we find this structure is adequate to protect us and the investor and to ensure everyone’s interests are aligned.” Randy Smallwood

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“And I would just add to that for the development stage assets, we generally don’t advance a significant amount of the upfront funds until permitting is in place, the mining company has secured all the financing required to build the particular project, and construction has commenced.” Gary Brown With whom do you see Silver Wheaton competing for investment opportunities over the next few years, and do you expect to see much consolidation across the industry in the near term? “There are a couple of other companies that have adopted our metal streaming model, but they have generally applied it to the gold space. We are a precious metal company focused on the silver space, and so we don’t anticipate as much competition on the silver streaming transactions. There have been murmurs that other purely financial investors, private equity funds and pension funds have considered entering the metal streaming space, but as Randy alluded to earlier, the key component in making a good investment in metal streaming transactions is assessing the technical aspects associated with the mining operation and the resource itself. We have a world class team of geologists, mining engineers and metallurgists that we deploy in assessing those risks. It is very difficult for purely a financial investor to assemble such a qualified team that can focus on that space. And with respect to the other players that are currently in the space, our key advantage is our size. We are the largest of the metal streaming companies out there. That provides us with the substantial cash flow which allows us to grow, it gives us excellent access to the capital markets both debt and equity, and with our highly diversified portfolio, it gives us a little more latitude with respect to risk tolerance. I don’t see the landscape changing significantly from a competitive perspective in the future and I see us as having a number of advantages over the current players.” Gary Brown Finally, can you tell us a little more about Silver Wheaton as an investment itself? How do you feel the investment opportunity compares to investment into a pure-play silver producer or an ETF? “Silver Wheaton provides shareholders with a much lower risk profile than a traditional mining investment and yet still delivers most of the rewards that are traditionally related to a mining investment.

When I compare us to an ETF, the first differentiating factor is that we provide a level of leverage to the precious metal exposure inherent in our portfolio. This leverage arises because we don’t pay fully for every ounce of silver or gold that we gain exposure to upfront. We defer a portion of the payment until the precious metal is actually delivered to us. This characteristic should result in us outperforming a straight investment in bullion which is supported by the fact that the returns we have generated for shareholders since the inception of the Company in 2004 are about three times that generated from an investment in bullion. We also provide shareholders with exposure to the exploration and expansion upside that our portfolio has shown a propensity to deliver. As we have previously stated, our portfolio is comprised of very good mines and some of them are very young in their development and have all sorts of opportunity for continued growth through expansion and exploration success and we deliver that to our shareholders. We also have the opportunity to make accretive acquisitions. We continue to grow and add value on a per share basis. One of the key stats that I have always admired is that the shareholders who acquired shares when this company was founded back in 2004 had about 1.5 silver equivalent ounces backing every share. We currently have about 6 silver equivalent ounces underlying each share in this company, highlighting just how accretive our acquisitions have been. We also pay a dividend which is based on a percentage of operating cashflow. With the cost of every ounce of silver or gold being delivered to us being virtually fixed contractually, basing the dividend on operating cashflows provides shareholders with direct participation in both our enviable organic growth profile and increases in underlying commodity prices. ETFs and bullion investments obviously don’t pay dividends. As a result of these characteristics, we believe that Silver Wheaton represents the best investment vehicle out there to gain precious metal exposure.” Randy Smallwood “And I would just add that shareholders are gaining access to the expertise of the company that has not only demonstrated the ability to consummate highly accretive transactions but, has also shown that it has the discipline to avoid investing in assets that don’t deliver shareholder returns.” Gary Brown


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Spotlight

The window of opportunity Only time will tell if we are witnessing a correction, a restructuring of the sector or just the start of the new normal. The capital decisions that companies make will be the key to their success.

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1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Gh]jYlaf_[Yk`Ögod]kk[Yh]p Source: S&P Capital IQ, EY analysis.

2016E

2015E

2014E

2013E

2012

2011

2010

2009

2008

2007

Consensus forecast

Net Debt/EBITDA

Net Debt/EBITDA

3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 -1,000 2006

This window of opportunity will remain open until equity markets for the sector recover fully and while large cap producers remain cautious about investing. Until then, those with access to patient private capital, including financial investors, will have a free run to take advantage of the current market conditions.

Top 14 globally diversified mining companies leverage and cash flow summary

2005

Meanwhile, there is a window of opportunity for those with confidence in the sector and access to longer-term, more patient capital. These investors are looking to capitalize on reduced competition for assets, lower valuations and a continued flow of divestments from the large cap producers.

Availability of capital to undertake M&A Gh]jYlaf_[Yk`Ögod]kk[Yh]p e!

What is certain is that this is a cyclical industry and one where the very factors contributing to the challenges will also force the solution: a lull in investment will eventually lead to a contraction in supply which will, once again, support higher commodity prices and investment.

“It’s an opportunistic time for those with access to longer-term capital and with confidence in the sector to capitalize on attractive investment opportunities in the current market.” Nicky Crabtree Mining & Metals Global Transaction Advisory Services, Assistant Director EY UKI

Free cash flows have been squeezed over the last 18 months due to low earnings and a record level of investment, which reached its peak during 2012. Across our sample of the top 14 globally diversified mining and metals companies, each company allocated on average $6.3b5 to capital expenditure, primarily on largescale, tier-one organic growth projects in an environment where costs escalated and initial budgets were exceeded. Leverage consequently soared as companies took advantage of the favorable lending conditions to fund growth.

In the immediate aftermath of recent market conditions and changes to management, we are witnessing a greater focus on yield. Dividends and share buybacks are being used to appease shareholders and compensate for a perceived under-delivery on capital returns. As the graph below shows, beyond 2014, the forecast ramp-up in dividends is highly affordable against the expected improved cash flows; a much lower percentage of cash is being paid out as dividends despite the relative level increasing significantly.

The industry has quickly reacted to this scenario: major producers are focused on achieving cost-saving targets, productivity improvements, divestments and scaling back capital expenditure, while pursuing only the top-tier projects and doing so incrementally. As a result of these actions, consensus forecasts show improved cash flows, after capital investment, albeit modestly during 2013 and then dramatically after 2014 to levels more conducive to investment, particularly as leverage begins to fall over the same period.

So the question is: how does management achieve the right balance between short-term yield and long-term capital appreciation? The danger in seeking the former is that growth projects are snubbed at the detriment of long-term value. Encouragingly, analysis suggests the large cap producers, at least, should be able to satisfy both criteria, given expected improvements to cash flows.

120%

;gfk]fkmk ^gj][Ykl

100% 80% 60% 40%

Dividend/FCF

1,600 1,400 1,200 1,000 800 600 400 200 0

20%

Dividend

2016f

2015f

2014f

2013f

2012

2011

2010

2009

2008

2007

2006

0% 2005

Dividend ($m)

However, while conditions lend themselves to a return to investment, a complex capital allocation challenge exists where investment decisions are tougher than ever. Companies are challenged to identify a unique strategy that sets them apart from their peers in an uncertain economic and commodity price environment, where returns can be marginal.

Top 14 globally diversified mining companies dividend summary