As printed in Business Day 14 May 2013
by David Holland and Brian Kantor[1]
Behavioral studies have shown that humans exhibit a strong anchoring tendency. When the world changes, they remain anchored to the one they know instead of adapting to the new order. Evidence for this behavior is ubiquitous when parsing through government and labour comments about the ability of mining companies to pay more or hire increased numbers of workers. This is undoubtedly a reason for delay and lack of resolution in discussions between government, organized labour and Anglo American Platinum about the company’s need to reduce costs and investment.
We would like to take a step back and assess how profitable platinum miners are, and calculate the expectations embedded in their market prices. Once we understand those expectations, we can focus on the best way forward for the business and its stakeholders.
The platinum industry has been one of great hope and now disillusionment. We aggregated the historical financial statements of the 5 largest South African platinum miners (Anglo American Platinum, Impala, Lonmin, Northam and Royal Bafokeng) and calculated the inflation-adjusted cash flow return on operating assets, CFROI, which is the real return on capital for the industry. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slumbered below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for platinum miners. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time (the average CFROI for global industrial and service companies is 6%). The rush to mine platinum and build company strategies around this effort was on, e.g., Lonmin bet its future on platinum.
The 2nd wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop to 1% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.
Unfortunately, operating returns have not improved much and have remained below the cost of capital throughout the global slowdown due to increasing labour, electricity and excavation costs, and lower platinum prices. By cost of capital, we mean the minimum return required of an investment in an industry with proper regard to the risks involved in its operations and financial constraints. The greater the risks, the greater the return required to sustain or expand the industry. Firms or sectors of the economy that prove unable to satisfy their cost of capital decline while firms that beat their cost of capital are strongly encouraged by shareholders and other capital providers to expand and to raise the finances necessary to do so.
The 2012 CFROI in the platinum sector of the SA economy was a miserable minus 0.6%, which is the lowest return on capital since 1992 when our calculations on realized returns in the sector begin. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders or the market place to support their operations. This has resulted in unavoidable cost-cutting, lay-offs and deep cuts to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.
And what does the future hold? We’ve taken analyst expectations for 2013 and 2014 and estimated the real return on capital. It remains very poor at a value destructive level of 0% for 2013 and a depressed 3.4% until 2017. There is no hint of a return to superior profitability in the share prices of platinum miners. The market has them valued to continue to realize a real return on capital of less than 6%, which is the average real return on capital for industrial and service firms throughout the world. As an aside, despite high gold prices, profitability for SA gold miners is no better. Their aggregate CFROI is expected to remain around a value destructive 3% for the next 5 years.
In a nutshell, South African platinum and gold miners are destroying value and are expected to continue to do so. They are in a dire economic state. To survive they have to reduce costs. Demands for wage increases that far exceed inflation are now totally unrealistic and cannot be fulfilled. These demands are anchored to a past that no longer exists. The tragedy is that for the workers who are bound to lose their jobs mining platinum, there are no forms of alternative employment that will provide them with anything like the same rewards.
All parties should focus on what is realistically possible and economically feasible. A wage freeze, reduced hours or some form of deferred pay are called for to minimize the pain. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits for those still fortunate enough to retain their jobs. Any improved employment benefits that may be extracted will go to even fewer surviving workers. There is however another way that makes much more economic sense for all stakeholders not least the government and SARS that shares fully in profits and also wages earned. Cooperation – yes, call it co-option if you like – is urgently called for.
In normal economic circumstances it is sensible for employees of a failing firm not to sacrifice current benefits to keep their employers going. Ordinarily, they can expect to find equally well-paid work with another firm in an industry willing and able to employ them. After all, skilled or even less skilled but experienced workers are a valuable scarce resource in a well functioning economy that sustains close to full employment conditions. Unfortunately, this does not describe the SA labour market with its relatively few insiders employed formally and the many others, particularly young potential workers so anxious to join them but unable to do so.
Moreover most workers prefer fixed predictable rewards to variable income. The risks of variable incomes are borne by shareholders and to a degree, managers with bonuses linked to the company’s operating performance. If a failing firm is unable to offer market related benefits to its employees or indeed its owners, then it deserves to fail and the scarce resources it was employing and in effect wasting could be transferred to other firms capable of employing resources more productively.
In the case of platinum and gold miners in South Africa, the prospect of alternative employment with anything like the same benefits is very bleak. Workers would be well advised to settle for less especially now and hope to make it up at a later stage should the prospects of the industry and its productivity improve. Deferred pay offers an inventive compromise where current pay sacrificed is exchanged for shares or even options on shares to be realized at some point in the future. It would then be in all parties’ best interest for productivity and return on capital to improve. If these cost savings were made or even expected to be realized, the shares the workers owned in the industry, exchanged for lower take home pay, would appreciate significantly. Sacrifices made now to hold on to jobs could be more than made up in the share market. And more valuable platinum and mining companies would be able to much more easily fund growth in output and employment rather than manage as best they can declining output and employment.
Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline further and its prospects deteriorate. Perhaps even to the point where nationalizing the industry with full compensation might seem a realistic proposition. It may cost relatively little to take over a failed industry. Nationalization however will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders who will have lost so much, carry the can for the failures of management and unions that must share the blame. The government and its agencies have many alternative and much better uses for tax revenues than to subsidise the already well-paid workers in a difficult, capital-intensive industry that is likely to realize poor returns.
The unions might think correctly that management subject to the discipline of taxpayers rather than shareholders would be a softer touch. Government and its taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. By taking stock of the poor economic performance of the platinum mining industry and its depressed expectations, all parties can negotiate from a shared set of financial and economic facts. These are difficult times and creative approaches are needed. All parties need to be anchored in the right bay signaled by today’s reality and expectations.
[1] David Holland is an independent consultant and senior advisor to Credit Suisse. Brian Kantor is Chief Strategist and Economist with Investec Wealth and Investment.
This article touches on the truths and realities for current SA mining operations. As an ex production and financial employee at major South African mines, it saddens me to see how costs (and skills) were allowed to runaway when commodity prices increased.