MINING REBOUND Why 2015 is the perfect year to prepare your mining operations for the next cycle

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MINING REBOUND

Why 2015 is the perfect year to prepare

your mining operations for the next cycle

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2 ROLAND BERGER STRATEGY CONSULTANTS 1 3 2

THE BIG

3

Mining

Companies

Performance

p. 7

2015

While the top 5 mining companies became cash flow positive in 2014,

the industry as a whole is expected to do so this year. 2015 is year 1

of the new mining reality and companies need to decide which role they want

to play in a more subdued yet more stable mining market.

p. 4

USD 91 bn

The mining industry holds USD 91 billion accessible cash reserves that can

be used for structural projects and solidifying efficiency gains. While

the amount of cash reserves is now back to 2008 levels and decreased

by almost 40% from its 2011 peak, the industry needs to think on how to

make best use of these assets.

p. 5

30%

Although results vary widely by individual commodity, in aggregate one third

of existing mines are unprofitable at current commodity market prices.

For these distressed assets action is needed to either lower production costs

further, divest the assets to those who can better manage them or even stem

the cash drain through closure.

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In 2015, China’s growth rate is expected to be the low-est in over two decades. Structural factors such as aging of the working population, lower investments on fixed assets and the rapidly narrowing technological gap with advanced economies forced China to cut its growth target to 7% for 2015, while many had predict-ed higher rate. Other trends have contributpredict-ed to the economic slowdown in China. Total debt as a percent-age of GDP rose from 150% in 2008 to 250% in 2014, imposing a heavy future repayment burden. Finally, slowing property starts also contributed to decelerate China’s expansion and the demand for commodities. This combination of lower demand and important ca-pacity ramp-up impacted the commodity metal price index which fell by 40% between 2011 and 2015. There is no more commodity price forgiveness for op-erating cost escalation. As 30% of capacity is unprofitable at current market conditions, miners must get back to basics in running their business, which means capturing value through productivity improve-ments and wisely deploying scarce available resources. The rise of the BRICs offered a decade of

unprecedent-ed growth for the mining industry. As growth in demand for most commodities exceeded the industry’s ability to add to production capacity, prices increased rapidly making less economically attractive reserves and proj-ects viable. This encouraged the expansion of existing capacity into the marginal zones of their reserves. It also brought on the development of several mega proj-ects in key commodities and a multitude of smaller high cost projects. The shortest possible time to mar-ket was the highest priority for miners in the late 2000s. The resulting averaging down of aggregate ore quality and the competition for mining inputs shifted costs up by over 350% from 2004 to 2012. Growth in demand for key commodities was also impressive. As an example, global iron ore seaborne demand in-creased from 606 million tons to 1,157 million tons between 2004 and 2012. Simply put the resulting 15% per year commodity price increases in the 2000s forgave the industry its development sins.

With the recent economic turmoil, growth in emerg-ing economies, and most notably China, slowed down causing mineral markets to be oversupplied.

The beginning

of a slow growth

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4 ROLAND BERGER STRATEGY CONSULTANTS All is not lost. With the downturn comes some input

price relief. Low oil prices and a strong US dollar will generally help all miners with US dollar revenues and local-currency costs that have not yet fully optimized their operations to cope with lower commodity prices in the short term. Moreover, key mining operations in-puts are more available and less costly. From haul trucks to their massive tires, from drilling services to explosives the monthly bills are getting easier for the mine managers to accept. Better availability of skilled labor will lead to lower operating and capital costs. In addition to these passive cost reductions the more proactive operators have spent the last few years vig-orously driving costs out of their operations.

These market gifts and hard won gains are begin-ning to pay off. The industry as a whole is becoming cash positive again in 2015 even though structural trends point towards a lower price environment, at least in the mid-term. This trend will force miners to identify opportunities to maintain low costs. Miners unable to capitalize on current market conditions to their own advantage will face the unfortunate pros-pects of scrambling for cash infusions or even shutting down operations. This creates an opportunity for consolidation in the market. Those generating positive cash flows will be well positioned to play a key role in the restructuring of the mining industry. A

2015 is the inflexion point:

mining

executives need to change their mindset

from purely cost control to well-thought

cash redeployment

A

EVOLUTION OF MINING COMPANIES FREE CASH FLOW [USD BN]

Source: Company reports, Reuters, Roland Berger Top 5 Others 2000 2002 2004 2006 6 6 7 5 15 24 38 37 24 5 67 41 -39 -16 -1 2008 2010 2012 2014 1

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Since the decrease of mineral prices in 2011, savvy operators have been very cautious in not depleting their cash reserves when they first needed time to adjust their cost structure to this new pricing environ-ment. Since then, cost, working capital and CAPEX optimization programs have started to deliver results and 2015 will be the first year of renewed positive cash generation.

Commodity prices are bottoming out and even the best operations are reeling from the effects of multiple cost cutting programs. Those in the industry who led the efficiency gains are in a position to ask the simple question “What is next?”. Miners can, of course continue to push cost reductions, but outside of continuous improvement programs the best operations

are beginning to encounter diminishing returns on new initiatives. If not further cost reductions what is next for the accumulated liquidity reserves and the potential future cash flows from leaner operations?

Balance sheet improvements through debt repay-ment and drawing down future closure liabilities on marginal properties are always an option. In addition, some long suffering shareholders of larger mining conglomerates may appreciate a buy back or dividend scheme. Investors in intermediate size companies or even juniors could be enticed into asset dispositions provided they do not generate embarrassing associated write downs. Miners holding a portfolio of properties and with a healthy balance sheet will also have the options of portfolio improvement and de risking. B

While their cash generation capacity

is recovering, collectively miners have

USD 91 bn in accessible cash reserves

B

EVOLUTION OF CASH AVAILABLE TO MINING COMPANIES1 _{[USD BN]}

1) Cash and short-term investments less a 6% provision of total long-term assets for rehabilitation costs Source: Company reports, Reuters, Roland Berger

2000 7 2002 7 2004 20 2006 55 2008 94 2010 152 2011 149 2001 8 2003 13 2005 37 2007 73 2009 113 2012 117 2013 88 2014 91 Precious Metals Total 2000-2014 CAGR [%] Gold Mining General Mining 4 20 20 22 -39% 2

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6 ROLAND BERGER STRATEGY CONSULTANTS

30% of mines are unprofitable at

current market prices,

and miners must

define their role in a lower commodity

prices environment

underperforming assets, raise additional financing or increase the profitability of current operations. The latter two options may be beyond the scope of the operations current management team as these firms have been tooled for growth in a continuously appreci-ating commodity price market.

In a market environment were assets are underval-ued, divesting might not provide the optimal return. With their limited cash generation capacity, these players already struggle to generate cash to payback shareholders and investors. Thus, seeking additional debt financing may result in increased borrowing costs to compensate for higher risk which in turn will further hinder cash generation capabilities. Therefore, with a large asset base generating low cash, miners in this category must understand how to increase the perfor-mance of their operations. This will require adding new management capabilities and fomenting an operating cultural shift from the mine shaft/pit to the ship loading facilities. Investors and management must also come together on a new vision for the assets to address turn-around-tolerance issues and potential exit strategies.

Efficient and conservative miners

Miners in this category generated a superior level of free cash flows compared to their peers over the past five years, thereby demonstrating their ability to best adjust their investments and mining capacity to the commodities market conditions.

As in any other process industries, operating mines necessitates long-term, large scale investment and capacity management, keeping in mind long-term returns and consistent investor remuneration. Compa-nies in the chemical, metal or oil and gas industry all follow a similar business development approach and seek to optimize their value chain positioning. Miners however, had an embarrassment of riches fomented from BRICs pervasive growth forecasts. Following a three-year restructuring period it is time to pause and assess how well this turnaround phase has positioned operations for the next phase and what could be done to further improve one’s competitive positioning.

In 2015, every mining operation and even planned project is in one of the four following mining quadrants. While some miners performed better than others, get-ting some transparency on where one stands will allow project proponents to properly plan the next phase of their development. C

Early cycle developers

Early cycle developers expanded their asset base over the last decade by building new plants, expanding their pit capacity, reinforcing logistical networks or growing through acquisitions. To do so, they invested signif-icant amounts of liquidity, but generated limited returns for their shareholders and investors. To free up cash and capture further opportunities, miners in this category have three options: sell and monetize

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General Mining Gold Mining Precious Metals -40% -60% -20% 0% 20% 40%

Capital Accumulation: 5-Year Annual Growth of Long-Term Assets

Ca sh g en er at ion : 5-Ye ar F re e C as h F lo w t o S al es R at io A ve ra ge Median +0.3% Median +15.8% EFFICIENT AND CONSERVATIVE Average revenue size: USD 6.3 bn MINING CHAMPIONS

Average revenue size: USD 6.0 bn

UNDERPERFORMERS

EARLY CYCLE DEVELOPERS

MINING COMPANIES 5-YEAR RELATIVE PERFORMANCE

PERFORMANCE

1) Mining companies in operations between 2008 and 2013 with revenues greater than USD 300 m Source: Company reports, Reuters, Roland Berger

-40 -20 -0 20 40 60 80 100 120 140 160

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ROLAND BERGER STRATEGY CONSULTANTS 8

While conservative miners’ lower rate of new capital accumulation can be explained by divestitures or lower investment in existing production capacities, these companies need to make sure that their CAPEX allo-cation policies are optimal and that the productive capacity of the assets are being maintained by the sustaining capital expenditure program.

Investors and management must be prudent to avoid operating assets so hard that it results in a degra-dation of production capacities such that they begin to rapidly deteriorate and become cash drains through efficiency losses. If this is avoided then miners in this conservative quadrant are in a favorable position to seize upcoming opportunities as they have proved their ability to run mining operations profitably. They also have the possibility to raise additional financing and have investor support to fund any potential oppor-tunity. In current market conditions, efficient but conservative miners should look at options to expand their asset base while maintaining their cash genera-tion capacity and keeping in mind long-term return generation for shareholders and investors. It is during the trough of the mining cycle that existing producing assets can be purchased at a significant discount to the cost of building greenfield capacity. Astute mining companies should seek to identify and acquire assets that are temporarily undervalued by the market.

Mining champions

Mining companies with high cash flows and high capital accumulation are in a rare and enviable position. These mining champions have been able to identify the most profitable mining assets and reserves while keeping their operating costs in line. With high capital accumulation and positive cash flow generation, min-ers in that category can take advantage of the current industry conditions to further expand their mining operations at low cost while de-risking their operations for long-term shareholder return. To do so, mining champions should continue to efficiently manage their business portfolio based on robust scenario planning and implement processes that will allow them to remain

Following a

three-year restructuring

period it is time

to pause and

assess how well

this turnaround

phase has

posi-tioned operations

for the next

phase and what

could be done

to further improve

one’s competitive

positioning

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As a result, potentially undervalued assets will be available over the coming years. While underperformers may represent an opportunity for efficient and conser-vative miners or mining champions, the underperform-ing assets may just have to face the reality that the foreseeable future will not support their plans.

In the very short term, underperformers should check their operations performance in-depth and seek to understand why they are not able to address what is going wrong. If operations cannot be further optimized due to fundamentals such as mineralogy or geographic remoteness, then underperformers must evaluate more drastic scenarios such as asset disposal or pool-ing resources with other minpool-ing companies with the final intent of maintaining operations afloat and protecting skills until market conditions recover. A very pertinent question underperforming companies should ask them-selves is whether another owner may be able to operate the assets more effectively. This line of thinking includes searching for possible synergies between different com-panies. If synergies are identified, the underperforming company may still be able to extract an attractive price from a buyer who is willing to pay for synergy value. All investors should be cautious of temporary reprieves that may be offered to these assets such as tax and royalty holidays or outright temporary subsidies. These programs will likely not compensate for many of the fundamental flaws in the underperforming assets. alert to upcoming acquisition opportunities. The

ac-quisitions need not be net expansions to their capacity. The champions may be able to accelerate closure on some of their more depleted reserves while swapping in substantially de-risked projects or even ongoing operations from other mine developers. Mining cham-pions are the ones that have the most potential to structurally reshape their activities, taking advantage of market conditions where they enjoy a dominant competitive position. An example of a long term initia-tive that a mining champion can undertake is to acquire the best available undeveloped ore bodies at low prices from financially distressed sellers. Indeed, it is often the quality of the orebody and its geographic location which determines a company’s position on the cost curve. A mining champion will be able to cap-italize on its relative financial strength by acquiring the best orebodies at the lowest cost, thus solidifying its future competiveness.

Underperformers

Mining underperformers have had difficulties in demonstrating their ability to generate sufficient free cash flows and grow their asset base. As they struggle to operate in a cash positive way, the current outlook of mineral prices could force underperformers to exit the industry.

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10 ROLAND BERGER STRATEGY CONSULTANTS

Now what?

Knowing where your mining operations stand is a first step in planning the future of your activities. 2015 is a turning point that gives mining executives opportuni-ties to implement transformational changes which will provide attractive long-term shareholder returns at an acceptable risk level. But where should you invest? And how do project proponents convince shareholders and financial partners? Though these are tough ques-tions to crack, our view is that they will invigorate an industry that has too long been forced to answer only one question of late: “Where do I cut now!?”

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Roland Berger Strategy Consultants

Roland Berger Strategy Consultants, founded in 1967, is the only leading global consultancy with German heritage and of European origin. With 2,400 employees working from 36 countries, we have successful operations in all major international markets. Our 50 offices are located in the key global business hubs. The consultancy is an independent partnership owned exclusively by 220 Partners. WWW.ROLANDBERGER.COM

ABOUT US

PREDICTIVE MAINTENANCE

Companies are increasingly seeing maintenance as a strategic business function as they seek to reduce both maintenance costs and downtime, and increase asset lifecycles. Gone are the days where maintenance was seen as a “necessary evil”; miners now have more alternatives than ever to employ a costly “run until it breaks” reactive maintenance strategy, or an inefficient “fix it regardless” preventative maintenance approach.

SCENARIO-BASED STRATEGIC PLANNING

The scenario-based strategic planning approach helps companies to account for complexity. It does by developing multiple scenarios and strategic options to counteract volatility. It stimulates companies to take a step back from the trusted environment and the more traditional thinking in order to reflect creatively with a fresh look about the future.

MASTERING 2020

Looking ahead to the next decade, which companies strike you as being ready for the changes that are approaching? More impor-tantly, how did they achieve it? Preparing for the coming years is particularly complex for firms, as they need to make strategic decisions regarding unprecedented challenges. In particular, these are the trend toward digitization, growing uncertainty regarding regulation, the navigation of emerging markets, rethinking the value chain and the need for more organizational agility.

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This publication has been prepared for general guidance only. The reader should not act according to any information provided in this publication without receiving specific professional advice. Roland Berger Strategy Consultants GmbH

The authors welcome

your questions, comments

and suggestions

SERGE LHOSTE Partner [email protected] DAVID WALDRON Senior Advisor [email protected] ROLLAND MORIER Senior Advisor [email protected] THOMAS APFFEL Project Manager [email protected] MATHIEU JOHNSON Consultant [email protected]

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