If there is one industry sector that would be associated closest with hard tangible assets, it would be the resources sector. There appears nothing more basic and tangible than extracting minerals out of the ground and selling them to someone else for refining. The corollary therefore is that the mining industry should have the least interest in things like intangible assets. By intangible assets we mean intellectual property, R&D, brand, alliances, staff competencies, etc., largely seen to be most relevant to service sector and high tech companies like Microsoft, IBM, Cisco and Amazon.
While this is still largely true, evidence suggests that mining companies that astutely manage their intangible assets, can achieve a significant and sustainable marketplace premium over their peers, and therefore far superior shareholder return.
The reincarnation of dormant “penny dreadful” mining stocks to dot.com start-ups during the dot.com boom of 1999/2000 was initially treated with amusement. However, when companies like Vengold Inc., a part-owner of a gold mine in Papua New Guinea, improved its stock price from six cents to $3.50 through changing its strategy from mining mineral gold to mining internet gold, there was a flood of dot.com reincarnations.
If we look behind the scenes at the types of entrepreneurs who start mining ventures in the hope of one day striking it lucky, we can easily see strong similarities to the modern-day dot.com entrepreneur. Both are trading on the huge upside potential should the venture be a success, and the inherent difficulty that the market has in valuing such a venture in its early stages. In both the various minerals booms over the past century and the most recent dot.com boom, it has been possible for start-up companies to create extraordinary (and unsustainable) market values on the back of miniscule tangible results.
So what can the resources sector learn from the dot.com boom? Well, it’s probably the other way around. However, in both cases we can see the impact of intangibles on company valuations. What we can learn is that the marketplace is willing to invest, and at times invest heavily in future promise, which is not necessarily vindicated by tangible results. We should also have learned that it is not possible to sustain extraordinary market valuations on the strength of a promise. What is clear, though, is that a good financial performance is no longer sufficient to assure superior stock market performance.
Intangible value in the resources sector
While not perfect, the most common means of assessing a company’s intangible assets is to look at the difference between a company’s market capitalization (what the market thinks it is worth) and the company’s book value on the balance sheet. This is often referred to as ‘market value add’. Over the past 15 to 20 years this differential has increased significantly on the back of the growth in service and high technology industries. Currently the average market to book ratio (M/B) across the S&P500 is over six times.
CFO Magazine publishes an annual Knowledge Capital Scorecard, which ranks industry sectors and individual companies according to their intangible asset performance. At the high end we see industries like computer software and hardware, biotechnology and pharmaceuticals with M/B between 12 and 18 times. At the other end of the scale we have aerospace and defense, airlines, automobile, chemicals and electric utilities at around two or lower. So how does the resource sector fare?
We can see that the effects of the commodity cycles impact on all players’ market capitalizations. What is interesting, however, is the ability of companies like Rio Tinto, BHP and now Alcoa to maintain a market premium over other players like Alcan, Anglo and Billiton (now merged with BHP). This premium in market value add of around 1.5 points translates to a significant differential in total shareholder return. The other notable feature is the upward trend. Over the past 10 or so years the market for intangibles in the resources sector has grown from a M/B of around 1.5 to around 2.5, which is significant, though still well below the S&P500 average of six.
Now let’s look at how these same companies performed in an operational sense. The market price to cash flow ratio is used as a measure of relative operational performance. What is most notable is that the market premium enjoyed by BHP, Alcoa and Rio Tinto is not reflected in their operational performance. In fact, in the year 2000 very little separated the top six in operational performance.
In comparing the two graphs we could assert that something other than pure operational and financial performance is driving share price performance. The leading companies in the resources sector (Alcoa, BHP and Rio Tinto) are enjoying a market premi- um over their peers that is being generated by intangibles, not operating performance.
As the M/B figure above has shown, scale does have its benefits. However, is it purely scale or the intangible benefits which come from scale that really drives market success? Is the Rio Tinto or BHP “brand” helping with investor perceptions? Are the larger companies able to better attract more talented staff? Do the larger companies attract more profitable joint venture opportunities because of their larger capital base? How important are these factors in comparison with maintaining a steadily improving financial performance?
Clearly mega-mergers like the BHP Billiton merger need to deliver more than simply the sum of the parts. The larger base of opportunities and funds available is expected to deliver some of the benefits from the merger. However, Paul Anderson, the CEO of the merged entity, has hinted as to some of the intangibles that he expects to deliver new value. Anderson states that he wants a greater focus on how BHP Billiton services its markets, rather than “what do we produce and how do we get rid of it”. He also offers as part of BHP Billiton’s vision going forward a program to leverage the knowledge that exists within the company by “redefining the company in terms of knowledge and service”.
The question still remains: is an improved focus on customers and improved knowledge-sharing across the company sufficient to deliver the radical change required by the industry? Does the industry require more radical innovation of the “dot.com reincarnations” type to transition from a low return, price-taking industry to one that is adequately rewarded for its endeavours?
We have already seen that the “if you can’t beat them join them” strategy for mineral company reincarnations, was largely short-lived. However, the field is still wide open with respect to how a company’s intangibles could be leveraged to break out of the commodity-only business. Interestingly, it is the area of e-business, fostered by the dot.com boom, that appears to offer the most potential.
Differentiation through intangibles
The inadequacies of current-day accounting systems to support the management of “new economy” companies has been extensively reported in the accounting literature. Traditional accounting refers to intangibles as “goodwill”. Goodwill traditionally provided a small addition to a company’s book value to cater for goodwill developed with long-term customers. This of course becomes nonsense when the “goodwill” value exceeds the book value, which is mostly the case today. Swedish researcher Dr. Karl-Erik Sveiby divides intangible assets into three types. Above is a representation of a typical intangibles balance sheet.
If we look at the resources sector in particular using the Sveiby intangibles framework, we could infer that the major area of focus has been on internal structure. In particular, a focus on operational excellence and cost reduction has been the main driving force. Interestingly, we have seen that while the cost focus has lead to improved price to cash flow performance for the industry as a whole, it has not been a differentiator among the leading firms. In other words, the leading firms have achiev
ed a market premium without a superior operating performance.
So, if operating performance is not a differentiator, then we need to look to external structure and/or individual human competence as points of differentiation and superior share market performance. Are the leading firms Rio Tinto, BHP and Alcoa excelling in either of these areas that might justify their market position? Anecdotally one could at least identify management competence, alliances (as evidenced by the recent merger and acquisition activities of BHP and Rio Tinto) and their established brands as attributes in support of superior external structure and human competence.
How the resources sector can improve its overall performance
We have previously indicated that the resources sector market value add (M/B) is currently around 2.5, compared with an S&P500 average of around six. Is it possible for the resources sector to increase its market value add overall? Conventional resources industry thinking would try to wrest a greater share of the spoils from its downstream customers in the value chain. However, downstream consumers like chemicals, aerospace or automobiles have similar or even worse M/B performance. In other words, improved performance is not going to come from “transfer price” battles along the traditional value chain.
The resources sector as a whole needs to make better use of its peripheral vision. It needs to look beyond its traditional value chains for value-creating opportunities. It needs to determine in which human competencies it excels. It then needs to leverage its alliances and customer base to identify opportunities to generate new value beyond its traditional stamping grounds.
Resources sector human competence capital
The resources sector is characterized by high-risk exploration, high capital mine and processing plant investments and, hopefully, long-term secure cash flows from operations. If we look at the elements of human competence required to operate a successful resources company, we would expect to see good entrepreneurial skills at the exploration and development phases, and excellent risk management and project management skills to develop the operational mines to exploit prospective orebodies. Financial skills are required to raise the required capital to develop mining operations, which could operate for the life of the resource, potentially decades. Once in operation, we would expect superior operational skills to generate the annuity style cash flows and returns required to achieve the required return on investment.
Using peripheral vision, it wouldn’t be difficult to identify opportunities that these skills could leverage. In fact if we look at the dot.com debacle, what appeared to be missing was a set of skills, which could envisage the path from a highly speculative prospect, through to a profitable operational business, and the requisite skills to make it happen. It may not require a company to leave the industry, like Enron, but simply to leverage using some innovative partnership models.
Resources sector external capital
External capital has been described as the “goodwill” encompassed in company reputation or brand, customer and supplier relationships and alliance partnerships. It has already been noted that the more established companies will have generated some degree of brand loyalty from long-term investors. It would be fair to say that resource companies tend to be focussed more on production capabilities than leveraging strong customer relationships. We also don’t see the degree of alliance partnerships that is often evidenced in, say, the oil and gas industry. We may see joint ownership of orebodies, but companies generally choose to develop their own facilities for exploitation, often to the detriment of the industry as a whole.
Supply has been an area ripe for cost reduction through strategic sourcing strategies. Some companies have outsourced non-core support services like information technology, human resources, payroll, property management, etc. The intent of these initiatives is reducing costs of either the sourced product or the trading transaction. However, relationships with suppliers, fellow industry participants or even customers can be leveraged in more ways than purely reducing costs. In fact one could argue that external capital is all about leveraging brand and alliances to generate new growth opportunities, which in turn would be rewarded with higher market valuations.
Learning from your partners, rather than squeezing the supply chain, is now seen to be a major driver of share market value. CSC Research Services has facilitated a series of research projects to explore the nature of partnerships and how they can be leveraged for maximum advantage. A clear determination from this work is that the real source of competitive advantage will come from working with partners across the full scope of the value networks in which a company operates, rather than limiting the focus to the primary supply chain.
Despite the relatively poor long-term performance of the resources sector, it has many endearing features. The sector has well-developed competencies in new venture and risk management as well as project and operational management (human capital). It is a reliable generator of cash for funding new growth opportunities (internal capital) and has a rich network of suppliers and partners (external capital).
Perhaps the biggest limitation is the how the sector describes itself, i.e., in tangible asset terms like orebodies, draglines, beneficiation plants, etc. It would be better off recognizing its excellent intangible assets like risk management skills, project and operational management expertise and alliance opportunities.