is diversification a bad word in the mining world by aditya mehra

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THE LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE

Is “Diversification” a bad word in the “Mining” world?

M. Sc. Finance (part-time)

2012-13

FM4T4: Cases in Corporate Finance

Exam Candidate Number:

Word Count: 6033 words

The copyright of this dissertation rests with the author and no quotation from it or

information derived from it may be published without prior written consent of the

author.

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TABLE OF CONTENTS

1. Introduction 2

2. Motivation behind diversification 4

3. Literature review 7

4. Data and Methodology 9

5. Performance comparison 14

6. Credit risk comparison 18

7. Value comparison 21

8. Functioning of internal capital markets 27

9. Stock market reaction to acquisitions/ divestments increasing/ decreasing

diversification 33

10. Conclusion and caveats 38

Annexure 40

Bibliography 81

Glossary 84

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1. INTRODUCTION

In this study, the author endeavours to determine if there are any benefits of

diversification in the mining industry over a business cycle (2007 to 2012). This has

been accomplished by comparing the diversified mining companies with their single

segment pure play counterparts, analyzing the performance of the internal capital

markets of diversified mining companies, and finally, by interpreting the reaction of

the stock market to transactions increasing or decreasing the level of diversification.

The top four global diversified mining companies on FTSE 100 were selected. These

companies are BHP Billiton (“BHP”), Rio Tinto (“Rio), Anglo America (“Anglo”) and

Xstrata (“Xstrata”) (collectively “Diversified miners”). A brief summary of these

companies is below:

Table #1.1 – Overview of Diversified miners

31 Dec 2012 Market capitalisation

USD 184.1 billion USD 105.3 billion USD 42.8 billion USD 51.6 billion

31 Dec 2012 Enterprise Value


2012 Revenues


2012 EBITDA


Segments (based on 2012 EBITDA)

Listed in UK and Australia UK and Australia UK and South Africa

UK and Switzerland

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Each of these Diversified miners has reporting segments based on commodities

(and not geographies), which is the focus of this study. The benefits of diversification

have been analysed over three dimensions - operating performance, credit risk and

valuation. Commodity-wise pure plays have been selected and compared against

the Diversified miners on these three dimensions.

One of the major characteristics of diversified firms is the existence of an internal

capital market. This study analyses the capital allocation between segments to

determine the efficacy of the process. Finally, the stock market is an important

barometer of managerial decisions on increasing or decreasing the level of

diversification. The stock market reaction to such transactions is also included in this

study.

This study is structured as follows – Section 2 delves into the motivation behind

diversification, which is followed by a literature review in Section 3. Section 4

describes the methodology adopted for this study. Sections 5, 6 and 7 compare the

operating performance, credit risk and valuation respectively between the Diversified

miners and their pure play counterparts. Section 8 analyses the internal capital

market of the Diversified miner whereas Section 9 is an event study to understand

the market reaction to acquisitions or divestments that increase or decrease the

diversification of the Diversified miners. Finally, Section 10 draws inferences based

on the previous sections to answer the question “Is “Diversification” a bad word in

the “Mining” world?” This is followed by the Annexure, which is an integral part of this

study, a Bibliography and Glossary.

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2. MOTIVATION BEHIND DIVERSIFICATION

The motivation behind corporate diversification is a puzzle, and a generalised

conclusion on the motives behind a move to diversify could be misleading. In the

Modigliani-Miller world, diversification should not have any impact on firm value.

Investors have the freedom to diversify their risk by holding a portfolio of investments

and hence do not require a corporate to front-run them. However, the truth is that

firms still do diversify.

Some of the motivations that lead to diversification are:

a) Synergies

a) Related diversification

The benefits take the form of economies of scale and scope due to

market power, better resource utilisation, better coordination in

production and supply chain, product and service bundling etc.

b) Unrelated diversification

These benefits take the form of economies of scale. There could be

efficiency benefits between unrelated segments (better capital

allocation via internal capital markets, avoidance of duplication of

management, better managerial oversight etc).

b) Debt co-insurance

The cash flows of a diversified firm, by their very nature, depend on

numerous segments which may not be correlated to each other. The

risk of a lender reduces unless there is a systemic shock which impacts

all the segments significantly. Further, various segmental assets can

be used as a collateral. This added comfort to the lenders helps in

reducing financing costs wherein cash generated by other segments

provides an insurance against the borrowing segment. This also

enhances the debt capacity of the diversified firm which could lead to

higher interest tax shields.

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c) Internal capital markets

When external financing is expensive, diversified firms have the option

of allocating capital across segments to avoid the expensive external

source of financing. Further, the cash flows of under-performing

segments can be diverted for investing into a good segment, thereby

increasing the overall benefit to the firm.

The imperfections in the external capital markets also lead to

diversification wherein the firm can internally allocate resources more

efficiently. Moreover, the miniature internal capital market replicates the

discipline of external financial markets.

d) Agency problems between management and owners of the firm

a) Empire building

Managements aspire to enlarge their area of influence and power by

acquisitions. This leads to firms undertaking acquisitions that increase

the perimeter whether geographically or along the value chain or

sometimes event unrelated.

b) Increasing managerial compensation and perquisites

Larger organisations generally have higher compensation and

perquisite levels. This leads to managements undertaking acquisitions

so that their permit increases, thereby increasing their overall

compensation and prestige.

c) Safeguarding their jobs

Managements enter into acquisition transactions to create a niche

within the organisation for themselves. This leads to management

entrenchment wherein they become indispensible to the larger

organisation.

e) Response to industry prospects and growth opportunities

If the industry in which the firm is operating has poor growth

opportunities, the firm would have a higher propensity to diversify into

an industry with good growth opportunities.

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f) Value considerations

On numerous occasions, firms simply acquire a new business because

it is undervalued.

g) Hubris

Managements at times believe that they have a “Midas touch” which

can be used to build larger, well functioning businesses.

h) Risk reduction

Managements have the belief that diversification will help reduce the

risk of the firm and that the firm can diversify better than the

shareholders.

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3. LITERATURE REVIEW

There is a significant amount of literature available on corporate diversification.

Some of the literature relevant for this study is below.

Value:

Early studies like Lang and Stulz (1994), Berger and Ofek (1995) and Rajan,

Servaes and Zingales (2000) concluded that diversified firms trade at a discount to

their single segment comparables. However, literature by Campa and Kedia (2002)

and Villalonga (2004) alluded to the fact that the value implications of diversification

were not negative but depended on a case by case basis.

Motivation:

Studies by Jensen (1986) and Jensen and Murphy (1990) have mentioned that

managers take the diversification route to increase their power and compensation. A

study by Amihud and Lev (1981) concluded that diversification reduces individual

employment risk. Finally, Shleifer and Vishny (1989) concluded that diversification

helps managements to entrench themselves.

Internal capital markets:

Poor performance of internal capital markets was found by Scharfstein and Stein

(2000) and Lamont (1997). Glaser et al (2011) concluded that managerial power led

to frictions in internal capital markets as divisions under powerful and connected

managers are able to secure more resources in a financially constrained

environment.

Over the cycle:

Yan et al (2010) found that investment declines in single segment firms while it

remains the same for diversified firms during times of recession. Further, they

concluded that internal capital markets become more efficient during depressed

market conditions.

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Re-focussing spin offs:

Stock markets tend to appreciate re-focussing spins offs as per Comment and Jarrel

(1995), John and Ofek (1995) and Desai and Jain (1999). On the other hand, a study

by Morck el al (1990) shows that firms increasing diversification had negative

returns.

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4. DATA AND METHODOLOGY

a) The largest diversified mining companies of FTSE were identified:

– This selection included BHP, Rio, Anglo and Xstrata. These companies

have a global footprint and mine multiple minerals.

b) These four companies were researched:

– Annual Reports, Earnings Releases, Company presentations and Press

Releases available on the company website, Bloomberg and Thompson.

c) The reporting segments of these four companies were identified and the

corresponding financial information available was collected.

– In most cases, the reporting segments were not appropriate for the said

analysis as the management of the companies had aggregated commodities

into certain segments based on their organisational and management

structure and there were changes in the segment perimeter during the period

of this study.

– In order to perform a reasonable analysis, 12 segments were identified

based on the segmental information available for each of the four diversified

miners. These segments are as follows:

i. Petroleum upstream

ii. Iron ore

iii. Coal

iv. Copper

v. Other base metals (Gold, Silver, Uranium, Lead and Zinc)

vi. Nickel

vii. Platinum

viii. Diamond

ix. Aluminium

x. Manganese

xi. Speciality products

xii. Industrials and Technology

– Reporting segmental information of the four Diversified miners was then

classified under these 12 segments. Any material corporate overheads and

assets were apportioned over these 12 segments so that the aggregate of the

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segmental information would tie in with the reported consolidated financial

results of the four diversified miners.

d) Pure play comparables were identified for each of the commodity segments:

– The endeavour was to determine pure play/ single segment firms in each of

the commodities. There were not many ideal pure play comparables as

mineral companies endeavour to sell whatever they can extract from the

earth. As minerals seldom come in their pure form, by-products play a role in

the economics of each company. In order to overcome this issue, companies

which had a high turnover from the relevant commodity were selected as a

proxy of the pure play wherever necessary. The comparables comprised of

the big players in each segment as opposed to the fringe pure plays. The

various criteria that were used to select comparables were – pure play, size,

geographic locations, production history etc. The search was further limited to

only public companies, as reliable financial information of private companies

was not easily available.

– In total 86 companies were considered and 36 were selected under the 12

segments. Annexure 1 on page 41 presents a table with all the close

comparables that were considered.

– For each segment, there were more than one comparables which were

selected and averaged out to obtain representative metrics for operating

performance and valuation for that segment

e) The appropriateness of the pure play comparables was compared:

– Selection of the correct pure play comparables was critical for this study. In

order to confirm the appropriateness of the pure play comparables, the actual

asset beta of the Diversified miners was compared with their implied asset beta

based on the asset betas of the pure play comparables.

– The actual equity beta of the four diversified companies was determined by

regressing their excess stock returns against the FTSE index.

– The Diversified miners have a high beta and no alpha as can be seen from their

t-stat below. The detailed regression output is in Annexure 2 on page 43.

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Table #4.1 – Summary of regression output

– There were not adequate pure play companies on FTSE to determine the

segmental beta and hence the comparable pure plays across exchanges were

considered. The underlying assumption is that markets co-move and hence an

average of the betas with respect to different markets would be comparable with

the beta of the Diversified miners based on the FTSE index. The global market

for commodities ties in with this assumption. The various equity betas were de-

levered based on the capital structure of the respective company assuming a

debt beta of zero. Annexure 3 on page 45 provides the individual equity and

asset betas for all the companies.

– The implied asset beta of the four diversified companies was the weighted

average segmental asset betas using their segmental EBITDA as weights.

Ideally, the weights should have been the value of each segment but the EBITDA

of the respective segment was used as a proxy.

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Table #4.2 – Implied asset beta of Diversified miners

– As there is not a significant deviation between the actual asset beta of the

Diversified miners and their implied asset beta, the chosen comparables were

considered as appropriate for this study.

f) Data of the Diversified miners and their comparables was gathered

– Information was collected from Bloomberg and Thompson for the Diversified

miners and their segmental pure play counterparts across six-monthly periods

during 2007–2012. The period of study was dividend into sub-periods

corresponding to the business cycle (H1 2007 – H1 2008 -> growth; H2 2008 to

H2 2010 -> recession; 2011 – 2012 -> recovery) in order to draw conclusions of

the effect of diversification over the business cycle.

– Suitable performance (EBITDA margin, EBIT margin, Revenue growth, Return

on assets, Net Working Capital/ Revenue) leverage (Net Financial Debt/

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Enterprise Value, Net Financial Debt/ EBITDA) and valuation metrics (Enterprise

Value/ Sales, Enterprise Value/ EBITDA and Enterprise Value/ EBIT) were

identified for this study and calculated based on data available. The data was

reconciled with the consolidated financial statements of the four diversified firms

in order to ensure accuracy and similar accounting treatment of investments

accounted for under the equity method.

– The performance and valuation metrics, as mentioned above, were averaged

out for each pure play comparable to determine the segmental performance and

valuation metric. The averaging procedure ensured that a reasonable and

representative estimate of the actual performance and valuation of the segment

was determined, thereby minimising the effects of the lack of pure plays or fully

comparable companies in some segments.

– Any extraordinary impacts on performance (start up, accidents, windfall gains

or losses etc.) and valuation (takeover announcement, extraordinary dividends,

class action etc.) were not considered in the averaging process in order not to

distort the segmental results.

– For Diversified miners, information on major acquisitions or divestments

impacting the level of diversification was gathered from the respective company

press releases. Stock price information for conducting an event study around the

announcement period was taken from Bloomberg.

– Lastly, for Diversified miners, data was gathered on the Capital Expenditure

spent on individual segments to calculate metrics such as Capital Expenditure/

Depreciation and Capital Expenditure/ EBITDA. This segmental information was

used to analyse the function of internal capital markets at each of the Diversified

miners.

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5. PERFORMANCE COMPARISON

Objective:

To determine if diversification led to superior operating performance over the

business cycle as compared to segmental pure plays.

Methodology:

The segmental operating performance of the four diversified companies was

compared against their pure play counterparts.

Profitability (EBITDA and EBIT margin), growth (Sales growth) and asset returns

(EBIT/ TTM Assets) of each segment of the Diversified miners and their pure play

counterparts was determined and compared for the 12 six-monthly periods during

2007-12.

Further, as the segmental working capital information was not available for the

Diversified miners, the total working capital was considered and compared to the

average working capital metric of the segmental pure plays.

Outcome:

As can be seen from the chart set 5.1, Diversified miners have (in terms of

profitability):

a) significantly outperformed their pure play counterparts in

a. Iron ore

b. Coal

c. Manganese

b) significantly underperformed their pure play counterparts in

a. Nickel

b. Industrials and Technology

c) initially outperformed pure plays in Aluminium, Copper and Other Base

Metals; however, for the last few years, profitability has dropped below the

average of competitors

The revenue growth comparison between Diversified miners and their pure play

counterparts also shows recent underperformance by the former. In segments like

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Nickel, Diamond and Speciality Products, this underperformance has been

consistently significant over the business cycle.

On pre tax RoA, the Diversified miners have outperformed the pure play

counterparts due to the fact that the asset base of the former is much older than that

of the latter thereby increasing the returns.

Figure #5.1 – Segmental over/ (under) performance as compared to pure plays

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The graph below depicts the average net working capital to revenue ratio which

clearly shows the superior working capital management of the Diversified miners.

Figure #5.2 – NWC to Revenue ration of average Diversified miners and average

segmental pure plays

Conclusion:

As can be seen from the segment wise performance graph in Annexure 4a to 4d

starting on page 47, there is a high correlation between the direction of segmental

performance and the direction of corresponding pure plays performance. This is not

surprising on account of the global market for commodities and the presence of well

established commodity pricing indexes for most of the commodities.

Diversified miners have significant competitive advantage in Iron ore and Coal due to

their large integrated (mining + infrastructure) operation in Western Australia and

Queensland respectively. Further, Iron ore and Coal comprise on average 51%,

82%, 55% and 35% respectively of the total EBITDA of BHP, Rio, Anglo and Xstrata.

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Due to this very high percentage share of total profitability, these segments are given

special attention from the management. Besides, the large scale operations have led

to cost optimisation thereby increasing profitability.

The Diversified miners have underperformed the pure play in Copper, Nickel,

Platinum and Industrials and Technology. From this list, except for Copper, all the

other operations are of marginal size and hence adequate management attention

and focus has been perhaps lacking. Further, under performance has increased in

the recent past. There is a recent trend in the underperformance in segments where

the Diversified miners had a clear advantage in the past like Copper, Other Base

Metals, Nickel, Platinum, Diamond, Aluminium and Speciality products. This is a

potentially alarming situation where past competitive advantage has not been

sustained by Diversified miners.

The Diversified miners have outperformed the pure plays significantly in working

capital management. This is on account of the integration with infrastructure

networks which the pure plays have not been able to achieve due to their smaller

size.

It can be inferred that the fall out of diversification is that management focuses on

segments which will have a significant impact on the companies’ profitability at the

expense of marginalising the smaller segments thereby questioning the strategy of

diversification itself.

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6. CREDIT RISK COMPARISON

Objective:

To determine if diversification has any impact the credit risk of the diversified miners.

Methodology:

As the segment wise net debt is not disclosed by the Diversified miners, the total

debt of these companies was analysed and compared to that of the pure plays.

The CDS of the Diversified miners was compared with the CDS of pure plays and

the iTraxx Europe CDX index for the period of this study. Finally, the credit ratings of

the diversified miners were compared with the individual credit ratings of the pure

play firms (where available).

Outcome:

Figure #6.1 – Comparison of average leverage of the Diversified miners

with pure plays

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In general the leverage of pure plays is much lower than that of the average

Diversified miner. This is understandable considering the lower credit risk associated

with the Diversified miners and hence the higher availability of credit. The Diversified

miners also have a lower net debt to EBITDA ratio thereby providing additional

comfort to the lenders.

The CDS spread graph of all the miners and ITraxx are identical in their movement

except the Petroleum and Coal pure plays as can be seen in Annexure 5a and 5b

starting on page 55. The CDS spreads were low during the boom period of 2007 –

H1 2008 but then drastically rose as the recession set in. The CDS spreads peaked

in H1 2009 but then reduced in 2010 as recovery kicked in. However, spreads rose

again in H2 2012 but did not reach their peak of H1 2009. Some of this phenomenon

can perhaps be explained by correlation breakdown wherein the correlation between

businesses increases in a recessionary environment. This leads to businesses with

low correlation in ordinary business environment co-moving downward during a

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recession, thereby reducing the benefits of diversification when they are needed the

most.

The CDS band of the Diversified miners has been much more stable than most of

the pure plays. The difference in the CDS between the Diversified miners and their

pure plays is the least during the boom phase of H1 2007 to H1 2008 but the

difference increases during the recession.

The credit rating of pure plays is lower than the rating of the larger Diversified

miners. There is only one pure play with a credit rating similar to the one of the larger

Diversified miners. A few pure plays have a similar credit rating as the smaller

Diversified miner. Annexure 6 on page 60 corroborates these observations.

Conclusion:

Diversification has lowered the credit risk of the Diversified miners somewhat.

However, there are pure plays with similar CDS levels and ratings. Hence, credit risk

does reduce by diversification but it does so perhaps due to size as can be seen by

the ratings of the larger pure plays.

Diversified firms have the advantage of various streams of cash flows and also size.

This combination leads to the Diversified miners being able to provide better

collateral to the credit providers thereby improving the rating and reducing the CDS.

Segmental pure plays do not have this combination and hence typically have higher

credit risk.

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7. VALUE COMPARISON

Objective:

To understand the impact (if any) that diversification has had on the value of the

Diversified miners.

Methodology:

Compare the actual Enterprise value of the Diversified miners based on their market

capitalisation with the sum of the parts implied Enterprise value based on the

multiples of segmental pure plays.

Work steps:

The six-monthly segment-wise trailing Revenue, EBITDA and EBIT for the period

2007-12 for the Diversified miners and their segmental pure plays was assimilated.

As far as possible accounting differences (equity investments, classifications etc.)

were taken in consideration and data modified to facilitate comparison. The

segment-wise Revenue, EBITDA and EBIT of the Diversified miners was reconciled

with their consolidated income statement. Any differences were allocated to the

segments in order to reflect the consolidated performance.

The Enterprise Value/ Revenue, Enterprise Value/ EBITDA and Enterprise Value/

EBIT multiples of the segmental pure plays were derived and averaged out in order

to determine the multiple for the respective segments. While calculating the average

multiple, the impact of any extraordinary events (accounting changes, losses,

takeover announcement, class action lawsuit etc.) on the Enterprise Value,

Revenue, EBITDA and EBIT of the segmental pure plays were normalised.

The average segmental pure play multiples were multiplied with the corresponding

segment-wise Revenue, EBITDA and EBIT of the Diversified miners. If the EBITDA

or EBIT were negative for any six-monthly period, the Enterprise Value was

computed by averaging the Enterprise Value immediately prior to negative EBITDA

or EBIT with Enterprise Value immediately after the period of negative EBITDA or

EBIT. The implied segmental Enterprise Value was aggregated separately based on

Revenue, EBITDA and EBIT.

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The final implied Enterprise Value was calculated by the weighted average of the

implied Enterprise Value based on Revenue (50% weight), EBITDA (25% weight)

and EBIT (25% weight). This averaging ensured that equal weight was given to top

line (Revenue) and bottom line (EBITDA and EBIT) multiples. Annexure 7a to 7d

starting on page 62 provides the detailed calculations.

Finally, the implied six-monthly sum of the parts Enterprise Value during the period

2007-12 was compared to the actual Enterprise Value to determine if the Diversified

miners traded at any premium or discount.

Outcome:

While the top two Diversified miners (BHP and Rio) on average traded at a slight

premium (1-6%) to their segmental counterparts, the smaller Diversified miners

(Anglo and Xstrata) traded at a significant discount (11-26%) to their corresponding

segmental pure plays.

There were no trends in the quantum of the premium or discount that were observed

across the sub-period of the study. However, Anglo has constantly traded below its

implied Enterprise Value.

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Figure #7.1

(Average diversification premium/ (discount) and Actual EV to implied EV ratio)

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Conclusion:

Larger the size of the diversified miner, more is the premium or lower is its discount

to their sum of the parts. As the discount at which Anglo and Xstrata trade is

significant, it can be inferred that the benefits of diversification increase with size. If

critical mass is not achieved, diversification actually penalises value.

The exposure of the Diversified miners to different commodities is different. Some

segments like Iron ore, Coal and Copper have a high beta; segments like Nickel,

Platinum and Industrials and Technology have medium betas; segments like Other

Base Metals, Diamonds and Aluminium have a beta close to the market beta

whereas Petroleum, Manganese and Speciality Products have low beta. The

exposure of the Diversified miners to these four classes of beta is as follows:

Table #7.1 – Exposure to segments with different betas

Valuation

Discount/

Premium

High

beta

Medium

beta

Market

beta

Low

beta

BHP Premium 60% 6% 10% 24%

RIO Premium 77% 3% 15% 5%

Anglo

American

Discount 49% 37% 8% 6%

Xstrata Discount 70% 14% 12% 4%

As can be seen from the table above, there seems to be no correlation between the

discount or premium that can be attributed to the exposure to the different

commodities.

The leverage of the Diversified miners was also analysed but could not explain the

discount/ premium. Rio and Xstrata have had high leverage but the former has, on

average, traded at a premium to implied value whereas the latter at a discount. The

graph below depicts the leverage analysis.

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Figure #7.2 - - Leverage of the Diversified miners

The discount or premium could be on account of the growth opportunities of each of

the Diversified miners. Though all the Diversified miners have a healthy pipeline of

growth opportunities, the quality of these opportunities may vary, which could

perhaps explain some of the discount/ premium.

The corporate governance of the four diversified miners was analysed to understand

if they could explain the discount/ premium. A comparison of the provisions is below:

Table #7.2 – Corporate governance provisions of Diversified miners

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The provisions followed by the Diversified miners are almost the same. The

only exceptions are:

i) Rio does not have the ability to grant pre-emptive rights to existing

shareholders.

ii) BHP and Rio’s board has the authority to issue capital, which Anglo

and Xstrata’s board does not.

iii) BHP and Rio’s senior management do not have a golden parachute.

iv) BHP and Anglo shareholders do not have the right to call a special

meeting.

v) Rio does not have a staggered board

The value impact (if any) of these governance provisions is out of the scope of

this study.

Finally, the difference in valuation between the Diversified miners themselves and

with pure plays can perhaps be simply due to idiosyncratic factors like quality of the

existing production assets, management etc.

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8. FUNCTIONING OF INTERNAL CAPITAL MARKETS

Objective:

To infer whether the internal capital market of the Diversified miners was functioning

appropriately by analysing the segmental capital allocation.

Methodology:

The segmental organic capex and segmental returns on assets was analysed to

determine if capital had been allocated to segments based on returns.

The segmental capex to depreciation and segmental capex to EBITDA ratios were

determined to identify the segments that are favoured for growth. Further, the

historical performance of segments favoured for growth were analysed to see if there

was any justification for the preferential treatment.

Finally, prevalence of any cross subsidisation in allocation of capital between

segments was analysed by comparing the proportion of segmental capex to total

capex with the proportion of segmental EBITDA with total EBITDA.

Outcome:

Well functioning internal capital market was observed for BHP.

The company has been in a significant growth mode over the duration of the study

as can be seen by the capex-to-depreciation and capex-to-EBITDA ratios. The

internal capital allocation has been functioning well as most capital is allocated to the

most profitable segments like Iron ore, Petroleum and Coal. Aluminium, Nickel and

Coal seemed to be the favoured segments while Copper seemed to be out of favour

and actually cross subsidizing the favoured segments. Diamond and Manganese

segments have had good returns but a small proportion of EBITDA and capex,

perhaps due to limited growth opportunities. No glaring aberrations in capital

allocation over the cycle were noted. In general, capex reduced as a fall out of the

recession but picked up again during the recovery phase. Annexure 8a on page 66

has the graphs on the segmental share of capex with the segmental share of

EBITDA.

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Figure #8.1 – BHP segmental capex and profitability

Note: Y-axis range of Capex/ Depreciation graph has been shortened to facilitate interpretation

Well-to-average functioning internal capital market was observed in Rio.

Like BHP, Rio has also been in a significant growth mode over the duration of the

study. The internal capital market has functioned reasonably except that the

Aluminium segment has received significant capital allocation despite low returns.

This could be perhaps due to legacy under-investments in Alcan which was acquired

in 2007. The Iron ore segment seemed to be cross subsidizing the Aluminium capex.

The other favoured segment was Diamonds which received higher than

commensurate capital despite negative returns. The Uranium segment received a

low share of capital in spite of good returns, perhaps due to the limited investment

opportunities. Other than these exceptions, a high proportion of capital had been

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allocated to the Iron ore and Copper segments in sync with their good profitability.

No major aberrations were noticed across the sub-periods. Annexure 8b on page 67


EBITDA.

Figure #8.2 – Rio segmental capex and profitability


Average-to-below average performing internal capital market was observed in Anglo.

Like the others, Anglo has been in the growth mode over the last few years. Some

major evidence of cross subsidization has been noticed. The segments of Nickel and

Platinum have received significant capital allocation despite low returns. This bias

has been observed uniformly across the sub-periods of this study. Platinum received

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more capital allocation than Coal despite earning a fifth of the return from Coal.

Manganese and Speciality products have received low capital allocation in spite of

excellent returns due to limited investment opportunities. Annexure 8c on page 68


EBITDA.

Figure #8.3 – Anglo segmental capex and profitability

Note: Charts below exclude a) Diamond business which is accounted for as an equity investment during the

period of analysis b) analysis for the period H1 2007 to H1 2008 due to differences in accounting treatment and

disclosure of capex


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Average-to-below average performing internal capital market was observed in

Xstrata.

This is a growth oriented company like the other three Diversified miners. There was

significant evidence of cross subsidization wherein Nickel was favoured despite low

returns. Over the period of study, Nickel has been allocated the same share of total

capex as the Copper and Coal segments which have returns more than twice the

returns of Nickel. The Ferro alloys segment did not receive capital allocation

commensurate with its returns. The largest segments like Copper and Coal which

have high returns have been allocated a major proportion of capex but lower than

their respective share of total EBITDA, thereby effectively cross subsidizing the

investments in the Nickel segment. Annexure 8d on page 69 has the graphs on the

segmental share of capex with the segmental share of EBITDA.

Figure #8.4 – Xstrata segmental capex and profitability

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Conclusion:

No general conclusion can be drawn on the functioning of internal capital markets of

the diversified miners. As has been seen previously, the internal capital markets of

BHP and Rio function well as compared to their smaller counterparts wherein there

appears to be significant evidence of certain segments being favoured at the

expense of more profitable segments. While there could be certain non-financial

consideration or commitments which led to the cross subsidization but the same was

observed across the sub-periods.

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9. STOCK MARKET REACTIONS TO ACQUISITION/ DIVESTMENTS

INCREASING/ DECREASING DIVERSIFICATION

Objective:

To understand and interpret the market reaction to transactions that increased or

decreased the level of diversification of the Diversified miners.

Event study:

The share price movement and the cumulative abnormal returns in the run up to and

post announcement of an acquisition or divestment deal that increased or decreased

the level of diversification of the four Diversified miners were analysed.

Methodology:

Acquisition transactions that increased the number of segments or increased the

size of existing segments substantially over the period under study for each of the

four diversified miners were selected. Considering the size of these global Diversified

miners, only acquisitions with an Enterprise Value of above USD 1 billion were

considered as smaller acquisitions had minimal impact on the value of these large

diversified miners.

Similarly, divestments made by the Diversified miners over the period of this study

that reduced the number of segments or reduced the size of existing segments

substantially were considered. No value threshold was used to filter these

divestments.

The data on the acquisition and divestment deals was taken from the press releases

made by the Diversified miners during the period 2007-12. Their share price and the

FTSE 100 index values were obtained from Bloomberg.

Excess returns from the stock price movement (using the risk free rate from Bank of

England) of each of the four diversified miners and the FTSE 100 was calculated. A

regression was run to determine the α and ß of the individual diversified miners. The

details of the regression are in Annexure 2 on page 43. Using these estimates of α

and ß and the prevalent risk free rate at the time of the individual transaction

announcement, the expected return was calculated and compared to the actual daily

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return over the 60-day period surrounding the announcement of acquisition or

divestment (-30 to +30 days from deal announcement) to calculate the abnormal and

cumulative abnormal returns.

Further, the share price and the FTSE 100 index value during this 60-day period

surrounding the announcement date was scaled to the price on the date of

announcement to observe any major movements.

Outcome:

Over the period of 2007-12, 34 transactions fit the criteria on the level of

diversification of the Diversified miners. This comprised of 15 acquisitions, 2 JVs, 2

mergers, 14 divestments and 1 spin off. The category-wise sub-period-wise details

are below:

Table #9.1 -- Acquisitions (2007 – H1 2008)

Table #9.2 -- Acquisitions (H2 2008 – H2 2009)

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Table #9.3 -- Acquisitions (2010 – 2012)

Table #9.4 -- Divestments (2007 – H1 2008)

Table #9.5 -- Divestments (H2 2008 – H2 2009)

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Table #9.6 -- Divestments (2010 – 2012)

Table #9.7 -- JVs and Mergers (H2 2008 – H2 2009)

Table #9.8 -- JVs and Mergers (2010 – 2012)

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Table #9.9 -- Spin offs (2007 – H1 2008)

Annexure 9a to 9d starting on page 70 have the graphs of the share price movement

and the cumulative abnormal return for the individual transactions.

Conclusion:

The table below summarises the inferences:

Table #9.10 – Summary of transactions increasing/ decreasing the level of

diversification

It can be inferred that during the boom period, the market did not provide a clear

verdict on acquisitions. This was perhaps due to a combination of the strategic

nature of some of the acquisitions along with the possibility of over-payment.

However, the market reaction to divestments and spin-offs which reduced segments

was categorically positive during this period.

As expected during the recessionary environment of H2 2008 to H2 2009, the market

reaction to acquisitions was categorically negative. However, it was strongly positive

to divestments which helped firms to focus their business and get rid of non-core

businesses.

During the recovery of 2010 – 2012, the market was positive on divestments, which

led to refocusing the business and providing much needed cash. The market’s

verdict on acquisitions and JVs was mixed.

Overall, it can be said that during the period under analysis, the market preferred a

reduction in segments and complexities with a focus on low cost and competitive

segments.

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10. CONCLUSION AND CAVEATS:

Even within the Diversified miners, there was a clear differentiation on the impact of

diversification based on size. The results of the analysis led to two groups being

formed – larger Diversified miners (BHP and Rio) and the smaller Diversified miners

(Anglo and Xstrata). The table below summarises the impact of diversification on

each of these groups.

Table #10.1 – Impact of diversification on larger and smaller Diversified miners

Impact of diversification

on:

Larger Diversified miner

– BHP and Rio

Smaller Diversified miner

– Anglo and Xstrata

Operating performance

Credit risk

Valuation

Legend:

Strong advantage Some advantage Neutral Some disadvantage Strong disadvantage

On the operating performance front, the Diversified miners performed better than

their pure play counterparts in segments that were large and critical for the overall

profitability of the respective miner. Segments which were small and marginal did not

get the required attention of the management because their impact on overall

profitability was low.

On credit risk front, Diversified miners due to their very nature provided better

stability on account of numerous streams of cash flows and collateral. But it was

observed that large pure plays were at par with atleast the smaller Diversified

miners.

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Finally, on the valuation front, the large Diversified miners have traded at a slight

premium whereas the smaller Diversified miners have traded at a significant

discount.

All in all, diversification has been more beneficial for the larger Diversified miners as

compared to the smaller Diversified miners. Whether this is because of better

functioning internal capital markets or lower credit risk or larger and better operations

is a question that will need to be further studied.

In the context of diversified versus single segment firm, the conclusion from this

analysis is mixed. However, the stock market has been consistent in its appreciation

of transactions reducing the level of diversification.

Any conclusion must take into account the following caveat:

a) Finding exact comparables is always challenging and more so in the said

analysis due to the diverse segments and geographical footprint

b) Period of this study is limited to the last six years only. A longer duration over

a few business cycles would perhaps provide better results

c) Only the largest 4 diversified miners were considered. Though these are

representative of the mining industry, a few other non FTSE listed miners may

provide better clues (e.g. Vale etc.)

d) Reflecting the value of equity investments is always challenging.

e) Each company has its idiosyncratic variables and controlling these variables

even by increasing sample size may not completely remove their effect.

While early academic literature on diversification concluded that diversified firms

trade at a discount to their pure play counterparts, the recent literature has been

open ended, suggesting that conclusions have to be made on a case by case basis.

In the context of the mining sector, this study reinforces the view mentioned in recent

literature. The question that this study set out to answer unfortunately does not have

a straightforward response.

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ANNEXURE

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Annexure #1 – Pure play sample selection

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Annexure #2 – Regression outputs of Diversified miner

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Annexure #3 – Segmental pure play and Diversified miner betas

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Annexure #4a – EBITDA Margin comparison

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Annexure #4b – EBIT Margin comparison

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Annexure #4c – Revenue growth comparison

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Annexure #4d – Six monthly pretax Return on Assets comparison

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Annexure #5a – Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)

Diversified miners and iTraxx Europe

Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)

Diversified miners and iTraxx Europe

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Diversified miners CDS (1 Jan 2007 to 31 Dec 2012)

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Annexure #5b – Segmental pure play CDS (1 Jan 2007 to 31 Dec 2012)

Petroleum upstream comparables

Iron ore comparables

Coal comparables

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Copper comparable

Other Base Metals

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Platinum comparable

Diamond comparable

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Aluminium comparables

Industrials and Technology comparable

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Annexure #6 – Credit rating and CDS band

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Annexure #7a - Value comparison - BHP

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Annexure #7b - Value comparison - Rio

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Annexure #7c - Value comparison - Anglo

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Annexure #7d - Value comparison - Xstrata

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Annexure #8a – BHP’s segmental share of capex vs share of EBITDA

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Annexure #8b - Rio’s segmental share of capex vs share of EBITDA

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Annexure #8c - Anglo’s segmental share of capex vs share of EBITDA

Note: 2007 figures not considered due to change in accounting in 2008 and onwards

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Annexure #8d - Xstrata’s segmental share of capex vs share of EBITDA

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Annexure #9a – Share price performance near announcement of BHP’s acquisitions

and divestment:

12 Nov 2007 – BHP’s initial offer for the acquisition of Rio Tinto

6 Feb 2008 – BHP’s revised offer for the acquisition of Rio Tinto

25 Nov 2008 – BHP revokes its offer for the acquisition of Rio Tinto

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5 Jun 2009 – BHP’s offer for the Iron ore JV with Rio Tinto

18 Oct 2010 – BHP terminates its offer for the Iron ore JV with Rio Tinto

18 Aug 2010 – BHP’s offer for the acquisition of Potash

15 Nov 2010 – BHP terminates its offer for the acquisition of Potash

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17 Jul 2008 – BHP’s offer for the acquisition of New Hope-New Saraji Project

22 Feb 2011 – BHP’s offer for the acquisition of Chesapeake Energy Corp

14 Jul 2011 – BHP’s offer for the acquisition of Petrohawk Energy Corp

1 Feb 2012 – BHP’s offer for the divestment of Richards Bay Minerals

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27 Aug 2012 – BHP offer for the divestment of Yeelirrie Uranium deposit

13 Nov 2012 – BHP’s offer for the divestment of its Diamond business

12 Dec 2012 – BHP’s offer for the divestment of its stake in East West Browse

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Annexure #9b – Share price performance near announcement of RIO’s acquisitions

and divestment:

12 Jul 2007 – RIO’s offer for the acquisition of Alcan

18 Aug 2009 – Divestment of Alcan Packaging Europe business

30 Jan 2009 – Divestment of Potash business

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5 Jul 2009 – Divestment of Alcan Packaging Americas business

5 Aug 2010 – Divestment of Alcan Engineering

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Annexure #9c – Share price performance near announcement of Anglo’s

acquisitions and divestment:

1 Jun 2007 – Spin off of Mondi

1 Oct 2007 – Anglo divests it stake partly in Ashanti Gold

17 Jan 2008 – Anglo’s offer for the control of MMX

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16 Feb 2010 – Anglo divests Tarmac’s European (continental) business

10 May 2010 – Anglo divests its Zinc business

14 Nov 2010 – Anglo divests it stake in Moly-Cop and Alta Steel

18 Feb 2011 – Anglo mergers T armac with Lafarge

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4 Nov 2011 – Anglo’s offer for gaining control of De Beers

24 Apr 2012 – Anglo divests Scaw South Africa

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Annexure #9d – Share price performance near announcement of Xstrata’s

acquisitions and divestment:

11 Apr 2007 – Divestment of Aluminium business

7 Aug 2007 – Xstrata’s offer for the acquisition of Eland Platinum

29 Oct 2007– Xstrata’s offer for the acquisition of Jubilee Mines

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6 Aug 2008 – Xstrata’s offer for the acquisition of Lonmin

1 Oct 2008 – Xstrata’s offer for the acquisition of additional stake in Lonmin

7 Feb 2012 – Merger announcement with Glencore

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BIBLIOGRAPHY

1. Academic literature

a. Amihud, Y. and Lev, B., ‘Risk reduction as a managerial motive for

conglomerate mergers’ Bell Journal of Economics, 12(2), 605 – 617, 1981

b. Berger, P. G. and Ofek, E., ‘Diversification’s effect on firm value’, Journal

of Financial Economics, 37(1), 39 – 65, 1995

c. Campa, J. M. and Kedia, S., ‘Explaining the diversification discount’,

Journal of Finance, 57(4), 1731 – 1762, 2002

d. Comment, R. and Jarrell, G., ‘Corporate focus and stock returns’, Journal

of Financial Economics, 37(1), 67 – 87, 1995

e. Desai, H. and Jain, P. C., ‘Firm performance and focus: Long-run stock

market performance following spinoffs’, Journal of Financial Economics,

54(1), 75 – 101, 1999

f. Erdorf, S., Hartmann-Wendels, T., Heinrichs, N. and Matz, M., ‘Corporate

Diversification and Firm Value: A survey of recent literature, CGS Working

Paper, Cologne Graduate School, 2012

g. Glaser, M., Lopez de Silanes, F., and Sautner, Z., ‘Opening the black box:

Internal capital markets and managerial power’, Working Paper, University

Konstanz, EDHEC Business School, Duisenberg School of Finance, 2011

h. Jensen, M. C., ‘Agency costs of free cash flow, corporate finance, and

takeovers’, American Economic Review, 76(2), 323 – 329, 1986

i. Jensen, M. C. and Murphy, K. J., ‘Performance pay and top-management

incentives’, Journal of Political Economy, 98(2), 225 – 264, 1990

j. John, K. and Ofek, E., ‘Asset sales and increase in focus’, Journal of

Financial Economics, 37(1), 105 – 126, 1995

k. Lamont, O., ‘Cash flow and investment: Evidence from internal capital

markets’, Journal of Finance, 52(1), 83 – 109, 1997

l. Lang, L. H. and Stulz, R. M., ‘Tobin’s q, corporate diversification and firm

performance’ Journal of Political Economy, 102(6), 1248 – 1280, 1994

m. Morck, R., Shleifer, A., and Vishny, R. W., ‘Do managerial objectives drive

bad acquisitions?’, Journal of Finance, 45(1), 31 – 48, 1990

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n. Rajan, R., Servaes, H., and Zingales, L., ‘The cost of diversity: The

diversification discount and inefficient investment’, Journal of Finance,

55(1), 35 – 80, 2000

o. Scharfstein, D. S. and Stein, J. C., ‘The dark side of internal capital

markets: Divisional rent-seeking and inefficient investment’, Journal of

Finance, 55(6), 2537 – 2564, 2000

p. Shleifer, A. and Vishny, R. W., ‘Management entrenchment: The case of

manager - specific investments’, Journal of Financial Economics, 25(1),

123 – 139, 1989

q. Villalonga, B., ‘Diversification discount or premium? New evidence from

the business information tracking series’, Journal of Finance, 59(2), 479 –

506, 2004

r. Yan, A., Yang, Z., and Jiao, J., ‘Conglomerate investment under various

capital market Conditions’, Journal of Banking and Finance, 34(1), 103 –

115, 2010

2. Anglo

a. Annual Reports, Earnings Release and Company presentations for the

period 2007 -12, accessed during 18 Apr 2013 to 13 Jun 2013 on the

website http://www.angloamerican.com/investors/reports/2013rep

b. Website information, accessed during 18 Apr 2013 to 13 Jun 2013

http://www.angloamerican.com/

3. BHP



website

http://www.bhpbilliton.com/home/investors/reports/Pages/default.aspx


http://www.bhpbilliton.com/home/Pages/default.aspx

4. Bloomberg accessed during 1 Mar 2013 to 13 Jun 2013

5. Rio



website http://www.riotinto.com/investors/results-and-reports-2146.aspx

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http://www.riotinto.com/

6. Thompson ONE Corporate Development subscription with Thompson Reuters

accessed during 1 Mar 2013 to 2 Jun 2013

7. UK risk free rate from Bank of England website

http://www.bankofengland.co.uk/Pages/home.aspx

8. Xstrata



website

http://www.glencorexstrata.com/investors/reports-and-results/xstrata/2012/


http://www.glencorexstrata.com/

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GLOSSARY

Anglo – Anglo America

BHP – BHP Billiton Ltd and BHP Billiton Plc

Capex – Capital expenditure

CAR – Cumulative abnormal returns

CDS – Credit default swap

Diversified miners – Anglo, BHP, Rio and Xstrata

EBITDA – Earnings before interest, tax, depreciation and amortisation

EBIT – Earnings before interest and tax

EV – Enterprise Value

NFD – Net financial debt

NWC – Net working capital

Rio – Rio Tinto Ltd and Rio Tinto Plc

RoA – Return on Assets

Xstrata – Xstrata COPYRIGHT

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is diversification a bad word in the mining world by aditya mehra

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