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Lonmin's situation offers an insight into the health of the commodity sector

21/12/2012

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

In recent articles such as Emerging risk and Losing its shine, we have highlighted our concerns about commodity producers – and platinum miners in particular. More recently, Lonmin, the world’s third largest platinum producer, has announced it has a problem that in essence, boils down to it having too much debt and not enough cash.

Over the last few months, the majority of Lonmin-related headlines have, quite understandably, focused on the social unrest associated with some of its mining operations and especially the unfortunate series of events at the Marikana mine in South Africa. Even so, this latest announcement hardly comes as a surprise to the market and speaks to an important – and indeed interlinked – economic point.

Around the world, miners have been arguing they should be paid more because of the associated hardship of what they do and the supernormal profits the industry has for a long time been making as a result. Somewhat ironically, Lonmin is no longer making any profits and indeed the industry in general has been trying to balance weaker demand and steadily-rising costs – an unsustainable equation.

In what would be its second rights issue in three years, Lonmin is looking to raise $800m (£497m) – a proposal that has set a number of alarm bells ringing here on The Value Perspective. One concern is that, as with any rights issue, the first thing the money will be used for is to pay down the company’s debt. That is good news for Lonmin’s debt holders but less so for its equity holders.

A further concern is the not inconsiderable uncertainty surrounding whether or not the economics of the mines Lonmin owns even support further investment. In other words, if you analyse how Lonmin’s costs stack up versus other platinum mines, there are reasons – and not just those associated with labour – why they are less profitable.

One final consideration is the unresolved issue with Lonmin’s ownership structure that arises from the South African government’s (BEE) programme. Taken alongside the rights issue, this should give shareholders pause for thought about how their existing equity is set to be diluted in the short term.

Lonmin’s situation also provides an interesting take on the way companies tend to think about mergers and acquisitions. Back in 2008, before it started making eyes at Glencore, Swiss mining giant Xstrata fell over itself to bid for the business at the equivalent of £62 a share. Frustrated in that aim, it ultimately settled for buying 25% of the company at £36 a share. Today Lonmin’s share price stands around £3.

So why are no companies falling over themselves to make a takeover bid at that price? It is because, in the current environment, people are so worried about the future they are failing to consider any value that may be on offer – whether it is measured by the business’s price versus its assets or any other metric.

That Xstrata is apparently uninterested in Lonmin at £3 a share yet felt sufficiently bullish to make a bid four years ago at more than six times that price speaks volumes about the psychology of investment. In many ways, it is the polar opposite of what we, as value investors, look to do.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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