Crash diet -Investors often underestimate how much a recovering business may have to shrink


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

Anglo-American executives may need a laugh after the mining giant reported a pre-tax loss for 2015 of $5.5bn (£3.9bn) but they should probably still steer clear of the Tom Hanks comedy The Money Pit. The 1986 film, in which a young couple plough ever greater sums of cash into their supposed dream property, may remind them a little too much of the company’s Minas-Rio iron ore mine in Brazil. 

The course of this project – which, in addition to the mine itself, required the construction of a port on the coast and a 300-mile pipeline connecting the two – has rarely run smoothly and indeed, when The Value Perspective first touched on the Minas-Rio story here in late 2012, the expected costs had already spiralled from $3.5bn (£2.5bn) up towards $8bn (£5.7bn). 

A few months later, an update from Anglo-American, which we discussed in Logic problem, showed the company had to that point spent closer to $10bn (£7.1bn) and was also planning to write $4bn (£2.8bn) off its investment. Things have not improved in the intervening period and the company has now written off a total of $11.3bn (£8.3bn) – in other words, more than three times what the project was initially expected to cost. 

In other, other words, the whole affair has been a disaster and the money Anglo-American has sunk into the Minas-Rio project has made no small contribution to the debt the company has on its balance sheet today. Nor do we seem to have reached the end of the saga, with the company still prepared to dip further into its coffers to drag the project to completion. 

Assessing options 

Indeed, having originally expected Minas-Rio to start production in 2011, Anglo-American recently felt optimistic enough about the mine’s prospects to declare that, in three years’ time – once all the final permitting and sustainability work had been carried out – then … the company would be in a position further to assess its options on what to do with its most infamous asset. 

Along with the company’s assets in South Africa, Minas-Rio had once been seen as the future cornerstone of Anglo-American’s iron ore production but the way the world of mining has changed since then means it will be nothing of the sort. For, when it unveiled its 2015 results, the company also announced its future would now be focused around three main divisions – platinum group metals, copper and diamonds. 

In this vision of Anglo-American in a brave new world of mining, therefore, iron ore is conspicuous only by its absence, which leads onto a value investing lesson that can be drawn from this sorry affair. The lesson is that interesting value prospects – and recovery-type ones in particular – often end the recovery process a good deal smaller than when things initially start to get tough for them. 

Based on their present plans, a number of mining giants, including Anglo-American, look set to be the latest in a long line of businesses that grew very large on the back of some very good times only to emerge from a more difficult period, such as we are seeing, a good deal smaller, a good deal leaner and, hopefully, a good deal stronger. Here on The Value Perspective, we would argue the UK’s banks are close to completing a similar kind of transition, which began after the 2008/09 credit crunch. 

These sorts of companies end up a lot smaller than they were, having been forced, say, to shut down unprofitable ventures they perhaps never should have had, or else to sell off other parts of the business to help shore up their balance sheets. We are seeing this with Anglo-American’s new focus on platinum group metals, copper and diamonds, which last year totalled revenues of some $12bn (£8.5bn) between them. 

New great hopes 

Those three divisions are the new great hopes of Anglo-American – a company of which we are shareholders and of which, most likely, we will continue to be shareholders in the future. Still, as an interesting point of comparison, we cannot help but recall that in 2011, at the height of the excitement about Minas-Rio, Anglo-American enjoyed total sales of $31bn (£22.1bn). 

Obviously there have been other factors at play here – the steep falls in commodity prices chief among them – and yet there is little doubt the Anglo-American that emerges from this difficult period for the sector is going to be significantly different to the one that entered it. That may of course be no bad thing – but it is a point of which investors do need to be keenly aware. 

A mistake investors often make (and undeniably one we have made ourselves at times) is to underestimate just how much any company going through the recovery process may have to shrink – certainly in terms of revenues and most likely in terms of profits too. 

Just think how different a business Royal Bank of Scotland is today compared with what it was in 2007 – or how Tesco might look in years to come once it has finished scaling back its domestic stores and Asian ambitions. In any such scenario, the key point is to ensure the business’s valuation already prices in such shrinkage and the costs of achieving it as, if it does, you should be protected by a generous margin of safety. 

When a company overextends itself in terms of debt and management scope, it will often end up as something value investors can pick over the bones of. We are only doing so because we believe a stronger and more valuable, if smaller, business could emerge. So maybe the Anglo-American executives should take a look at The Money Pit after all – if only to remind themselves disastrous projects can still have a happy ending.


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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