The untold story of valuation

VALUATION underlies the current chaos stemming out of China and Greece and reports suggesting the world's leading mining houses have written off 90% of asset value from all M&A activity since 2007, Queensland resources lawyer Robert Milbourne says, writing for International Coal News.
The untold story of valuation The untold story of valuation The untold story of valuation The untold story of valuation The untold story of valuation

Robert Milbourne

Staff Reporter

With the Grexit occupying front page news, China's stock market in freefall, the International Monetary Fund encouraging the US Federal Reserve to hold interest rates at historic lows and the Australian dollar losing ground rapidly, the only thing that is clear is that there is a growing sentiment of widespread instability.

Clearly these economic conditions have an impact on M&A, capital markets listings, debt finance and project development.

Australia has lost perhaps 20% in foreign exchange over the last year or so alone, reducing the US dollar value of Australian resources stocks.

At the same time, China appears to be heading for a very volatile period that may have much more severe consequences than the Grexit. One theme underlies all of these developments, and that is valuation.

Investors are quite rightly conservative when lending or investing assets into any project. This risk aversion can be amplified when valuations around assets can fall by 30% over a month, or double over a year, as we have seen in the Chinese market.

In the resources sector it is often quite straight forward to budget for capital and operating expenses to bring new infrastructure into production.

The hard bit is deciding what the fair market value of the new piece of infrastructure is, once commissioned, and, as a lawyer, finding a fair and equitable solution in the event of a dispute. If an investor is exposed to dispute settlement in the middle of such instability, it can be very difficult to determine asset investment protection, if guarantees are not put in place – which are becoming increasingly rare.

In the mining sector, we have seen gold junior stocks trading at 10% of their recent highs in valuation. If you are an investor, how do you negotiate your investment terms when an asset can trade at 1/10th its value one or two years after your initial investment.

The asset – a gold mine – is the same, and in fact the global market may not have changed significantly in aggregate demand for production. So how do you protect yourself?

If you can’t put adequate protections in place, it is unlikely you will want to continue to invest in such a volatile sector. The result is that market valuation certainty is becoming a key factor in impeding new projects in Australia, thereby further exacerbating the challenges in the sector.

The historic assumption that investors will seek higher returns for greater risks doesn't seem to be playing out as projects are simply not being funded, and this is, in my view, due to fundamental uncertainty around contractually protecting against these broad and sudden swings in asset valuation.

Following a decade of unprecedented growth in China and many of the BRIC nations, investors were handsomely rewarded.

But in the last two to three years we have seen incredible volatility in key sectors of the Australian economy – ports, rail, mines, power projects, and the like. Dozens of major infrastructure assets are operating at a loss, and states considering divestment of assets are in some cases seeing that infrastructure might have nil value under current valuations.

If operating assets have no market value today, it makes new project valuation far more difficult. But the real challenge is when project economics appear on the surface to be positive, and the parties close a transaction which one or two years later ends up in dispute.

Unfortunately, closing transactions today, when there is a fear that future market fundamentals may not be adequately or fairly recognized in future valuations, makes financial closure very difficult. When a mine may temporarily lose 90% of its "fair market value" there is almost no way investors can able to recover their investment in spite of the default and liquidation provisions.

This is not an entirely new or unknown phenomenon. Many industries face this problem, but the instability we are now seeing with the Euro, in China, and in the BRIC nations, is exacerbating the volatility – particularly in the industries relevant in Australia – infrastructure, energy and resources, at the time when these industries are most in need of capital, and at a time when, based on historic multiples, these assets are extremely cheap.

The result is that even though "bargain basement" deals can be struck, investors are broadly ignoring these sectors.

I have represented an iron ore junior developer who has developed a fully licensed project that is ready for construction and operation.

The project could have generated perhaps $100 million in profit five years ago, but now the owners are having a hard time finding investors at even severely discounted values.

In my view, the reason is that investors have lost confidence that there will be adequate stability to ensure sufficient security against default. The result is these sectors are being starved – which in a vicious cycle, leads to more instability and even lower valuations.

Traditional dispute mechanisms, such as appointing independent experts for valuation in the event of a fundamental disagreement, are no longer as trustworthy as they used to be given the tremendous swings and variation in assumptions.

So the transactions I have been involved in recently seek very rapid repayment – within one to two years. Few projects stack up in that case, so many of my clients at the moment are waiting for market sentiment to change to seek financing.

In my view, we need to develop a greater sense of long term valuation in order to bring projects to the market. Some of the largest new mine infrastructure projects in the Galilee basin are allegedly (according to some estimates) not economically viable in current circumstances – but from a longer term perspective they may be extremely valuable.

Investors and sponsors need now, more than ever, to agree on valuation and recovery mechanisms in dispute based on longer term time frames to ensure projects can get financed and developed.

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