DBRS Morningstar Chasing the Majors: A Look at the Junior Mining Producers
Written by Brian Szeto MA, CFA at DBRS Morningstar
The mining industry is composed of senior producers, intermediate producers, junior producers, and nonproducing exploration / development companies. In this commentary, DBRS Morningstar provides a perspective on rating the junior producers and the key factors that we consider in determining a producer’s Business Risk Assessment (BRA) and Financial Risk Assessment (FRA) profiles.
Mine development cycle
The mine development cycle begins with exploration, which is the core focus of all nonproducing exploration and development companies. These companies are constantly in competition with each other in a race to make the next major discovery in the mining industry (Exhibit 1). Funded primarily with equity, it may take many years before a mineral resource can be delineated. Even then, there is no certainty that the deposit will be economically viable.
Mining engineers consider many factors when determining the economics of a project, including the size of the deposit, ore grades, topography of the region, access to infrastructure, mining method, and processing method, just to name a few. Only projects that can generate a meaningful net present value or internal rate of return will earn the right to move forward to the construction phase. Even then, it assumes the project can be successfully permitted with the approval from different levels of government, has the support from local communities, and can access construction funding from the capital markets.
Only a handful of exploration and development companies progress to the production phase. Some projects simply don’t have the project economics to support being developed into an operating mine, and some are acquired by a producer that is looking to bolster its own project development pipeline. Once producer status is achieved, investors are already eyeing the next phase of growth where producers can increase in size, through organic and external growth, from junior to intermediate producers. Ultimately, the goal is to reach senior producer status – on par with industry leaders such as BHP Group Limited (rated “A” with a Stable trend by DBRS Morningstar), Rio Tinto Plc & Rio Tinto Ltd. (rated “A” with Stable trend by DBRS Morningstar), Vale S.A. (rated BBB (low) with a Stable trend by DBRS Morningstar), and Barrick Gold Corporation (rated BBB with a Stable trend by DBRS Morningstar).
Weak BRA driven primarily by lack of diversification
There is no set definition of what constitutes a junior producer in the mining industry; however, it is typically categorized as a mining company that is in production and generates less than USD $500 million per year of revenue.
The cost of delineating mineral resources and converting mineral resources into mineral reserves can be an extremely time-consuming and expensive endeavour. As such, it is not unusual for development-stage companies to delineate an ore body that can support an operation of eight to 10 years before considering putting the project into production. Although there might be significant resources that can be converted to reserves in the future, DBRS Morningstar typically views reserves of less than 10 years as noninvestment grade (BB or below) from the perspective of Reserve Quality in its BRA analysis (refer to DBRS Morningstar’s Global Methodology for Rating Companies in the Mining Industry).
Junior producers are also typically single-asset companies focused on the production of one commodity from a single geographic location. This description concisely captures the problem with this subset of producers: The lack of diversification creates significant risk when the operation faces business disruptions either from internal or external forces. Business disruptions for a single-asset company can quickly impair its ability to service debt obligations. This generally leads to a poor assessment from the perspective of the Diversification (Product / Markets) factor in the BRA assessment.
Where the operation is positioned relative to the industry cost curve is also an important consideration in the determination of a company’s business risk profile. Most junior producers are situated in the bottom half of the cost curve. Typically, junior producers have a high level of fixed costs that cannot be spread out over multiple operations, which leads to lower margins and generally results in a below investment-grade assessment for the Operating Efficiency business risk factor.
Mine Plans optimized to rapidly improve credit metrics
Junior producers are also typically companies that have only recently reached commercial production with a new mine, or a restart of a past producing mine under a new economic model or a stronger commodity price environment. To achieve either initial production or a restart of operations, mining companies will generally issue a significant amount of debt to fund the project through the development phase. As a result, in the early years of production, the company’s credit metrics can be weaker. The key credit metrics we consider are (1) cash flow-to-debt, (2) debt-to-EBITDA, (3) EBITDA-to-interest, and (4) debt-to-capital as illustrated in Exhibit 2.
It is worth nothing that most mine plans are structured to maximize the net present value of the project and will generally target a higher-grade portion of the mine in the first few years of operations, thereby maximizing cash flow and minimizing the payback period of the overall project. As a result, the ability of the mine to pay down and service its debt obligations is usually the highest closer to the early years of operations.
Next steps for junior mining producers
Junior producers are generally single-asset companies operating within a single political jurisdiction. The lack of diversification can create significant risk when the operation faces business disruptions either from internal or external forces and can quickly impair a company’s ability to service its debt obligations. In addition, this subset of producers is generally highly leveraged because of the initial capital required to either build a new mining operation or restart a past producing operation. As a consequence, junior producers can have weaker financial metrics when compared with well-established intermediate or senior producers. Overall, in order for a junior producer to materially improve its BRA profile, it has to acquire a second operating asset in a new geographical location that will allow it to achieve some diversification from single-asset risk and reduce country risk. Additional sources of operating cash flow will also allow the company to more quickly reduce financial leverage, leading to stronger FRA metrics.