Debt warning for small resource stocks as a rate squeeze worsens
Major miners have been investing in cash-strapped juniors and this trend will likely increase as credit becomes harder and more expensive to source.
Investors should take note of the red debt-flag flying over the resources sector with smaller companies at greatest risk, as the toxic mix of interest rate hikes and commodity price falls take effect.
Rising interest rates impact everyone, but with mining there is a problem in trying to align erratic (commodity exposed) income with fixed costs which, in the case of companies still in the exploration or early development phase, is not easy.
What the debt issue means is that extra attention should paid to quarterly cash reports, which contain a breakdown of financing/banking facilities, which provide a clue as to when a miner might need a cash top up.
Capital raising stampede
One solution to the unfolding capital squeeze is to raise funds by issuing more shares, a process which turned into a stampede last month as it became clearer that central banks were serious about stamping out inflation.
In the first few days of August, a blizzard of small cap raisings took place, including Cobre (ASX: CBE, $7 million), Medallion Metals (ASX: MM8, $5.2 million), American West Metals (ASX: AW1, $2.7 million), Lindian Resources (ASX: LIN, $3 million), Castile Resources (ASX: CST, $5.5 million), Thomson Resources (ASX: TMZ, $2.2 million), Vital Metals (ASX: VML, $45 million), Arafura Resources (ASX: ARU, $32 million), Caravel Minerals (ASX: CVV, $3 million), Lanthanein Resources (ASX: LNR, $1.75 million) and Celsius Resources (ASX: CLA, $3.5 million).
Issuing new shares remains a way out of the debt squeeze, but it is getting harder as share prices fall and becoming restricted to companies with the highest credit ratings.
Funding deals
Another solution to the growing cash squeeze is to strike a funding deal with a well-heeled sponsor which is what rare earth project developer Hastings Technology Metals (ASX: HAS) has just done with iron ore miner Fortescue Metals Group (ASX: FMG).
The Hastings move, which will see it “borrow” $150 million through an issue of a three-year convertible note to FMG, has cleared the way for the relatively small company with a market value of $550 million to buy a 22.1% interest in a Canadian rare earth processing business.
Positive as the deal is for Hastings it is also an excellent investment for FMG, not simply because it could eventually become a major shareholder in a rare earth producer, but also because its $150 million will be earning close to 12% interest, payable quarterly in cash or by Hastings issuing more notes.
What Hastings has signed up for is a form of hybrid debt priced at roughly equivalent to the bank bill swap rate (BBSW) which yesterday stood at 3.1% for six-month bills plus 9%.
The reason the Hastings deal is interesting is that it is a guide to the high cost of debt for a small company with a similar deal struck in April an example of how a bigger business can get cheaper debt.
Size matters
In April, Iluka Resources (ASX: ILU), which is also developing a rare earth refining operation to complement its mineral sands mining operations, secured funding from the Australian Government’s critical minerals facility to help pay for a processing facility in WA.
Because of Iluka’s size (market value $4 billion) and strength of the financier (government backed) the terms of a non-recourse loan for up to 16 years are the BBSW plus 3% which, at current rates is a funding cost of around 6%, or half what Hastings is paying.
For investors the importance in comparing the funding mechanisms of Hastings and Iluka is that it demonstrates the importance of size and track record when it comes to debt funding.
Both companies should emerge as winners given the high level of global demand for rare earths, but Iluka will do it cheaper.
Mega miners lock-in deals
Other deals which see big miners using their balance sheet power to fund a smaller business are starting to emerge, especially at the exploration phase where mega miners such as BHP (ASX: BHP) and Rio Tinto (ASX: RIO) have been busy.
Earlier this year BHP invested $40 million in a promising but early-stage nickel project in Tanzania with privately owned Kabanga Nickel, and earlier this week Rio Tinto agreed to invest US$18 million to become the majority owner of the Elder Creek copper project in Nevada.
Deals which marry big and small mining companies will become more common as traditional funding avenues dry up, banks close their doors, hybrid deals such as that between Hastings and FMG gets more expensive, and equity becomes harder to issue as investors duck for cover in a falling market.
What’s happening, at all levels of finance from the government down, is a tightening process which started earlier this year when the US central bank (the Federal Reserve) lifted its funding rate by 0.25% to 0.5%, a 17 March shot that continues to reverberate around the world with another 0.75% increase expected later this month as the bank heads for a target of 4% by early next year.
Australia, as every borrower knows, is following the Fed with this week’s 0.5% increase taking the Reserve Bank cash rate to 2.35%, perhaps on its way to the 4% level last seen in 2012.
Tight money triggers cash scramble
Tighter money caused by the central bank fight against inflation has unleashed a scramble for cash around the world.
In Australia, the cash hunt has reached the highest levels of government with the relatively new Treasurer, Jim Chalmers, calling on superannuation funds to help pay for infrastructure, aged cars and renewable energy – three sectors normally left to government.
Big super funds are wary of the request from Chalmers because they have a duty of care when it comes to wisely investing the savings of members
In the US earlier this week, a rush developed among big companies to stock up on capital by issuing bonds ahead of the next Fed rate increase, which is expected to be another 0.75% on 20 September.
Some of the biggest names in US business dipped into the bond market, seeking an estimated US$40 billion, including McDonald’s, Union Pacific, Target, Lowe’s and Walmart.
That burst of capital raising saw corporate debt rates reached their highest in 13 years at around 4.87%.
Smaller companies, as seen in the Hastings versus Iluka example, will now have to fight for what’s left over and that almost certainly means paying close to double the rate of the big boys of business.
As for a small business without a source of recurrent income, such as an explorer or early-stage mine developer, the cost of debt could soon become unaffordable, if it’s even available.