Will consolidation help the gold mining industry?
Cliff Droke
According to a recent Associated Press article, the airline industry is worries that the war in Iraq could easily add $10 billion to world airline losses and deepen what is already the worst crisis in the history of commercial aviation. The airline industry said it expects international passenger travel to drop 15-20% during the war, depending on the region of the world. According to the article, airlines have already reported accumulated losses of $30 billion since the Sept. 11, 2001 attacks in the United States reduced air travel.

On top of this, there is the looming specter of bankruptcies for some of the major airlines (the ones that don't already have bankruptcy protection). For example, the article noted that the world's largest airline, AMR Corp.'s American, is teetering on the brink.

So what is being proposed as the panacea to the airline industry's ills? Not surprisingly, more mega-mergers (as if the industry hasn't already seen enough consolidation!) According to one industry spokesman quoted in the A.P. article, governments must help airlines tap financial markets for cash and allow them to merge to survive the crisis. "We need the economies of scale that mergers and acquisitions can provide," he said.

It seems that whenever a company or industry segment experiences a downturn in business or else wants to expand in a hurry, the quick-fix panacea is to go the merger and consolidation route. "Merger mania"was all the rage in the mid-to-late '90s during the broad market boom. Unfortunately, however, the insatiable desire to grow in a hurry via mergers and acquisitions led to the demise of a countless number of companies and in large part was responsible for the bear market we are currently undergoing.

So now that the gold stock sector is shining it comes to nobody's surprise that consolidation is fast becoming the buzz word in the mining industry as many gold mines (and advisers to the gold industry) have been talking consolidation. But the question that the industry should be asking is, "Will consolidation ultimately help or hurt the gold mining sector?"

This was one of the great myths that the 1990s equity bull market was founded on, namely, the idea that mergers and acquisitions help corporations achieve "economies of scale" and make them better suited to compete on a global basis. But the events of the past three years have shown us the folly of this line of thinking, most recently with AOL/Time Warner.

Now it seems, certain influential gold analysts and investment bankers are proposing that the gold mining industry embrace the idea of mergers and greater industry consolidation as a means of increasing productivity and revenues, and in order to gain greater control over supply. But would the business model that fails so miserably for many companies in the ‘90s somehow work for the mining industry today? Not likely.

A recent study on the effect of mining industry consolidation found that mergers and acquisitions and the related transactions of management buy-outs, buy-back schemes, disposals, and minority buy-outs, are major strategic moves that frequently have a significant negative impacts on the companies. A study by Price Waterhouse Coopers of mergers and acquisitions across several industries showed that only 1 in 6 increased shareholder value for the buyer (1999).

Another study found that profit to sales ratio and profit to equity ratio declines sharply immediately after most mergers or takeovers. Mergers of big companies within a given industry were found to generally provide less shareholder value and a lower rate of profitability in the years immediately following the merger. In many cases, profitability is never achieved (see AOL). Time and experience have shown that the key to a vibrant, profitable industry is diversity and competition, not uniformity and consolidation. The greater the number of companies there are in a given field, the greater the potential for a healthy bull market when the cycle turns up since each company must actively compete for market share in the most efficient way possible without going too much into debt. When the consolidation trend builds momentum and becomes an industry-wide phenomenon, the playing field becomes smaller as lesser competitors are either acquired or pushed aside because they cannot compete with the mega-mergers. This in turn allows the consolidated competitors to dominate the industry landscape, which creates all sorts of problems. It also enables the "big players" to control market supply a lot more easily, which means price can also be controlled. In short, consolidation tends to upset the natural balance of supply and demand. Mining industry observer Bob Moriarty made an excellent observation on the subject of mining industry mergers, one that I can't help but agree with: "It's just a gut feeling of mine but mergers seem to make the combined company only as strong as the weakest party to the merger rather than the strongest which is what everyone would like us to believe," he said. "For example, Franco Nevada was a brilliant company with a clear goal. The new Newmont seems to be rudderless. Same people, different results. I'm not impressed."


April 1, 2003

Clif Droke is the editor of the weekly Bear Market Report, a combined forecast and analysis of U.S. stocks and indices and international precious metals stocks, and is the author of numerous books on finance and investing, including most recently "Gold Stock Trader's Almanac 2003." Visit his web site for free samples of his analysis at www.clifdroke.com