How poor choices Savaged Pasminco
July 13 2002
As big problems brewed at the zinc miner, hubris triggered a fateful takeover …
A little more than a week ago, the Pasminco administrators, John Spark and Peter McCluskey, of Ferrier Hodgson, tabled a report to Pasminco creditors that contains for the first time a comprehensive analysis of the group’s collapse.
Everything that could go wrong, did – all at the same time. The zinc price crashed to record lows, the Australian dollar did likewise, and the combination of high levels of debt and a disastrously misconceived hedging strategy ensured an unavoidable and unpleasant outcome. A company once valued at $2 billion imploded.
The Ferrier report, however, indicates that the company made one pivotal decision, based on flawed data, that ultimately destroyed it.
In early 1997 Pasminco bought the Century project from CRA (now Rio Tinto) for $345 million, raising nearly $700 million of new equity to fund the deal and develop the project.
The development cost Pasminco $788 million and it also took on another $250 million of lease finance for the project infrastructure – its total investment in Century was almost $1.4 billion.
At that point, hubris emerged. The company, under CEO David Stewart and chairman Mark Rayner, adopted an ambitious plan to achieve a $5 billion market capitalisation and the goal of nearly doubling output to a million tonnes of zinc a year.
That pursuit of growth led to a bid for Savage Resources in early 1999. The $457 million hostile bid eventually succeeded.
According to Ferrier, Pasminco and its adviser, Credit Suisse First Boston, valued Savage’s zinc assets at $341 million and, after asset sales, expected to pay a net $342 million. It actually ended up paying $342 million for assets later valued at $313 million. It was also relying on cost reductions which, if they didn’t eventuate, would reduce the value of the Savage assets retained by $50 million.
Pasminco also under-estimated Savage’s net debt, expected to be about $US62 million, by about $US50 million, and Savage missed Pasminco’s forecasts of its earnings in its first two years of Pasminco ownership by $27 million and $29 million respectively.
The critical aspect of the Savage deal, however, was Pasminco’s evaluation of Savage’s hedge book. Pasminco believed the book contained $US510 million of contracts. The contracts actually amounted to $US800 million.
Pasminco had a hedge book of its own. As most of its income was in US dollars, it borrowed in US dollars and then hedged any difference. Just ahead of the Savage bid, it had options totalling $US1.2 billion at average strike prices between about US66c and US58.5c.
It had taken out that cover after considering the consensus forecasts of 42 banks in January 1998, when the spot price was US64c. The consensus saw the Australian dollar appreciating to US69c by January 1999.
Pasminco modelling for the bid was predicated on the exchange rate continuing to rise, to US73c. After the bid succeeded, the Savage book was restructured to conform with Pasminco’s. The changes resulted in the Savage component of the book growing to $US970 million.
By January 2000, the Australian dollar was trading at US63.6c. Pasminco decided to put “collars” around its book, with a US3c band, which produced a book with $US2.3 billion of options over five years with an average “cap” of US68c and floor of US65c. The dollar kept falling, finally to below US50c in 2001.
Ferrier’s analysis of the hedge book shows that the Pasminco proportion ended up $214.2 million out of the money at the point of Ferrier’s appointment. The Savage proportion of the book was $662 million out of the money. By the time Ferrier closed out the book, it had cost Pasminco about $850 million.
While the falling dollar was wreaking havoc, the zinc price was also diving. In September 2000 it was $US1206 a tonne. By last September, when Ferrier was appointed, it was at $US801 a tonne. With $US100 a tonne equivalent to $150 million of revenue, Pasminco lost more than $600 million of revenue in a year.
Ferrier says management information systems contributed to its failure because management was unable to adequately prepare forecasts, particularly of cash flow performance.
Pasminco typically performed below forecast, the administrators say, failing to meet targets for controllable items like production volume and costs. In the three years before the administrators were appointed the average annual shortfall was $73 million.
With hindsight, the reasons for the collapse are obvious. It expanded too aggressively and funded the expansion unwisely.
The combination of the Century development and the Savage bid stretched its balance sheet, introducing too much debt.
The directors then, without knowing it, bet the company on the market consensus on the exchange rate and got the call completely wrong. The dollar fell sharply when they had bet that it would rise strongly.
The ending was inevitable. From the moment Pasminco made that ill-fated, and poorly considered, hostile bid for Savage it was doomed.