The Globe and Mail, Report on Business, Guest Column
July 21 2006
There are big decisions being made in the resource sector these days, as there are in the housing market, and at their core, the decisions are very similar.
Let me start by saying that I've never come close to running a resource company or other type of cyclical company. It seems logical to me, however, that the management of these companies should know how to play their business cycles. They, better than anyone, should know how good or bad it can get and have a strategy to deal with it.
In broad terms, that strategy should look something like this: When things are booming and profits are flowing, the focus should be on paying down debt and getting more liquid in anticipation of tougher times ahead. When everyone is falling all over themselves to buy assets and take over competitors, management should keep its powder dry and stay on the sidelines. When the tougher times come, the company's stock will be pounded down like everyone else's. But it won't matter because the company won't need new capital to survive the downturn. Indeed, that's when management can go on the hunt and look for opportunities to add to its asset base.
We all know that every cycle is different and totally unpredictable, but management doesn't have to get too scientific about it. If everyone in the industry is losing money and rationalizing production, it's the down part of the cycle. That's when they want to be in a position to do some buying. When profits are great and return on equity is north of 20 per cent, they're in the up cycle. It's time for senior management to go on holidays and let the production teams deliver the goods.
Despite the logic of this approach, it's a rare company that pursues this strategy. A few come to mind. The management and board at Methanex know they're in a highly cyclical business - methanol. They have always prided themselves in being disciplined about allocating capital and being in a good position to deal with a weak market. Methanex is always able to make opportunistic purchases or build new plants. And importantly, they haven't been forced to dilute their shareholders by raising capital at an inopportune time. A Canadian name from the past, Donohue (a forest products company that was swallowed up by Abitibi a few years back) was also pretty good at it. On a number of occasions, they were able to buy assets at distressed prices at or near the bottom of the cycle. Exxon, the world's largest company by market capitalization, has always been disciplined about its spending. Management has taken heat from time to time for not being more aggressive when the company is generating barrels full of cash, but they have stuck to their discipline. They recognize that the energy business is cyclical and have been good at keeping an even keel and not getting too carried away in the heady times.
On the other side of the ledger, there are two current day situations that have brought me to write about this topic. One is the Phelps Dodge takeover of Inco and Falconbridge and the other is the housing market.
It strikes me that if the Phelps Dodge/Inco/Falconbridge deal goes through, it may go down in the business annals alongside Time Warner's takeover of AOL and Noranda's purchase of MacMillan Bloedel back in the eighties. Phelps Dodge is offering shares as part of the purchase, but it is also leveraging up it balance sheet. It is taking on billions of dollars worth of debt at a time when commodity prices and asset values are high. It sounds backward to me.
I think we can draw a parallel to what is happening in the housing market. Prices have risen considerably and competition for desirable properties has been intense. Despite the fact that financing has been easy (and is getting easier), it is not a time to be tacking on a big mortgage to buy a high priced asset. To my way of thinking, it's the wrong point in the housing cycle to add to your asset base. If family considerations allow, it would be better to keep your powder dry and use any excess cash (if there is such a thing) to de-leverage your personal balance sheet (i.e. pay down the loans and mortgage).
Like the resource boom, the housing cycle could go on for a while longer, although there are some signs (outside of Alberta) that the best is behind us. But like the resource companies management, we don't have to be too scientific about it. If the market has gone up a lot, properties are selling above asking price and everyone is talking about real estate, we're in the up cycle. And that means we should act more like Methanex and Exxon and less like Phelps Dodge.