Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
If Sirius Minerals (LSE: SXX) raises £2bn of new debt to finance its potash development, its interest costs will likely hover in the region of £200m a year or more, which is a good enough reason to avoid its stock at least until more clarity emerges on its capital structure (the amount of equity, debt and other forms of capital that will be used to finance its operations).
Wait & See
You may have to wait a bit longer before deciding what to do with SXX: stage one of the financing is expected to be completed by end of Q1 2016.
Negotiations between Sirius and its lenders are ongoing, but hefty interest costs are a key assumption in my base-case scenario until further notice. In my view, its balance sheet should carry a large chunk of equity capital rather than a huge amount of debt at this stage of maturity, but management may have different ideas.
Of course, its cost of equity will be significant based on its current valuation.
Management Team
For those familiar with Sirius, it’s hard to determine the fair value of its shares based on the information that is currently available. Financial details are sketchy, but it’s clear that its management team is eager to use debt to support its ambitious expansion plans.
That doesn’t surprise me. Its chief executive officer, Chris Fraser, is a banker with a strong background in finance and mining, having spent almost 20 years at Citigroup, Rothschild and KPMG.
Its chief financial officer, Thomas Staley (previously corporate development director at Sirius), has experience across various segments of debt capital markets — from project finance to corporate debt via high-yield debt and export credit.
Mr Staley has experience in equity capital markets in multiple jurisdictions, according to a recent presentation, but Sirius intends to use mostly debt to finance its development plans.
Why is that?
Shareholder Value
“The stated and ongoing strategy is to access debt markets for the majority of the project construction because the underlying economics of the project business model lend themselves to high leverage and because that should be in the best long term interests of shareholders,” Sirius said on 10 July, only a week after it had announced that the members of the North York Moors National Park Authority had “resolved to grant permission for the project’s mine and mineral transport system planning application”.
On paper, high leverage means high return on equity if things go according to plan. But when leverage is too high, it contributes to value destruction. Just think of your mortgage if it was 90%+ financed by debt in a plunging housing market and at a time when your cash flow stream comes under pressure. Disaster!
It’s understood that the Sirius financing will be split into two tranches of about £700m and £1.3bn.
If the entire project is financed by debt, it is reasonable to assume that it’ll carry a blended cost of between 8% and 10%, or between £160m and £200m in interests annually.
In my base-case scenario, I assume that Sirius will need to negotiate a grace period according to which the principal is not repaid for at least three years. Financing costs could be higher, though, and Sirius may have to pay part of the principal sooner rather than later.
Revenues
It’s been widely reported that Sirius is targeting revenues of £1bn-£1.2bn.
Now, if we trust these projections and we assume that its operating income (Ebit) margin will hover between 15% and 35% (which is in line with the level of core profitability at several similar businesses around the world), its Ebit will range between £150m and £420m at some point in future — but we need to pay taxes and interests on this amount.
Then, if the debt component is lower — say, at 50% of the total fundraising — interest costs will likely hover around £100m a year, which is a possibility, but to invest in Sirius:
- You really must hope that its sales target will be achieved, and swiftly;
- Operating costs and capital expenditures must remain within budget;
- You must assume that Sirius will be able to grow at a fast pace to deliver a significant equity premium to its shareholders, given that larger companies in the space trade at relatively low multiples, while their growth rate isn’t particularly impressive.
Finally, you must also consider that favourable credit conditions may not last forever, and refinancing risk may be much higher than Sirius expects it to be in future.
