Digging for goodwill in SA mining deals

Digging for goodwill in SA mining deals

WHY are mining companies averse to the creation of goodwill on an acquisition? A common response to this question is that goodwill is something found when acquiring a corner shop, because when you buy a corner shop you do not gain many assets; perhaps the building and some inventory. However, you would pay probably a multiple of earnings for that business. So the difference between what you paid and the fair value of these assets is goodwill. This concept is understood and accepted.

But in a mining company? No, it is not possible. What do you buy when you buy a mine? Yes, there are surface assets, some sort of processing plant, some buildings, perhaps some stockpiles and some stores. There are the shaft system and equipment, and these are all-important, expensive to replace. But what you are really buying is primarily two things: the mineral resource ”” this is irreplaceable; and the hole in the ground. In deep-level mines, this is very important because it costs billions of rands to get to 4km underground, whereas for shallower mines, it is not as critical.

So people say that if you value the hole in the ground and the mineral resources, well, then all there is to be valued has been covered and there cannot be goodwill. ”What goodwill?” they say. There seems to be a fear that if a mining company creates goodwill on a transaction, the market will see it as having overpaid. There cannot be any goodwill like the corner shop which has loyal customers. Here there is none of that. So if you end up with goodwill, what else can it be than having overpaid? Or, so the market says.

Accounting standards have come a long way and the changes during the past 10 years have been phenomenal. Accountants and auditors spend hours trying to stay up to date and on top of all these changes and developments. It is therefore not surprising that the market in general is perhaps not so much on top of these developments, and if they see goodwill as having overpaid, then it is time to set the record straight.

IFRS 3 is the accounting standard governing the accounting for ”business combinations”, better known as acquisitions. The standard is a 120-page document which explains how the accounting should be done.

The key concept I want to highlight is that of ”allocating the cost … to the assets acquired and liabilities assumed”. One needs to contrast this with the valuations done when the decision was made to make the acquisition. It is important to understand that it is completely different as the valuations were done for completely different reasons and purposes.

When conducting a valuation to make a decision on a potential acquisition, it is necessary to consider the fit of the target in your current business; whether it gives you diversification or critical market share. It is necessary to consider all synergies from which it is believed you can profit with the acquisition or by combining the acquired company with your operations. You consider your own management and operational expertise that might be able to unlock more value from the operations of the acquired company, or how its management could complement yours.

When it comes to the accounting, you ignore all of these considerations because that is exactly what goodwill is, as intended by IFRS 3, and these factors should not be taken into account when valuing individual assets.

In terms of accounting, it is necessary to go down to the individual identifiable asset level and evaluate these as standalone, separate assets that will typically result in a lower total value than the enterprise value. As a result, goodwill makes up the rest of the purchase price. So the equipment, processing plant, shaft structure, perhaps specific areas or portions of the mineral resource, are valued separately as standalone assets and not together as a well-oiled unit.

The point is that goodwill represents the coming together of all these assets and making the whole worth a lot more than the sum of its parts.

There are two things with which it is worth taking issue; the first is the word ”goodwill”. This is probably an unfortunate word choice. The second is the problem that it is no longer permissible to amortise goodwill. In the mining industry, where operations do not have an indefinite lifespan, this is a problem. This means one can expect to see fairly regular impairments of goodwill in mining companies going forward; the market should not read such occurrences as evidence of problems, but rather should understand that this is merely the inevitable ”depletion” of some of the benefits the company saw when goodwill was initially recognised.

For example, a mining group with 20 operations may acquire another which has significant synergies with an existing site. Clearly, that synergy would be included in goodwill, and clearly it will have a finite life, as it will only have a benefit until one or both those operations close. Since it is not possible to amortise this goodwill, it will be necessary to impair it from time to time until it reaches zero at the time these operations close.

It is necessary that analysts and the market understand these very important issues and interpret them correctly. Goodwill in the mining industry is a valid concept.

”–Herbst is partner, industrial products, at Ernst & Young.

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