Understanding business models and the importance of capital allocation

Brandon Snow's picture

Two recent items were brought to my attention by our analyst Chris Lichtenheldt which reinforced the importance of capital allocation.

First, as the analyst who covers Franco Nevada (FNV), he highlighted that in 2007 FNV was spun out of Newmont Mining (NEM) with a market cap 5% of its size. While both companies are leveraged to the price of gold, which has been very volatile, their current market caps are now basically the same ($9.5 billion for NEM vs. $8.53 billion for FNV). While FNV has raised equity to fund investments since it went public, the cumulative relative underperformance of NEM is 89% (+265% vs -60%). This is due to both a superior business model and prudent capital allocation. We have been holding FNV for over a year now and are excited about the value it will create during this down-cycle.

The second amazing item that Chris brought to my attention was related to Cliff’s Natural Resources (CLF).  As many will recall, CLF purchased Consolidated Thompson (CLM on TSX) in 2011 for nearly $5 billion to get access to a high cost iron ore development in Northern Quebec. Purchasing an unproven asset at close to peak prices should give anyone pause, but the outcome here is worse than just overpaying. Last week, CLF announced it plans on closing the mine, with the new CEO calling the investment a “disaster” and highlighting the fact that the company did not make any money on the investment. To add insult to injury, CLF announced it could cost up to $700 million in closure costs.  CLF’s market cap today sits at just $1.25 billion.

The purpose of this discussion isn’t to pick on any specific company or industry, but to highlight how important the capital allocation decision making process is to value creation in the long term. The first step in analyzing an industry and company is, of course, to understand the operations and characteristics of the business itself. But what truly differentiates core versus non-core holdings is this separate piece. There are many things companies can and should do with cash flows they generate including pay a dividend, buyback stock, or invest in the business (organically or inorganically through mergers and acquisitions). At different times each could be the best use of capital. What we look for in a company is a management team and board of directors who have a clear and consistent philosophical approach to capital allocation, with shareholder value in mind. 


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