The year 2011 involved a number of major quarry acquisitions that have created a great deal of interest from smaller quarry operators as to the value implications to their quarries.
Every quarry is unique, and even if one shares the same geology as another quarry, it is often located in different markets, and may have specific planning conditions or other licensing regulations imposed upon it which sets it apart, and so every individual quarry value needs to be assessed by itself. Most of the individual site circumstances are reflected in the quarry royalty, which for valuation purposes is multiplied by the estimated future output to form an annual income (derived from the actual profits or the rental), which is then capitalised over the life of the quarry.
This paper considers the application of capitalisation rates for quarry valuations, which is the main driver of the quarry income and, if wrongly applied, can produce significant over valuations.
MARKET EVIDENCE
The best way to assess the capitalisation rate for quarry valuations is to consider the market evidence of past transactions. Most of the major quarrying companies are listed either on the Australian Stock Exchange (ASX) or other international share markets, and due to the need for disclosure have to publish information on acquisitions within their annual reports or disclosure statements to the stock markets.
Consequently, many of the major quarry business sales in Australia of the last 10 years or so have been made public and many of the companies provide their opinion of the earnings multiplier for the transaction, which can be converted to establish the capitalisation rate derived. Coupled with this, there is additional information within the public domain that allows quarry valuers to decipher the details of each quarry transaction, in order to assess likely values for individual sites, which then allows the quarry royalties to be calculated for the transaction.
For the quarrying industry, the capitalisation rates have been broadly consistent over a number of years. Below are a range of capitalisation rate charts to illustrate the most recent trends in the market.
As with most long-term valuations it is usual to consider the long-term trend of capitalisation rates to best reflect the typical future trends.
CAPITALISATION RATES
Long-term trends
Figure 1 (see page 52) indicates that the long-term trend has involved an increase from 12 per cent to 13.4 per cent over the last 10 years or so, but has been generally consistent with the range of plus or minus two per cent of the trend. Alternatively you could take the average of all the transactions which equates to around 13 per cent. Therefore quarry sales transactions have generally not followed other property market trends, which up to the Global Financial Crisis (GFC) had all virtually showed shrinking yields and which following the GFC rose quite sharply and have perhaps in the last few years stabilised (but still at much higher levels than the pre-GFC scenario). So quite clearly there has never been any link or relationship to other property yields and the quarry industry operates in its own separate market.
The key thing to recognise for many quarry-related assets is that the greatest amount of risk is involved with the geology; sudden changes to the site?s geology can impact on the quality and types of products, and in turn their selling prices. However, the larger quarry companies tend to carry out extensive drilling programmes at most quarries in order to remove many of the geological risks. The other risk factors involve the fluctuating outputs of quarries, and in turn revenues, and again the major quarry companies can minimise these risks, with internal supply arrangements to their own pre-mixed concrete plant, asphalt plants, concrete products work and other similar operations.
Larger quarry companies with diversification benefits can absorb risk much better than smaller quarry companies who have a higher risk exposure to market fluctuations.
Post-GFC
Figure 2 considers the circumstances of the market post-GFC and shows the trend as dropping from 14 per cent to 12.8 per cent. This is a more accurate assessment of the market over this period, but more importantly is broadly in line with the more recent long-term trend of 13.4 per cent or the long-term industry average of 13 per cent.
Short-term trends
Figure 3 (see page 54) shows the trend over the last 18 months or so, which again shows a tightening from 13.2 per cent to 12.6 per cent. Again this appears to be consistent with the stabilising of the quarrying industry post- GFC, and indicates an average of 13 per cent which is broadly in line with the long-term trend figure of 13.4 per cent and confirms the long-term industry average of 13 per cent.
Conclusion of typical capitalisation rates
Both the long-term and short-term trends for capitalisation rates are typically within the range of 12 per cent to 14 per cent, with the current long-term average derived as 13.4 per cent, the long-term average of 13 per cent and the short term average of 12.7 per cent, and so an industry wide capitalisation rate of 13 per cent would generally be a well accepted benchmark for use as a starting point for assessment of any quarry valuation.
It should be notes that Figures 1 to 3 are for businesses sold as a going concern and we would expect these to have a lower risk due to existing goodwill and diversification benefits compared to a single entity. It should also be considered that the capitalisation rate adopted for the quarries would perhaps be lower for well located high output operations compared to remote low output operations. We believe that an independent quarry operator would warrant a similar capitalisation rate to those of the market as a whole. We would then make adjustments to reflect the local circumstances of the particular site.
Capitalisation rates quarry from former leased quarries
Capitalisation rates are also derived from quarry sales transactions which involve a lease, whereby the tenant has acquired the landlord?s interest to create a freehold interest. We have market evidence of several transactions for these type of sales, but many of the transactions tend to show slightly lower capitalisation rates as compared to business sales, and this can be due to under-assessed royalties, restrictive lease conditions, the negotiating strengths of the tenant, in that if the tenant does not obtain favourable terms, then they can continue with the lease instead, and a variety of other reasons.
For clarity we have also plotted our lease evidence from market sales to all of the charts, and interestingly the additional data has derived virtual horizontal trend lines over the longer and shorter term. However, there are some other notable differences between the capitalisation rates adopted for business sales as compared to lease evidence derived from a tenant acquiring the freehold, in that the business sales are based on the profits of the quarry operation, whilst the lease sales are based on the rental value of the royalty.
Therefore, it depends upon the purpose of the valuation as to which method of valuation the valuer would be using, which is typically either the Going Concern value, which is based on the actual quarry profits, or the asset value, which is based on the rental value of the quarry, with both methods then capitalising the profits or rentals over the life of the quarry.
Premiums and discounts
A premium is the term used for market sales transactions, where it is perceived that the purchaser has paid over and above the market value for a business. There are reasons why a quarry company may pay a premium. An existing competing quarry company may be prepared to pay a premium to gain market share, and they could also transfer their mineral production to the site, in effect significantly raising the site?s value by increasing the output. Alternatively, a new company to the market may pay a premium to enter the market.
There could also be synergies by incorporating the management of the business into their own business, but also there are often supply benefits for pre-mixed concrete plants, which can secure cement supplies controlled by the purchaser. Where an existing quarry business owner also will not sell, then often the purchaser has to offer a premium over and above the market value to entice them to sell.
A discount is the opposite of a premium, in that the quarry business owner is desiring to sell, while the quarry buyer is not necessarily in the market to buy, but if the sale is made attractive, by offering a discount to the perceived market value, then they would acquire the business.
In certain circumstances, the purchasers of quarry businesses can be considered to be ?special purchasers?, as due to them operating similar businesses in a given area, they can afford to pay premiums where an acquisition can benefit their existing business. Where you have a ?special purchaser? sale, then this is not considered to form the ?market value? based on the definition from the International Valuation Standards Committee and endorsed by the Australian Property Institute, and so the sale would then contain either a premium or discount, which in effect would be the difference between the actual purchase price and the market value.
ROGUE SALES AND OVER VALUATION
There is a notable difference between premiums and discounts and rogue sales, in that premiums and discounts are often quantifiable; the benefits can be easily identified and equated into a benefit to other parts of the purchaser?s business. However, for rogue sales, there are often no such benefits, in that the purchaser does not own any other operations where values can be transferred or synergies gained and it is merely an overpayment for a particular quarry business. There are a number of rogue sales in the market, whereby the purchasers of a quarry have paid well in excess of the perceived market value. These sales tend to involve ?new entrants? to the market, whose lack of experience and understanding of the mechanisms of the industry then makes it difficult for them to compete in the market and ultimately often ends up with the business failing a few years later. Many of these rogue sales are easily identified as existing quarry owners tend to quote them, as being comparable to their quarry, at the time of a valuation. But also capitalisation rates for rogue sales have been as low as six per cent, which nowhere near reflects the risks of the business. Many of these sales take several years to unfold, and typically go back on the market for over-inflated asking prices, until the financiers pull the plug on the business.
There are many instances of inexperienced quarry buyers convincing inexperienced valuers, who often act for major banks, that a purchase is viable, especially when they quote rogue sales as being the norm within a particular area or region. This often then adds to the problem, especially for the banks, who are completely unaware of the additional risks they are exposed to. However, this scenario has changed post-GFC, as banks have reduced their loan to values for quarry acquisitions or lending purposes, and new entrants to the quarry industry are no longer willing to risk a higher proportion of their own money; so there have been fewer rogue sales since the GFC. However there are still a number of past rogue sales where the banks have taken a larger slice of the risk and which may come to market at some point.
So the main drivers of over valuation tend to firstly involve the incorrect application of capitalisation rates which artificially inflate values, but do not reflect the actual risks of the business. If a purchaser has overpaid for a quarry business, then quite often the return on capital factors through to the selling prices of the products makes them uncompetitive compared to rival operators and in turn reduces the outputs and profits until such stage as the quarry business fails. The other main driver of over valuation involves the value in the ground methodology of a quarry resource, whereby quite often a quarry owner has been advised by a mineral investigation operator, who benefits by carrying out work for the owner, in that the more investigation work they do, the more valuable the resource. However this is often not the case, as it is the market demand that drives the value of a quarry business, and not the market supply. It is not just the quarry owners who are exposed to these risks but often the banks who are financing these operations and quite often they are unaware of the risks they have exposed themselves to until it is too late.
Roderick Stephens is a certified practising valuer. Email: rodstephens@optusnet.com.au