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Here’s why there are more mining collapses on the way

Resource shares

Fairfax media has reported that US investors are selling out of billions of dollars worth of bonds and loans because low iron ore and coal prices are making it increasingly unlikely they will ever be repaid.

According to Fairfax’s coverage, bonds issued by the miners Fortescue Metals Group Limited (ASX: FMG) and St Barbara Ltd (ASX: SBM), and mining services companies Ausdrill Limited (ASX: ASL) and Emeco Holdings Limited (ASX: EHL) are trading at discounts to par value as investors sell down their stakes.

While this is not immediately relevant to those companies ongoing operations, there are two major points of concern:

One, as investors wise up to the risks of not receiving the agreed repayments on their investment (thanks to companies lacking the cash flow to make repayments), it becomes more difficult for companies to raise additional funds.

With razor-thin margins in both the iron ore and mining services sector, a company with insufficient cash reserves and unable to raise additional debt could be knocked over by an unexpected financial shock. It also becomes more difficult to invest additional capital into the business; capital that may be required in order to improve competitiveness.

We saw this just recently with Fortescue Metals cancelling its $2.5 billion bond issue just one day after it was announced, as a result of US investors demanding higher rates of return to cover the additional risk.

(Motley Fool contributor Ryan Newman covers Fortescue’s bond issue in his excellent article here)

Two, and this is the critical one, bonds and many other financial instruments rank above shares in the priority of repayments from the division of assets after a bankruptcy.

If your company buckles under heavy debt, there’s a fair chance that, as an ordinary shareholder, you won’t receive anything for your shares.

With the mining services industry a buyer’s market, companies like Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) can demand, and receive, better terms from their construction contractors.

In fact, Rio Tinto told suppliers explicitly to tighten their belts in late January this year.

With iron ore and construction profit margins hindering cash flow (leading to a dwindling ability to repay debt), and the increasing reluctance of investors to issue more debt, I suspect that more company collapses are on the way.

Dodge the bullet by avoiding the resources sector entirely, and invest the Warren Buffett way – in companies with durable competitive advantages and prospects for long term growth.

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Motley Fool contributor Sean O'Neill owns shares in Rio Tinto Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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