How can investors benefit from mining sector mergers?

MoneyWeek article: Soaring commodity prices have left the mining industry awash with cash, encouraging firms to join in with the mergers and acquisitions boom that has set the rest of the equity markets alight. But who will be next to enter the consolidation race? And should investors target bidders or targets?

By Graham Buck

published 21 December 2006

in Features

Soaring commodity prices have left the mining industry awash with cash, encouraging firms to join in with the mergers and acquisitions boom that has set the rest of the equity markets alight. This week saw US group Freeport-McMoRan Copper & Gold (NYSE:FCX) buy Phelps Dodge (NYSE: PD) for $25.9bn in a deal that will see Freeport overtake BHP Billiton (ASX:BHP) as the world's largest publicly traded copper producer, with combined annual revenue of $16.6bn (although Grupo Mexico may yet pitch in with a rival bid).

It's an abrupt change of status for Phelps Dodge; less than six months ago, the company was a potential predator in a protracted six-way bidding fight for control of Canadian nickel producers Falconbridge and Inco (NTC:INCLF). It offered $40bn for control of both firms, but was thwarted by the deeper pockets of its rivals. Swiss mining group Xstrata (LON:XTA) took Falconbridge, while Brazil's CVRD picked up Inco. Ever since then, Phelps Dodge has been a sitting duck, with either Freeport or Grupo Mexico expected to pounce at any time.

But these mega-deals and a host of smaller ones will have barely had an impact on the scope for further consolidation. As the FT's Lex observes, the industry has generated almost $50bn in free cash flow since 2000 and is struggling to spend it. For example, Morgan Stanley analysts forecast that BHP Billiton, the world's biggest miner, will have operating cash flow of $10.8bn for 2006, says Jim Jubak on MSNMoney.com, comfortably exceeding outgoings of $5.4bn for capital spending, $2bn for dividends and $1.7bn for buybacks. BHP's excess cash flow is likely to reach $4bn in 2007, $10.4bn in 2008 and a huge $33.4bn by 2010. The obvious choice, given strong commodity prices, is to invest in new mines but a scarcity of manpower and equipment poses a problem. That points to one thing: growth through acquisitions. Buy, or risk being bought is the maxim, says Chris Tinker, equity strategist at ICAP: "The mining sector stocks have all got so much cash on their balance sheets there is a risk they are getting vulnerable." Phelps Dodge's fate demonstrates the truth of

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But which group could be the next bid target? Even Anglo American (LON:AAL), the world's second-biggest mining group, is not immune to speculation after South Africa's Oppenheimer family, the group's founder, sold one third of its stake to Chinese billionaire Larry Yung. Reports suggest JP Morgan is attempting to assemble a bid and has been talking to potential partners, who include BHP Billiton's former CEO, Brian Gilbertson. Perhaps more plausibly, platinum producer Lonmin (LON:LMI) has long been viewed as a potential candidate. Recent reports suggest Barrick Gold, which already has South African platinum interests as a result of buying Placer Dome last year, is keen. Newmont Mining is also said to be interested, along with Russian and Chinese producers, or possibly a private-equity bidder.

Two weeks ago, bid speculation briefly pushed Lonmin (LMI, 2980p) up 5% in one day to 3,247p on reports of interest from Barrick and Newmont. On a forward p/e of 13.9 and a dividend yield of 2.1%, it's not cheap for its sector, but has much going for it, even if a bid doesn't materialise. The outlook for platinum is bullish, and Lonmin is the lowest-cost platinum producer, say analysts at Morgan Stanley; they recently upped their price target on the firm from 4,000p to to 4,200p. Lonmin's purchase of Canadian miner AfriOre for C$500m has been generally well received by analysts.

Australia's Newcrest Mining (NCM, A$23), the world's seventh-largest gold miner by reserves, is another long-mooted takeover candidate. While possible suitors GoldCorp and Barrick have recently made big acquisitions, and so may have taken themselves out of any contest, a bid by Newmont still seems likely. However, if takeover speculation comes to nothing, there's considerable upside in the firm as a turnaround play. Newcrest has an excellent set of assets, but has struggled in recent years with frequent profits downgrades and problems at its Telfer mine. However, new chief executive Ian Smith seems to be setting things right and shares are beginning to rerate in response. Gold miners trade on much higher p/es than other miners, but at 29 times for financial year 2006/2007 and 18.5 times for financial year 2007/2008, Newcrest looks a decent buy for gold bulls.

Graham has spent the past three years as a cash management editor at Deutsche Bank. Graham started off as a Risk Management Professional editor at Perspective Publishing for two years, then became a writer at The Treasurer for 5 years and then an editor at gtnews.com for 5 years. He then freelanced for 5 years where he reported on corporate treasury issues, risk management, insurance/reinsurance and pensions. Graham has a degree in English Literature from the University of Bristol and he has contributed to MoneyWeek’s share tips.