Australia | May 08 2007
By Greg Peel
Life must be pretty frustrating for stock analysts at the moment. With private equity buyouts raging across the market, traditional stock valuations start to look a bit meaningless. Who cares what the discounted cash flow is? What shareholders want to know is: will someone come in with a 30% premium bid?
Not that a decent price is necessarily enough, as Qantas (QAN) aspirants have learnt. But it seems that every day brings a new deal, across all sectors of the market – except one.
Traditionally, the mining sector has never been a popular haunt for private equity and leveraged buyouts. As a cyclical business, exposed to commodity price volatility, the usual strictures of internal rates of return and debt servicing through cash flow come into question. Private equity looks to time horizons of 3-5 years. It would not pay to pick up a copper company at the top of the copper price cycle.
To date, private equity buyouts in the Australian mining sector have been conspicuously absent. There have been public corporate takeovers and mergers, but not private, debt-backed assaults. Is the mining sector immune from LBOs?
Stock analysts are beginning to think not. And resources stock analysts have started to become sick of saying that two stocks in particular are cheap, cheap, cheap. They are, of course, BHP Billiton (BHP) and Rio Tinto (RIO). In the FNArena database, BHP shows a B/H/S rating of 7/3/0 and Rio 9/1/0. Average target prices are 15% and 13% respectively above Friday’s closing prices.
What’s more, resources analysts are becoming more and more convinced in the “super cycle”. There just does not appear to be any end to the China story, and the US economy does not look like melting down. While there is some supply catch up expected over the next year or so, commodity prices are not expected to do much else but continue to be strong into the foreseeable future. Whereas traditionally private equity may have shied away from “cyclical” miners, this particular cycle could yet last decades.
But a private takeover of BHP or Rio? You can’t be serious. BHP is capitalised at US$140 billion and Rio US$80 billion. They are the number one and three diversified miners on earth. Surely it can’t be possible.
Analysts have started to entertain the idea nevertheless. The deals, however, would not be fully private. They would involve the participation of another large listed mining company. What is actually possible is that either one of BHP and Rio could be involved in taking over the other.
Analysts at Merrill Lynch are not for a moment suggesting that private equity will take a swing at BHP. “The risks may be too great”, they say, “and the commitment for both debt and equity too large”. But this hasn’t stopped the analysts entertaining the idea. In fact, they’ve given it a great deal of thought.
What they have decided is that a private equity bid for BHP could indeed deliver attractive returns.
Merrill Lynch has calculated that BHP could generate an internal rate of return in excess of 30% over three years. Private equity usually requires 6-8% return over the highest debt cost, which equates to in excess of 20%. Merrills also suggest the sale of BHP’s Petroleum business could earn as much as US$25 billion in a short space of time. And private equity likes nothing better than to sell or spin a few things off.
If the market’s not prepared to pay up for the long term value of BHP’s assets, then maybe private equity will, says Merrills. And the analysts’ numbers are rather compelling. Were a consortium to pay a premium of 30% over 90-day VWAP, it would still deliver a sufficient return. (90-day volume-weighted average price is a standard benchmark used to pitch takeover premiums). BHP’s cash flows are ample to cover interest payments on required debt by a number of times.
That much debt would not be easy to raise, so Merrills has assumed a 30% equity component. This is still US$54 billion, which is about five times the size of the Qantas bid alone. Hence another major global miner would be a likely partner in a successful bid. Companies that come to mind are Xstrata, Anglo American, CVRD and, yes, Rio Tinto.
On an exit EBITDA multiple of 8-10x (in other words the price a consortium could sell for), Merrills calculates a potential three year IRR of 34-52%. On break-up valuation, the three year figure is 34%. All calculations are made using the analysts’ forward assumptions for commodity prices and the exchange rate.
If it wasn’t for a matter of sheer size, these sorts of numbers should really be a shoe-in for private equity, one would think. Considering BHP’s balance sheet strength, huge cash flow generation, undervalued petroleum business (based on recent transactions) and exposure to low-risk bulk commodities, the thought is clearly compelling. A buyer may also have the option, the analysts note, of forward selling some commodities on various exchanges.
But sheer size aside, what are other considerations that might render such a deal beyond the realms?
We have mentioned commodity price volatility, but there is also the small matter of lack of mining company expertise, notes Merrills. It is not just miners, engineers and geologists that have become thin on the ground since the commodity boom got going, it’s anyone experienced in the mining industry, particularly with the right sort of financing skills to put such a deal together. However, there are a few CEOs about to hit retirement…
Merrills also makes the point that – perhaps contrary to popular belief – private equity investors tend to be conservative. While there is obviously some hedge fund involvement in private equity funds, there is a significant proportion of pension fund, bank and insurer participation. Actual individuals average only around 7%. With the amount of debt required, this could hardly be seen as a conservative deal, even if the numbers do look good.
Is there enough money out there? Yes there is. The current “unspent” private equity pool is calculated to be around US$500 billion with US$200 billion being raised only last year. Add leverage, and that’s a lot of potential. However the largest individual private funds still only hold around US$20 billion and they don’t like to put any more than about 20% into any one deal. Diversity is the name of the game. Thus Merrills believes it would take five or six private equity funds, a number of investment banks, and at least one big miner looking for growth.
It would also be a deal employing double the amount of debt of the previous largest deal. That would be a lot for debt markets to handle.
And then of course there’s the Australian government. Sell BHP? It’s a bloody Aussie icon mate. Mind you, this government wasn’t too concerned about losing Qantas. But then why did Qantas fall down? Because the price wasn’t good enough? Because Macquarie Bank and co stood to make ridiculous amounts in fees? Or because mum and dad investors didn’t want grubby foreigners getting their hands on OUR airline?
More importantly, there would certainly be issues for competition watchdogs – around the globe. But this is probably only an issue in iron ore if CVRD or Rio were involved. However, it is a potential break-up of the world’s biggest diversified miner that may prove the greatest attraction. Merrills calculates, based on recent transaction benchmarks, reserve valuations, and a three-year exit earnings multiple of 8x, that BHP could generate US$201 billion in sales over three years. That’s a US$61 billion profit, give or take.
What is there to sell? The world’s biggest miner earns its billions on a split of 17% petroleum, 9% aluminium, 31% “base metals” (which is mostly copper but includes, strangely, uranium), 1% diamonds, 15% “stainless steel materials” (nickel), 15% iron ore (BHP is the world’s third largest sea-borne producer), 1% manganese, 7% metallurgical coal and 3% “energy” coal.
While there has been recent M&A activity within various commodity sectors allowing Merrills to pitch some sort of valuation benchmark, uranium is an interesting case. It is well known that BHP is locked into long term supply contracts, and is even struggling to deliver on those. Olympic Dam is, however, the world’s largest uranium resource, and the company plans to triple the size of production into the next decade. However, if one were to use the current uranium resource valuation based on the share price of Paladin Resources (PDN), Olympic Dam is alone worth US$220 billion!
So there you have it – in theory, it can be done. But it would be a big effort, involving a lot more than one Kohlberg Kravis Roberts and one Macquarie Bank, and requiring at least one other global mining giant with the inclination. Or perhaps the Chinese government?
And so what of Rio Tinto? If US$140m is just a bit out there perhaps US$80m is a better bet. Certainly Merrill Lynch considers that Rio is also a possible target, and Citigroup agrees. Says Citi:
“Rio Tinto’s strong cash flow and nominal gearing may bring it into the crosshairs of private equity…”
And that is exactly the formula that Merrills believes makes BHP attractive, but Citi analysts have decided that a “much more likely bidder” for Rio is, in fact, BHP alone.
Private equity notwithstanding, there are several other stand alone corporates who could perceivably find Rio an attractive proposition, Citi suggests, but there are drawbacks involved.
BP or Royal Dutch Shell are big enough, but they both exited metals & mining over the last couple of decades and are unlikely to be looking to get back in. (In fact, the Billiton in BHP Billiton is ex-Shell).
Xstrata and Anglo American are certainly potential candidates, but at US$50bn and US$80bn respectively would need to make large equity issues, as well as large debt deals, in order to pull it off. Furthermore, while both have significant operational presence in Australia, neither are listed here, and that would not go down well with the Australian government.
CVRD is the number two global mining company, and a worthy contender, except for the small problem of iron ore. CVRD is the world’s biggest producer of iron ore, and Rio is the second biggest, which means all sorts of antitrust problems.
Citi does not dismiss private equity, but as Merrills suggests with BHP, a private equity consortium would still need to include a major miner such as those above anyway.
That leaves BHP as the obvious contender. As BHP is an Aussie company, the government would be happy. The ACCC might still have issues in the areas of iron ore and coal, but these would not be insurmountable, Citi suggests.
In analysing a possible bid for Rio by BHP, the Citi analysts similarly assume a bid premium of 30%. They assume a 50/50 split of debt and equity scrip. They assume BHP could raise the debt at 6%. Although this figure looks relatively low, the analysts believe that is conservative. BHP is A+ rated and recently issued US$2.25bn in bonds at less than 5.5%.
But the big advantage in a BHP/Rio merger would be synergies.
Citi has assumed a synergy measure of US$500m which happened to be the saving figure in the original merger between BHP and Billiton. While this will stem from corporate/head office and operational synergies the analysts suggest it is not hard to envisage significantly higher levels due to BHP’s and Rio’s overlap of commodity and asset exposure.
In fact Citi can envisage potential synergies of US$500m in just the iron ore business alone.
The analysts have calculated, using these assumptions, that the deal would be 7% accretive in FY08 and FY09. Pushing the synergy assumption out to US$1bn would add another 2%.
A merging of the two iron ore businesses may cause some consternation across the globe. At the moment it’s CVRD #1, Rio #2 and BHP #3. Add BHP to Rio and the business is roughly the same as CVRD’s. There shouldn’t be a problem in the European market, as CVRD is far and away the biggest supplier already. The US market should be okay, because it sources a lot of domestic iron ore anyway.
The likely stumbling block would be Japan, where Rio and BHP battle it out as the #1 and #2 suppliers. As the annual iron ore price negotiation is an aggressive affair between supplier and buyer, one cannot see the Japanese being very comfortable with the idea. The question is, however, can the Japanese do anything to block a merger?
It is more likely, says Citi, that the result would simply be a souring of customer relations. But Japan is not in any position to turn elsewhere for its iron ore, as currently it is “scrambling for every tonne it can get”. It would only be a problem if the iron ore supply/demand balance settled down once more. Perhaps, suggests Citi, BHP could appease the Japanese by offering minority stakes in the business – something they have been after for a while.
Thermal coal is another area of dispute, given a combined entity would also move into the #1 spot in world supply of that commodity. But BHP presently supplies the Atlantic region and Rio the Asia Pacific, notes Citi, so it should be okay.
All in all, the deal looks a reasonable possibility.
So should the market expect a move on either company by the other, or by private equity, or both, anytime soon? Not particularly. The analysts have really just gone through the exercise as a matter of interest. But that doesn’t mean it won’t happen.
Such mega-deals are not without precedent, as in the morning of this article going to print the market has learnt of a hostile takeover bid in the aluminium market from Alcoa over Alcan. At US$33bn it is not quite in the same league, but significant nevertheless.
Coming back down the scale, the fact that analysts are entertaining the idea of takeovers of the two biggest players in the market does not preclude smaller mining companies. One of the fundamental assumptions here is that commodity prices will remain strong for some time yet, and that this could alleviate traditional private equity fears of commodity cycles and volatility. Hence any diversified miner could yet be a target.