Tags: Mining, Take Over

Three Ways to Profit From the Mining Sector's Takeover Boom

By , Money Morning •

By Martin Hutchinson
Contributing Editor

If you bought Rio Tinto PLC (RTP) following my recommendation in November's Money Map Report, you've made out quite nicely. The stock is up about 30% since my recommendation on the news of the $153 billion takeover bid by Australian minerals giant BHP-Billiton Ltd. (BHP). Now the question is: should you hold or buy, hoping for a higher bid, or should you step back?

The takeover bid, which initially valued Rio Tinto at $142 billion, offered three BHP shares for each Rio Tinto share. This would be only be moderately attractive, because you will still own shares in the combined entity, and would be subject to the inevitable post-merger difficulties. However, BHP has since been lining up a $70 billion credit line, which would be used to provide a cash alternative to the deal, making it potentially much more attractive. Indeed, as an added inducement, BHP is now promising shareholders it will mount a $30 billion stock-buyback campaign once the deal closes.

The combined entity would be the world's largest minerals-extraction company. And with BHP's offer, Rio Tinto has been "put in play," and so arbitrageurs have stepped in - hoping for a higher bid from a third part.

The Tricky Financial Algebra of a Minerals Company

There are some important differences between bids for mining companies and ordinary takeover bids. With a normal company, it is pretty easy to borrow money and leverage the deal, hoping to sell assets and generate cash flow from operations to pay down debt and return the merged company to a reasonable leverage ratio. Companies that make beer or soap powder, for example, have a very reliable demand-and-cost pattern that even the world's dimmest leveraged buyout artist can't destroy in the short run, so it's easy to borrow pretty well all the cost of a takeover and profit as debt is paid down. A recession, a cool summer or a sudden fashion shift to dirty, "grunge" closing can mess up your cash-flow forecasts, but not by much.

In minerals, this isn't true. Minerals are commodities. And we've all seen this year how the price of a commodity can zip up and down faster than a Duncan yo-yo, so minerals companies have to hoard cash as a reserve for soft periods, which can last a decade or more [Just look at gold, which languished at a painful $300-per-ounce nadir through all of the 1990s].

And even if prices rocket to stratospheric levels, demand can either:

  • Decline somewhat as a lower number of consumers grudgingly pay the higher prices.
  • Increase, as a flood of hedge-fund capital washes into the sector, as the "hedgies" hope to make a windfall profit from the increase.
  • Or can collapse altogether, as consumers find a cheaper substitute that meets t heir needs just as well.

Supply and costs can vary wildly, too, as new mineral supplies are discovered [For instance, this week's discovery of a modest new oilfield in Brazil has helped drop the price of crude oil by about $7 per barrel].

Who Can Play the Takeover Game?

What this all means is that it's very difficult to borrow huge sums in order to finance a minerals-company takeover. In flush times like the present, mid-sized mineral companies can be bought out with relative ease, because big companies with acquisitive aspirations have amassed massive war chests of cash and want to use that capital to make a big splash in their own markets. But the largest mineral companies, like Rio Tinto, are much less vulnerable, except through a share-for-share merger, because very few people have $142 billion in cash in their pocket available for a deal.

That's why the market is speculating that the new ogres of the global capital markets, the sovereign wealth funds, may be interested in Rio Tinto. After all, they have the cash in hand, and the need to invest it.

But I can tell you one player than won't be a buyer. China's foreign exchange reserves total $1.3 trillion, but its sovereign wealth fund, the China Investment Corp., set up a few months ago, has only $200 billion. And guess what? It has squandered about two thirds of it trying to bail out the hopelessly bad-debt-ridden Chinese banking system, devoting $130 billion to the cause of making Chinese bank balance sheets add up.

As hard as it is to believe, China can't afford Rio Tinto. With only $70 billion left in its state-run investment fund, China would have to create a new fund to make a run at Rio Tinto. And let me tell you this: The bad debt that remains in China's banking system could easily consume that cash, too.

The Way to Play the Minerals Market

So what's the bottom line? Well, Rio Tinto itself is a great company, but it's probably not worth buying it at a high price in the hope that you'll profit from an exciting takeover duel [the whole "Barbarians at the Gate" saga involving RJR-Nabisco comes to mind here].

BHP is a great company, too, but its earnings are likely to be horribly diluted if by some mischance it succeeds in getting Rio Tinto. There is brave talk by BHP of $3.7 billion worth of annual cost saving. And while the two firms most certainly have some duplicative operations, it's hard to believe they'll yield nearly $4 billion a year in savings in perpetuity. And when you look closely, $2 billion of the proposed savings is due to the group's ability to ship higher volumes of commodities - in other words, to gouge customers by establishing a monopoly or two. That's the typical brave talk of a big takeover deal, although history shows that it hardly ever materializes.

Minerals prices have backed off their highs, a bit, but if Federal Reserve Chairman Ben Bernanke cuts interest rates again, as Wall Street wants him to, mineral prices will zoom up and smash all previous records.

With those kind of odds, why roll the dice on a takeover play? Instead, try Brazil's Companhia Vale do Rio Doce (RIO). With the world's largest iron ore deposits, Companhia Vale do Rio Doce is still quite reasonably priced at 15 times earnings.
Or, since gold is the commodity most likely to enjoy a "buying panic" if interest rates are cut again and inflation fears reignite, try either the StreetTracks Gold exchange-traded fund (GLD), or an actual gold-mining company like Barrick Gold Corp. (ABX), which is trading at only 19 times leading earnings.

Just as heavy-metal music can ravage the eardrums long-term, heavy-metal takeovers can savage your wallet, and your investment portfolio.

But if you make the moves I've outlined here, you're likely to end up singing a sweet aria - all the way to the bank …

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