Commodity Prices, Fortescue Metals

BHP/Alcoa, it’s just a hedge fund dream
It’s very easy for markets to get obsessed with a single short-term issue. The issue de jour in global markets is the collateral damage from the melt-down of the US sub-prime lending market.

Sub-prime is a headline grabber on “Wall st”, but the effect on “main st.” is minimal. As Fed Chairman Bernanke said last nigh there had been no spill-over into the prime mortgage market. All the super-bears will say “yet”, but at the end of the day “the biggest loser” in all this is hedge funds and the principal books of investment banks that have been left carrying the baby. Investment bank bonuses go out the door and Wall st gets upset, but 3 Billion Chindian’s don’t care about Wall St bonuses. Call me too optimistic, but losses by hedge funds and investment bank principal trading books, while spectacular and headline grabbing, really come in the “so what” category in my way of looking at things.

These losses do cause short-term volatility in all asset classes as these traders sell other in-the-money investments to fund the losses in their interest rate investments, but every time something like this has occurred it has been an excellent buying opportunity in the right long-duration equities.

We don’t claim to be sub-prime experts, actually my brother James at UBS London is, but we are psychology and market experts and we are certain you are seeing the crescendo of this sub-prime fall out.

With global equity markets basically trading at all-time highs sub-prime losses are simply another excuse to take profits. When profit taking occurs it occurs first in the stocks that have performed the best in the shorter-term and in an Australian context that is clearly the resource sector. Yet again, the trading market is making the fundamental error of mistaking resources with risk.

In our view resources remain the lowest risk sector of all. On all investment criteria resources are the outstanding value in the Australian market. However, every time some global macro or market concern comes along they get hit hard with profit taking. You must use this opportunity the market is providing you before the corporate world does.

The perfect resource storm continues

We believe the stars are aligned for the resource sector and the conditions are currently in place for a “perfect storm” over the next 12 months. The continuing strength of the global economy is providing very positive macro fundamentals. In addition the recent aggressive commodity upgrades are supporting a further earnings upgrade cycle. As a result the resource sector is currently reflecting a unique combination of value and growth. Consequently we believe the resource sector is on the cusp of a violent PE re-rating.

However, we believe this PE expansion will be supplemented by a massive increase in M&A and takeover activity. There is no doubt that resource P/Es have merely expanded in line with earnings, and in contrast to non-bank industrials, current earnings multiples are not reflecting any takeover premiums .In fact the current FY 08 resource sector PE is still just 11x which represents a 20% discount to the long term average. Consequently we think current valuations will support a massive consolidation of the global mining industry and the domestic sector will be at the forefront.

There is no doubt that the current global consolidation theme is all about scale. BHP initiated the process with the successful bid for Western Mining to access the massive resources of Olympic Dam which is truly a Tier 1 world class project. The rationalization of the Canadian nickel industry, with the Xstrata takeover of Falconbridge, and then the CVRD acquisition of Inco, was implemented with the clear aim of achieving a dominant industry position.

Xstrata is leading the global mining consolidation and clearly has further aspirations to become a major diversified miner. Xstrata’s aim is to build scale, diversity and the acquisition of long life assets. In global mining, bigger is most definitely better. Scale translates to a lower cost profile and improved production leverage. The result is a significant increase in pricing power and earnings growth. There is no doubt that the “stronger for longer” theme in the global mining industry has prompted a new mantra which is “bigger is better”.

RioTinto doing strategic back flips

The consolidation of the global alumina/aluminium industry began with the merger of Rusal and Usal, the major Russian producers. We believe the Alcoa bid for Alcan was directly prompted by the Russian merger, and Alcoa’s desire to regain the No 1 position in the global alumina refining industry. Alcan found a white knight in RIO, and now RIO is being de-rated for what was clearly a defensive move at a very full premium.

Interestingly, our direct feedback is that RIO Chairman Paul Skinner is getting a very lukewarm reception from domestic investors as he does the rounds explaining the 180 degree back flip the company has done strategically with this Alcan bid. It was clearly a defensive move and domestic RIO shareholders are not happy about it and likely to vote against the deal. RIO hasn’t bought anything of scale for 10 years and now they pay a massive multiple for Alcan, an asset we would consider just 1st tier. It all looks very, very defensive to us and we think RIO shareholders are right to be questioning the logic of the transaction.

RIO has basically missed the cycle. In a relative sense they have been completed outplayed by others such as Xstrata who have exploited the equity market discount arbitrage using debt. RIO’s balance sheet became an embarrassment (of riches), and as we have consistently written their capital management was far too timid. Then they started feeling the very warm breath of private equity and others on their neck as all long-duration under-geared companies do. They had to do something and do it quickly.

So they bid for Alcan at an unprecedented premium using cash yet many of the merger benefits go to the target (board seats etc). Using cash leads to a re-gearing of the company and effectively saw off the private equity threat. In one fell swoop they managed to wipe out any potential takeover of RIO and you can see why RIO shareholders are agitated. Their previously pristine balance sheet is now moderately geared, while the wonderful iron ore earnings stream is diluted with downstream Aluminium businesses. Again, you can see why RIO shareholders are agitated.

BHP/ Alcoa; we can’t make it work

UK hedge funds and vested interest investment banks are pushing the story that BHP Billiton (BHP) will now follow RIO’s lead and take out Alcoa. The BHP for Alcoa rumour has been around for the best part of 10 years, but every now and then when the hedge funds get excited they push the rumour very hard. Recently you can see hedge funds and traders have been aggressively shorting BHP and bidding up Alcoa on the expectation of a BHP bid at a substantial premium. BHP has fallen -7% from recent highs purely on the fact hedge funds believe they are about to bid for Alcoa.

The hedge funds and traders then spread a rumour into the financial press that BHP has appointed bankers to explore the deal, and before you know it the deal is considered a matter of “when” rather than “if”. The story is also helped by the fact incoming BHP CEO Marius Kloppers is considered more likely to be an aggressive M&A participant that his predecessor.

BHP under Chip Goodyear would probably also consider themselves (with the benefit of hindsight) a touch conservative through this cycle to date. However, they have been far more aggressive than RIO and clearly more of a true believer in the sustainability of the cycle than RIO. BHP did buy WMC while RIO didn’t even bid. BHP effectively stole WMC. BHP has invested heavily in the medium-term production growth profile (both greenfields and brownfields) and has a much stronger organic production growth profile than RIO. BHP’s net-debt-to-equity has consistently been higher than RIO’s through the cycle to date, while capital management has been far more aggressive.

BHP: it’s all about upstream

BHP’s strategy as far as we can tell is about being upstream in large scale, long mine life, high barrier to entry assets. They have been exiting fabrication and conversion businesses for the best part of a decade and it has been the right strategy. All the high margin and commodity price upside exposure is upstream. All the true pricing power and barriers to entry are upstream. All the ROE is upstream. BHP is an upstream company and we can’t see them suddenly changing strategic tact and heading downstream to “low margin land”.

Alcoa, an inferior business to Alcan

As the BHP bidding for Alcoa rumour gathered steam we decided to do some genuine research homework on Alcoa. We have spent a lot of time studying Alcoa and we have come to the conclusion that there is only one business inside Alcoa that BHP would want and it only represents 27% of earnings.

That business is the upstream Alumina business. That is a world-class business with extremely high EBIT margins and extremely high barriers to entry. It is a cashflow machine and it carries the entire Alcoa business, yet it’s only 27% of the asset base.

You have to ask yourself why BHP would bid for Alcoa at a premium to buy a single asset inside Alcoa? Why pay a premium to an already implied premium in the Alcoa share price for a single asset? Why take the disposal risk on the other 73% of the portfolio which is arguably over priced and vulnerable to swings in power prices and other input prices? This 73% are low barrier to entry and low margin.

The traders and rumour mongers argue BHP will bid with private equity for Alcoa. Again, we just don’t see this happening as the alumina business BHP would want is over-priced inside the broader Alcoa portfolio. There is also the complicating factor of the Alcoa/Alumina (AWC) relationship to consider. Again, why would BHP want AWC?

BHP will not “do a RIO”

One thing we are certain about the way BHP behave is that they have consistency of strategy and they execute to that strategy. They are not “flip floppers” and we strongly believe they are not going to be pressured by hedge funds, traders, and investment bankers into a transaction that makes very little strategic or financial sense. The ghosts of Magma Copper remain in the BHP closet.

Our long-held belief has been the expectation that a rationalization of the world’s base metal industry would eventually result in an oligopoly similar to the global dominance of the “big three” iron-ore producers. The three producers dominate seaborne iron-ore trade with over 70% of global production. Their dominant industry position promotes both financial and production discipline, generating higher returns through the cycle. We expect the iron-ore oligopoly will provide the template for global resource consolidation.

The logical extension of the current consolidation is the formation of global oligopolies in all the major commodity and base metal groups. We expect this concentration of power will result in 3-4 major producers controlling over 70% of global production in the industry groups. The result will be commodity prices remaining well above long-term averages and generating massive cash flows and windfall profits for the oligopoly companies.

We believe M&A activity and the current trend to global resource consolidation will intensify in the next 12 to 18 months. The time horizon might be shorter but the price action will be violent. There is no doubt that private equity will also play a significant role. In addition the Chinese are coming with $US1.1trillion in reserves in order to protect the security of long term production. The Russians are already here with the Norilsk bid for Lion-ore. Clearly the theme of current consolidation is scale and leverage and no company with a dominant industry position in a strategic commodity should be complacent.

BHP will NOT buy Alcoa

However, we believe the current market rumour of BHP bidding for Alcoa is wide of the mark for numerous fundamental reasons that we explain above. It would be a complete breach of BHP’s well established financial discipline and in our opinion they will not bid for an entire company when they are only potentially interested in 27% of the asset base. They simply will not do it in our opinion.

Buy BHP today from shorters

BHP shares shave been smashed by shorters on this misplaced (in our opinion) yet widely believed Alcoa rumour. This is ahead of a record profit to be reported in August and ahead of record dividends and further capital management being announced. They have also been somewhat effected by de-risking by hedge funds on US sub-prime issues which is truly ridiculous in the context of what drives BHP’s earnings (not the US).

BHP has been our best big cap recommendation over the last 4 years. We feel we understand the company and the financial strategy (discipline) well. BHP is an upstream company. BHP will remain an upstream company in our opinion. BHP remains the best buy in the top 20 and we strongly encourage you to take advantage of the current round of hedge fund shorting ahead of what will be tremendous profit numbers. Our medium-term BHP price target remains $44.00. Hedge funds should do themselves a favour and cut their long Alcoa positions and cover their BHP shorts before the world realises BHP will NOT move on Alcoa. We can’t see how being short BHP into a record profit result is a smart strategy either.

Go Australia.