M&A Won't Go Away

The Allco bid for Baycorp has put the cat among the pigeons. Although a widespread private equity driven merger and acquisition (M&A) cycle is unlikely to break out (as some think), I do believe a private equity presence will force some M&A among listed companies. Listed sector balance sheets are in great shape, and you will see the corporate world move to lock in low interest rates via acquisition.

Cross-media here we come

Remember, it's never the pretty ones that get taken over. It's the "branded laggards", and the domestic media sector remains primed for widespread M&A activity. WIN TV is trying to give the biggest hint possible by accumulating 8 per cent of Ten Network (TEN); and, while the sector continues to underperform on valid margin pressure concerns, the opportunity should be taken to pick up strategic domestic media assets.

Now that the Federal Government has control of the Senate, more strategic stakes in listed media assets will be bought on-market. The Fairfax (FXJ) register is wide open. The stock has been a dreadful underperformer for three years, the group is CEO-less and directors are leaving. It looks a stock absolutely ripe for a carve-up of some kind.

De-risking of resources

Clearly, the mid-cap resource sector is ripe for more consolidation. The balance sheets have never been in better shape, the free-cash generation has never been better, yet, despite this, the average price/earnings (P/E) ratio remains 6-8.

The debt-free nature of most resource sector balance sheets is a huge development. It reduces the overall "risk" within the sector. In previous commodity cycles, resource companies have geared up to fund expansions to take advantage of higher commodity prices only to see commodity prices collapse and their interest bills go through the roof. Previously, there were companies with the dangerous combination of commodity price leverage and financial leverage. In the down cycle, the weight of both was too much for some. It was a clear boom-bust cycle.

Pasminco was a casualty due to a nasty combination of leverage and inappropriate hedging. The reborn PAS, Zinifex, has no debt or hedging, yet, on our numbers, the stock trades on a p/e of 4 on next year's earnings. Why? Because investors have long memories. But they aren't comparing apples with apples. Sure, they are the same assets, but now they don't have financial leverage.

The chart below is of mid-cap mining stock gearing ratios (net debt to equity):

The 2005-06 P/E chart for mid-cap miners is a reminder that these earnings are set off our 2005-06 commodity price estimates, which we acknowledge are clearly drafted in anticipation of positive revision:

Portman Mining (PMM) has no debt and trades on a P/E of 4. Surprise, surprise, it has been subject to two takeover bids, one from CSM and one from Cleveland Cliffs. On our numbers, either would get its entire investment back, funded out of earnings, within four years.

The question is, who next? You will not see these mid-cap companies with long-duration assets continue to trade on such low forward multiples, and debt-free, for long.

A consortium has bought a stake in Iluka Resources (ILU) and, on the multiples, there should be no doubt that Zinifex (ZFX) must be in the crosshair of a global corporate. Like the PMM example, the entire outlay will be back in four years. Somebody is going to take advantage of that.

The registers are so wide open there might not be a mid-cap resource sector in a couple of years. Many people tell me, "Charlie. the P/E ratios are meant to contract at the top of a cycle". There's just one problem with that argument: it isn't the top of the cycle!

Investors and brokers think it's the top of the commodity cycle, as implied by low forward p/e ratios and earnings forecasts, but the corporate world does not, and nor do futures traders.

And it is not just metal stocks where there is potential for M&A activity. It is the oil and gas sector, too. WTI Oil hit another high, $62.50, over the weekend, and there remains a very large arbitrage between what the equity market is discounting ($42 a barrel) and what NYMEX Futures traders are pricing right out to 2010.

CNOOC (The Chinese resources giant that recently made an unsuccesful bid for the US resource company, Unocal) is coming to the Australian oil and gas sector. It, or any other foreign government, will never be allowed to buy Woodside (WPL); but pretty much everything else is likely to be fair game.

This arbitrage will not persist in the medium term, so take advantage of it before the global and domestic large-cap oil players. With nobody having real exploration success, cash is burning a hole in pockets. The answer is to buy production '” and it can be done very cheaply in the Australian oil and gas sector.

Our no. 1 overweight recommendation remains the energy sector: underestimated earnings, underestimated cashflows, underestimated balance sheets, underestimated political stability and underestimated M&A potential.

Go Australia.