Resources M&A: it's just beginning

Well, all hell broke lose in resources the day after I flew out of Australia a fortnight ago. By the time I arrived in London, market rumours surrounding the future of Rio Tinto had reached fever pitch, while my support for Fortescue Metals lit a bonfire under Fortescue’s share price and again had all the non-believers scratching their heads. Alcoa also lobbed a bid for Alcan, which added fuel to the fire.

Although some of the speculative heat has come out of the sector after BHP Billiton and Rio denied merger plans, the simple fact remains that what we have witnessed over the past two weeks was a trading "dress rehearsal" for the next 12 months, as the global resource M&A cycle accelerates. The resource market showed you how it would respond to large scale M&A, and it showed you that the "next generation" would get huge trading support. Rio went up 20% then down 10%, yet Fortescue rose 60% and then lost 10%.

I have been consistently positive on commodity prices and constantly bullish on the fundamentals for resource companies since the start of the current cycle. In fact, at regular intervals when the consensus view invariably turned negative, I have remained firmly committed to the commodity super cycle theme. I see absolutely no evidence suggesting a change to that positive view. If anything, I believe there is more and more evidence that the 100-year bear market in commodities is ending.

This strong view has been based on the expectation of a structural change in the long-term demand/supply fundamentals. The massive increase in demand, from the industrialisation of China, has occurred against a backdrop of continuing capacity constraints due to decades of underinvestment in future production. Only with significantly and sustained higher metal prices can new investment in production be justified on return on capital invested (ROCI) measures.

At the same time, base metal inventories are at dangerously low historic levels, and there are critical shortages of skilled labour, machinery and equipment. The result is continuing delays in the supply response, and an extension of the cycle. I believe the current conditions will last for another two decades, albeit with the expected shorter-term volatility.

In addition, I have always believed that the company-changing cash flows, driven by higher for longer commodity prices, would inevitably result in significantly higher dividend yields. Consequently, my belief is that the major resource stocks will experience an expansion in price/earnings (P/E) multiples similar to the re-rating for the domestic banks over the past decade.

This will not happen overnight, but it will happen, and you will get a taste of it at the August reporting season. My biggest long-term strategic call is that resources stocks will experience P/E expansion once they pay similar dividend yields to banks. Ask yourself: how does Telstra command a 50% P/E premium to BHP in a commodity super cycle? It's all about dividend yield multiples: that's how the Australian equity market is priced.

Resource companies have experienced virtually no P/E expansion this cycle, except for those that have paid out significantly higher dividend yields, such as Jubilee Mines and Minara Resources. In fact, share prices have basically expanded in line with earnings. This is in total contrast to previous cycles, in which resource multiples have expanded aggressively. Consequently, resources are currently trading at 10 times 2007-08 earnings compared to the long-term sector average of 14 times earnings.

Takeover multiples

In contrast, the majority of big-cap, non-bank industrials are trading at 19–20 times’ earnings. This is well in excess of the long-term average of 15.5 times. In addition; industrial earnings growth is slowing, with the past two months revealing negative revisions for non-bank industrials. There is little doubt that the influence of private equity has played a major role in this significant non-bank industrial P/E expansion ahead of earnings.

Additionally, it appears that creative arithmetic, where 1 plus 1 equals 2.5, is making a comeback. This miraculous event happens where shareholder value is instantly created by the repackaging of exiting assets such as the recent demergers by Toll Holdings (TOL) and Publishing and Broadcasting (PBL).

As a result, the big-cap, non-bank industrials are currently trading at similar multiples to the historic highs preceding the 1987 crash, and at the height of the dotcom boom. It seems highly leveraged private equity takeover multiples are being increasingly capitalised into valuation assumptions, and I am struggling to find value in large-cap, non-bank industrials.

In contrast, I think the domestic resource sector offers the best risk-adjusted value in the Australian market – perhaps in the equity world. There is inherent value in resources. Where there is value there is opportunity. I smell a big opportunity to generate outperformance in the resource sector, compared to the broader non-bank industrial market, where investment themes are narrowing and P/Es are stretched.

Ironically, the catalyst for an expected P/E expansion in resources may not be earnings, but a significant increase in M&A activity. Clearly investors are happy to rerate industrials on the prospect of further private equity takeovers. The bears will argue with me, but there's no takeover premium built into the Australian resource sector.

There has been ongoing global mining M&A activity and industry consolidation since BHP initiated the process with the takeover of Western Mining in August 2005.However, in the past two years the pace of industry consolidation has significantly increased.

It has largely been driven by the aggressive aspirations of Xstrata to become a major global diversified miner. Incredibly, in the five years since Mick Davis became CEO in 2002, Xstrata's market cap has risen from just under a $US1 billion to a massive $US51 billion.

I think the potential consolidation of the domestic industry has been accelerated with the aggressive actions of Xstrata in overbidding Norilsk by 16% (at $C25) in the LionOre (LIM) takeover battle. (Norilsk has now countered with a higher offer delivered this morning, May 25, of $C27.50).

LionOre is the last of the few significant nickel producers remaining after the rationalisation of the Canadian industry. The equity market priced it at $17, the corporate market is pricing it at $30 and the bidding hasn't finished. It may well end up that the takeover premium is 100%. This bidding war for LionOre is telling you where the nickel insiders believe the nickel price is going.

LionOre said this week it had an unprecedented cash balance of $US643.4 million at the end of March, after a record quarterly profit of $148.3 million. Incredibly, ex-hedging the profit would have been $US235.8 million. This represents the big prize for the successful bidder.

The Australian nickel industry is still highly fragmented and the global majors are coming to Australia with big balance sheets and massive cash reserves. The aggressive bidding war for LionOre underpins our view that the price action will surprise on the upside.

Aluminium mergers

The consolidation of the alumina/aluminium industry is currently under way with Alcoa's recent bid for Alcan. Alcoa and Alumina (AWC) through the AWAC joint venture 23% of global alumina production and 11% of aluminium. AWAC recently surrendered its leading industry position after the recent merger of the two largest Russian producers Rusal and Sual.

Subsequently Alcoa is attempting to reclaim the number one position with the proposed merger with Alcan, and additionally as a defensive tactic against a takeover.

I think the ultimate aim of the current industry consolidation is to build an oligopoly position with the aim of breaking the current alumina/aluminium pricing mechanism.

Copper next?

The first signs of a similar consolidation have already begun in the global copper industry with the recent merger of US producers Freeport McMoran and Phelps Dodge. Subsequently, Freeport has become the world's second largest copper producer with 9% market share behind Codelco, the global leader with 12% market share.

However, the global copper market is still very fragmented. As a result, I think the global mining consolidation is highly likely to continue in the major copper producers.

Scale and long life assets

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. This is what everyone misses in the Fortescue story; scale. (For more on Fortescue, see Tim Treadgold's lead feature today. It's worth remembering that Fortescue will be the world's only large-scale pure play on iron ore, and I urge investors to start taking this company seriously, particularly before it gets a significant ASX 200 index upweight in July. James Packer has been to see the Fortescue assets, have you?

Steel

Unsurprisingly, the rationalisation of the global steel industry is also acting as a catalyst for the increasing pace of global mining consolidation. The Indian steel maker Mittal Steel has led the rationalisation with a tidal wave of mergers, and is now the world's largest producer with a 10% market share, after recently acquiring Arcelor, the largest producer in Europe.

Mittal is also leading a drive for vertical integration by steel makers to reduce their exposure to spiralling raw material input costs by securing coal and iron-ore capacity. Mittal has already announced the intention to significantly lift its self-sufficiency in raw materials given bulk commodity costs have approximately doubled in the past four years.

I expect a further rise in contract iron-ore prices next year due to continuing strong demand/supply fundamentals. Additionally, the Indian Government has already imposed a 6.5% export tax on iron-ore in attempt to meet surging internal demand. The result has been a 40% increase in iron ore spot prices, representing a 25% premium over the contract price.

As a result, Mittal is targeting 50% increases in coal and iron-ore production by 2010.

This will further exacerbate the global mining consolidation, increasing the premium paid for resource companies with low-cost, long-life products I think there is a real possibility that Mittal and another steel maker will bid for a major iron-ore and a coal producer.

The logical extension of the current consolidation is the formation of global oligopolies in all the major commodity and base metal groups. I expect this concentration of power will result in three or four major producers controlling more than 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.

Top five

Currently the top five companies control more than half the production in the majority of the main bulk commodity and base metal groups. The exceptions are coking coal, where the top five producers control about half of global production; and the copper and zinc markets, which remain relatively fragmented.

The top five producers control just under 40% of global copper production; Codelco, the industry leader, has 13%. In the zinc market, the top five producers account for just 26% of the world production, with Zinifex the second-largest with 5%. As a result, I expect these two commodity groups will be a focus of industry consolidation. However, any top five global producer, in any commodity or strategic industry group, remains highly vulnerable.

No one is safe

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, and no company should feel complacent about their position. That includes BHP Billiton (BHP), which could become a break-up target. There should be no doubt that BHP is worth significantly more in pieces, but of course I would hate to see that happen.

In the same context of the current takeovers, the trend will be driven by the pursuit of scale, diversity of production and pricing power. I expect the end result will be the formation of global diversified mining oligopolies comprising three or four companies, representing all the major base metal and bulk materials groups. I expect this to result in a massive P/E re-rating for the remaining mining companies.

Is your portfolio set for that eventuality? If it's not, I believe you are making a big mistake. Outside the majors, I continue to recommend Fortescue, Oxiana, Minara, Western Areas, Consolidated Minerals, Kagara Zinc, CBH Resources, and Iluka. All eight will either be taken over or genuinely re-rated over the next two years. The national interest is clearly served by these companies and their cash flows remaining Australian controlled, so we either need to price them appropriately, or be happy for them to go to offshore predators.

BIG, BIG, dividends are coming from the Australian resource sector this reporting season, and YES, you now do buy resource stocks for dividend yield.