When two become one

Two recent share-swap mergers have one thing in common – a big balance sheet combined with strategic opportunities. A similar logic could easily be applied to BHP's tilt at Rio Tinto.

There is an interesting way to view the two big agreed share-swap mergers. In both the Zinifex/Oxiana and Incitec/Dyno Nobel deals a big balance sheet is being aligned with opportunities.

This is seen most clearly in the merger of Zinifex and Oxiana. After the sale of its smelter interests Zinifex has a big and heavily cashed-up balance sheet but limited prospects. It has one a key resource, the Century mine, with a lucrative but limited life. Oxiana has a lot of projects and prospects in the pipeline but would be stretched if it tried to pursue them all aggressively.

One dimension of that merger is that, in effect, Oxiana is making a massive placement, at a relatively modest discount (in the context of recent market volatility) to its pre-merger share price that will enable it to fund its project pipeline.

Alternatively, Zinifex could be said to be acquiring a portfolio of growth projects without paying the massive premiums that have become commonplace in the sector.

It is the strategic and financial fit that makes the nil-premium merger concept work conveniently around a 50:50 split – each company’s shareholders end up with the same exposure to the merged entity and its prospects. The logic was so compelling that neither side jeopardised a deal by trying to over-finesse the terms.

The Incitec merger with Dyno isn’t a pure scrip deal – about a quarter of the consideration will be cash – but the parties appear to have approached the merger discussions with a similar philosophy to their counterparts at Zinifex and Oxiana, even though the relativities were nowhere close to equal and Dyno will end up being subsumed into the far larger Incitec.

Incitec will pay a premium for that privilege, albeit not an excessive one. Using mainly scrip underscored the complementary nature of the two sets of operations and strategies and ensured it isn’t making a big bet on the commodity cycle.

Incitec is purely a domestic business with a strong balance sheet and a currency for expansion that had trebled over the past year. Dyno is a company with a strategic international presence and a portfolio of expansion opportunities that have been hobbled by massive costs blowouts at its Moronbah ammonium nitrate project in Queensland – a potentially very valuable vehicle for an assault on Orica’s regional dominance of that market.

There is an industrial logic to the deal – it brings strong secondary exposures, flowing from nitrogen-based chemical manufacturing to both hard and soft commodity markets. It is, however, the ability to bring Incitec’s financial strength next to Dyno’s international growth options – its ability to enter the markets it relinquished when the original Dyno was broken up by Orica in 2005 – as well as providing the financial capacity and scale to enable the merged group to more easily contemplate completing Moronbah.

Dyno’s share price, which has languished below its original float price for almost its entire listing period, meant it was constrained in raising large lumps of capital to accelerate its own ambitions. Incitec will solve that problem.

In the present market, where debt is expensive and there’s a lot of uncertainty and risk around, share-based marriages that have operational, financial and strategic logic are an attractive option, giving both sets of shareholders continuing exposure to the upside – and in the process limiting the premium that has to be paid by the larger partner.

Even within the buoyant resources sector, the sheer volatility of commodity prices and uncertainty about the economic outlook means that paying big cash premiums means someone takes on significant risk. For the bid vehicle that risk is over-paying; for the company being acquired the risk is that it sells the upside short.

The BHP Billiton pure share-swap bid for Rio Tinto was framed so that whatever the direction of the commodity cycle neither set of shareholders would be exposed to any more risk – or have their exposure to the upside materially reduced – relative to their position today.

Rio might argue that the 45 per cent premium on offer still doesn’t fully value the contribution it would make to the merger but it is no longer arguing as vigorously that the offer isn’t in the ballpark.

As with Zinifex/Oxiana and Incitec/Dyno the latent value that could be created by bringing complementary portfolios and balance sheets together is the core rationale for BHP’s bid, although in its case the logic is all operational and relates to the synergies, scale and portfolio resilience that the merger would generate.

Zinifex, Oxiano, Incitec and Dyno appear to have been as focused on the value and options their combinations could create, haggling for the last drop of advantage for their shareholders in the merged entities. At some point – particularly if the resources boom were to falter, although that isn’t a pre-condition – Rio might pressured by the market into doing the same.