Why BHP will not buy Alcoa

It’s not often you fly all the way to London for just 48 hours, but when you are raising capital for the next generation of leading Australian resource companies you have to go the world’s new financial capital, London.
The increasing influence of London as the home of risk capital is reflected in my own passport. This year alone I have been to London four times. Everyone one of those trips was to broke next generation Australian investment ideas to UK hedge and pensions funds. Every time I go our schedules get longer and longer, and it seems the interest in “Chindia” and Australian resource stocks gets exponentially larger as each month passes.

While it’s all very bull market and jet-setty to find yourself in London every few months, the most disappointing aspect for me as an Australian is why do we have to go to London to find risk capital for Australian resource companies when we should be using Australian superannuation to fund these projects? Look at the photo above, we even had to call on the House of Lords!

Why don’t we believe?

No offence intended to our highly supportive UK friends, but you shouldn’t be even getting a look in at these deals. Australia has legislated growth capital in the form of compulsory superannuation and the Future Fund, and it’s Australian’s who should be funding and profiting from the success of these next generation resource companies.

The common complaint from all next generation resource company management teams that I speak to is that they are disappointed by the lack of Australian institutional support for their company. Look at Oxiana (OXR) for example. Here is an A$6bil market cap company with no substantial Australian shareholder. What does OXR have to do to get proper domestic institutional support?

Of course, the company ourselves and JP Morgan are currently raising capital for , Fortescue Metals Group (FMG), has basically no Australian institutional shareholder of any note other than some index funds. We are hoping to change that during the current bookbuild process. Once domestic institutional investors realise this will be the last decent scale equity capital raising from FMG they will most likely come onto the register.

Paladin Resources (PDN) is another one. Here is an A$5bil market cap pure play on uranium that no Australian institution is a substantial shareholder in. So between OXR, FMG and PDN there is A$20bil of next generation leading resource company with no real Australian institutional ownership. The question has to be asked “why won’t we back our own?”

UK, European, Asian, and American institutions have backed these companies but Australian institutions haven’t until this point. Australians own the big boys in BHP and RIO, yet they are nowhere to be seen on the next generation registers. The point I am making is that when OXR, FMG, and PDN are all spinning off huge cashflows and dividends over the next few years the vast bulk of that cashflow will be lining the pockets of foreign investors, not domestic superannuants.

If you take the risk you get rewarded, but it genuinely disappoints me that we seem to broadly lack the vision in this country to back our own next generation resource companies. We’ll back just about any industrial company with a hair-brained scheme (i.e. the tech boom), but when it comes to resources just about the only stock we feel comfortable with is BHP. Well, we recommend BHP too, as hard as anyone as you know, but the scenario we believe in sees structural change in commodity pricing, P/E’s rising across the sector to reflect this, and dividend yields rising to match the bank sector through time. Under that scenario you must be exposed to more than just BHP.

Hunted becomes hunter

While we were in London RIO bid for Alcan at a price most people though was aggressive and that set the metals sector globally alight. The market reacted correctly because RIO has previously been a very conservative company and they have suddenly changed tact and become a consolidator.

Clearly RIO has known for some time they were being hunted. The classic corporate response of the hunted is to become the hunter. RIO bidding for Alcan almost ensures that the hunter of RIO now has to reconsider their position. Perhaps RIO shareholders would have liked a bidding war for RIO, but they may have to wait a little while for that to occur now.

The global metals cartel

You can see that a global “metals cartel” is forming. There is just cash bid after cash bid for trophy assets because it remains cheaper to buy existing production from the still disbelieving equity market than build greenfields projects (with a few exceptions). By the end of all this there will be 5 giant diversified mining houses. BHP, RIO, CVRD, Anglo-American, and Xstrata. It will be very similar to the oil majors, and we have all see the effect of industry consolidation on the oil price.

The consolidation of supply into fewer hands will lead to structural change in commodity pricing. It is as simple as that. These 5 companies will control supply and control pricing. Commodity producers will possess pricing power due to consolidation, and that pricing power will lead to long-term ROE and profit growth. Long-term ROE and profit growth will lead to P/E expansion once the world realises these companies are dramatically less cyclical than in previous cycles.

The play book is clearly iron ore. Look at the pricing power the iron ore major’s possess. There is absolutely nothing cyclical or commoditised about the seaborne iron ore market in my opinion. The 3 major players basically set the price and control the vast bulk of new supply. It’s the cosiest of oligopolies and it’s led to BHP and RIO having the best profit to sales ratios of any Fortune 500 companies. Iron ore is the best business in the world once you are in the oligopoly.

I just get the feeling that all this consolidation in base metal producers is going to lead to metals eventually being priced on annual contracts similar to how iron ore is price. I think you will eventually see very small spot markets in base metals and very large contract markets. We have had this view for many years and we genuinely think this is the way metal pricing is heading in the medium term.

P/E’s must expand to reflect pricing power

All this global consolidation must lead to P/E expansion. The market was right in sending up just about every resource stock 5% on the RIO/Alcan news. The long-term assumptions RIO must be using to justify the price it is paying for Alcan are dramatically higher than those broking analysts are prepared to use. That’s why the market slammed RIO shares because “they were taking a big risk”. Rubbish, the long-term commodity price forecasts RIO are using to justify buying Alcan will prove conservative. When will the broking community wake up and realise that the commodity prices of last century are not the commodity prices of this century?

This rear-view mirror forecasting is just ridiculous. The one thing that came up in every meeting in London was just how inaccurate commodity price forecasting had been from the major broking houses. This “Chindian” led structural change in commodity prices is the biggest event of the next two decades, but there’s still not a single medium-term commodity price forecast above any current spot price. You are considered a “bullish” commodity analyst if you only see commodity prices falling -30% from current spot over the next 12 months. It’ a joke. Do yourself a favour and throw all broker commodity price research in the bin. That commodity research is the most likely research to cost you money and performance of all the research out there.

Where is the supply response?

I believe this woeful commodity price forecasting (or backcasting) by the major global broking firms is one clear reason (excuse) why Australian institutional investors have broadly missed being exposed to next generation resource stocks. If you used “consensus” commodity price forecasts for the next 5 years and jammed them in a next generation resource company model you simply couldn’t make the investment case stack up. If anything, most would look like outright overpriced sells.

2 years ago consensus was for the nickel price to be US$6.00lb, copper US$1.20lb, WTI Oil US$50.00bbl and Zinc 80clb by now. Iron ore prices were also mean to be -40% lower as the “supply response” rolled in. Here we are today and nickel is US$18.00lb, Copper US$3.60lb, WTI Oil US$73.00bbl and Zinc $1.50lb. Iron ore prices will rise another 25% in March.

Sure, the Australian Dollar is significantly higher than forecast 2 years ago, but the 20% it has rallied only marginally offsets the commodity price moves. The point is that commodity price forecasting has been appalling, absolutely appalling. You would never have bought a single resource stock if you had believed consensus commodity price forecasts and you would have missed anything form 200% to 1000% gains in the underlying leveraged equities.

Here we are again and I don’t think anything has changed. There is still a massive arbitrage between consensus forecasts and likely reality, and as long as that arbitrage exists we will continue to aggressive recommend resource stocks of all market caps.

Cash bids; sector scrip is shrinking

Yet when you think about it the sector is shrinking in investable size. Just about all the major mergers and takeovers have been cash. Cash taking out scrip permanently, and also competing with companies buying back scrip. There is hardly any issuance and that must lead to a re-rating of what is left.

As we did the rounds in London with FMG the audience was big because, as we were repeatedly told, “you are the only large scale company issuing scrip in a politically stable operating environment”

This was a very good point. The investors we saw told us most recent capital raising roadshows through London in the global resource sector were basically for “venture capital” to finance projects in far flung places like Cameroon for example. As a couple of investors said to us “ an iron ore project in Australia located between BHP and RIO’s operations is way down the risk curve compared to what we have been shown lately”.

With the notable exception of FMG, there is a complete lack of scrip being issued by companies in politically stable operating environments. Clearly, Rusal is listing in London, and that’s a big scale deal, but it comes with associated Russian political risk.

Political stability premium

These conversations with UK investors reinforced to me that Australian resource stocks should command a substantial political stability premium to the rest of the resource world. If the world is now headed to Russia and deepest Africa for the “supply response” then that says to me existing production in Australia is worth a substantial P/E premium to the global market for political stability alone. Add in proximity to markets, quality of management and quality of balance sheets, and our resource companies deserve to be the highest rated in the world.

1^st class syndrome

Anyone who owns Qantas will like this story. The FMG roadshow to London had been organised for some time. However, being a disorganised stockbroker I had left booking my ticket a little late. The week before last I started trying to book myself a single return ticket to London. I was thinking QAN fly 47 times a week to London this will be a piece of cake. Incorrect. There was not a single ticket on any class in QAN either way. They were fully booked in all classed for the two and a half weeks that were domestic school holidays. I did starting thinking conspiracy theories along the lines of we were against the QAN takeover and had now been banned from booking on QAN, but the truth was the airline was completely fully booked.

So my travel agent went through Thai, Emirates, Singapore and BA all to no avail. Eventually we got a 1^st class seat on Cathay Pacific but I had to go via Hong Kong and endure a 7 hour stopover in Hong Kong on the way back. This was the only way I could get to and from London at short notice.

I can’t say I’ve done much 1^st class travel so I was looking forward to the experience. When I walked on they all started calling me “Mr. Aitken” and I thought they must have read Under the Southern Cross! Incorrect, this is just what happens in 1^st class. I put on the pyjamas and settled into some caviar and Krug champagne. Little did I know that caviar and turbulence didn’t mix well and I managed to spill a good couple of ounces of caviar all over my pyjamas and seat. That’s a great start to a 24hr flight!

However, if you are a QAN shareholder you can look forward to some serious earnings surprise in fy08 as these high yield load factors translate to profit and dividend growth. QAN will be a $7.00 stock in 12 months time.

Go Australia

We look for under-rated opportunities and the vast bulk of those opportunities we continue to see in the Australian resource sector. I encourage you to support this FMG capital raising and get onto the register of what will be a top 20 company in just a few years time.

It is about time we stood up and supported our own. You have the chance to do that right now in FMG. Resources are the biggest story of our investing generation and being under-exposed is the biggest error you can make. Let’s not let all the profits and cashflows head overseas.

Go Australia.