Ideas Lab: Elemental Minerals' discount window

For a few brief months in 2010, potash was one of the hottest resources on the planet. The world’s biggest miner, BHP Billiton, had launched a takeover bid for Canadian giant Potash Corp and enthusiasm for fertiliser bloomed.

Three years later and the potash price has barely budged and the attention of the world has moved on. Potash miners have been savaged in a world where the only hot resource is a sensible business paying reckless dividends. One irrationality has been replaced by another.

Yet not everyone has forgotten potash. Elemental Minerals, for one, has been developing the Sintoukola project in the Republic of Congo since 2009. It has uncovered an impressive resource that is high grade, shallow to mine and large enough to be worth the effort. Best of all, it is located near a deep water port for easy transportation. Potash, like iron ore and coal, is logistics masquerading as mining.

Developing Sintoukola is beyond Elemental (see review on 28 Mar 13 (Avoid – $0.30)) because the project requires at least $2bn to construct. But now it might happen. Chinese investment group Dingyi has made an all cash offer of $0.66 per share, valuing the business at $190m.

The opportunity

A dreamer chasing an impossibility would not usually pique our interest but there is opportunity here. Against the offer price of $0.66 per share, Elemental’s share price trades at just $0.525 today. A quick 26% return is still possible by buying now and selling into the offer.

The bid ticks a lot of boxes (as noted in Takeover arbitrage profits ease on 26 Jul 10). It is a binding, all cash offer; it has been recommended by both boards; the current price is at an attractive discount and the conditions aren’t onerous.

Dingyi has already completed technical due diligence. Even better, the offer is not conditional on funding or on government approval. The Chinese group also claims to have secured over US$200m in finance, more than enough to fund the deal.

Major shareholders of Elemental have already agreed to sell into the bid leaving Dingyi to secure just 37% of the company. Considering the bid is more than double the pre-bid price and above an independent expert’s valuation, securing those votes shouldn’t be a problem.

The biggest risk is a disaster – either natural or political – scaring away the bidder. With a high likelihood of success, why is the market valuing the business at a 21% discount to the bid?

The catch

There is no obvious reason but suspicions around the bidder may be one. Dingyi is a relatively unknown Chinese holding company, best known for investments in beer and pubs. It is not famous for its resources nous. Another reason for market scepticism may be the failure of several Chinese takeover bids in the resources industry.

The failure of Chinese bids for Discovery Metals and Sundance Resources has lowered confidence in Chinese bidders. Discovery has lost 90% of its value after a bid was withdrawn while Sundance lost more than 80%. Could a similar fate await Elemental?

Although possible, it’s unlikely. In the case of Discovery, a working mine was found to have several problems during technical feasibility, prompting the bidder to walk away. For Sundance, financing and Chinese approval could not be secured.

Those pitfalls are unlikely to be repeated. Technical feasibility has already been completed and funding secured. The powers that be in China could still scuttle the deal but, since several government agencies are financing it, the deal appears to have government endorsement.

If the bid falls over, shares in Elemental are likely to fall back to their pre-bid prices of around $0.25, a fall of 52% from today’s price. With a fixed upside of 26% and a large downside, this isn’t a punt for everyone but the odds are attractive for this classic Ideas Lab. NO VIEW.