Ideas Lab: Perilya saved from peril

Falling commodity prices may have miners weeping into their calloused hands but, for buyers of commodities, it’s a time to be greedy. Takeovers, especially of local resource projects by Chinese companies, have increased markedly during the market decline, providing some interesting opportunities. Our recent Ideas Lab, the takeover of Elemental Minerals by Dingyi Group, is moving towards a favourable outcome (see Elemental Minerals discount window on 08 Jul 13).

Now another opportunity has arrived. Perilya Mines is a Broken Hill metal miner that operates the original deposits that gave birth to BHP. Its majority shareholder, Zhongjin, has lobbed a full cash takeover bid at 35 cents a share in a deal that values Perilya at $269m.

That’s a 59% premium to the pre-bid price and a 10% premium to the share price today. There is an opportunity here for a small, quick gain by buying shares in Perilya and selling into the takeover.

Not every bid trading at a discount is an opportunity. As we highlighted in Takeover arbitrage profits ease on 26 Jul 10, it takes a special combination to interest us in risking capital on what are usually small, short-term returns. This bid meets those prerequisites.

Deal details

The deal is all cash, has board approval and Zhongjin is already a major shareholder in Perilya, owning 53% of the business. The acquirer is also an existing off-take partner (meaning it is a buyer of metal concentrate from Perilya), which suggests it may be able to extract genuine savings from owning the mine. This is a deal that makes some sense. 

To this we add another caveat: in the resource space particularly, asset quality matters. Takeover bids for decent quality assets are more likely to be completed than those for inferior assets. That’s why we ignored the apparent opportunities presented by bids for Sundance Resources and Discovery Metals, for example. Both those companies have become case studies in failure and a spur to caution.

This case, however, meets our quality criteria. Perilya operates an ageing, complex orebody that has been in production for more than a century. It has a long history of successful mining.

Making money the hard way

Mining zinc is a notoriously tough business because concentrate containing several metals is almost always produced. Profits are made by refining and marketing the metal rather than mining it. Outside of a boom, few zinc miners make decent returns because of high refining and treatment charges.

In times when prices are low, profits are even scarcer. Zinc prices have fallen from post-GFC highs of $1.20 a pound to about 80 cents a pound today (see Chart 1). Lead prices (Perilya mines a zinc/lead ore) have fared no better. As a result, the miner posted a loss last year but it has shown it can generate profits in better conditions.

The deal requires the blessing of both Chinese and Australian regulators before it can complete. For the Chinese, this is already implicit. Zhongjin could not have made the takeover offer without support from the government, its majority shareholder. In Australia, the Foreign Investment Review Board (FIRB) must approve the deal and it's perhaps here that concerns are centred.

FIRB can be unpredictable, with discretion playing a role in decision making. Previous deals for OZ Minerals and Woodside Petroleum, for example, were rejected on national interest grounds. This is unlikely to be the case this time. Perilya is tiny, although it does include the historic mines which spawned BHP, and there is some concern about a company with Communist Party links owning Australian assets. Several agriculture and telecom deals, for example, have been scrutinised for Chinese government links.

An independent expert also needs to sign off on the deal, but we are yet to see a proposal fail at this hurdle. Unusually, the risks lie here in Australia.

Likely to happen

The deal will be put to a shareholder vote in December but, so far, it has been greeted with relief and looks certain to be approved. Perilya carries a modest geological endowment and towering debt. It will have to stump up additional cash for capital expenditure this year and next. It’s not a business we would want to own without the offer. If the bid fails, the share price is likely to fall back to pre-bid levels of around 22 cents, a 31% fall from today.

So the opportunity is clear: a high probability of a 10% gain and a wee chance of a larger loss. In our view, the bid is likely to go ahead without new bidders or any further complications, giving it all the ingredients for an ideal Ideas Lab.