Marriage of the miners

This is the background to the proposed merger between Henry Walker and Eltin, the result of which could produce a group with impressive statistics. By combining forces Henry Walker Eltin, as the new company would be known, would have annual sales of around $1.3 billion, an order book of $1.9 billion and a market value in excess of $291 million, based on prices at the time of the announcement on February 9, 1999. This would rival Leighton Holdings in terms of size, relegating the new kid on the block, the Downer Group, to third spot.

Is size everything?

Clearly, there's a belief that bigger must be better in this market and shareholders of both companies should ask if this is indeed the case. We believe there are a number of reasons to concur: Firstly, institutional investors are generally turning to larger companies with open arms while shunning the second-tier. A newly merged, larger group may well look more enticing. Secondly, with a broader customer base, the new group will be less reliant on individual contracts.

Perhaps of most importance though is a trend that's really a backlash from the move towards outsourcing. This was all the rage in the mid-1990's and smaller operators did very well but as competition intensified and falling commodity prices accelerated, mining companies cost cutting measures and the pressure on contractors to deliver lower prices intensified.

Mining companies were granted their wish of lower rates but at the expense of developing in-house expertise and some operational flexibility. But contract mining is a cash cost and with many companies under extreme pressure to reduce costs, some have taken operations back in-house. This takes the cost from the profit and loss statements and back into the balance sheet - a smoke and mirrors move that won't last forever. What does this mean for the contractors? An increased risk of individual contracts not being rolled over and perhaps a smaller pool of contracts altogether. If this represents a secular change in the industry, then big is indeed better.

So what are the strengths of the proposal? Apart from delivering critical mass, the combined strength of the well-regarded management teams and contract network is a real boon. The expanded company will have a diversified geographical exposure to New Zealand, Africa, Indonesia and South America as well as Australia.

It will also have a larger range of projects covering mining, construction, civil engineering, transport services and land development and a capacity to undertake projects that the two companies couldn't undertake on their own. This diversity should lead to a reduction in earnings volatility. A reduced leverage to the fortunes of resources companies is also a major plus while financially, the larger balance sheet provides the strength to tackle larger projects with less risk.

But what about the weaknesses? Although not abnormal for capital and equipment intensive contracting companies, gearing remains high. After the merger we would expect cashflow to be used to immediately reduce debt. Surprisingly, there are only two common clients so operational overlap will be minimal. We believe the combination of expertise will only strengthen Henry Walker Eltin's ability to service clients more effectively. Overhead cost savings are also on the cards down the track although initially more money will be spent to achieve these in the longer term.

Merger opportunities

So where does the shareholder fit in to all of this? Henry Walker will offer Eltin shareholders 84 cents per share plus six shares for every seven Eltin shares held. Eltin shareholders will own around 37% of the new company that will be a major force in mining and the broader contracting industry. We believe this is a positive for shareholders in the merged entity.

While the trend away from outsourcing is a major threat, it's likely to hit smaller companies with greater force. Contract mining still accounts for 72% of total revenues but at least the company has scope to expand operations in the civil engineering, transport and environmental sectors where demand remains strong. The principals of both companies are no strangers to doing it tough and their ability to look ahead should place the new group in a strong position. We recommend shareholders of both companies accept the board's recommendation. ACCEPT MERGER PROPOSAL.