Wesfarmers bids for Kidman

We could see the case for Wesfarmers' takeover bid for Lynas Corporation. We really could. But yesterday's $776m offer for Kidman Resources? Not so much.

It's now clear that Wesfarmers is indeed betting on electric vehicles and the batteries that power them. In fact, the fourth slide of its presentation to acquire Kidman Resources was titled 'Global uptake of electric vehicles presents attractive opportunity'.

Kidman owns a 50% stake in the Mt Holland lithium project in Western Australia. Lithium hydroxide is a key input into batteries, and therefore the electric vehicle supply chain. But lithium is not particularly uncommon, as Gaurav Sodhi explained in Lithium, zen and the coming bust, and an avalanche of supply is indeed on the way. In response, lithium hydroxide prices are down by around 30% since their peak in early 2018.

The Kidman takeover suggests Wesfarmers is trying to build a narrative - the growth of electric vehicles - around its acquisition ambitions. But investing by theme is problematic because you risk overlooking the details, the execution of which drives financial returns. Managing director Rob Scott said yesterday 'we try and not get seduced by a thematic' but his actions might suggest otherwise.

Mountain high?

The Kidman acquisition also looks risky because the Mt Holland project is yet to commence construction. If Wesfarmers wants lithium exposure there are other companies that are already producing revenues, although admittedly this particular deposit is high grade and long life.

The other obvious reason that Wesfarmers seems to prefer Kidman is that the remaining 50% of the Mt Holland project is owned by Sociedad Quimica y Minera de Chile (SQM), the world's second largest lithium producer. Wesfarmers expects to bring together SQM's lithium experience with its own expertise in building chemical processing plants in Western Australia. Apparently, SQM supports Wesfarmers' bid for Kidman.

But, whether you're building a house or a mine and refinery, projects invariably take longer and cost more than you expect. As Gaurav has explained, other lithium producers have had trouble getting their projects off the ground.

For what it's worth, Wesfarmers currently estimates its share of the project capital expenditure to be $600m, with first production from the refinery in 2022. This is of course on top of the $776m acquisition cost of Kidman itself.

To our minds, Lynas remains the more interesting prospect because of its strategic exposure to Neodymium-Praseodymium, the fact it's already generating revenue, and the political difficulties it's currently experiencing in Malaysia. The Lynas bid is an example of Wesfarmers using its size, capital and - potentially - political influence to pursue an underappreciated asset.

Hole lot of nothin'?

Kidman, by contrast, seems a somewhat more conventional asset. If indeed you can call it an asset at all; the Mt Holland project isn't even a hole in the ground yet.

While the Kidman takeover is subject to due diligence, it's more likely to complete than Lynas. Lynas remains in Wesfarmers' sights but seems uninterested in engaging further, whereas Kidman has agreed to be acquired. No doubt the 47% takeover premium helped Kidman's directors make up their minds.

If Wesfarmers completes the purchase of both Kidman and Lynas, it will be betting $2.3bn on the electric vehicle industry. However, both assets require significant capital expenditure - at least $1bn - before shareholders will see much return.

We hope this isn't a case of management overconfidence; Wesfarmers' capital allocation under previous management was sometimes poor and there were early signs Rob Scott might be a better steward. The Kidman Resources acquisition, however, gives us pause for thought.

Of course, in the scheme of things, a few billion dollars won't make a huge difference to Wesfarmers, which is itself capitalised at more than $40bn. If these acquisitions fail it won't be disastrous although it will put a dent in our investment case. We are paying management to make sensible bets - and of course they may turn out well.

Adjusting for the Coles demerger, Wesfarmers' share price is up 17% since we upgraded the stock a year ago. Our Buy price remains unchanged and we're sticking with HOLD.

Disclosure: The author owns shares in Wesfarmers.

Note: Our Model Growth and Model Income portfolios own shares in Wesfarmers.

Note: The Intelligent Investor Equity Income Fund owns shares in Wesfarmers.