September 27, 2010 / 1:27 PM / 9 years ago

Analysis: Cash bounty lures miners into risky empire-building

LONDON (Reuters) - Recent takeover bids by BHP Billiton BLT.L (BHP.AX) and Vedanta VED.L show that a bounty of cash from high metals prices may entice miners to chase pricey takeovers and build unwieldy conglomerates.

When mining groups seek acquisitions in new sectors like fertilizer in the name of diversification they can easily destroy value by paying full prices when synergies are lacking, analysts warn.

In many cases, they may create more value by distributing excess cash to shareholders.

The miners run the risk of repeating the disastrous cycle of oil companies that sought to become sprawling resource giants decades ago but ended up unwinding their takeovers when the strategy failed.

“I think the predicament for miners is: where do they go now?” said analyst Peter Davey at Ambrian Capital.

“We are almost going back to the days of the 1960s, 70s, 80s when oil companies had so much cash they didn’t know what to do with it. They started buying things loosely associated with their business... and we have seen all of that unwind over the last 20 years.”

BHP, the world’s top mining group, surprised many investors last month when it unveiled a $39-billion hostile bid — the largest takeover offer so far this year — for the world’s biggest fertilizer maker, Canada’s Potash Corp POT.TO.

Two days earlier, Indian-focused Vedanta had also stunned the market when it said it planned to add oil and gas to its portfolio by spending up to $9.6 billion to clinch control of Cairn India CAIL.BO.

The upturn in M&A activity occurs as miners find themselves in a hugely changed situation from last year, when they were scrambling to conserve cash amid the economic downturn and tumbling metals prices.

Instead of raising funds through emergency rights issues and cancelling dividends, they are now swimming in cash from a sharp rebound in metals prices.

Nomura estimates that by the end of next year, UK-listed miners will have $175 billion of headroom on their balance sheets and will be increasingly tempted to put it to use.


“The first thought is what can we go and acquire because they’ve still got the mentality from last year when everything hit very low valuations,” said Nomura analyst Gavin Wood.

After repeated waves of consolidation in mining, companies are finding it more and more difficult to find decent takeover possibilities in metals.

“They can’t find in traditional mining, metals and bulk commodities the opportunities to make acquisitions so it’s almost as if they’re just searching further afield,” Wood said.

Investors will hope top miners resist the temptation to build empires and instead return excess cash to shareholders or buy back shares, as Brazil’s Vale VALE5.SA (VALE.N) recently announced.

Part of the quandary is the scope of possible acquisition targets are narrow for the majors, which are only interested in very large, long-life deposits with low production costs.

Since many top-quality assets are either not for sale or ruled out due to competition concerns, they have to look further afield to areas such as fertilizer and oil.

Vedanta has no experience in the oil sector and could stumble in an apparent effort to build a sprawling resource empire mainly focused on India, some analysts say.

Critics of the BHP-Potash deal say it is unlikely to add value since there are no synergies and BHP has scant experience in the sector. BHP argues it has expertise in large capital projects and the takeover will further diversify the group.

“The market will be very skeptical of doing deals that don’t have synergy, in businesses the companies don’t already know, and without any sort of clear strategy about how you will create value from running that business,” said HSBC analyst Andrew Keen.

“BHP-Potash is an example, probably the first example, of a real crossover,” he added. “I think it could be driven by the same sort of things that drove the oil industry.”

Diversification was the byword when the oil industry, flush with cash, branched into mining decades ago.

But the strategy unraveled and by 1989, BP (BP.L)(BP.N) sold the famous Bingham Canyon mine — which has produced more copper than any other mine — to Rio Tinto (RIO.L) (RIO.AX).

That marked the dying days of the oil industry’s foray into mining, which was roundly derided as a disaster that destroyed shareholder value, including among many oil company executives.

Royal Dutch Shell was one of the earliest oil majors to try its hand at mining when it bought Dutch metals and mining group Billiton in 1970, but finally gave up and divested it in 1994.

“The oil companies just went out willy nilly buying the mining companies really as a way of doing something with their cash,” said Tim Williams, director of mining and metals at Ernst & Young.

“It seemed like a good idea at the time but they made an unholy mess of it because mining is more complicated than oil.”

Williams said while potash is a commodity that is dug out of the ground, broadly within BHP’s core expertise, shareholders could easily invest in potash companies if they wanted that exposure.

Although BHP and Vedanta are entering new areas, analysts take heart that at least they are staying with the resource sector.

Keen said he would be surprised in the majors moved too far away from resources and ended up resembling India’s Tata Group. Tata, founded in 1868, has almost 100 companies spanning tea, steel, luxury hotels, cars and software.

“We will probably see people filling out their portfolios, but I personally would be very surprised if we saw them wandering off too much.”

Editing by Sitaraman Shankar

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