Merger and acquisition activity in the commodity sector has been growing over the past few months. Inmet Mining (IEMMF.PK) and Equinox Minerals (EQMIF.PK) are locked in a bidding war for Lundin (LMC), BHP Billiton (BHP) acquired of Chesapeake Energy’s (CHK) shale gas field, and Newmont Mining’s (NEM) $2.3 billion dollar purchase of Fronteer Gold Inc. (FRG) stand as a few recent examples.
Mid-tier commodity producers are looking to add assets, while major metal producers across the board are flush with cash and surveying the landscape. The big question is: What assets are likely to be in favor and acquired next?
While natural gas is the obvious choice, due to its low price from high inventories and increasing production, there are some questions regarding recent purchases as evidenced in the Marcellus Shale region, where resource estimates appear to be overly optimistic.
An alternative -- off the radar screens of many investors but gaining interest -- is aluminum. Aluminum is becoming an alternative to steel in the automobile industry, where auto manufacturers are looking to lessen the weight of cars in order to increase fuel economy. Consumer electronics is another burgeoning area, with aluminum content in laptops expected to increase 30% over the next three years as manufacturers look to aluminum's heat conductivity, durability, and light weight as attractive features. In fact, one of the iPhone (AAPL) rumors is that the backing of the phone will once again be made from aluminum.
In the copper markets, aluminum can be substituted in electrical wires, although transmission losses are greater, making aluminum a less-efficient conductor of electricity.
During the recent market selloff, the aluminum spot price moved sideways, holding support despite high inventories. This strength is an indication that, when the market begins to turn higher, lagging commodities like aluminum will lead the next leg up.
Looking at the futures curve, aluminum is in contango, with prices continuing to move higher in lockstep with the spot price.
Of the major, global aluminum producers, Rusal is tied up in a sticky situation with Norilsk Mining; even if resolved, it would not be open to an acquisition. Chalco is a state asset to China and Alcan (AL) is owned by rival Rio Tinto (RIO). A year ago, Brazil’s Vale (VALE) sold its aluminum business to Norsk Hydro ASA (NHY) for $4.9 billion, which was settled a week ago.
This leaves Dow Jones Industrial Average component Alcoa (AA) the only remaining major independent aluminum producer. Alcoa levered itself up before the credit crisis and has spent the last few years reorganizing and paying down debt. Currently, it has $9 billion in debt and $1.55 billion in cash on the balance sheet. Revenues for the fourth quarter were up 7% sequentially with the full effect of the fourth quarter rise in aluminum prices to be felt this quarter.
Alcoa has been moving into new markets for aluminum, touting its lightweight and durability. While a major producer, Alcoa could be potential takeover target for a major mining firm looking to expand into the aluminum sector.
As for potential acquirers, BHP Billiton may be interested, given some of CEO Marius Kloppers' recent comments.
BHP Billiton is one of the largest commodity producers, with diversified global operations and status as a major player in the copper, nickel, iron ore, thermal and metallurgical coal markets. During the second half of 2010, revenues rose 39% to $34.2 billion dollars and net operating cash flow rose to $12.2 billion dollars on the back of strong commodity demand across all business segments. Currently, BHP has a very strong balance sheet with $16.1 billion in cash on hand, and it's expanded its share buyback program to $10 billion dollars.
After the recent earnings announcement, BHP’s stock sold off as investors were not happy to hear that the company would forego the acquisition route after failed runs at Rio Tinto and Potash Corp. (POT). The new strategy would be to invest $80 billion internally over the next five years. Afterwards, Kloppers speculated that high commodity prices have made takeover targets expensive, but indicated there are areas where BHP is weak and can add to its portfolio.
A few days later, BHP announced the purchase of Chesapeake Energy Corporation’s Fayetteville, Arkansas shale gas interests for $4.75 billion, giving BHP an entry into the shale gas business. The transaction will give BHP access to 487,000 acres with 2.4 TCF proven reserves and 10 TCF risked resource.
With natural gas prices low in the U.S. because of high inventories, and additional supply coming online, the transaction makes sense from a long-term perspective for BHP. It is able to buy low and add an attractive asset at a reasonable price.
BHP is currently one of the top seven producers of primary aluminum worldwide -- a large but not major player, especially when compared to Rusal and Rio Tinto’s Alcan division. In terms of comparison, BHP’s market cap overwhelms Alcoa’s by an approximately 14:1 ratio from $249 billion to $17.6 billion, so an all-stock transaction would not be significantly dilutive to current shareholders. On an enterprise value basis, the ratio is lower at 10:1, with BHP’s enterprise value being $241 billion against $24.7 billion from Alcoa, but still not very dilutive.
From a revenue perspective, Alcoa’s $21 billion would add significantly to BHP’s top line revenue of $62.61 billion. EBITDA is a much higher difference, with BHP’s being $30.91 billion to Alcoa’s $2.72 billion, but this can be explained partially by BHP’s coal products being in high demand worldwide and aluminum’s drop in prices after the 2008 collapse, which is only now beginning to gain steam.
In the second half of 2010, BHP’s net operating cash flows totaled $12.193 billion, while Alcoa’s cash flow from operations totaled $1.762 billion.
BHP could offer a combination of cash and stock at 1x revenues for Alcoa as a starting point. This would be a decent premium to Alcoa’s closing price and be only slightly dilutive to current BHP shareholders.
Alcoa’s debt is not out of line with the combined cash flow from both parties, and can easily be paid down within a couple of years.
For BHP, an acquisition of Alcoa would make sense from the standpoint of diversifying its iron ore and copper portfolio into an asset that would benefit from the substitution effect.
Aluminum is a metal whose price has been beaten down since 2008 and is only just now recovering. This gives BHP price upside and the ability to become a major player in aluminum.
An acquisition of Alcoa fit nicely with Kloppers' recent comments about adding assets at a reasonable price in an area where it is weak.
Disclosure: I am long AA.
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