A Potash Auction?

The giant Anglo-Australian mining concern BHP Billeton (LSE: BLT) -- which has a stock symbol that reminds me of a sandwich -- has bid $38.6 billion for Potash Corp., of Canada, and has also put on something of a charm offensive, seeking to persuade Canadians that locals will continue to run the place.

Canadian regulators have taken a permissive attitude of late toward foreign companies who want to take over the mining concerns of the Great White North. Xstrata, of Switzerland, bought Falconbridge (a nickel miner) without a fuss, for example.

Anyway, the key question here is: how much will Potash go for? Can the incumbent board set off an auction? You need more than one bidder for a good auction. Potash is apparently in discussions with a couple of Chinese concerns: the Sinochem Group and Hopu Investment Management.

As you can see from the chart, the course of BHP's stock price has been pretty rocky since April. Nonetheless, the company has deep pockets, and analysts are convinced it can sweeten its offer if it has to.

Indeed, Marius Kloppers, the CEO of BHP, has referred to the bid -- which stands at US$130 per share, as "full and fair." If he had wanted to say "last and best," he would have done so.

Best Way to Ensure Competition

A deal long in the making, the acquisition of one global mining company by another, won't happen. It has been sideswiped not so much by the credit markets (just two weeks ago BHP insisted it was going forward notwithstanding) -- it has been sideswiped by the competition policy of the EC.

I refer of course to BHP Billiton, the Anglo-Australian company that had planned to buy the Rio Tinto Group with a share swap at 3.4 to 1.

As I noted back in June, when world credit conditions looked a lot better than they do now, even then the stock of the target company was trading at a level below that suggested by the 3.4 to 1 ratio suggesting that even then the market was concerned that regulators would scuttle the deal.

BHP is the larger of the two concerns, but Rio has the more illustrious history. Rio traces its origins to Spanish mines so old the ancient Roman empire had minted coins from the metal taken from that earth. In 1873, two Rothschild firms -- the Parisian and the London -- joined with other investors to buy the Spanish government's interest in these mines. They restructured the company and turned it into a profitable business run from London.

At any rate, the deal faced scrutiny from regulators in several of the countries in which both companies did business, including South Africa and Australia. But it was the EU that did the scuttling, by making unexpectedly severe demands in terms of the assets that would have to be sold off by the combined entity.

I'll use my humble blog to express baldly an opinion. Scuttling mergers is NOT the best way to ensure competition. There are several reasons for this. One of them is that the predictable action of authorities along such lines preserves incumbent managements against the threat of takeover -- and that the threat of takeover is a valuable deterrent to laziness or self-dealing by incumbents. I'm not making any such charge against the Rio Tinto management, by the way. I'm only saying that in general when authorities act as those in the EU have done, they remove a worry from corporate managers -- and the public needs to have corporate managers worry. Takeovers are among the things they should be worried about.

The best way of ensuring competition is to look for barriers to entry and then lower them. Why is some well-capitalized industrial company somewhere not even now putting money into a start-up iron ore mine? Because the market demand for iron ore doesn't make it profitable? or because there are administrative barriers? If the latter, then the EU might look into how those barriers can be lowered. That would give existing managements more, rather than less, to worry about

BHP/Rio Tinto

In November, the huge Australian mining company BHP Billiton announced a bid to acquire a rival company, the Rio Tinto Group, with a 3-to-1 share swap. In other words, it wanted Rio stockholders to turn in each of their shares for three shares of the new, larger, combined company.

The offer was sweetened a bit in February (3.4 to 1) and in that form is still on the table. Oddly, the prices of the two companies haven't really been trading as if the market finds this offer credible.

If there were a significant amount of arb activity, and a general expectation that the deal would go through, one would expect that the price of a share of Rio stock on the market would be, roughly, 3.4 times the value of a share of BHP stock. So if (just choosing my numbers to make the math easy here) BHP is trading for Aus$40 on a given day, you'd expect to see Rio shares trading for Aus$136.

Why? Because there's a good deal of speculative activity out there that is specifically in the merger arb business. (Sometimes, much less fittingly, called "risk arb," a usage I'll ignore). If the two company's market valuation got out of line, you'd expect the people and institutions in the merger arb business to act on it. Suppose, in may example, BHP is at $40 and Rio is a good deal lower than the valuation implicit in the 3.4 to 1 ratio. Suppose Rio went to $80, which implies a 2:1 ratio. What would happen?

The merger arbs would move in and buy Rio shares like mad. They'd do so in the expectation of being able to trade in each one for their 3.4 shares of BHP -- getting a return of $136 for each investment of $80, an easy $56 if ever there was one. The very fact of their moving in to do this would constitute an increase of demand for the stock of course, increasing its price -- forcing its price up to the level dictated by that 3.4 offer.

To repeat, that's what would happen IF two conditions obtained: there was a general expectation the deal would close, and there was a lot of arb activity.

Apparently one or both of those conditions is missing. Rio is trading at a discount of more than 8% to where it "should" be on such reasoning. Why? I'm guessing the market believes regulators in one or another of the many affected jusridictions will intervene and stop or complicate the deal.