Chinese bargain hunters are outsmarting Oz companiesJohn...

Chinese bargain hunters are outsmarting Oz companies
John Robertson*, 11 August 2011


LARGE gaps between project valuations and what the equity market is prepared to pay are giving Chinese corporates arbitrage opportunities at the expense of local shareholders.

There was a time not so long ago that Chinese partners were a value accretive attribute for a budding resource house. They were perceived as more willing than others to pay a full price because of their strategic drive to access raw material supplies. Companies welcomed an alternative to rapacious western bankers. For investors, any party that could deliver funding and sales added certainty.

Perhaps the benefits were always overstated. After all, Mount Gibson Iron has been a continuing example of fractured relationships between a company and its putative Chinese saviours.

The situations of Sundance Resources and Pluton Resources illustrate a new slant on the participation of Chinese corporates in the Australian industry. They had both been angling to get Chinese partners to fund their respective iron ore mine developments. The anticipated scale of operation was different but the structure of the deals being sought was substantially the same in both cases.

Sundance Resources has a deposit in west Africa estimated to cost some $A4.6 billion to bring into production. Pluton Resources is aiming for a more modest $A700 million development on Irvine Island off the coast of Western Australia and adjacent to Cockatoo Island. Both companies were looking for a joint venture partner willing to buy a half share for a price equal to 50% of the estimated capital costs of the project and willing to fund its share of the ongoing capital needs.

In theory, under this structure, Sundance and Pluton could move ahead without having to go back to shareholders for any additional capital. In reality, a large difference between the capital needs of the projects and the market value of the companies pulls the rug from under this model.

Sundance effectively wanted someone to outlay $4.6 billion for a 50% share of the project. But, at the time of writing, Sundance is valued on the market at just $1.5 billion. That means a savvy, cash rich Chinese corporate such as Hanlong Mining Investment which announced on July 17 that it wanted to buy 100% of Sundance only needs $6.1 billion to take 100% of the company and develop the mine.

Other Chinese parties could be asked for $2.3 billion by Hanlong at a later stage for a 50% interest, reducing Hanlong?s outlay for 50% to just $3.8 billion, a saving of $800 million over the Sundance asking price.

The Pluton situation is directly comparable. In round numbers, Pluton has a market capitalisation of $70 million at the time of writing. It will need $700 million, according to its prefeasibility study, to finish the project. Pluton wanted another party to pay $350 million for a 50% share and contribute another $350 million as its share of the ongoing capital needs.

Even Pluton?s preferred Chinese partner, Timeone Holdings, has apparently baulked at this commitment and, presumably, all the other contenders have walked away entirely. Under the agreement announced by Pluton on August 4, Timeone is effectively saying, ?give us 30% of the company now for $30 million and we will talk about the joint venture arrangement later?.

Timeone must have done the maths. At a minimum, it can get 30% of the company for $30 million and, if the numbers do not change, 50% of the project for $350 million. It will also need to contribute $350 million as its contribution to the joint venture.

This would leave it with direct and indirect interests of 65% for a total outlay of $730 million, equivalent to a price tag of $1.123 billion for 100%.

Alternatively, it could bid for 100% of the company some time between now and the end of 2012. Let?s say markets improve and the share price has risen by 50% by then so that it has to pay $105 million for the shares it does not already own. With the $700 million it must pay for development, the total cash required for full ownership would be $835 million.

As long as Timeone has the cash, the second strategy makes more sense. By putting up $30 million now in response to the pleadings of a cash poor company, Timeone can shut everyone else out and improve its position by $288 million (the difference between $1.123 billion and $835 million) with the $30 million investment. Of course, if the share price does not go up, so much the better.

There are three implications that stand out. Firstly, from an investment perspective, the advent of this China factor should expunge any lofty ideas about investing in the development of Australia?s natural resources or supporting long term development plans. The investment opportunity becomes purely tactical. A company will be unable to cultivate a long term shareholder base.

Secondly, any notion of competitive tension or a takeover premium will have been removed. Multiple bidders from China are likely to be sidelined. Some of the old central planning habits linger.

Thirdly, over time, investors will come to realise, if they have not already, that the beneficence of the once coveted Chinese investor has been overstated. Everything else being the same, a company with a Chinese investor should be accorded a lower market value.

A ?China discount? will need to be taken into account around the board table as the shareholder value proposition is being considered by directors working out their funding options.

*John Robertson is a director of EIM Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, business strategist and investment market professional for nearly 30 years after starting his career as a federal treasury economist in Canberra.