treadgold on possible mining takeover targets

What's next for mining stocks? As the underlying price of many base metals, gold and oil hit a downturn, the action moves instantly to takeovers. In the coming months some of the world's most powerful miners are expected to move on Australian listed stocks, and the bulk of that activity will be in three select spots: Mt Isa in Queensland, and Kambalda and the Pilbara in WA.

Last year, the small end of the mining sector was an easy way to make money. Today, it’s a fast way to go broke, but among the wreckage can be seen the first signs of a bottom-fishing strategy. It’s called consolidation.

Great care is needed in identifying mining takeover targets because some of the corporate deals that will emerge over the next 12 months will be designed to prop up two (or more) companies that have run out of money, lost whatever skinny management skills they had and lack the most important asset of all: minerals in the ground.

That means the first rule of looking for value in the consolidation phase of the mining market is to go to Australia’s most richly mineralised areas, and there are really only three to consider:

Mt Isa, and north-west Queensland, for the consolidation of copper stocks;
Kambalda in WA for consolidation of nickel stocks; and
The Pilbara region of WA for consolidation of iron ore stocks.

In each area there is a case to argue that small companies that own valuable assets lack the scale and competency to develop a mine, or expand an existing project. They also need to consolidate for cost savings in a much tougher business environment.

There are other possible geographic locations to analyse, such as Broken Hill in NSW, and the mid-West of WA. But Broken Hill fails because it is largely a source of zinc and lead, two of the weakest metals in terms of price, while consolidation in the mid-West is already well under way courtesy of Chinese investors.

In fact, it’s Sinosteel success in winning control of the iron ore miner Midwest Corporation, and in the way fellow Chinese steel maker Ansteel is providing most of the funds for the mine plans of Gindalbie Metals, which serve as a template for what is likely to happen at Mt Isa, Kambalda and in the Pilbara.

In each case the mineral being produced is in high demand in China, and even if the price is down today, the Chinese are buying for tomorrow.

I've applied two tests to this consolidation hypothesis. First was a trawl through the flood of June 30 quarterly cash reports. These documents reveal how much cash a mining company has and, of equal importance, what it expects to spend in the current quarter.

The accounts of an alarming number of small miners are getting close to the bottom of the barrel (less than $1 million in the bank), a situation solved in three possible ways: discover a mine and go into production quickly (unlikely), raise fresh capital (even more unlikely in this market), or merge to survive, offering the only asset on the books: in-ground minerals.

The second test was a poll a few days ago of mining company directors and stockbrokers at the annual Diggers & Dealers forum in Kalgoorlie, which I found to be a sombre affair, totally lacking the spark of the previous five years.

Speaking at Kalgoorlie, Brian Rear, a director of the Mt Isa copper miner, CopperCo, said there is no doubt that a phase of consolidation was about to start and might have begun already. “We have our eyes open, but we’re not doing anything, yet,” Rear said.

Gindalbie chairman George Jones agreed. He said the twin motivating forces behind the next wave of deals would be companies seeking access to cash and a belief that Asian demand for commodities has not diminished.

Andrew Simpson, recently appointed chairman of the iron ore miner Territory Resources, said the key would be to focus on companies in, or close to production. “We’re keen to acquire additional assets, at the right price and in the right time.”

Hugh Wallace-Smith, a director of the stockbroking firm Bell Potter, said the next phase for the mining sector was corporate action. “The values will be in cash and minerals in the ground,” he said.

One of the key speakers at the conference, the Canadian company promoter Robert Friedland, echoed the views of the Australian directors while also talking up the investment appeal of his freshly floated local vehicle, Ivanhoe Australia, which has raised $125 million and is focusing its mining and acquisition efforts on the Mt Isa/Cloncurry area of north-west Queensland.

Friedland’s interest in Mt Isa incorporates two of the key factors in following a successful consolidation investment strategy. Ivanhoe has cash and Mt Isa is richly mineralised, predominantly with copper, the commodity that has held up best in the widespread metals sell-off of the past month.

Ivanhoe Australia is not, however, one of the stocks for a consolidation portfolio. It is more likely to be a predator, buying smaller companies as it assembles a package of assets for future mine developments.

At the top of the list of potential Ivanhoe acquisitions Exco Resources, an emerging copper producer in the Cloncurry area, which has already received financial support from Ivanhoe and the mining investment specialist Lion Selection.

During the June quarter Ivanhoe and Lion exercised options to boost their shareholdings in Exco, paying 35¢ per option to add $8.5 million to Exco’s bank account and help pay for final feasibility studies into its Cloncurry copper project, which could produce up to 25,000 tonnes of copper a year.

Since Ivanhoe and Lion paid their 35¢ a share the price of Exco has dropped to 25¢, raising an interesting question: if professional mining investors saw Exco as a good way of gaining additional exposure to the copper market at 35¢ a share then perhaps it’s an even better investment at 25¢?

Friedland, always the salesman, left the audience at Diggers & Dealers in no doubt that he remains a commodities bull, especially when it comes to selling minerals to China. His master company, Ivanhoe Mines, is partnering with Rio Tinto in developing the giant Oyu Tolgoi copper mine in Mongolia, and wants to build “a major mining company in Australia”.

Interestingly, there are a two other potential predators stalking the Mt Isa/Cloncurry area. Swiss mining giant Xstrata is keen to grow its copper business after acquiring the previous dominant player in the area, MIM Holdings, for a bargain price during the last mineral price downturn in 2003, and the less-well known CopperCo.

Brian Rear is the man running CopperCo with an eye on acquisitions, but the real power behind the company is a one-time leader of the Australian gold industry, Robert Champion de Crespigny. It is de Crespigny who has been orchestrating the slow motion merger of CopperCo and Mineral Securities, and who has been waiting on the sidelines for asset values to fall (which they now have) before making his keenly-awaited expansion moves.

A broadly similar picture can be seen in the other target locations.

In nickel-rich Kambalda there are potential major players such as Xstrata and the Russian nickel miner, Norilsk, looking at possible expansion strategies though a more likely acquirer is the cash-rich junior Mincor, which started buying mothballed nickel mines from WMC Resources (before it was acquired by BHP Billiton) in 2002.

In the Pilbara, the big iron ore miners BHP Billiton and Rio Tinto, are unlikely to be interested in small fry, but the other big new player, Fortescue Metals Group, might be a buyer, while from within the pack of emerging exporters a “consolidator” could emerge, such as he cashed-up Aquila Resources.

A call of the card looks like this:
Mt Isa. Possible consolidators are Xstrata and CopperCo. Target companies are Exco, which has fallen from a 12-month share price high of 51¢ to 25¢. Universal Resources, down from 11.5¢ to 6¢, and Matrix Metals, 17.5¢ to 4.9¢.
Kambalda. The leading potential consolidator is Mincor. Targets are Independence Group, $9.39 to $2.49. Panorama (formerly Sally Malay), $4.71 to $1.99. Western Areas, $12 to $7.28, and Breakaway, 77¢ to 28¢.
Pilbara. The leading potential consolidator is Aquila Resources. Targets are Atlas Iron, $4.37 to $2.30. BC Iron, $1.97 to $1.01. Brockman Resources, $3.21 to $1.41, FerrAus, $2.02 to $1.11, and Iron Ore Holdings, $1 to 58.5¢.

The problem, as seasoned investors know, is that buying in the hope of a takeover bid can be a very risky strategy. That means being very selective and picking only the companies most likely to get a bid.

In Mt Isa that means Exco. In the Pilbara it means Atlas. In Kambalda it means Independence.