Behind the Mining Merger Mania

Industry players are combining to gain greater clout in the global marketplace, but the M&A rush has left shares at unattractive valuations

by Vaughan Scully and Isabelle Sender From Standard & Poor's Equity Research

A frenzy of merger activity, both confirmed and unconfirmed, is driving up share prices of the world's largest mining companies. Investors are betting the industry is entering a period of major consolidation in which leading companies will offer significant premiums for smaller rivals in order to gain scale and compete globally over the next decade.

Growing demand for industrial metals, particularly from Asia, has been pushing up prices of copper, aluminum, nickel, and iron ore for the past five years, boosting profits for mining companies. Now those companies are looking to consolidate their positions within an increasingly global supply chain, and they have the financial resources to do so.

Bigger Bargaining Chips

"Consolidation in the metals and mining industry is being driven by the need to become larger in order to lower costs and increase bargaining power of producers in dealing with customers, suppliers, and governments," says Standard & Poor's equity analyst Leo Larkin. "A combination of rising stock prices, high metals prices, generally strong balance sheets, and ample free cash flow is making these deals possible."

An unconfirmed report by Dow Jones (DJ) that BHP Billiton (BHP), the world's largest mining company by enterprise value, will make an offer for Rio Tinto (RTP), the fourth largest, drove shares in both companies to record highs this week. Shares in Rio have risen more than 15% since the end of April.

Shares in AK Steel (AKS), an Ohio-based steelmaker, have also surged in recent days after an unconfirmed Financial Times report suggested Arcelor Mittal (MT) will make an offer for the company.

Alcoa Intent on Alcan

Shares in Alcoa (AA) and Alcan (AL) both surged this week after Alcoa, already the world's largest aluminum producer, offered to buy its Canadian rival in order to better compete with emerging competitors in Russia, India, the Middle East, and China, the company said. In a sign of how intent Alcoa is on acquiring Alcan, Alcoa is making its offer directly to Alcan shareholders, having spent the past two years trying without success to negotiate a merger with Alcan's management.

"The proposed merger just makes sense in order for Alcoa to stay competitive, because the rest of the industry is consolidating," says Larkin. "They'll be in a better position to deal with their competitors, suppliers, and customers. You need scale."

Buying Alcan would make Alcoa the fifth-largest mining company in the world, with operations in 67 countries and 21% of the world's aluminum production capacity—far more than its largest competitor. A Rio Tinto/BHP merger would combine the world's second- and third-largest iron ore exporters. While mining companies need to grow in order to stay competitive, the surge in stock prices has made them relatively unattractive investments, purely on a valuation basis. This week, Larkin cut his ranking on Alcan to "hold" from "buy" and on Alcoa to "sell" from "hold." He cut his ranking on AK Steel to "hold" from "buy" this week as well.

Larkin says he doesn't think there's much room for shares in either Alcoa or Alcan to rise further over the next year. "Long term, we think the merger would make Alcoa more competitive," Larkin says, "but with the shares trading above our target price of $36, we do not currently view them as attractive."

Possible Obstacles

Several potentially negative factors exist for mining stocks. It is entirely possible that Alcoa's offer for Alcan will not be accepted—Alcan's management has said it will review the offer before making a recommendation to shareholders—or that a bid for Rio Tinto or AK Steel never materializes. However, Larkin thinks an announcement of a competing bid for Alcan, or a bid for Alcoa itself, is equally possible. Alcan shares are trading well above the $73.25-per-share offer made by Alcoa, suggesting that investors think a higher bid is likely.

Furthermore, as the largest companies get even larger, they are bound to run into antitrust concerns from regulators as their competitors disappear and their market share rises. Issues of national pride may arise when landmark companies such as Alcan fall into foreign hands. Alcoa's management said they have already contacted regulators regarding their offer and are confident they will be able to resolve any snag that might appear.

Scully is a reporter for Standard & Poor's Editorial Operations. Sender is a reporter for Standard & Poor's Global Editorial Operations.