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BHP Will Increase its Takeover Bid for Potash Corp.

By Jim Fink on August 26, 2010

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Potash, better than any other resource, illustrates Canada’s good fortune. The country’s potash reserves, at around 75 billion tons, are among the most extensive and the richest in the world. Potash, along with phosphorous and nitrogen, is critical to modern agriculture. The three major nutrients have no substitutes. That means higher fertilizer prices for at least the next several years.

Roger Conrad, Canadian Edge

When I heard on August 18th that Australia’s BHP Billiton (NYSE: BHP) was making a hostile bid for Canada’s Potash Corp. (NYSE: POT) at $130 per share in cash, I was surprised. BHP had repeatedly told analysts that it intended to “go it alone” in Canada with its Jansen potash mine. Even after the bid, BHP claims that it will move forward simultaneously with the Jansen project, but BHP appears to have concluded that it is cheaper to buy existing potash mines than dig new ones. According to some analyses, the cost of expanding existing “brownfield” potash mines is 50% cheaper than developing new “greenfield” mines.

Anyway, Potash Corp. is Canada’s fifth-largest company by market cap, so this takeover talk is a big deal. As I am wont to do whenever a Canadian company is involved, I consulted the “How They Rate” table in Canadian Edge, Roger Conrad’s investment service that covers virtually every Canadian stock under the sun. Roger had rated Potash a “buy” up to $100.  Potash closed under $100 as late as July 28th, so subscribers have had plenty of time to take his buy advice and do extremely well. Nice call, Roger!

BHP Will Raise Its Offer

The question is what to do now. Potash CEO and native Chicagoan Bill Doyle has rejected the $130 per share offer, calling it “grossly inadequate.” Potash stock is currently trading at $145.50, much higher than BHP’s $130 offer.  Obviously, the market believes that BHP will raise its offer to at least $145.

I think the offer will go even higher for a number of reasons:

Unique Asset. Potash Corp. would immediately catapult BHP into a leadership role in the fertilizer market. According to Potash Corp.’s own website, it is the world’s largest fertilizer company with control of 20% of the world market.  In addition, along with fellow fertilizer companies Mosaic (NYSE: MOS) and Agrium (NYSE: AGU), Potash is part of an export cartel called Canpotex that controls 40% of the world market and has market power to keep prices high.

India and China are already the top two consumers of potash in the world and fertilizer demand will only increase in coming years as emerging markets continue to develop and need to feed more people. Not only will there be more people, but they will be wealthier and will be able to pay for more expensive food choices like beef, which requires a lot of fertilizer-dependent food stocks like corn and grain. Potash fertilizer, which helps crops grow in dry soil by strengthening roots and boosting crops’ ability to withstand disease, is absolutely essential for farmers in increasingly water-starved areas.

Furthermore, Purchasing Potash would immediately transform BHP from a non-diversified, cyclical industrial metals and coal miner with unstable cash flows into a diversified company that received roughly one-sixth of its earnings from fertilizer. Wall Street pays a higher earnings multiple for companies with smoother earnings.

No Shareholder Vote Required Up to $145. Under United Kingdom securities regulations, a listed company must obtain prior shareholder approval for all “Class 1 transactions,” which include acquisitions that equal 25% or more of the acquiror’s market capitalization. In the case of BHP, an acquisition of Potash would only constitute 25% of BHP’s market cap if the $130 offering price was increased to $145. According to some analysts, a price of up to $160 per share would still be accretive to BHP’s earnings, so even if shareholder approval was required, shareholders would probably approve the deal.

BHP is Financially Strong with Low Debt.  In its recently-released full-year financial results (p.21), BHP revealed that it holds $12.5 billion in cash and has a low debt-to-capital ratio of 15%.  Even if it employed all debt to buy Potash for $145 per share (i.e., $43 billion), its debt-to-capital ratio would still be a reasonable 43%.  BHP already has a $60 billion credit facility ready to use. Furthermore, it is highly profitable with an operating margin of 41% and a return on capital of 26%, so it could use its cash flow to pay down debt quickly. Full-year earnings more than doubled in FY 2010 to $12.7 billion.

Don’t Expect Much More Than $145 Per Share

On the other hand, Potash shareholders should not expect BHP’s offer to go above $150 to $160 for a few reasons:

Doyle’s Personal Interest. A deal will make Potash CEO Bill Doyle a very rich man. Based on a February 26th management information circular (p. 71) filed with the Canadian Securities Administrators (CSA), Doyle owns stock and options totaling 3.4263 million shares. Multiply that by $130 and you get a payday of more than $445 million. A higher takeover price would cause that $445 million to grow even larger.

Normally, stock options vest over many years and are not immediately exercisable. But Doyle has a “change of control” clause in his employment contract that causes all of his options to vest immediately if Potash is taken over. Doyle will not antagonize BHP with unreasonable demands and risk having BHP walk away. Keep in mind that Doyle has never said that Potash is not for sale – in fact, he recently stated:

I am not saying that we are opposed to a sale, but what I am saying is we are opposed to a steal of the company.

In other words: Doyle wants to be cashed out, but at a slightly higher price.

BHP Has a History of Not Overpaying. BHP CEO Marius Kloppers is a hard-nosed South African who has emphasized that BHP will be “disciplined on this bid.” History supports this assertion. Back in November 2007, just a few months into the CEO job, Kloppers initiated a hostile all-share bid for fellow Aussie miner Rio Tinto (NYSE: RTP).  He raised the offer three months later by 13% in an effort to close the deal. Rio continued to balk, however, and Kloppers did not hesitate to withdraw the offer later in 2008.

No Non-Chinese Company Can Match BHP’s All-Cash Offer.  Many other companies have been identified as potential bidders, but none other than the Chinese have the financial firepower of BHP.

  • Rio Tinto is still struggling over the debt it incurred to acquire Canada’s Alcan Aluminum for $38 billion back in 2007.  It has actually been forced to sell some of its potash assets to reduce debt and is unlikely to reverse course now and incur debt to buy potash assets.
  • Brazil miner Vale (NYSE: VALE) has expressly denied preparing a bid, stating that it is focused on developing its fertilizer assets in Brazil and Peru.
  • China’s Sinochem has the cash to compete with BHP, and its Sinofert fertilizer subsidiary is already 20% owned by Potash Corp., but virtually nobody believes the Canadian government would allow a Chinese state-owned entity to purchase Potash Corp. With China one of the largest consumers of potash, the Canadian government is concerned that Sinochem would be directed to underprice potash exports, which would reduce royalties due to Canada. The fact that China isn’t exactly a democracy doesn’t help either.

BHP’s Jansen Mine. BHP’s bid for Potash Corp. may have put its “greenfield” Jansen potash mine on the backburner temporarily, but it is still committed to developing it if Potash Corp. is unreasonable. The threat of increasing the supply of potash by developing the Jansen mine — and thus depressing potash prices — may be enough to discourage other companies from bidding.

Bottom Line

Expect BHP to raise its offer to at least $145, but it may take many months of sparring before Potash Corp. agrees to the deal.  In the meantime, the price of Potash Corp. may drift back down to the $130 level as speculators sell on any rumor that the deal is falling through. If I owned Potash Corp., I would probably hold on since, in my view, a deal will occur. In contrast, as a potential new investor, I would wait to buy on dips down near $130.

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