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Has BHP Gone Mad?

On the television news last night there was a typically ill-informed tone around the report that BHP Billiton ((BHP)) had just made a takeover offer for Potash Corp of Saskatchewan. Why, asked the reporter, would the world's biggest diversified mining and energy company suddenly want to get into agriculture? Those paying attention to the stock market would know that BHP has had fertiliser in its sights for some time. A potential offer for Potash Corp had long been muted, but its likelihood was complicated by BHP bidding for rival Rio Tinto ((RIO)) instead. Marius Kloppers still sends Graeme Samuel Christmas cards for not having managed to reach any sort of ACCC decision on such a merger before the GFC hit and exposed Rio's perilous debt position. But a takeover also diminished in likelihood when BHP simply moved in next door to Potash Corp. Crops require three main sources of nutrients – phosphate, nitrogen and potassium – in order to grow healthily. Across the globe, farmers deliver these nutrients through fertilisers, and the potassium element is provided most commonly by potassium chloride, although other potassium compounds can be used – all known throughout history collectively as “potash”. Potash reserves are found in land basins where ancient oceans have long ago evaporated, and the three largest basin sources are found in Russia, Belarus and Canada. Canada boasts the largest reserves (52% compared to Russia's 21% and Belarus' 9%), found in the sweeping central prairie state of Saskatchewan. This has allowed the Potash Corp of Saskatchewan to become the world's biggest fertiliser company. There are two reasons mining and oil company BHP would be interested in fertiliser. Firstly, while BHP's businesses are diversified across minerals and metals and oil, all its products largely follow the same cycles. But food is a staple – more staple even than oil – and hence it is not necessarily beholden to those cycles. By expanding into fertiliser BHP can thus diversify its cyclical exposure, and obviously the rise of emerging middle classes in the likes of China and India offer unfathomable upside for food demand. It's not just a matter of population growth, it's a matter of that population moving up the economic scale from subsistence farming to supermarket shopping. Secondly, potash is mined from deep underground. And BHP has a bit of experience in mining. Prior to 2006 the potash price was relatively stable, but when global demand began to outstrip new supply the price began to take off. While food is a staple, potassium fertiliser isn't necessarily, and as such it still suffers from simple price elasticity. Goldman Sachs notes global potash demand peaked in 2008 but then plunged 28.5% in 2009. When the GFC hit, farmers simply couldn't afford it so they just had to live without it. But we're not expecting a GFC every few years. While pundits have long thought a cash-laden BHP might make a move on Potash Corp, instead it first entered into a joint venture with (2006), and then acquired all the shares of (2008), Anglo-Potash. Anglo-Potash's operations are also based in Saskatchewan, and it was only in June that BHP announced a potash reserve at its Jansen project in Saskatchewan of 3.37bn tonnes at 25% potassium oxide. So realistically, BHP now has the capacity to be another Potash Corp on its own, albeit first sales are not expected until 2015. With such a reserve under BHP's belt, analysts began to assume a takeover offer for Potash Corp was no longer on the cards. This was further reinforced when BHP espoused a post-GFC strategy of “building, not buying”. Analysts rate BHP highly not just for its existing iron ore business but for its many and varied greenfield and brownfield projects across the globe. And Rio's disastrous takeover of Alcan provided a stark reminder to BHP that organic growth is much safer than acquisitive growth. There but for the grace of God. So to suddenly take a swing at Potash Corp, BHP is bald-faced in contradicting its own stated strategy preference. What could be the benefits? Well firstly, Potash Corp has long been up and running and Jansen is a 2015 proposition. Obviously there are synergies to be had in also acquiring all the potash reserves that are all but next door, and clearly along with the reserves comes decades of potash market expertise and nous. Potash Corp also has a 54% stake in one one of the world's largest distributors of potash – Canpotex – which would thus give it an immediate channel to market. Secondly, at US$130 share (the current offer price) analysts calculate the deal to be about 3% earnings accretive, so it's not necessarily like BHP is throwing good money after bad. UBS speculates BHP is anticipating the proposed iron ore JV deal with Rio will be disallowed, and hence it will not have to fork out the US$5.8bn equalisation fee. This will help with the US$39bn BHP is offering to Potash shareholders. The problem is BHP will simply have to pay more than US$130 per share. As this represents only a 16% premium, and most takeovers are won on at least a 30% control premium, there's no surprise the Potash Corp board took only a heartbeat to reject the offer. One assumes, however, that BHP has simply been caught out by the weather. Obviously, Kloppers did not just wake up on Monday morning and declare “Let's go and buy Potash Corp”. There would have been weeks or months worth of work behind the scenes to arrive at a US$130 bid. Only last month Potash shares were trading at US$85 which would make US$130 a 53% premium, but drought and fires in Russia and floods in China and Pakistan have sent global grain prices soaring in the meantime. Where goes the price of food goes the price of fertiliser. BHP's offer probably looks a bit wimpy simply on a matter of unfortunate timing. So what will BHP have to pay? Well, Deutsche Bank suggests it could pay US$155 before the deal is not value accretive (3% accretive at US$130), which would be a more realistic 38% premium measured from the same starting point, while Citi adds in a synergy assumption to suggest the deal is still earnings accretive at US$170. Yet talk in the market is that the Potash Corp board would snub anything under US$180. The other problem is that even at US$130, assuming an all-cash bid, BHP's gearing level would rise above the company's limit of 50%. This would likely mean asset sales elsewhere, but it also would rule out any capital management. BHP shareholders are not likely to get Potash and a share buyback. Credit Suisse notes that if BHP spent the same amount on a buyback it would immediately be 10% earnings accretive. So what do analysts think of the idea of BHP increasing its offer? Perhaps Citi sums up the feeling with its headline this morning: “Walk Away Before You Overpay”. But BHP has already gone “hostile”. This means it does not try to negotiate a price the Potash board is happy with but goes straight to Potash shareholders instead. Indications are, however, that major shareholders are also going to hold out for more. It is for this reason BHP shares have been given a caning yesterday and today. Rio shares have risen in contrast, because suddenly Rio looks like the safer bet for iron ore exposure if BHP is going to start throwing money around willy-nilly. And then there's Incitec Pivot ((IPL)), Australia's largest fertiliser producer. The global agricultural sector has already been set on fire by M&A activity (see AWB Bid Fires Up The Agri Sector), and BHP's bid for Potash has sparked a re-rating of all fertiliser producers. Credit Suisse believes earnings upgrades for Incitec are “inevitable” anyway given rising soft commodity prices and falling soft commodity inventories, and that BHP's bid highlights the fact Incitec is currently inexpensive. Deutsche agrees the bid is positive for the sector as a whole, but does not believe a bid for Potash Corp automatically makes Incitec an obvious target as well, and certainly not from BHP. Incitec produces diammonium phosphate (DAP) and not potash, and 50% of the company's earnings come from explosives, not farming. In 2006, when BHP entered the potash JV with Anglo-Potash, it also sold its Southern Cross fertilisers phosphate business to Incitec. If BHP does buy Potash Corp it will also pick up the company's smaller phosphate and nitrate businesses, and perhaps will divest them. The target for BHP is clearly the fertiliser product it can mine. But what are the prospects for the potash price, as opposed to the Potash Corp price? Citi notes that 2008's peak demand for potash globally was 50mt, which fell to 30mt in 2009 and is forecast to be 45mt in 2010. Global capacity currently stands at around 60mt, so Citi can only see BHP's move as a “long term call” on the potash market. Aside from BHP's own potash reserves at Jansen and Potash Corp's own expansion plans, America's fertiliser giant Mosaic and BHP rival Vale of Brazil are also moving to expand supply. There is a risk BHP is trying to buy into what will become a crowded and potentially oversupplied market, at least in the nearer term. By Greg Peel