Rio Tinto-Alcan: Just the Start

Heated M&A in the sector could create a mining giant while driving Alcoa to a deal and pulling private equity firms into the game

Editor's note: This is an updated version of a story that first appeared on on July 11, 2007

The sizzling mining sector is getting even hotter. After days of volatile stock movements across the sector as merger rumors swept the markets, London-based Rio Tinto (RTP) made a $38.1 billion bid for Canadian mining company Alcan (AL) on July 12, snatching it away from U.S. aluminum giant Alcoa (AA), which had earlier launched its own $27.9 billion offer for Alcan.

If the deal goes through, the newly renamed Rio Tinto Alcan would become by far the largest mining company in the world, controlling 11% of the world's aluminum supply and 14% of global bauxite reserves. The merger comes at a time of growing consolidation in the natural-resources sector, when high commodity prices driven by Chinese economic growth are lifting mining stocks to record highs.

Rio Tinto's move likely puts an end to Alcoa's attempt to buy Alcan. "Alcoa has been outbid," says Charles Cooper, a mining analyst at brokerage NCB London. The company could respond with a higher counteroffer, but most analysts think the price set by Rio Tinto is now too rich for Alcoa to beat.

Priced Out of the Market?

What might happen instead is that another mining concern, such as BHP Billiton (BHP), Xstrata (XTA.L), or Brazil's CVRD (RIO), could turn around and grab Alcoa. There have been persistent rumors for the last month that BHP might bid as much as $40 billion for Pittsburgh-based Alcoa, perhaps in partnership with private equity players.

Analysts caution, though, that the high price set for Alcan could raise the bar and make Alcoa too expensive to swallow. Its shares were up 2.7% in early trading July 12, to $45.47. That gives the company a market capitalization of $39.5 billion, and any takeover deal would certainly have to include a premium over that.

Targets for Private Equity

Given the eye-popping amounts spent in recent private equity transactions, such a deal is not out of the question. Indeed, a report issued July 11 by consulting and accounting firm Ernst & Young suggests that mining companies could soon become a target for big private equity firms such as the Blackstone Group (BX) and Kohlberg Kravis Roberts.

A private equity move into mining may be not so far-fetched. Flush with cash and in stronger, more consolidated positions, mining companies could make tempting targets for private equity capital that's unafraid to take a chance on an historically risky sector undergoing a prolonged bull run.

Base metal commodity prices, notorious for their boom-and-bust cycles, have been riding high since the start of the year. "From what we've seen recently, it looks likely there's going to be a longer bull run in commodity prices than many people first thought," says NCB Group's Cooper.

Price-Setting Power

The steady rise of commodity prices over the last two years underpins any possible move of private equity into the mining sector. Unrelenting demand, mostly from developing countries, continues to outstrip supply, with copper, for example, hitting a two-month high on the London Metal Exchange at $8,015 a metric ton on July 9. Such levels are not expected to last forever but, according to JPMorgan Chase (JPM), base metal commodity prices should more than double by 2010 compared to the last bull market, in 2002.

Booming commodity prices aren't the only reason private equity is taking a closer look at the mining sector. The spate of merger-and-acquisition activity within the sector over recent years has given the likes of BHP and Rio Tinto greater price-setting power through their control of the volume of metal entering the market. And better pricing power helps reduce the risk for possible investors.

According to Ernst & Young, global M&A deals in the mining industry have gone from $16 billion in 2005 to $68 billion in 2006, and many analysts believe Alcoa will be the next company to fall to competitors.

This consolidation could be a double winner for private equity firms. Buoyed by strong demand from China and India, mining companies are moving away from their cyclical model to one based on more basic supply-and-demand concerns. According to Michael Lynch-Bell, head of mining and metals at Ernst & Young, this makes the sector extremely attractive for private equity as it limits the risks historically associated with the sector. He says, "The miners are flush with cash and there is, arguably, unrecognized value in the mining sector."

Expecting a Price Downturn

The recent M&A activity also could see private equity snap up downstream mining assets, such as packaging and manufacturing plants, as companies sell off noncore businesses to focus on their upstream mining and smelting assets. This could be particularly attractive to private equity firms, says Lee Downham, director of Ernst & Young's global metals and mining division, especially if companies are looking to off-load assets quickly to pay down debt used to buy competitors. "If time is more important to acquirers than the ultimate value [of the assets], it could be very interesting to private equity," he says.

Despite bullish commodity prices and the mining companies' strengthened positions, it might not be all clear sailing for private equity players willing to enter the sector. JPMorgan is predicting a downturn in metals prices during 2008. And should buyout firms pony up big bucks to purchase mining outfits, they would still be faced with heavy, long-term spending necessary to develop new mineral discoveries. That prospect could prove daunting to some would-be buyers.

Rio Tinto's $38.1 billion Alcan bid shows there is still plenty of appetite for deals. The chance of huge rewards apparently outweighs concerns about prices and debt. That means private equity outfits could soon be staking their claims in the mining sector.

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