Game afoot on BHP potash bid

[] — BHP Billiton’s near $40bn swoop for Potash Corp., a Canadian company, caught a lot of us in Johannesburg completely by surprise. It shouldn’t really, however. BHP Billiton has been building a presence in that industry for some time following its $280m acqusition of Anglo Potash in 2008, and in January this year, a successful $320m bid for Athabasca.

Strategically, the move is aimed at capitalising on a broad agribusiness fundamental: while per capita consumption and absolute population numbers are increasing, the amount of arable land globally has remained unchanged. More efficient use of land is therefore required which puts demand into the nitrogen, phosphate and potash industries which are used in the production of fertilisers. Set against this, the last two years of economic contraction has put fertiliser use at near record low levels which suggests this may be a good time to move for potash, at a time when a bottom is believed to be forming in the industry.

In this respect, potash represents a long-term opportunity not unlike the boon metals experienced from the urbanisation of China’s working classes, itself a function of a broad fundamental triggered in the Seventies when China’s central government allowed farmers to sell crops for profit. (This is now being followed by a perhaps even more important liberalisation of laws that enable Chinese farmers to sell property for profit which will hasten urbanisation in the country).

BHP Billiton’s offer is also akin, in some respects, to its presence in the oil and petroleum business. Potash, as with oil, is subject to a different cycle to metals. Therefore, adding a sizeable interest in the potash industry takes some of the volatility out of BHP Billiton’s future earnings profile. The proposed acquisition also provides some insight into how Billiton views the metals business going forward: with economists undecided whether the western economies are in full recovery mode, or not, the health of the metals business lies with China demand and India, to a lesser extent.

We also shouldn’t be terribly shocked at the proposed acquisition price. At $38.6bn, about a third of BHP Billiton’s market cap and equal to $130 per Potash Corp. share, this bid is somewhat lower than the $44bn BHP Billiton was prepared to spend merging with Rio Tinto in 2008. The difference one suspects is that from a diversification point of view, this is capital much better spent – and the potential spending may only start at $40bn.

For its part, Potash Corp is confident it can rustle up rival bids, possibly from Brazilian company Vale or even from food groups seeking integration with an upstream supplier. That means BHP Billiton’s $130/share offer to be the first only, especially as Potash shareholders are likey to agree with management that the offer undervalues the business’s potential.

Unlike its bid for Rio Tinto, Potash Corp. doesn’t present any competition obstacles to overcome, or duplications to smooth out with their unpopular cost cutting. I would have said, until recently, that BHP Billiton has finally got what it wanted out of Rio Tinto by means of the proposed asset level joint venture in Australia’s Pilbara iron ore district. That deal may be on the rocks, however, although Tom Albanese, Rio Tinto’s CEO, has denied the matter. It all makes for an interesting time when BHP Billiton reports its annual results on Wednesday.

Macquarie Securities believes a successful bid for Potash Corp. adds a fifth to BHP Billiton’s aggregate size, while from a funding point of view the enormous $40bn bid doesn’t quite “top out’ the balance sheet which could absorb a $55bn bid for Potash, equal to $185/share. The stockbroker observes, however, that the bid for Potash Corp raises questions about BHP Billiton’s interest in developing its Jansen potash project in Canada which has estimated capital expenditure bill of between $8bn and $10bn.

Perhaps Marius Kloppers, BHP Billiton CEO, believes the Potash Corp removes the risk of developing Jansen as the group doesn’t really have an established presence in the mineral even though it well understands the dynamics of deep, bulk tonnage underground mining and marketing. Potash also brings with it immediate cash flow whereas the Jansen project, while a quarter of the capital cost, does not.

From a funding point of view the enormous $40bn bid doesn’t quite “top out’ the balance sheet which could absorb a $55bn bid

So if all this evidence marries; that the bid for Potash Corp is a smart, diversifying, value enhancing transaction one, why is BHP Billiton’s share price struggling so, down 7% since the bid was first announced on August 13 and last trading in Johannesburg at R206.66?

In truth, BHP Billiton’s share price was under pressure well before the announcement of the bid, but one suspects it’s the huge gambit Kloppers is making. Sure, the group’s balance sheet is looking pretty lazy amid excellent cash flows, but $40bn? The other negative of this transaction were it to be a success is that it effectively removes BHP Billiton from the merger and acquisition market for the next three to four years. For a company with an asset spread that is all about flexibility, and with possible double dip economic conditions coming our way, a bid for a single commodity could limit BHP Billiton’s growth elsewhere and unnerve investors.