Mining Mergers & Acquisitions in 2006

01 March 2007

Tookie Angus, adviser to Fasken Martineau DuMoulin LLP, with the assistance of Jean-Michel Noël, student at law

This article first describes the mining M&A story of the year - the proposed Inco/Falconbridge merger. A review of other Canadian mergers of note follows as well as an examination of future M&A trends in the mining industry. An exploration of the business reasons behind mergers and acquisitions in the mining sector concludes the article. 

The Mining M&A of The Year 

In 2006, the mining merger with the most media exposure was without a doubt the saga involving Inco Inc, Falconbridge Ltd, Phelps Dodge Corp, Xstrata PLC, Teck Cominco, Companhia Vale do Rio Doce and Freeport-McMoRan Copper & Gold Inc. It was a courtship with many twists and turns, which resulted in three mergers and three spurned suitors. 

It started in October 2005, when Inco, a nickel producer with a market capitalisation of $11.5 billion, negotiated a $12 billion cash and share friendly takeover of Falconbridge, another nickel producer with a market capitalisation of $10.8 billion (September 2005 value). The merger would have created the world’s largest nickel producer with a nickel output of approximately 735 million pounds in 2005. Inco touted Falconbridge as the perfect match since significant cost savings would result from combining their mining operations in Sudbury, Ontario. However, while the competition authorities of the U.S. Department of Justice and the European Commission were still studying the proposed merger, new players entered the field. 

On 8 May 2006, Teck launched a $17.8 billion cash and share unsolicited takeover offer for Inco. The bid was conditional on Inco dropping its planned merger with Falconbridge. Teck, a leading producer of zinc with a market capitalisation of $15.5 billion, believed that the merged Teck/Inco firm would create a financially sound and broadly diversified mining venture that would be a market leader in zinc, nickel and metallurgical coal. Then on 17 May 2006, Xstrata, a metal mining company based in Switzerland with annual revenues of US$8 billion, entered the fray. It offered to purchase the 80 per cent of Falconbridge shares it did not already own for $16.1 billion in cash, thereby valuing Falconbridge at close to $20 Billion. Xstrata viewed the Falconbridge acquisition as the next step in becoming a global mining company since the combined companies would create the world’s fifth largest diversified mining company, with leading market positions in copper, nickel, thermal and metallurgical coal, and zinc. On 31 May 2006, the boards of directors of both Inco and Falconbridge rejected these hostile takeover bids and stated that they would continue with their planned merger. The search for a white knight began. 

The white knight appeared in the form of Phelps Dodge, a US copper miner with a market capitalisation of US$15.5 billion. Phelps Dodge offered $40 billion in cash and shares to acquire the combined Inco/ Falconbridge company. This three-way deal would have created the world’s largest nickel producer and the largest publicly traded copper producer, resulting in a combined annual cost savings of US$900 million by 2008. However, the dream of the biggest corporate takeover in Canadian mining history ended on 28 June 2006, when less than 50.01 per cent of Falconbridge’s shareholders tendered their shares to Inco by the offer’s expiry date. Thus, Inco was forced to bow out of the race for Falconbridge, paving the way for an Xstrata takeover. 

Xstrata had effectively scuttled Inco’s acquisition of Falconbridge by raising its all cash bid for Falconbridge by 7 per cent. This increase valued Falconbridge at $24.1 billion. Inco had miscalculated; it believed that Falconbridge’s shareholders would be willing to accept its lower bid price since the long term benefits of the three-way merger were superior to the long term benefits of the Xstrata/Falconbridge merger. In reality, most long term investors had already sold their Falconbridge shares to arbitrage investors who were strictly interested in short term gain. Therefore, the long term benefits of the mergers were no longer an incentive for the new shareholders. The only incentive that counted was cash, which Xstrata gladly offered. Once Inco was no longer a contender, Falconbridge’s board of directors recommended the Xstrata offer. By the end of the day on 14 August 2006, the expiry date of Xstrata’s offer, 67.8 per cent of the outstanding common shares had been tendered, which in combination with the shares already owned by Xstrata totalled 92.1 per cent of the shares outstanding. The fight for Falconbridge was over: Xstrata had taken control. Meanwhile, the bidding war for Inco was heating up. 

Only three days after Inco withdrew its offer for Falconbridge, Teck raised its bid for Inco to $18.6 billion in an effort to edge out Phelps Dodge, which had pledged to acquire Inco whether or not the Inco/Falconbridge merger proceeded. Inco’s board of directors rejected Teck’s offer on 7 August 2006. Then, on 11 August 2006, the world’s fourth largest miner with a market capitalisation of US$55 billion entered the fray with a $17.2 billion cash offer for Inco. 

The Brazilian miner, CVRD, believed that Inco could be used as a platform to expand CVRD internationally and facilitate the raising of capital outside of Brazil. Teck bowed out of the bidding war once it realised that it could not raise the financing needed to sweeten its offer. Then on 5 September 2006, Inco cancelled its proposed merger with Phelps Dodge in advance of its special shareholders’ meeting when it became clear from the proxy votes that Inco’s shareholders were not going to approve the merger. With the proposed Phelps Dodge/Inco merger cancelled, Inco was at liberty to discuss a potential merger with CVRD. On 24 September 2006, Inco’s board of directors recommended the CVRD offer to its shareholders. On 24 October 2006, CVRD obtained control of Inco, and on 4 January 2007, Inco became a wholly-owned subsidiary of CVRD. 

As for Phelps Dodge, on 19 November 2006, it announced that Freeport would acquire it for US$25.9 billion. This friendly takeover would create the largest publicly traded copper company in the world and significantly expand the geographic presence of both companies. The transaction is expected to close at the end of the first quarter of 2007. 

Thus ended the 2006 mining merger of the year. 

Other Mining M&A of Note in 2006 

Although, the Inco/Falconbridge saga was one of the more compelling M&A stories of 2006, there were several other major mining M&A transactions in Canada. The first transaction of note was the acquisition of Glamis Gold Ltd by Goldcorp Inc for US$8.7 billion in cash and shares. The acquisition was completed on 4 November 2006, creating a combined company with a market capitalisation of approximately US$21.3 billion. The company thus became the 19th largest publicly trade company on the Toronto Stock Exchange and the third largest global gold producer. The acquisition was beneficial to both parties since it allowed Goldcorp to significantly increase its gold reserves and permitted Glamis to choose a suitor on its own terms before it became the target of a hostile takeover. 

The second transaction of interest was the acquisition of Bema Gold Corporation by Kinross Gold Corporation for US$3 billion. The Bema shareholders approved the proposed acquisition on 30 January 2007, creating a geographically diversified US$7.9 billion gold producer with nine mines in five countries across three continents. 

The third major transaction was the acquisition of EuroZinc Mining Corporation by Lundin Mining Corporation, completed on 31 October 2006 for US$1.6 billion. This transaction created a leading copper, zinc and lead producer with operations in three different European countries. The combined company’s US$3 billion market capitalisation and the cross-listing of its shares increased the liquidity of its shares. The increased liquidity and analyst coverage should facilitate the company’s future financing. 

The last transaction of note is the acquisition of Cambior Inc by IAMGold Corporation for US$1.2 billion. The transaction, which completed on 8 November 2006, created a company with a market capitalisation of US$3.6 billion. The financial rationale for the combination was to significantly increase production, resources and reserves, diversify geographic risk and lower the cost of equity capital. 

Future Mining M&A Trends in 2007 

M&A activity in the mining industry will not slow down in 2007. Granted, most of the big players will be busy digesting their latest acquisitions but the mid-cap mining companies will likely consolidate among themselves or acquire some of the promising junior mining companies. In 2006, the Raw Materials Group located in Stockholm, Sweden, estimated that there were approximately 4,100 mineral companies in the world. Of those, 149 were qualified as major companies while 957 were categorised as medium-size enterprises. The remaining 3,067 were classified as junior companies. Therefore, with so many medium-size and junior players, consolidation is inevitable. This is especially true in the precious metals sector of the mining industry.

The price of precious metals has been soaring for the last two years, with gold hitting US$725 per ounce in May 2006. Although many analysts believe that gold will pull back due to lower demand in Asia, it will remain well above its lows of 2001. Platinum and silver have also seen significant increases in the last two years. Therefore, it is likely that 2007 will see a rush of M&A activity in the precious metals sector. After all, higher precious metals prices means that the companies mining them have higher cash flows and therefore can afford to pay a premium for their competitors in the race to acquire higher production outputs and reserves. In prospect, 2007 looks to be a golden year for M&A. 

Another trend in the mining industry in 2007 will be the continuing expansion of Chinese mining companies on the international stage. China’s metal demand, fuelled by an estimated 2007 GDP growth of 10 per cent, will push the larger companies such as China Nonferrous Metal Mining Group to secure raw materials overseas. This will likely be done with the help of joint ventures with host governments or by acquisitions of medium and junior mining companies. Of course, any foray abroad by Chinese companies will have to be approved by the Chinese government, a slow and timeconsuming process. 

Business Reasons to Merge or Acquire 

Why does one mining company acquire another? Well, there are several business reasons for one company to merge with or acquire another. First, acquiring another company in the same line of business can create cost savings through economies of scale. A prime example of this would have been the cost savings anticipated by the now defunct Inco/ Falconbridge merger. Mining companies can also cut costs by merging their administrative functions or their distribution operations. 

Secondly, bigger companies normally have higher share liquidity and are followed by more analysts. Therefore, by increasing its size, a company may lower its cost of equity financing. For example, one of the reasons behind Inco’s acquisition by CVRD was to use Inco as a platform to facilitate the raising of capital outside of Brazil. In addition, a larger company normally has a stronger balance sheet than a smaller counterpart and its larger cash flow allows it to build capital reserves to carry it through any commodity downturn. Therefore, a larger company should be more financially sound than its smaller counterpart. Furthermore, bigger companies can become market leaders and have more pricing power, leading to increased margins and greater financial stability. 

Thirdly, mergers and acquisitions are an effective tool against bad management teams. Companies with ineffective managers are prime targets for hostile takeovers since they are undervalued in the market. By acquiring such a company and replacing the underperforming managers with a more proficient management team, the acquirer can unlock the value of the target company. 

Fourthly, exploration and development of mines are not only risky but also very time consuming and expensive with equipment and other costs increasing because of booming demand. Therefore, it can make economic sense to buy an existing mine with proven reserves and resources since the risks involved are minimal and the returns are almost guaranteed. Mergers and acquisitions allow larger mining companies to increase their reserves, output and production while reducing their overall risk exposure. The initial mining company which incurred the exploration costs carries the significant exploration risk. The larger mining company simply pays a premium for the risk incurred by the smaller company to find and start the exploitation of the mineral reserve. In effect, exploration risk is transferred from the larger mining company to the junior mining company, which decreases the overall risk of the larger mining company and thus lowers its cost of capital. Of course, in a perfect zero sum market, the premium paid for the junior company would equal the savings from the lower cost of capital. 

Fifthly, corporate coffers are swelling from higher commodity prices. Mining executives are faced with three choices, they can build up a cash reserve in case of a commodity downturn, return the money to shareholders via dividends, or purchase some of their rivals. Nine out of 10 times the executive will choose the last option, even though the first is financially responsible and the second is theoretically correct. The reason for this choice is often called the agency problem. Not only is it more exciting to launch a takeover offer for a rival company, it also increases the prestige of the executive (especially if the bid is successful). In addition, levels of managerial compensation tend, on average, to be positively correlated with firm size (Jensen and Murphy, 1990). Therefore, executives are inclined to take greater risks with shareholders’ money for their own personal gain. One should not discount the human factor in M&A decisions. 

Sixthly: consolidate or be consolidated. Sometimes a company must enter into a friendly merger to stave off hostile bidders. The prime example would be the bid from Phelps Dodge for Inco and Falconbridge. Sometimes a hostile takeover is triggered to thwart a rival’s bid on another company. Take the bid of Teck on Inco, for example.

By bidding for Inco, Teck effectively hamstrung Inco from placing a higher bid for Falconbridge since a higher bid for Falconbridge would decrease Inco’s share price, making the Teck bid more enticing to Inco’s shareholders. In essence, it was a defensive play in which Teck forestalled the creation of a large Canadian mining competitor. Another cautionary lesson we should take from the Inco/Falconbridge saga is that once a company enters the takeover arena, it can easily put itself in play. After all, of the seven companies involved in the saga, only Teck neither acquired nor was acquired by another party.

Finally, mining companies are unique since their base of operations is dictated by the location of their mineral reserves. M&A allows mining companies to geographically diversify their sources of revenue – their mines. Although a recent study argues that international diversification is associated with a reduction in value of the average firm (Denis, Denis and Yosi, 2002), the mining industry is an exception to the rule. In effect, a mining company can lower its overall risk by diversifying into several geographical locations – lowering both its geopolitical risk and risks from natural disasters. The agency cost associated with international organisations does not outweigh the benefits of that risk reduction. However, a study regarding the benefits of international diversification with respect to mines should be conducted to further investigate the matter. 

Conclusion 

2006 was a tumultuous year in the mining industry with several large consolidations. Although the Inco/Falconbridge merger seized most of the headlines, there were several other large mining mergers in Canada. While 2007 will not see a slow down in the number of M&A deals, a decrease in the size of the deals is quite possible. High commodity prices and a fragmented industry will fuel further consolidation. As long as mining executives base their M&A activity on financially sound business reasons, further consolidation will be beneficial for the overall industry since it will allow for the efficient allocation of economic resources and risks among the participants. Once the wave of M&A activity recedes, the mining industry as a whole should emerge stronger than before.

It is not possible to buy entry into Who's Who Legal

terms and conditionscontact us