Acquisition fever burns hot--here are three stocks to profit from the frenzy

08/27/2010 11:52 am EST


Jim Jubak

Founder and Editor,

Acquisition frenzy is upon us. August is on a path to be the second best August ever for acquisitions. Making a profit from one of these deals ought to be as easy as shooting fish in a barrel.

Except it’s not.

Many of the barrels as completely void of deals: fire away as you like you’re not going to hit anything. Others are full of nothing but minnows: Nothing you hit is going to be worth the ammo.

There is a way to improve the odds, though.

If you understand the reasons behind the surge in acquisitions, you can figure out where the big fish might be hiding. (For more on the acquisitions boom see my post )

That can help you eliminate some barrels and prioritize others.

Using that process, I’ve come up with three acquisition candidates that I think are worth putting in your gun sights.

Two different motivations are driving this acquisition trend.

First, for companies and their CEOs acquisitions mean a shot at higher profits in two ways. There’s industry consolidation. You’re probably familiar with this story since it’s the motivation for deals like BHP Billiton’s (BHP) $40 billion hostile bid for Potash of Saskatchewan (POT). Consolidation works to increase profits because it eliminates competitors who might have been tempted to cut prices to grab market share and it produces significant increases in margin as companies shut inefficient facilities, combine redundant operations, and reap efficiencies of scale.

And there’s vertical integration. A company that can make steel, supply the iron ore and metallurgical coal to make the steel, do the trading to buy the raw materials and sell the finished product, and maybe even transport it all has the opportunity to capture more of the value chain than a non-integrated company that specializes in just one of these functions. The effort to add the last piece of this structure—the internal trading operation—is also behind many of the cross-commodity acquisitions of the last year or so. If an iron miner and steel maker wants to build a trading operation, buying an oil producer makes a certain sense since it increases your trading clout in the global markets.

Understanding this motivation won’t help much to indentify barrels full of fish, but once you’ve identified the barrels to shoot at, any fish you aim at should exemplify this logic.

To find the barrels themselves look at motivation No. 2.

Second, for companies, especially in state-controlled, state-funded, or state-influenced industries, acquisitions are a way to gain access to raw materials in a world where a ready supplies of commodities at a reasonable price are by no means guaranteed. Can’t run a steel industry without iron ore or metallurgical coal. Can’t make a profit in that steel industry if the price of raw materials—from independent suppliers that want to make a profit themselves—keep rising. Acquiring the supplies and suppliers of the raw materials you need solves both these problems.

It’s this logic that can help you most to identify the barrels to aim at.

And I think it points at three barrels: iron ore, metallurgical coal (the coal used in making that iron ore into steel), and thermal coal (the coal used by utility power plants.

Everybody from Brazil’s Vale (VALE) to India’s steel makers to China’s state-controlled steel companies is buying iron ore producers you’ve never heard of in countries you’ve never thought of as iron ore producers.

For example, last week Xstrata (XSRAF) agreed to a $381 million acquisition of Sphere Minerals (SVESF), an Australian mining company with iron ore deposits in Mauritania. Mauritania is the only West African country that currently exports iron ore, but, according to the U.S. Geological Survey, the region has he potential to produce 10% of the world’s iron ore supply.

If you invest in the commodity sector, you know that China has been aggressively buying iron ore reserves. But it’s not just China. Pretty much every developing country with a steel industry (and that means just about all developing countries) is in the hunt.

For example Saudi Iron & Steel, the largest steel maker in the Persian Gulf, is on the hunt again. In 2007 Saudi Iron & Steel’s parent Saudi Basic Industries (Sabic) pulled out of a deal to develop an iron ore mine in Mauritania. Now with the company looking to increase its steel production to 16 million metric tons by 2020 from 5.5 million metric tons at the time it cancelled its Mauritania deal, Sabic is combing through North Africa Central Asian, and West Africa looking for iron ore deals.

Can’t make steel without metallurgical coal, of course. As you might expect then, if there’s a global iron ore rush, then there’s also a global metallurgical coal rush.

For example, ArcelorMittal (MT), the world’s biggest steel producer, bought a 14.9% stake in Australia; Macarthur Coal (MACDY) for $560 million in May. The acquisition is part of the company’s strategy to lift the company’s 15% self-sufficiency rate in coking coal. (Macarthur is the world’s largest producer, according to the company’s web site, “of low volatile pulverized injection coal used for steel making.” At the end of June ArcelorMittal increased its stake in Macarthur to 19.9% after talks on a possible takeover ended without a deal.

And lastly, there’s good old thermal coal. About 80% of China’s power plants burn coal to produce electricity. For India the figure is 70%. And coal demand is growing—at about 4% to 6% annually in China, for example.

Over the last five years or so coal supply has kept up with demand thanks to rapidly expanding production in China, India, Indonesia, Australia, and South Africa. But looking forward that period of rapid supply increases seems to be drawing to a close as problems such as insufficient infrastructure damp growth. Coal production in Indonesia, for example, which grew by 80% over the last five years, is projected to grow by just 20% over the net five. In Australia and South Africa port and rail capacity need a period of heavy investment if they aren’t to become a bottleneck constraining growth. In India an inadequate rail system means that the country will rely on imports to fill part of its needs. Supply and demand in China will remain in balance in 2010 and 2011, but after that supply will struggle to keep up with demand for coal-powered electricity.

So in this sector too there’s a global race to secure demand that has seen Chinese, Indian, and U.S. companies such as Peabody Energy (BTU) race to buy stakes in the coal sectors of Australia and Indonesia, in particular. (For more on Peabody see my post )

So if those are my three barrels, what fish would I be aiming at now?

Some we can eliminate quickly. I think you’re late to the game in iron ore. The companies being acquired now are very small and very speculative. I think the risk here outweighs the gains. Indonesia would be very attractive for fish shooting, except that the government’s policies restrict foreign ownership. Joint ventures, minority stakes, yes. Takeovers, no.

My top three acquisition plays?

Macarthur Coal (MACDY). The company looks like it may become the focus of a bidding war between ArcelorMittal and Korean steel giant Posco. ArcelorMittal’s stake is up to 19.9% and Posco recently bought a 10% position.

Whitehaven Coal (WHITF) is certainly behaving like a stock that’s in play. The company has been linked to rumored deals by Posco, Xstrata, Peabody Energy and Macarthur (with Whitehaven acquiring Macarthur and vice-versa.) The company has said that it is in talks but not with whom or about what sort of deal.

The company is a producer of high quality thermal coal and is one of the few Australian coal miners that doesn’t yet have a tie up with an overseas strategic investor.

Walter Energy (WLT) is a U.S. producer of hard coking coal for the steel industry. Total production in the second quarter came to 1.54 million metric tons, an increase of 31% from the second quarter of 2009. In the third quarter the company projects production of 1,7 million to 19 million metric tons of coking coal. The April 2009 spin-off of the company’s financing business certainly enhanced the attractiveness of the company as an acquisition.

It’s easy to get giddy about the potential profits from an acquisition and say, I’ll buy at any price. But you’d really like to buy at a reasonable price so that if a deal doesn’t materialize you’ve still got a good shot at making money on the company’s fundamentals.

I’d look to buy Macarthur coal (MACDY) at $21.50 or below; Whitehaven Coal (WHITF) at $5.70 or below; and Walter Energy (WLT) at $70 or below.

Full disclosure: I don’t own shares in any of the companies mentioned in this post in my personal portfolio.
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