No one likes a breakup. They are messy and painful, and it's no fun to watch potential love go down the tubes. Thankfully, Wall Street functions in a different prism than does human emotion, and when large-scale merger and acquisition activity is called off, there are opportunities for investors to profit. Take the natural resources sector for example, in past month, two mega acquisitions have been called off.
Alpha Natural Resources (NYSE:ANR) was the first to be left at the altar when Cliffs Natural Resources (NYSE:CLF) called off its $2.7 billion purchase of its rival. A mere seven days later, mining giant BHP Billiton (NYSE:BHP) ended its 18-month and $68 billion courtship of Rio Tinto (NYSE:RTP).
To be sure, these breakups are more the result of ill-timed courtships. We've all heard that line before, "The timing is just off...". Well, these may be the examples for which the timing excuse is believable. All four companies operate in the commodities space and are heavily dependent on high commodity prices and demand to bolster their bottom lines. And since the commodities bull market screeched to a halt earlier this year, marriages among rivals became significantly less attractive.
Let's take a look at the post break-up performance of these firms:
|Post Breakup Performance|
|Alpha Natural Resources||$119.30||-25%|
|Cliffs Natural Resources||$121.95||6%|
Mr. Market has Been Most Unkind
As we can see from the above table, market reaction to these failed marriage attempts has been surly, with only shares of Cliffs Natural Resources moving up after the announcement of its break up with Alpha Natural Resources. This reaction was predictable considering Wall Street needed no further confirmation the commodities party was officially over. The Reuters/Jefferies-CRB Index, a benchmark for major commodities, already confirmed the weakness and is down more than 120 points in the past year to close December 8 at 219.36 points.
Name Change and No Partner
Cliffs even went so far as to change its name in anticipation of acquiring Alpha Natural. The company formerly known as Cleveland Cliffs is the largest producer of iron ore pellets in North America and relies heavily on steel makers and Asian markets for the bulk of its profit - talk about a toxic customer base. In the past year, shares of steel companies have been battered, with the Market Vectors Steel ETF (NYSE:SLX) down almost 70%. Cliff shares are down more than 50% and Alpha Natural shares have plunged just under 50% during the same time.
Cliffs shares have potential for longer-term investment here. Trading at 1.3 times their book value and a P/E ratio of 4.6, Cliffs shares look reasonably priced, though a rebound in Asian economies and demand for steel will need to occur before any substantive share price appreciation does.
Alpha Natural is actually a coal company and that sector has been repudiated just as other commodity groups have. The company recently announced a mine closure and layoffs, which may help in the near-term. However, Alpha Natural has lowered its profit and production outlooks for 2008, signaling a partnership with Cliffs may have been in its best interest.
Alpha Natural shares trade at roughly 2 times book value and have a P/E ratio of 8. These are probably fair valuations, if not a tad high, given the coal industry's rapid deterioration. On the other hand, coal stocks have become favorite shorts of hedge funds seeking to generate cash to meet forced margin calls. In theory, this means a short-covering rally could be on the horizon, though when that happens is anyone's guess and making that bet is a risky proposition, as is buying Alpha Natural shares.
The Big Wedding That Got Canceled
BHP Billiton's hostile takeover of rival Rio Tinto was initially valued at $147 billion, making it the Titanic of resources acquisitions. As is the case in a forced relationship, one party often gets pensive and walks away, which BHP did as the value of Rio's shares dwindled forcing the final acquisition price down to less than $70 billion.
BHP is the world's largest miner and the third-largest iron ore maker. Predictably, its outlook is quite dire. Its American Depositary Receipts (ADRs) are down 50% in the past year and the company has warned it is scaling back production. Although BHP trades at about 2.5 times book value, other value indicators to note include a P/E ratio of about 7 and a $1.64 annual dividend.
While we have noted Alpha Natural was probably better off with Cliffs, Rio Tinto can likely survive on its own, and probably thrive again when commodities demand picks up. Though its near-term forecasts mirrors that of BHP with job cuts and reduced production on the horizon.
Its shares appear even cheaper than BHP's, trading at less than twice book value with a P/E of 3.2. The company is also selling its stake in a Chinese aluminum venture to raise cash rather than slash its hefty $5.44 annual dividend. (To spot value plays, read Use Breakup Value To Find Undervalued Companies.)
The Bottom Line: Wait for a Rebound
At this point in the commodities cycle, only fools rush in. So the prudent move is to probably stay on the sidelines until China and other emerging market economies signal their appetite for industrial commodities is back. That said, BHP and Rio Tinto with their dominant market positions and lofty dividends could be compelling value plays in the long term.
For added insight into the sector, check out How To Invest In Commodities.