Big Deals Underway
The Daily Reckoning PRESENTS: The markets have been quite volatile in the last few weeks – and it’s volatility that has a few companies thinking beyond short-results and really focusing on long-term positioning. Justice Litle explores…
BIG DEALS UNDERWAY
“Examples of private firms in commodity businesses include Cargill and Koch Industries. People at both firms will tell you public shareholders would gag at their volatility and their long-time horizons.”
– Howard Simons
Volatility has hit more than stock prices in recent weeks. Entire companies, and industries, have been caught up in volatile waves of their own as large players look to consolidate, and smaller players debate whether to go along willingly or fight to maintain their independence.
There are three deals on the table that stand out for size and scope. At a combined $21 billion-plus, Anadarko Petroleum’s joint bid for Kerr-McGee and Western Gas Resources ranks as the eighth biggest energy deal of all time, according to Thomson Financial and The Wall Street Journal. Yet that is the smallest of the three deals recently bandied about. In base metals, Phelps Dodge has put together an even more audacious bid, worth $40 billion, for Canadian mining companies Inco and Falconbridge. And finally, Indian steel magnate Lakshmi Mittal looks to have prevailed in his multi-month, drawn-out takeover battle for the number two steelmaker Arcelor, after fighting off ugly management tactics, derailing a sketchy Russian merger and upping his bid to more than $33 billion.
Wall Street is typically distrustful of large mergers and acquisitions. The ones forking out the cash wind up with the short end of the stick more often than not, and the most touted deals can wind up destroying shareholder value. The footing is not always sound: It is sometimes the case that the CEO has an ego to feed and wants a shot at climbing the Fortune 500 league tables or thinks a bigger expense account would go well with a bigger company. But on the flip side of things, when a big acquisition actually has solid strategy and skillful execution behind it, the long-term benefits can be well worth the cost.
What is the rationale behind these three recent plays? In each case, the logic is unique, but the underlying theme of strategic focus is similar. These companies are looking beyond short-term results and thinking about long-term positioning.
In Anadarko’s case, the Kerr-McGee and Western Gas bids are a contrarian bet on natural gas in the Rocky Mountain region. Natural gas in general, and the Rockies in particular, have been mostly written off this year, with plenty of natgas in storage after a mild winter and no sign of a supply shortfall. But farther-dated energy futures tell a different story: While front-month natural gas is trading in the neighborhood of $6 per MMBTU, contracts two and three years out are trading 40% higher. The compelling element of the natural gas story is the ongoing decline of North American gas wells; even with significantly increased exploration and drilling efforts, overall production has flat-lined. Producers are running to stand still as demand creeps higher, pushed by consumer use, commercial use and even demand from energy-intensive recovery operations like the Canadian oil sands. A disruptive summer weather event, or the return of cold winter, could get natural gas rocking and rolling again in a hurry. Anadarko is acting now because it sees the inevitable trends that will keep natural gas supply tight and make expanded production profitable. Nor does it hurt to snap up a roster of high-quality geologists and engineers, as Anadarko is doing, when they are in perpetually short supply.
The Phelps Dodge bid is harder to suss out, as it represents third-party entry into a multiparty bidding war already under way (Both Inco and Falconbridge are being aggressively bid on by other suitors, even as one bids for the other). Shareholders are questioning the logic of the deal, but it is clear Phelps Dodge wants to diversify, hoping to become not just the biggest publicly traded copper mining firm, but the biggest nickel miner, too.
In his bid for number two steelmaker Arcelor, Lakshmi Mittal of Mittal Steel is interested in diversity of markets, rather than product, seeking access to Arcelor’s higher-margin opportunities. Mittal also hopes to tap the negotiating clout and bargaining power that comes with huge size, as the combined Arcelor Mittal would be a global steel behemoth four times the size of its nearest rival.
Managers here are deliberately taking a long-term perspective; they are looking many years out and positioning themselves for the landscape ahead. That is what Outstanding Investments looks to do also. Our thesis is built around the idea that the great infrastructure arbitrage is still in its early days. As globalization takes hold, bigger could well prove to be better, as long as big does not preclude lean and nimble. And as long as Wall Street continues to undervalue the earnings power of well-managed energy companies, and continues to underestimate the value of a long-term perspective, the merger and acquisition fever will still have legs as savvy companies like Anadarko seek to unlock value for themselves. Plus with the oil majors still on the prowl and new reserves hard to find, the biggest of big deals could still be in the works.
Commentators like Andy Xie of Morgan Stanley (who wrongly beat the drum for a speculative oil price collapse in 2005) think inflation pressures will be a problem for the next few years and that central banks will bruise the markets in an ongoing battle with inflation. We suspect Mr. Xie could be as dead wrong here as he was on crude oil.
Why? Because here in this odd twilight of Bretton Woods II, it is possible for inflationary problems to become deflationary ones very quickly.
Much, if not all, still hinges on the American consumer. The gradual withdrawal of consumer spending power is a potentially deflationary force. The housing bubble doesn’t have to implode spectacularly for consumer spending to fall sharply. As the cost of mortgage service rises, discretionary income is squeezed. If the average homeowner keeps the house payments intact, but cuts the budget to the bone to do so, we could have a “stealth” crisis that slips in the back door – and a creeping recession even if home prices flat line, rather than implode.
If the Federal Reserve is perceived as losing its handle on inflation yet again, gold will benefit, and for the past few years, gold has been seen as an inflationary hedge. But gold’s real run may come in the teeth not of inflation, but of deflation. If Bernanke does not come to the consumer’s rescue fast enough – and odds are good it is already too late – then deflationary forces could roll in with a heavy weight of debt behind them, leaving the Fed to “push on a string” (meaning stimulus without effect). In a scenario in which economic activity falls as the Fed stimulates, the dollar rapidly loses value (due to more and more dollars being pumped into the system) and gold becomes a proxy for stable cash. When deflation reigns, cash is king – and gold is the only cash equivalent not subject to debasement by frantic central bankers.
At this debt-laden hour, the only way for the world to avoid a deflationary endgame is for global central bankers to get together and pull off a massively coordinated reflationary effort…in which case, gold still wins. Either way, inflation or deflation, gold comes out on top. The reason for this is not some magical property bestowed upon gold; it is because the reality of America’s Empire of Debt (and Asia and the Middle East’s mercantilist participation in its buildup) has brought us to this point. When the debt gets onerous enough, the only choice left is to liquidate, and the ultimate mechanism of liquidation is debasement of the currency. It just becomes a matter of how to go about it, and under what circumstances. Whichever we get, inflation or deflation, gold is the other side of the inevitable debt liquidation trade.
for The Daily Reckoning
July 27, 2006
Editor’s Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert’s Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).
Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas – among other things. This monthly gathering includes the cream of the crop of financial minds – and for a limited time, the Agora Financial Reserve is open to the public.
“In the past three years America has been enjoying an unusual combination of low inflation and rapid growth,” writes Anatole Kaletsky in the London Times. “This happy combination cannot continue much longer. In the months ahead, either inflation will continue to accelerate or economic growth will have to slow abruptly, to the point where unemployment starts rising and businesses start going bankrupt.”
Our friend, Byron, believes bankruptcy is going to be a popular practice for lawyers in the years ahead, like IPOs and mergers and acquisitions in years past.
He has an explanation for the word, too. “Bankruptcy comes from ancient Rome,” he points out. “Merchants used to operate from a ‘bankus’ – a sort of workbench or counter. If they couldn’t pay their bills, the local authorities would come over and break their bench – bankus ruptus. In England, they kept the bankruptcy procedures left behind by the Romans after they left, even the part where they sold the bankrupt person into slavery. Only, it wasn’t slavery anymore, it was indentured servitude. And many were sold into indentured servitude in the colonies.”
Byron blames it all on one of our Big E’s – Energy.
“It’s because of oil,” he says. “We’re at peak production right now. But there are five billion people who are looking forward to the life that we Americans now lead. In China alone, if people lived as we do, they’d consume 100 million barrels of oil a day. And here we are at maximum production and the whole world only puts out 84 million barrels.
We keep telling these people that they should want what we have. Democracy. Capitalism. ATM machines on every corner. Who’s going to tell them the bad news? They can never have it because there’s not enough cheap oil. The fact is – they can’t be us, because the Earth can’t produce enough oil to allow everyone to live like us. In fact, we can’t be like us either. At least, not all of us. What’s going to happen is that the people who are now getting wealthy in the rest of the world are going to use the oil that lower- and middle-class Americans expected to use.”
Many Americans won’t be able to afford the new, higher prices of petroleum products.
Meanwhile, in the Times, Anatole Kaletsky continues:
“The U.S. economy is now clearly slowing, and what started as an orderly retreat in the housing market is turning into a rout. Yet the slowdown in housing and consumption has come too late to prevent a steep increase in inflation. On Wednesday, U.S. government statisticians reported a further jump in inflation to 4.3 per cent. This was the highest inflation rate reported since 1991 (apart from a one-month blip after Hurricane Katrina).”
Kaletsky has been very bullish on the world economy. In fact, he has been engaged in open warfare with such well-known bears as Marc Faber, for example. Now, he seems to be reading the papers.
In the papers, the Associated Press tells us that existing and new house sales, combined, have been going down for the past seven months. “Area home prices drop,” adds the Washington Post, noting that the median price of a house in nearby Loudon County, VA, is off 1.2% over the year before. To make sure we get the point, it has a photo of a man who is giving away a new car to whoever will buy his suburban house.
Nationwide, inventories are up; sales are down. Prices are falling in key areas, though they are still above a year ago on a countrywide basis.
In Massachusetts, foreclosures are up 66%, says the Boston Globe.
And, we got word from a friend who is trying to sell his house in Santa Barbara that not a single person came to look at his pad in a two-week period.
Kaletsky goes on:
“Inflation in America is now running at a truly alarming 4.8 per cent. How can the Fed commit itself to price stability and rapid growth? How can it halve U.S. inflation from 4.5 to 2 per cent without allowing even a brief period of rising unemployment? Professor Bernanke offered no answers. If he performs these miracles, he will go down in history as an even greater financial wizard than Alan Greenspan. If he fails, he may be likened to another Bush appointee who promised painless victories without much idea of how to achieve them. Is Ben Bernanke the Fed’s Donald Rumsfeld?”
More news from our blog – The Desidooru Saloon…
Byron King has this post:
“Chinese oil companies are aggressively seeking potential deals. Chinese firms are attempting to outmuscle big international oil companies, which is not all that difficult, because Western firms tend to be beholden to Wall Street demands for short-term growth.”
Short Fuse, reporting from Vancouver…
*** Day two of the conference started out with Steve Forbes…and while we don’t necessarily agree with everything he had to say (he thinks our economy is looking good just the way it is), he still received a standing ovation at the end of his speech.
Forbes also got more than a few chuckles out of the crowd. At one point, he quipped: “You shouldn’t complain about the price of your children or grandchildren’s tuition – it’s nothing compared to how much it’s going to cost to educate Bernanke.”
Not all of the speakers held the same view Mr. Forbes – and most financial commentators agreed on the ineptitude of Helicopter Ben. In fact, Mark Skousen thinks Bernanke is the only one who can save us from the mess Greenspan left. Hmmmm…
And the day didn’t end there. Our very own Maniac Trader, Mr. Kevin Kerr, filled us in on what strategies work in trading the commodities markets and advised the audience to make sure that at least five to 10 percent of their portfolios were tied up in resources.
The conference is far from over. Today and tomorrow will bring speeches from Doug Casey, Justice Litle, Chris Mayer and Byron King – just to name a few. Stay tuned…
Now, over to Bill and a look at more of our Big Es…
*** The grand Exodus of money and power, from West to East. One of the biggest trends in economic history was the rise of the West – centered roughly in Manchester, England, and Manchester, New Hampshire – in the 18th century. Then, in the 19th century, all of Europe, and the European outposts in the New World, spurted ahead of the rest of the world. By the end of the 20th century, the average worker in Western Europe or the United States earned about 20 times as much per hour as a similar worker in China or India.
But the averages masked the new trend. Today, wages in India and China are rising sharply. Those in America and Europe are stagnant. Yesterday’s Financial Times tells us that real hourly incomes in America are lower today than they were five years ago. In India, they have almost doubled.
Meanwhile, China is growing faster than at any time in the last 10 years – with a GDP growth rate over 11%. India is not far behind. Both economies are graduating hundreds of thousands of new chemists and civil engineers, whereas American universities turn out young people trained in sports therapy and theatre design. And while both economies are plagued by the usual assortment of bullies and bureaucrats, Asian parasites are much cheaper than ours, which, along with low wages, gives them a tremendous advantage.
Is the Chinese economy dangerously exposed to a slowdown in U.S. consumption? Yes. Is the Chinese economy laden with contradictions, obfuscations and swindles? Yes. Are the Indians burdened by inefficient transportation and nerve-fraying business frustrations? Yes. But if they had not these sorts of problems they would already be rich. Instead, they are still poor, which is the source of their competitive advantage.
“Look,” said a friend from India. “You’re doing all this computer processing work in your business. And you’re doing it in very expensive places, like London. I can put you in touch with people in India who can do it a lot cheaper. I mean, you pay an IT guy probably about $80,000 in the United States. In India, you can get someone just as competent for $20,000. Really, you should be outsourcing that kind of work.”
That is what we are hearing. Other businessmen must be hearing the same thing. Who can resist?
Will this trend end soon? Certainly, it will see some setbacks and countertrends. Prosperity is a matter of more than just money. It will take time to knock down all the obstacles. But why should it end? We can think of no reason. What is happening is nothing more than a reversion to the historical mean – when people in Asia and people in Europe earned about the same thing. At least at the bottom, pressure from Asia should hold down wages in the West for another 20 or 30 years. And buying from Asia should push up prices for things that Asian labor cannot produce: oil, for example…and food, raw materials, Old Masters painting, antiques, and gold.