Money, Mines and Nickel

THE SUDBURY BASIN is a major geologic structure located in Ontario, Canada. It is the second largest known meteorite impact crater on the face of the Earth. (Vredefort crater in South Africa is the largest verified impact crater on Earth, and there may be one even larger buried under the ice of Antarctica.) The Sudbury Basin is part of the Canadian Shield. The nearest city is Greater Sudbury, Ontario.

Sudbury Basin

The Sudbury Basin, or what is left of it, is about 37 miles long, 17 miles wide, and 9 miles deep. It formed about 1.85 billion years ago when a 6-mile-wide meteorite (some researchers believe that it was a comet) struck the Earth at a hyper-velocity. The impact penetrated the crust as far down as the mantle, and was of such scale of energy that large pieces of the Earth’s crust were in all likelihood blown back, and accelerated far into outer space. It must have been a true Star Trek moment.

The present size of the Sudbury Basin is just a small remnant of what is believed to have been the original crater of about 155-mile diameter. Subsequent geological processes in Precambrian time, as well as extensive erosion over the past billion years, have extensively deformed the crater into its present, smaller oval shape. And it is certainly one fascinating body of rock.

The original impact crater rapidly filled with magma from the Earth’s mantle, which, over time, crystallized into minerals containing nickel, copper, platinum, palladium, gold, and other metals. As a result of these mineral deposits, the Greater Sudbury area is one of the world’s most important mining districts. The rock formations of Sudbury hold within them some of the world’s largest deposits of nickel and copper ores. One of the major producers of nickel ore and associated nickel products is the International Nickel Co., or INCO, and its subsidiary the International Nickel Company of Canada Ltd.

Smacked Upside the Head by a Meteorite

Last week, the management of INCO, a worldwide metals producer, must have discovered what it was like to get smacked upside the head by a giant meteorite, when shareholders of Falconbridge, another mining company and a significant nickel producer in its own right, rejected an INCO takeover offer. Let’s back up to last year and review what happened.

On Oct. 11, 2005, INCO announced that its board of directors had agreed with the board of directors of Falconbridge Ltd. that INCO take over all of the outstanding common shares of Falconbridge, by way of a “friendly” takeover bid that included both cash and INCO shares. INCO’s assets total in excess of $12 billion. Falconbridge owns over $13 billion in assets. The combined INCO-Falconbridge organization would have been one of the world’s largest producers of both nickel and copper, and controlled one of the mining industry’s most attractive portfolios of low-cost, profitable new mining projects.

Falconbridge, a Canadian company founded in 1928, is one of the world’s leading producers of nickel, copper, zinc, and aluminum. In June 2005, a few months before the INCO offer was announced, Falconbridge had dramatically increased its size by merging with another venerable name in the mining business, Noranda. Thus a merger between INCO and Falconbridge would have created a colossus in the nickel and copper mining business.

In late 2005 and throughout 2006, the INCO offer for Falconbridge was held up by regulatory review in Canada, the U.S., and Euroland. And all the while, commodity prices for nickel, copper, zinc, cobalt, and many other products were moving upward at a rapid rate. In no small measure, this was because of industrial demand from China.

Xstrata Crashes the Party

In May 2006, another mining company named Xstrata PLC made an unsolicited offer to purchase for cash all of the outstanding common shares of Falconbridge. Xstrata is a major global diversified mining group, listed on the London and Swiss stock exchanges and with headquarters located in Zug, Switzerland. Xstrata produces six major types of industrial commodities. These are copper, coking coal, thermal coal, ferrochrome, vanadium, and zinc, with some additional production of gold, silver, and lead. Xstrata’s operations span five continents, namely Europe, Africa, Australia, South America, and North America (more specifically, Canada).

Initially, Xstrata offered C$52.50 in cash for each share of Falconbridge. Falconbridge management replied that it believed that the offer was not enough and did not reflect the full and fair value of Falconbridge shares, nor did Xstrata’s offer give shareholders the opportunity to participate in the growth that was anticipated as a result of the INCO-Falconbridge merger.

In mid-July 2006, Xstrata increased its cash offer for Falconbridge to C$62.50 per common share in cash. Under the terms of the offer, the Falconbridge shareholders would also receive a special cash dividend of C75 cents per common share declared by Falconbridge on July 16, 2006, representing total proceeds of C$63.25 per Falconbridge common share.

The bottom line for Falconbridge shareholders was that the INCO offer was “higher” in the sense that it added up to more in terms of cash per share, plus INCO shares, totaling about C$65.25 per share. But the Xstrata offer of C$63.25 was all in cash and offered a fast payout. For INCO to be successful in its takeover bid for Falconbridge, INCO had to obtain a majority of shares tendered by Friday, July 28, 2006. This did not happen, and thus, the deal fell through.

Money Listens, Money Talks

In the week or so before the July 28 deadline, INCO had only obtained about 20% of the Falconbridge shares to its side of the takeover proposal. But in the past year or so, a large number (estimated to be about 40%) of Falconbridge shares have been bought up by hedge funds. These hedge funds are pools of funds that are invested with a promise of generating a specific return, regardless of whatever else occurs in the financial markets.

In a sense, hedge funds are emblematic of what you might characterize as “tactical” investors who are chasing the highest yields possible over the shortest time frames. A tactical investor is simply pursuing a stock position in a particular situation, almost without regard for the underlying company itself. To the extent that a hedge fund has any investment strategy, it is a “strategy of tactics.” That is, hedge fund managers have little, if any, loyalty to a given company. The hedge fund managers own shares with the expectation of seeing a run-up in the stock price. Then they will move to liquidate the position for the best gain possible. The mandate of hedge funds is to make fast money in the stock market, not to focus on long-term issues of corporate governance.

The competing offers for Falconbridge by INCO and Xstrata illustrate the point with great clarity. INCO offered Falconbridge shareholders cash and stock totaling more than the Xstrata offer, and with the prospect of the resulting merger allowing the shareholders to participate in future growth of the company. Xstrata’s deal offered a slightly lower overall value (by about C$2), but it was all in cash, thus allowing the hedge fund managers to take the money and run. There was no real need for the hedge fund managers to consider the future prospects of the nickel market, or markets for other industrial metals, that a merged INCO-Falconbridge firm would produce in the future.

Compounding the problems for INCO, many of the hedge funds that own Falconbridge shares also own shares of INCO. The recent announcement by Phelps Dodge that it wants to take over INCO has already placed INCO into play on Wall Street. Teck Cominco also has announced a hostile bid for INCO. And now the hedge fund managers are anticipating that other mining firms might enter into the fray and drive up the price of INCO. Thus the “strategy of tactics” for the hedge funds is to take the Xstrata payday and hold onto their INCO shares in anticipation of another bidding war for the mining firm.

As if on cue, Grupo Mexico SA, one of the largest copper producers in the world and parent of Southern Copper Corp., has reportedly hired U.S. financial advisers to explore taking over Phelps Dodge, and, by implication, INCO. In addition, Companhia Vale do Rio Doce (CVRD) has expressed interest in acquiring INCO. And other firms, such as Rio Tinto, BHP Billiton, or even Russia’s Norilsk could decide to make a play for INCO, if not for Phelps Dodge.

Restructuring the Mining Industry

So the near-term future of the mining industry is probably going to be one of competing takeover offers and eventual consolidations on a massive scale. But whatever happens to INCO, and to the other companies in the heavy metals mining industry, it appears that hedge fund money is going to control the outcome.

In the world of hedge funds, the proverbial tail wags the dog. Hedge fund thinking is entirely short-term, such that any deal will have to be structured to offer cash, instead of commercial paper or other forms of stock. This means that acquiring companies have to issue debt and hope that future prices for their products will be sufficient to pay it down. Keep in mind that while the mining business is inherently a long-term effort (over and above the fact that Sudbury is a 1.85 billion-year-old ore deposit), long-term corporate governance is not high on the priority list for hedge fund managers.

Lots of people, including me, like to think that markets and market mechanisms work even in a massively regulated global industry such as what the mining industry has become. If hedge funds are driving the results of mergers and consolidations of the biggest players in the mining industry, then so be it. Whoever said that company managers should not have to justify their efforts frequently, as opposed to getting a free pass that might otherwise extend for years to construct that so-called “shareholder value”? The hedge fund managers will, in all likelihood, make their short-term plays, take their money off the table, and meet their numbers along the highway of industry consolidation. I do not doubt that they will feel darn good about themselves as they make their visits to the bank.

The free-market implication of all this is that in a world that works, a hedge fund-driven “strategy of tactics” ought to lead to the “right companies” with the “right managers” controlling the “right assets” and running them “right.” The corporate managers who control the big mining companies are just going to have to figure out how to run what are, at root, long-term businesses in an environment of short-term financial pressures and associated manipulations. So the people best at showing “results” will have to rise to the top, and preferably not of the same “results-oriented” ilk as those that ran Enron. It would be a terrible thing for mining assets to fall into incompetent hands, especially in that it takes 6-mile-wide meteorites slamming into the Earth every billion years or so to create some of the really good digs.

But what if things do not work out the way we hope? What if a “strategy of tactics” leads essentially nowhere, and to an end point of no real long-term strategy? What if the “wrong companies” with the “wrong managers” wind up controlling the big assets, and in the long-term, they screw things up because they have structured themselves into unworkable business forms burdened with unpayable debt? Does this wave of big-dig consolidation, being driven by short-term hedge fund thinking, amplify the risk that the mining industry will become a relatively small group of really massive, overleveraged, overly indebted, underinvested behemoths that run their businesses right into the ground? I suppose that is what bankruptcy courts are for, but I would hate to see it come to that.

It takes a long time to make an ore deposit (1.85 billion years at Sudbury). It takes a long time to open a mine, and it takes a long time to get good at running one. Considering all of the moving parts and other rotating machinery involved, you really do have to know what you are doing when you pull ore out of the ground. Then again, in a world of hedge funds and rising commodity prices, I suppose the world will get exactly what it deserves.

Until we meet again…
Byron W. King

August 1, 2006

The Daily Reckoning