Updated from 3:53 p.m.
Shares of giant copper producer
tumbled Monday as Wall Street took a dim view of the price it is paying for Canadian nickel miners
Reasons for caution on the deal include growing distaste for the high volume of merger activity in resource industries of late, as well as a medium-term bearish outlook for copper prices relative to those of nickel. That view, however, is not universal, as some say the secular trend of industry consolidation along with longer-term bullish commodity cycle bode reasonably well.
Wall Street is interpreting the transaction as an acquisition of Inco and Falconbridge by Phelps Dodge, although the terminology is open to interpretation. Ultimately, the breakdown of ownership in the combined firm will be relatively equitable, with Phelps Dodge shareholders controling 40% of the combined entity, while Inco shareholders get 31% and current Falconbridge holders own about 29%.
Whatever the semantics, however, investors lost no time in deciding the "acquirer," Phelps, was parting with too much value in bringing the Toronto firms into its fold. By early afternoon, shares of Phelps were trading down over 8% at $76, having moved sharply lower on the opening following the deal news. Meanwhile, shares of Inco were up over 10% at almost $65, while Falconbridge shares were up over 5% at $52. The combined company would be the world's largest nickel producer and North America's biggest copper company.
A prominent economist wasn't surprised by the price drop. "There's a technical term for this," says Lawrence J. White, professor of economics at NYU Stern School of Business. "The shareholders get screwed."
White notes that such deals are an example of poor corporate governance whereby senior management pursues a transaction that "make them feel better, but that is not in the interests of their shareholders." For instance, managers use merger-and-acquisition activity to expand the revenue and market capitalization of companies they run to boost their own pay and power; often, their visions of synergies prove optimistic. Phelps estimates it will save $900 million through 2008 from cost cutting at the merged company.
"The initial reaction is the market's best guess on the effect on the shareholders," White says. In fact, that guess reflected well on the deal as a whole -- though just barely. The combined market capitalization of the three companies went from $46.6 billion as of Friday's close to about $47.3 billion by the close Monday, with the gains accruing entirely in Inco and Falconbridge.
Regarding Phelps, the skepticism goes beyond a general distaste for the wave of corporate marriages sweeping the metals world (
and Arcelor also announced a deal during the last 24 hours). Rather, it has as much to do with underlying fundamentals which will underpin the business of the merged entity.
The strength in Inco and Falconbridge -- again, two nickel companies -- could present a selling opportunity for stockholders. That's because while the nickel market looks robust both in terms of strong demand and relatively constrained supply, copper looks weaker. Hence, the poor earning potential of copper could drag overall profits down for the combined entity.
"It's unrealistic for prices of both metals to go up on a sustained basis," notes Neil Buxton managing director GFMS Metals Consulting, a London-based specialty advisory firm. "In that respect, nickel is better placed than copper."
Buxton says that supply sources of nickel going forward are unlikely to grow rapidly. At the same time, strong demand for use in stainless steel manufacture looks set to help support the price level, or at least avoid a precipitous drop.
The same, however, cannot be said for copper.
"Two years ahead we'll be seeing $3,000-$4,000
a metric ton level
for copper," says William Adams, a metals analyst with basemetals.com. The benchmark copper contract on the London Metal Exchange today traded at approximately $6,600, down from an average of over $8,000 a ton in May. "We'll have moved through this speculative run and I think we'll probably have an economic slowdown and stocks
of copper will grow," hence putting downward pressure on prices.
He also noted that metals markets had a tendency to overreact on both the upside as well as the downside with the presence of hot money from hedge funds worsening cyclical volatility.
Phelps' decision to diversify away from copper toward nickel, in and of itself, has some convinced that the copper market could be ready for a correction.
"We presume that PD
Phelps Dodge does not like the current copper market climate, or else they would have simply done nothing and let their business throw off $1-$2 per share PER MONTH
his emphasis," writes John Tumazos, Prudential Equity's metals stock analyst in a report published today. He advises investors to underweight their holdings of Phelps Dodge and classifies the stock as high risk.
Tumazos' outlook for the copper price is even more bearish than that of Adams: It will plunge to an average of approximately $2,800 a ton in 2007 and 2008 before slipping further below $2,400 thereafter, his report states.
However, once the next business cycle is through, Buxton and Adams are actually optimistic. They say the continuing consolidation in the industry together with heavy secular demand from China and India could help support the industry and avoid the wild price swings of the past.
Buxton thinks market demand will remain robust enough to keep the price of copper falling back to under $1,400 a ton, as it had in the 1990s