–Giant mergers among resource companies…record-setting initial public offerings for commodity traders…these are usually the events that signal the top of the commodity cycle, aren’t they? Well…yes…but not automatically.
–For example, how are you to evaluate whether BHP Billiton’s possible $46 billion bid for Woodside Petroleum is a good deal? It’s certainly an exciting deal. Riding a pony is exciting too, when you’re five years old. And everyone loves a parade. But is it a good deal?
–This would be an important question not just for existing shareholders of BHP and Woodside, but anyone who was thinking about buying BHP in the future. BHP has $16 billion in cash, thanks to surging iron ore and coal prices. Buying Woodside’s energy assets would add to BHP’s energy portfolio. But would it add to BHP’s profitability?
–“What determines a company’s value is in any industry,” wrote Greg Canavan in the February 23rd issue of Sound Money. Sound Investments, “is the rate of profitability it can generate on newly invested funds.”
— He pointed out that new investments (or acquisitions) can actually have the effect of lowering a company’s intrinsic value if the rate of profitability on the new assets is lower than what the company is already getting.
–In BHP’s case, it reported a 41% return on capital in its last half-year profit statement. The big driver behind that incredible return (for a company its size) was the surge in iron ore and coal prices. BHP’s bid for Woodside now—to match or equal that return on capital—depends massively on rising oil and gas prices.
–Of course, oil and gas prices ARE rising now. And they could go a lot higher. But if BHP pays too large a premium for Woodside now—the $46 billion is a 26% premium on Woodside’s Friday closing market cap of $37 billion—it will looks foolish if oil prices fall. In his February report, Greg reckoned that at around $42, Woodside’s share price was already pricing in growth for all of 2012.
–We shot him a note this morning asking about the deal and he wrote back:
If BHP does make a bid for Woodside, expect debt to feature in a big way. That’s because at current prices plus a takeover premium, Woodside isn’t cheap. A scrip-based takeover would dilute BHP’s existing strong profitability, (and therefore reduce its intrinsic value) because Woodside isn’t as profitable as BHP is. Return on equity (ROE) is a good proxy for profitability. BHP will generate a ROE of around 45 per cent this year (2011) while Woodside’s ROE, once Pluto is up and running, will be in the vicinity of 20–25 per cent.
Bringing Woodside’s balance sheet into BHP’s will therefore dilute the company’s overall profitability. This would be fine if Woodside was going cheap, but it’s not, and it’s certainly not relative to BHP’s share price.
BHP is one of the few large Aussie-listed companies that genuinely knows how to create shareholder value, either through disciplined acquisitions or capital management initiatives. It would be difficult to imagine it making a bid for Woodside unless it was cash and debt funded (i.e. no equity raising.)
–Greg will no doubt be following up in his mid-week alert. And by the way, the February report included valuations of BHP, Santos, and Oil Search as well. If you’re interested in reading the report, you can sign up for a trial subscription to Sound Money. Sound Investments with a new quarterly billing offer. Go here to learn more.
–We wouldn’t be having this conversation if Brent Crude wasn’t at a 30-month high of US$126.12. And THAT wouldn’t be happening if the Middle East andU.S. dollar weren’t slowly disintegrating.
–The first story here is on oil’s supply side. Blackouts in Venezuela affected refineries there. And Nigeria—one of Africa’s largest oil exporters—has elections this weekend with interruptions in oil production possible. But by far the biggest worry on the supply side continues to be the Middle East.
–In the most recent issue the Australian Wealth Gameplan, published Friday, we wrote that investors are underestimating the threat to global oil supplies from Middle East uncertainty. That’s because it’s not just uncertainty. It’s a geopolitical revolution. It will last years and put in doubt the security of energy supplies coming from the world’s most oil-rich region.
–The change in the political landscape of the Middle East puts a premium on proven non-Middle Eastern oil reserves (the subject of the investment recommendation in the AWG report). It also makes conventional and unconventional natural gas a lot more appealing, which partly explains BHP’s Woodside interest.
–The other factor behind the rising oil price is the state of the U.S. dollar. And what a sorry state it is. The dollar index chart below shows that the greenback is getting ready to break below support at 74 on its way to new lows. It’s also important to note the dollar has failed to rally on the “flight to safety” trade as it did in 2008 and early 2010. Not even an historic earthquake/tsunami/nuclear crisis has moved investors back into the dollar.
Dollar Index threatens to make new low
–And why WOULD anyone buy the dollar or loan the U.S. government money for any length of time? The weekend shenanigans between the President of the United States and the so-called leaders of the U.S. Congress were farcical bordering on the surreal and rage-inducing. Someone should send a memo to the ass-clowns in Washington that the United States of America is broke. Get it! Broke!
— If cutting $33 billion in non-defence discretionary spending is the best these guys can do, they have shown how profoundly unfit they are as guardians of the nation’s purse strings. What a bunch of entitled, elitist morons. They should all be fired and then deported, although we wouldn’t wish that kind of export on our worst enemy.
–The image below from the Congressional Budget Office tells you part of the U.S. budget story. In simple terms, 61 cents out of every tax dollar is mandatory spending, under the current budget rules. The “Mandatory” chunk includes Social Security, Medicare, Medicaid, unemployment, Veteran’s benefits, and public pensions. By statute, it’s money the government can’t “unspend”.
–That is why last week’s negotiations were supposedly so dramatic. The cuts had to be made from non-defence discretionary spending, even though that makes up just 19% of the total Federal budget. The lawmakers were arguing over a variety of smaller, boutique Federal programs that are near and dear to the corrupt hearts of various legislators.
–By the way, we’re counting the 6% interest payments on the $14.3 trillion national debt as mandatory, too. It is possible, of course, that the U.S. could, at some point, stiff its bondholders. When you can simply print them the money you owe, defaulting seems overly dramatic. But you can see why Bill Gross has exited his Treasury position and compiled a $54 billion cash war chest.
–It gets worse for America. Federal receipts in 2010 totalled $2.16 trillion. That was just enough to cover the “mandatory spending” part of the Federal budget, which amount to about $2 trillion. The other $1.3 trillion in spending—defence and discretionary spending—was all financed by Federal borrowing. And the morons were arguing over $33 billion. Unbelievable. Laughable. Pathetic.
–Think about that scenario for a second. The United States is barely garnering enough in tax revenues to pay for mandatory spending. And the best its political leaders can do is agree, at the 11th hour, to cut $33 billion in spending. It shows you just how completely removed from reality America’s political class is.
–No wonder gold and silver are spiking. Now that is a reality we can get behind.
–It’s pretty obvious what the U.S. ought to do. First, it ought to end its long wars in the Middle East and Afghanistan, bring home troops from the 135+ nations in which they are currently deployed, including Japan and Germany more than 50 years after the end of World War Two. That would be a start. The U.S. has more than enough submarines and nuclear weapons to defend itself.
–Then the U.S. would have to begin rewriting the “social contract” that has made entitlement spending mandatory. People won’t like that. No one likes a lower standard of living. Look at the arguments raging in Europe.
–But the debate is not about what kind of country you want to live in. The debate is about what the country can afford. And when the country is broke, you either face reality and make some very hard decisions…or you kick the can down the road like a coward.
–Trouble is, there’s not much of the road left. America’s statutory debt limit of $14.3 trillion will be reached sometime in early May. Of course the Congress can raise that ceiling by law. But it can’t make people buy the dollar or U.S. debt if they don’t want to own them. And fewer and fewer investors (that aren’t the Fed) want to own U.S. debt.
–The global attitude toward the dollar is fast reaching a tipping point. This is one reason the Aussie dollar continues to break record after record. U.S. leaders will either make a serious and believable effort at real spending cuts. Or the next move down in the dollar crisis will be even more disruptive for financial markets, and even more bullish for precious metals.
For Daily Reckoning Australia