Three’s a Crowd

Phelps Dodge's attempt to merge with a pair of other companies — again — shows why such triple plays are rare.

In planning their mining-company megamerger, Phelps Dodge Corp., Inco Ltd., and Falconbridge Ltd. thought they had hit a rich vein with this June’s $40 billion, stock-and-cash proposal to combine all three into a new company called Phelps Dodge Inco Corp.

The idea seemed solid. If approved by shareholders, the resulting “industry-transforming” giant would rank first in nickel production and second in copper at a time when prices for both metals are surging in markets heated by Chinese demand. Promising $900 million in synergies by 2008, the Phelps/Inco/Falconbridge combination would forge a North American powerhouse that could also withstand the advances of merger-hungry smaller players. In fact, before Phoenix-based Phelps approached Inco and Falconbridge, both Toronto-based, the two Canadian companies had proposed merging themselves to defend Inco against a hostile bid from Vancouver-based Teck Cominco Ltd. Meanwhile, Switzerland-based Xstrata Plc went after Falconbridge with an all-cash bid.

But in mining terminology, Phelps’s three-way deal played out early. Falconbridge shareholders rejected the transaction’s first stage — Inco’s purchase of Falconbridge — in late July, leaving Xstrata as the likely buyer. Analysts and investors who had questioned the complex “triple play” were left to wonder about a Phelps/Inco deal that Phelps previously rated as second-best. Also, Teck Cominco sweetened its Inco offer, and Phelps itself was mentioned as a potential target, boosting its shares and turning even more holders against a Phelps/Inco combination.

“Exponentially More Complex”

When more than two players formulate a grand merger strategy, complications multiply. Harvard Business School professor Stuart Gilson, noting how few three-way mergers there are, suggests that they are rare because adding a second target makes a deal “exponentially more complex,” from the sharing of executive power to deciding which jobs will be eliminated to integrating IT and other systems.

PricewaterhouseCoopers merger expert Mark Sirower guesses that Phelps/Inco/Falconbridge was the invention of investment bankers “who are often more focused on imagining the evolution of an industry than on the pure economics of a single transaction.” (Phelps’s financial advisers were Citigroup Corporate and Investment Banking and HSBC Securities.)

From the beginning, hedge fund Atticus Capital, one of Phelps’s largest shareholders, said it preferred other options, including the sale of Phelps. And analysts expressed frustration, noting that they had to sort out too many scenarios. Negative reviews of the original three-way started coming in early from the global press, too. A columnist for Melbourne, Australia’s Herald Sun accused the companies of “trying to be too clever, and on the cheap.” (Phelps, Inco, and Falconbridge later sweetened their price, which confused the situation even more, since two separate scenarios had to be recalculated.)

Carol Levenson, director of research for bond analysis firm Gimme Credit, says Phelps’s triple trouble might have started when it envisioned “a white-knight suddenly swooping to the rescue” of Inco and Falconbridge. In June she wrote of concerns that pro forma debt would surge “from less than $1 billion to a staggering $20 billion,” and complained of an initial lack of detail about plans for reducing leverage.

Like Levenson, Bear Stearns & Co. analyst Anthony Rizzuto saw debt as more problematic than complexity, especially when the ability of Phelps/Inco/Falconbridge to repay under favorable conditions reflected market prospects for their metal. “The world is a little more uncertain than it was six months ago, with interest rates, geopolitical instability, and oil prices,” says Rizzuto, who also noticed signs of a deceleration in Chinese demand for copper, which is being challenged by alternatives like plastics and aluminum.

“I did see the strategic rationale for the long term in wanting to put the three companies together,” he says. “But the core asset strength leaned more heavily on the side of Inco and Falconbridge” — the part of the deal that was abandoned. Indeed, $550 million of the projected three-way synergies involved Falconbridge.

Phelps CFO Ramiro G. Peru, who would be Phelps Dodge Inco’s finance chief, notes that Phelps on its own is “significantly undervalued” because of its strong connection to one market, copper. Adding nickel and other metals would bring it “closer to the [global] super majors,” led by BHP Billiton and Rio Tinto. A Phelps/Inco-only merger would combine the world’s number-two producer of nickel and its number-three in copper, but would be much smaller without Falconbridge.

The Second Time Around

For Phelps to win shareholder approval of a combination with Inco sans Falconbridge, the company will have to retool some effusive language about how the triple play would revolutionize metals mining. Phelps executives declined to be interviewed, but in talking to analysts, CEO J. Steven Whisler had claimed that “the stars have aligned, and the marketplace is going to share this excitement.” Asked why Phelps rejected “the alternative of doing nothing” in the thriving copper market, the CEO said, “Sometimes it takes bold moves. If we ran everything by looking backwards, we wouldn’t get anywhere.”

Whisler’s assertion that Phelps would benefit from having previous acquisition-integration experience raised Rizzuto’s eyebrows. As rare as three-way mergers are, points out Rizzuto, Phelps had tried another one in 1999: simultaneous hostile bids for Cyprus Amax Minerals Co. and Asarco Inc., totaling $2.77 billion. Phelps did manage to snare Cyprus Amax, but a bidding war developed for Asarco, and Grupo Mexico SA’s all-cash bid eventually won the day. The Cyprus Amax deal that went through increased Phelps’s leverage sharply, Rizzuto notes. “Now, it’s taking on all this debt again, after it’s worked so hard to pay the debt down,” he said before the Falconbridge deal fell through.

One That’s Working

Another attempt at a three-way deal in recent years involved aluminum makers Alcan, Pechiney, and Algroup, of Canada, France, and Switzerland, respectively. That $19 billion (in assets) deal was blocked by European regulators on antitrust grounds. Antitrust wasn’t the problem for Phelps’s three-way, which cleared such hurdles in both the United States and Canada.

For a three-way to sail smoothly, it helps if it is simple and not complicated by preexisting hostile bids. Within a few days of the Phelps/Inco/Falconbridge proposal, Houston-based Anadarko Petroleum Corp. offered $21.1 billion to buy rival oil and natural-gas producers Kerr-McGee Corp. and Western Gas Resources Inc. in two friendly deals.

Anadarko is paying special attention to explaining its plan for reducing debt from the $24 billion in financing it receives from UBS, Credit Suisse, and Citigroup. Issuing equity and selling assets “will produce a net $15 billion of proceeds to take down the debt,” Anadarko CFO Al Walker told analysts, with other proceeds coming from the “very free, cash-flow-rich situation” involving the two acquisitions.

With the cost of acquisition-related growth these days comparing favorably with exploration growth, it is not surprising that so many natural-resources deals are cropping up. “There will continue to be lots of M&A activity,” says analyst Rizzuto, “from alumina through zinc.”

Roy Harris is a senior editor at CFO.

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