A play on food prices

BHP/Potash: BHP Billiton has turned the spotlight on itself. The miner’s unsolicited $39 billion all-cash bid for Canada’s Potash Corp of Saskatchewan was firmly rebuffed. Though the soft commodity mined by the world’s largest fertiliser group appears on the brink of a rebound, BHP will be under pressure to prove any deal is a good use of its cash.

On the face of it, Potash Corp fits all of BHP’s acquisition criteria. It commands a 20 per cent share of global potash capacity and has 34 years’ worth of reserves in one of its mines. Prices are recovering and should rise with growing demand for food that requires fertiliser.

BHP’s efforts to expand into the business organically have not been encouraging. The miner has spent roughly $800 million since 2006 on exploration in Canada, according to a person close to the company, but is not yet producing potash and is probably several years from making a profit.

Despite a recent flurry of deals in the sector, Potash Corp’s size means there is unlikely to be an all-out bidding war. Rival Rio Tinto can’t afford a bid, and an offer from Brazil’s Vale could be hindered by the group’s complicated ownership structure and its recent poor experience with a Canadian nickel miner.

Despite the apparent absence of synergies, BHP probably has some scope to raise its initial $130-a-share offer. A bid worth $142 a share - the level at which Potash Corp’s shares traded after the initial offer was disclosed - would value the company at around $42 billion. Using consensus 2011 earnings forecasts of around $2.2 billion, that implies a return on investment of 5.2 per cent – in line with BHP’s likely cost of borrowing, according to analysts at Liberum Capital. If prices and demand rebound to peak levels in 2008, when investors feared a global food shortage and Potash Corp made a net profit of $3.4 billion, the return rises to eight per cent.

However, it is not immediately obvious that BHP could extract much more from Potash Corp than its existing management. Following the failed takeover of Rio Tinto in 2008, investors will fret that BHP is overly eager to put its strong balance sheet to work. The company will have to work hard to persuade them it has better uses for the cash than they do.