Private equity targets mining stocks

How can debt-heavy private buyers justify targeting cyclical mining stocks...?

"PRIVATE EQUITY will next move into the mining industry which has seen net profits rising by 64% and return on equity reaching 33% in 2006," reports Mineweb.com this morning.

  "PricewaterhouseCoopers (PWC) said at the release of an annual report titled 'Mine - Riding the wave' that it believed private equity, which is flexing its muscles internationally, will find growing value in the mining sector."

   You don't say? To finance a deal with debt, private equity loves businesses with regular cash flows. Those cash flows pay the interest on the debt the pirates dump on the balance sheet of a takeover target. Because commodity prices are traditionally both cyclical and volatile, the pirates have stayed away from the mining sector and its unpredictable cash flows. But not anymore.

   "Hugh Cameron, PWC global mining leader...said the sector now offered value as sums of its parts surpassed total company values. However, private equity groups which do have the cash to acquire large mining companies would still have to contend with the issue of higher costs in the industry."

   The pirates are probably less worried about future cash flow when they see the large cash war chests sitting on some miner's balance sheets. But the pirate interest in mining stocks indicates the pirates are either desperate and stupid, eager to bag a deal – any deal – before the easy money dries up. Or it indicates that the entire financial industry is now prepared to treat mining companies more like non-cyclical companies and value them on price-to-earnings ratios rather than the present value of future cash flows.

   Is this a giant mistake, another sign of the top? "There are two kinds of resource investors," our friend Rick Rule says. "As a resource investor, you're either a victim or a contrarian."

   At the end of cycles, investors find (or invent) all sorts of reasons why higher valuations are justified. "It's a new era...Mining is not cyclical...This is a super cycle." All of those could be true in the case of the mining industry. But it wouldn't bother us too much if the Pirates were about to become victims, either.

   Bank of America President Kenneth Lewis said yesterday that private equity firms will continue to have "unprecedented" access to cheap money and that the liquidity boom won't end anytime soon, at least not until a monster deal goes bad. "You'll have a percentage of these deals going bad because they're just levered too much," Lewis said. "I think it's several years off...You've got unprecedented liquidity...I've never seen anything like this."

   So where does that leave us? The pirates are cashed-up and on the prowl. The mining majors are cashed up and on the prowl. Maybe the best-strategy in all of this is to buy mid-tier mining companies and wait for the consolidation to elevate share prices.

   According to Mineweb, "Both Canada and Australia are 'well-positioned' with a historically strong junior and mid-tier sector in Canada and a rejuvenation of mid-tier companies well underway in Australia."

   What do you think? Here at the Australian Daily Reckoning, we just ran a poll online between BHP, Fortesuce, Rio, and "other".

   Funnily, "other" came in second. So our readers must have ideas of their own about which Aussie mining stock is hottest. Either that, or they're keeping quiet because they're about to make a private equity bid.