One big story set to run into 2008 is BHP Billiton’s mooted takeover of its fellow mining behemoth Rio Tinto. What exactly should we read into the ‘two ballparks’ by which Rio's chief executive Tom Albanese claims BHP is currently undervaluing his company? This question is intimately linked to another that looks set to bedevil analysts through 2008 - are mining shares cheap, or not?
Most large-cap mining stocks have rerated upwards significantly through 2007. Yet the same dynamic that allows Mr Albanese to claim, even at current bid-up levels, that Rio is significantly undervalued also allows BHP Billiton to ignore the simple question of why a deal makes sense now, when Rio shares were far cheaper a year ago. The supposed ‘commodity super-cycle’, based on Chinese and Indian industrialisation, justifies all.
If this big idea holds up, mining shares are indeed still relatively cheap, as earnings will be maintained at current levels for the foreseeable future and PE ratios will remain, as now, below the All-Share average. But if commodity prices do pull back significantly in the next couple of years, at current share price levels forward PE ratios would balloon, and miners bought now - which in retrospect will clearly have been the top of the cycle - will look quite expensive in the medium-term.
2008 will be a watershed in establishing whether the supercycle does indeed have legs - the ongoing credit crunch will test, possibly to destruction, the assertion that emerging markets have managed to meaningfully decouple their economic cycle from US-led, developed world demand. And this adds frisson to long-standing M&A speculation, boosted by BHP/Rio, surrounding peers such as Anglo American, Xstrata and Lonmin. Even if a done deal between the big two doesn’t scare others into consolidation, at the very least it should see forced divestments tantalising these players. But under which scenario - top-of-the-cycle or more-yet-to-come - will the market value such assets by the end of 2008?
