It is a fact of life that any company listed on the sharemarket is up for sale. There could be no better illustration of this than BHP Billiton’s audacious – and immediately rejected – takeover bid for rival mining behemoth Rio Tinto last week.
The $275 billion bid is the largest takeover bid ever mounted. Assuming that BHP is successful, the combined entity would be worth about $350 billion before the sell-off of unwanted assets. In anyone’s language, it’s a mega-deal.
But BHP’s bid for Rio shows another fact of life on the sharemarket: that in the short term, takeovers are usually better for the shareholders of the target than the predator. Rio Tinto’s shares surged by more than 25 per cent to record highs after the announcement of the deal – while BHP’s actually fell.
This is because the market knows that BHP will have to pay more than the three BHP Billiton shares it has offered for each Rio Tinto share. Using customary formal language, Rio Tinto rejected the deal, saying that it “significantly undervalued” the company. Both companies know that BHP will have to pay more, and the market knows it too.
The acquiror usually sees a drop in its share price because it is spending cash and crimping its near-future earnings per share (EPS); or in this case, offering its own scrip.
“There is usually concern over how much they’re paying for the target,” says John Robertson, consulting economist at investment newsletter The Big Picture.
“If it’s cash, the concern may be the debt requirement and the effect on EPS; if it’s scrip, the concern may be the dilution effect on existing shareholders. Then you’ve got the other issue, of how effectively the management team can bring the two businesses together, and how quickly the proposed synergies and efficiencies can be achieved.
“A better and bigger company is usually the aim, but shareholders are entitled to be concerned about how long that process may take.” But as happy Rio Tinto shareholders will tell you, a takeover approach is usually a short-term turbo-charge for a company’s share price.
What investors most want to see is a bidding war in which their company is sought by more than one party. Then, the share price gains can escalate quite quickly.
A prime example is Australian Leisure & Hospitality Group (ALH), the company into which Foster’s Group floated its pub and liquor-store assets in 2003. Shares in ALH fell below the issue price of $2.40 on their first day of trading in November 2003. By July 2004, they were trading at $2.48, but began to move as the market smelled a takeover bid, rising to $3.14.
The market was right. Bruandwo (a joint venture between Melbourne hotelier Bruce Mathieson and Woolworths) bid $2.75 a share for ALH in July 2004. The ALH board rejected the bid as “grossly inadequate and opportunistic”.
In September 2004, private equity group Newbridge Capital offered $3.05 a share for ALH, which the ALH board accepted; shareholders saw with satisfaction that Bruandwo responded with a new bid of $3.15.
Then, in October 2004, a new player entered the game: CMM, a joint venture between Coles Myer and Macquarie Bank, offered $3.35 a share for ALH. Bruandwo responded by lifting its offer to $3.50.
Four days later, with ALH shares now $3.60 on the market, CMM countered with a fresh bid – the sixth – of $3.75. Bruandwo came back with its fourth bid of $3.76 a share, which was ultimately successful. Action like that sure beats the hard work of long-term capital growth on the back of rising earnings.
Similarly, the share price of WMC Resources jumped 41 per cent after Swiss-based mining group Xstrata bid for the company in October 2004. WMC Resources told its shareholders to take no action and openly solicited other bidders. In expectation of another bid, the market pushed the WMC Resources share price higher: Xstrata increased its offer, only to be gazumped by BHP Billiton in March 2005, at a price that gave WMC Resources shareholders a 60 per cent gain.
Allan Furlong, manager of private client services at broking firm Joseph Palmer & Sons, says the rule for retail investors is don’t rush to react to a takeover bid made for a company. “You can afford to sit tight and watch the situation play itself out,” he says. “More often than not, the first offer is not the last offer, and it could flush out a higher bid. In the meantime, you’ve got that downside protection of that first bid being on the table.”
Furlong says another factor in the BHP-Rio Tinto situation is the fact that Rio shareholders eventually accept BHP’s scrip offer, they won’t incur capital gains tax (CGT) on their Rio Tinto shareholding – which they would if they sold the shares on-market.
The quick gains to be made on a takeover bid often attract investors into companies considered likely takeover targets – companies said to have “corporate appeal”. Robertson says this is a highly specialised form of investment.
“There are specialised funds that build their portfolio around potential takeover candidates – some of them even put the companies into play. Particularly in the last couple of years, in an environment awash with liquidity, plenty of companies have been perceived as takeover targets and that has probably helped to keep share prices higher than they would otherwise have been.
“The problem is, if you try to look around the market for takeover candidates, you can get trapped in under-performing companies. A classic example is Foster’s, which has been talked about as a takeover target for the last decade. Every six months the story comes out that someone is poised to take it over, but it’s never been taken over. You can get stuck in those situations.”
Robertson says there is no substitute for buying companies that are well-managed, doing the job properly and earning a good return for shareholders. “They’re the companies that will deliver good earnings growth and strong sharemarket performance. You can find a likely takeover target, but you’ve still got to cover the risk that while you’re waiting, the management continues to perform badly – and the stock does not get taken out.”