James Gerrish - Morning Note - Tuesday 24th August

There is now talk that China's Sinochem and Brazillian miner Vale have approached Potash Corp for some initial talks regarding the acquisition of the company. It's only rumor at this stage however any competition to BHPs bid is going to increase the pressure for higher prices. Vale is in a similar situation to BHP however it does already have Potash assets - my main concern would be if the Chinese Government puts its weight behind a bid through Sinochem that could potentially blow BHP out of the water. 

Its important that BHP stays disciplined in the deal and looking at the potential Return on the Asset, it seems BHP needs to stay around the $US150 a share. At any level the acquisition is going to be earnings dilutive in year one however if BHP stays below 150 then earnings will become accretive in year two.  Return on Asset (RoA) will be improved if BHP sells off the non-core assets (phosphate and nitrogen) as well as the companies other equity investments. This could push the RoA for year two up to 8.5%. 

As I mentioned yesterday, BHP invests for the longer term and if we look at the growth of its other assets we can start to see the deal become more attractive. Over the past 12 years, BHPs Tier 1 assets have increased in value from around $13 billion to $113 billion on the back of higher commodity prices and increased production. Return on Assets for the company is expected to be 37% in 2011 and this growth is likely to continue. So its important to look at Potash Corp as an acquisition based on its longer term strategic value which is likely to be supported by significant growth in emerging markets. I discussed this theme in STOCK WATCH yesterday.

Looking at the valuation of BHP, its trading on 8.5 times 2011 earnings. This is cheap from historical standards however one of the main measures I like to consider is Return on Equity (RoE). BHP is expected to generate 38% RoE next year and when you think about a bank term deposit at 6%, it starts to look quite attractive. From a technical perspective I think we may see lower prices in the near term so I'd be looking to enter positions nearer to $36. 

On the market last night, the DOW JONES lost -39 points or -0.38% to 10174. The FTSE 100 added +39 points or +0.76% to 5234. Locally, SPI FUTURES are suggesting a drop of 21 points on the open this morning. 

There's been mixed reports overnight about state of the election with the Telegraph suggesting that a deal had been made between Labor and one of the independents. This has since been rejected however we are seeing betting agencies confirm Gillard at the favorite for the top job. 

Resource companies were higher on the market yesterday on the back of optimism that the mining tax was dead in the water. This doesn't appear to be the case so we may see some selling in the sector today. BHP may also be under pressure if the market becomes concerned about the rumors of rival bids forcing BHP to raise their significantly higher. Looking at the price of Potash Corp shares, $US150.20, they're certainly expecting some type of bidding war.