Have Mining Stocks Peaked?

Look closely at the bidding wars for Canadian miners Falconbridge  and  Inco . Shareholders are demanding cash rather than stock for their shares. While that doesn't seem interesting at first, what is interesting is the timing. Not long ago, acquirees were perfectly willing to accept shares or a mix of shares and cash. Times were good, and metal prices and subsequent stock prices were rising to heights not seen in years. However, shareholders, who are likely the most educated about the space, are sensing that the likelihood of further gains is lower than it once was, even as a few as six months ago.

This "show me the money" attitude implies a peak in commodity stocks, if not in commodity prices. When shareholders, both individual and institutional, want to cash out, it is pretty clear that they see higher-return opportunities out there and that commodity stocks will either level off or decline. The momentum is losing its steam.

So Where Did It Begin?
Mining companies have been on a roll in recent years, reaping the benefits of increased demand from emerging economies. As a result, mining companies are rolling in cash.

Traditionally, an increase in cash on hand leads companies to a) increase exploration and development budgets to propel internal growth, b) return the extra cash to shareholders, and c) buy growth through friendly and hostile takeovers. Given the strong short- to medium-term outlook for commodities, commodity producers are falling over themselves to increase production and capitalize on record-high prices. However, discoveries are rare, and attractive projects are too far off in the future to satisfy their current cravings. Takeovers are an instant fix, and, not surprisingly, we have seen a rush of merger and acquisition activity in the mining sector.

What is surprising, though, is the market's reaction to the takeover offers. "Cash is king" has become the new mantra. Take the long and involved saga going on in the Canadian mining sector. Inco and Falconbridge's attempt at a friendly cash and stock-based merger was thwarted by Xstrata's all-cash offer for Falconbridge. Despite attractive synergies between Inco and Falconbridge's Sudbury operations and the inclination toward resource nationalism, the Swiss miner's offer was more palatable to Falconbridge's shareholders. The shareholders wanted to cash out of the commodities boom, which is a clear indication that they do not believe current share prices are sustainable.

The theme was the same when  Phelps Dodge's  shareholders opposed its friendly takeover of Inco and Falconbridge. Shareholders instead wanted Phelps to either buy back shares or sell the company outright.

With  Teck Cominco's (TCK) hostile bid for Inco, the story is the same: Teck raised the cash portion of its cash and stock bid to make its offer more attractive to Inco shareholders. And when Teck wanted to raise $5.2 billion in the equity markets to pay more cash to Inco shareholders, the markets said "No, thanks" and Teck was forced to rescind its offer.

When  CVRD (RIO) made a bid for Inco on Aug. 11, the company probably sensed the market's aversion to stock offers and instead made an $18 billion all-cash bid, financed through additional debt. CVRD said that Inco's nickel assets will let it capitalize on high nickel prices immediately rather than wait for its two nickel projects to come online in three years. While Phelps' offer for Inco is technically higher than CVRD's, the latter is more favored by the market and CVRD will end up taking over Inco, in all likelihood.

Our Take
Market signals, if present, tend to be subtle and difficult to detect. Usually, only after the event occurs do we notice the signal. We believe shareholders in the mining sector are voicing their signal loud and clear that the likelihood of stock prices leveling off or declining for mining companies is much more likely than a rise in stock prices. Consider this when looking at the stocks in the space.