Chinese M&A benefits from cost of capital arbitrage (May 09, 2011)

China’s mergers and acquisitions are “stepping up a notch” and with access to cheaper capital from state-owned banks, the Chinese will “continue to outbid the existing producers for assets,” predict the authors of a recent Citi Investment Research report in Australia. 

“With financing rates generally sub 5%, China’s cost of capital is lower than equity markets’ return requirements, especially in emerging regions,” the authors write. “This  cost of capital arbitrage has allowed China to buy these mining assets from under the noses of the other mining companies and the broader market.”

Citi believes that Australia will remain a “core hunting ground” and views copper, uranium, coal and iron ore as the core focus commodities. Its analysts believe that companies with large long-life resource bases will become the most sought-after and sees Western Areas (WSA-T, WSA-A), Paladin Energy (PDN-T, PDN-A), Resource Generation (RES-A), and Iluka Resources (ILU-A) as potential takeover targets.

Despite China’s large investments in natural resources, it has yet to build a national mining champion and “would like to create a diversified miner to rival the likes of BHP, Rio, Anglo and Xstrata,” they argue.

In 2004, China had eight listed mining companies with an enterprise value totaling US$19 billion. Today it has 33 companies with an EV of more than US$320 billion. China’s EV is second only to the United Kingdom, with US$427 billion, the report states.

“Investment (as well as privatization and development of the local industry) has seen China evolve into the world’s largest mining market in EV terms,” Citi’s authors state. “China has more listed mining companies than Canada (greater than a US$2-billion EV cutoff).”

According to Citi’s figures, over the last 10 years there have been 217 deals involving roughly 75 different Chinese entities buying offshore metals and mining companies – excluding direct asset investment into regions like Africa.

“The deal book has accounted for US$49.3 billion of deals,” Citi says. “Since the start of 2010, US$19.3 billion of the deals were announced. And during the dark days of the global financial crisis, China used its balance sheet well, acquiring US$26 billion of assets in the 2008/09 period… China’s investment in the mining space is unlikely to dry up any time soon.”