Events in the US Mining Industry - Assignment Example

Q1. [4 marks] Summaries the events (in the mergers and acquisition landscape in the US mining industry) leading up to the November 2006 announcement by Freeport-McMoRan that it will acquire Phelps Dodge. (1.5 marks) Mergers and acquisitions continued to grow in 2006 as the year kicked off with the acquisition of Pixar Animation Studios Incorporated by Walt Disney and Guidant Corp by Boston Scientific Corporation. [Map07]. These mergers were followed by a series of M&A deals throughout the year in a myriad of sectors including banking, finance, insurance, mining, telecommunications and pharmaceuticals. Apart from the U.S, mergers and acquisition also grew across the globe during the same year. Some of major of the M&A deals in the mining sector include a merger between Mittal Steel Co. and Arcelor SA for $22.7 billion, a merger between Xstrata Plc and Falconbridge Ltd. for $21.2 billion and a merger between Goldcorp Inc. and Glamis Gold Ltd. for $8.6 billion. Phelps Dodge, which was by then the world's second-largest copper producer, would be acquired by Freeport- McMoRan Copper & Gold, a much smaller competitor that had at the time been involved in human rights and environmental controversies in Indonesia, in a cash and stock deal worth $29.6 billion[And06]. After its announcement, the merger would create the world's largest copper miner effectively beating Codelco, which is based in Chile. Like its counterparts, which had been involved in other mining mergers, the management at Freeport-McMoRan believed that increased capacity would afford the merger a sustainable competitive advantage over other key players in the industry. Richard Adkerson, the president and C.E.O of Freeport-McMoRan's pointed out that several companies were aiming at increasing their production capacity as the industry was increasingly consolidating into fewer and larger companies. J. Steven Whisler, the chairman and C.E.O of Phelps Dodge, also revealed that the two companies had been planning to merge for about a decade. One of the main reasons that led Phelps Dodge to accept Freeport-McMoRan’s offer was the fact that it had offered an above-market price for its stock. Phelps Dodge shareholders received $88 a share in cash plus 0.67 of a Freeport-McMoRan share. Basing on the closing price of the company’s stock on 17th November 2006, the deal was offering Phelps Dodge roughly a 33% premium[And06]. Freeport-McMoRan, which had a significantly lower market capitalization ($113 billion) compared to Phelps Dodge's ($194 billion) was able to finance the transactions by borrowing at least $7.5 billion. Several critics argued that Phelps- Dodge found itself being acquired by Freeport-McMoRan because of its failure to acquire Inco, a large Toronto-based nickel miner earlier that year. Inco had approached Phelps Dodge in a bid to solicit help with its M&A deal with another Canadian nickel miner, Falconbridge. Phelps Dodge would have been required to fund this transaction and in exchange Inco's board would have agreed to sell the company in a cash and stock deal worth at least $17 billion. When the three-way deal eventually fell through, Phelps Dodge was outshined by Xstrata of Switzerland, which won the bid for Falconbridge. Nonetheless, Inco was acquired by a Brazilian miner Companhia Vale do Rio Doce, which offered about $17 billion in cash for the company. Apart from failing to impress Inco's shareholders, Phelps Dodge also provoked a lot of criticism from its own shareholders who argued that the move would have increased the company's debt levels from close to nothing to more than $24 billion. Some stakeholders proposed that Phelps Dodge should have instead sold itself as opposed to becoming larger and this is how the company ended up being acquired by a smaller company. Assess Phelps Dodge’s operating and financial performance in 2006 by reference to relevant financial ratios and performance indicators that you have calculated*. Suggest some reasons (‘economic rationale’) why Phelps Dodge was an attractive target for acquisition by other players (Freeport McMoRan for example) at that time. (2.5 marks) Key Financial Ratios for Phelps Dodge Corporation 2006 2005 2004 Liquidity Ratios: Current ratio 2.33 times 2.53 times Quick ratio 2.22 times 2.32 times Cash flow liquidity 1.52 times 1.2 times Average collection period 39 days 46 days Days inventory held 20 days 23 days Days payable outstanding 146 days 100 days Cash conversion cycle -87 days -31 days Activity Ratios: Accounts receivable turnover 9.42 times 8.06 times Inventory turnover 19.12 times 16.03 times Payables turnover 2.52 times 3.65 times Fixed asset turnover 2.03 times 1.72 times Total asset turnover 0.81 times 0.8 times Leverage Ratios: Debt ratio 38.9 % 37.08 % Long-term debt to total capitalization 9.1 % 10.79 % Debt to equity 0.74 times 0.69 times Financial leverage (FL) 1.9 times 1.85 times Times interest earned 57.9 times 22.45 times 11.97 times Fixed charge coverage 57.9 times 22.45 times 11.97 times Profitability Ratios: Gross profit margin 42.85 % 36.26 % 34.11 % Operating profit margin 35.49 % 21.3 % 22.99 % Net profit margin 25.34 % 18.7 % 16.1 % Return on assets (ROA) 20.62 % 14.96 % Return on equity (ROE) 39.24 % 27.66 % Market Ratio: Earnings per share $ 14.92 $ 7.92 $ 5.53 The liquidity ratios indicate that the company’s financial health was both commendable and relatively stable in 2006. This is evidenced by the fact that both the current ratio and quick ratio, which measure the ability of the company to meet its short term financial obligations as and when they fall due were both greater than 2 in 2005 and 2006. More precisely, this implies that the company has more than $2 of liquid assets available to cover each dollar of current liabilities for both years, even without including inventory in the computation. The company also registered an improvement in the average collection period and days inventory held, which was an indication that it was in a better position to transform its inventory and receivables into cash compared to the previous period. Other than that, the ratios for both years are relatively modest, which suggests that the company has adopted very effective debt management strategies. The fact that the company has a good financial health made it very attractive to potential acquirers. Unfortunately, while Phelps Dodge became more effective at collecting its debts, it is evident from the days payable outstanding that it took longer to pay its invoices from trade creditors. Even though this could be beneficial to company when the time value of money is taken into account, it could be detrimental to its credit worth. Moreover, the company does not take advantage of trade discounts, which could result in considerable cost savings. As afore mentioned the company apparently adopted more effective debt management strategies in 2006. While it took less time to collect its debts from clients it was also more effective in extending credit and collecting debts as evidenced by the increase in the accounts receivables turnover. The same trend was exhibited by the inventory turnover, fixed asset turnover and total asset turnover. Not surprisingly, the payables turnover ratio dropped slightly suggesting that the company was taking longer to pay off its suppliers than in 2005. All the above ratios imply that there was an improvement in the overall efficiency of the company and as such, this makes it even more attractive to potential investors and acquirers alike. The debt ratio and debt to equity ratio both measure the company’s financial leverage. There is a slight increase in debt to equity ratio which implies that the composition of debt in the company’s capital structure was slightly higher in 2006 compared to 2005. From the shareholders’ reaction when the company attempted to acquire Inco, it can be deduced that this trend is not favorable for the company. This is because, high debt to equity ratios are associated with volatile earnings due to the additional interest expense. Notwithstanding, the long-term debt to capitalization ratio suggests otherwise because it was characterized by a slight decline. This is a likely indicator that company relies more on short-term debt to fund expansion projects. On the bottom line, the financial leverage increased suggesting that there was indeed an increase in the percentage of debt in the company’s capital structure. From the discussion in question one, it is evident that an increase in financial leverage made the company less attractive to its stakeholders thereby motivating the management to accept an acquisition offer. Additionally, the times interest earned and fixed charge coverage both more than tripled since 2004. This is an indication that the company’s ability to meet fixed financing expenses such as leases and interest has increased significantly. This also makes it attractive to external stakeholders. The gross profit margin, operating profit margin, net profit margin, return on assets (ROA) and return on equity (ROE) all increased significantly from 2005 to 2006, which suggests that the company’s overall profitability increased. From the foregoing it is evident that the company, was not only very profitable in 2006 but was also very efficient and had good financial health. For this reason, it must have been very attractive to potential acquirers such as Freeport-McMoRan. The stakeholders also pressured the management to sell the company due to the increase in its financial leverage. Q2. [4 marks]  Identify JPMorgan’s and Merrill Lynch’s involvement in the merger transaction prior to the announcement. (1 mark) The two investment banks were involved in all the activities that led to the announcement of the merger, from merger advisory to debt and equity underwriting. They also had a long term relationship with Freeport-McMoRan, which was one of the reasons they were selected to represent the company in the merger. JP Morgan and Merrill Lynch helped in the acquisition of all aspects of the capital raising such as identifying the general needs and priorities, advising the company on merger valuation, the mix of cash and stock, timing and likely shareholder reaction.  Identify the tasks that the two investments undertook to do following the announcement to guide the acquisition to a successful conclusion. (1 mark) Investment banks play a myriad of roles in mergers and acquisitions including underwriting, facilitating private placements, providing venture capital and asset based finance, investment management, merchant banking, carrying out research and offering corporate advisory services. JPMorgan and Merrill Lynch however undertook two major tasks following the announcement of the merger, that is, underwriting and book-running all the financing.  Describe (giving details) any significant risks in their undertaking for the investment banks. (2 marks) Capital Risk This is the financing risk associated with the commitment by the investment bank to underwrite the acquiring firm in relation to financing the acquisition. By agreeing to fund the acquisition through underwriting financing, the bank would assume the responsibility of not only setting up meetings between the management of the issuing company and potential investors but also persuading the latter to subscribe to the offering. Market Risk The investment banks are exposed to market risk by offering to buy the securities at the offered price in the event that investors fail to do so. To achieve this, capital has to be set aside by investing in risk-free securities such as treasury bonds, which generally offer a lower rate of return than the shareholders’ equity return requirements. This represents an opportunity cost, which contributes to market risk. Reputation risk. Reputation risk arises from the fact that the investment bank is associated with the company for which it is attempting to raise capital or facilitate the completion of an M&A transaction. The bank should therefore take the quality of the clients they represent into consideration because any negative publicity associated with such clients will more often than not be generalized to the bank Q3. [4 marks]  Why do you think JPMorgan and Merrill Lynch were selected to perform the tasks identified in Q2 instead of sharing the tasks with other investment banks? (2 marks) JP Morgan and Merrill Lynch were selected to underwrite and book-run all the financings because they collectively committed $6 billion in bridge loans and pledged to underwrite the entire sum of $17.5 billion through debt financing coupled with $1.5 billion in lines of credit. This resulted in a significant risk because the interest of FREEPORT-MCMORAN and the two firms were aligned, particularly by placing the debt and credit with each other’s institutional investors and banks. Because this commitment was instrumental in facilitating the merger and acquisition transaction, FREEPORT-MCMORAN found that it was in its best interests to give all the book running and M&A business to the two firms. Other than that, the latter had provided guidance to FREEPORT-MCMORAN throughout the conception of the M&A pre-deal and the actions that were taken while targeting Phelps Dodge. Finally, both JP Morgan and Merrill Lynch were preceded by their reputation in Financings and M&A and had pre-existing fruitful and long term relationships with FREEPORT-MCMORAN’s management. It should however be noted that the main reason why they were selected was because of the risky commitment they had made to provide bridge loans just in case placement in the capital markets proved to be unsuccessful.  What was the role of the leveraged finance group at JPMorgan and why was its involvement important to the acquisition? (1 mark) The main role of the leveraged finance group was to make the bridge financing commitment that would allow FREEPORT-MCMORAN to make a firm for Phelps Dodge on behalf of JPMorgan. In order to facilitate the completion of the M&A transaction, the acquisition financing had to be availed. The leveraged financing therefore played a critical role in the transaction because FREEPORT-MCMORAN had been prompted to obtain a huge chunk of new debt in order to acquire a company that had a higher market capitalization than itself. The leverage finance group had to scrutinize the new capital structure of the firm and evaluate the impact of this new structure on its credit ratings and possibility of reselling the debt to other banks and investors. Additionally, the group was in charge of leading the efforts to secure internal firm commitments and gain acceptance for associated capital charges. The group’s appreciation of the market was pivotal to the success of the acquisition.  Explain what it means for a firm to set aside capital when it completes underwriting transactions. (1 mark) When firm completes underwriting transactions, capital has to be set aside by investing in risk-free securities such as treasury bonds, which generally offer a lower rate of return that the shareholders’ equity return requirements. Even though this represent a significant opportunity cost, such capital has to be set aside to act as collateral in case shareholders fail to accept the issuing company’s offer. Q4. [4 marks] Which group within an investment bank has the primary responsibility to work with companies regarding rating agency considerations? How important are the credit rating agencies in the Freeport-McMoRan transaction? (2 marks) It is important to understand that credit rating agencies’ main function is to determine the qualitative and quantitative risks of the entities. This information is very crucial to investors so as to enable them make wiser decisions. In this case, the credit rating agencies are important in since the played a big role in evaluating the worthiness of Freeport-MacMoran report and at the same time played a big role in offering sound advice to the company. Describe the role of an Equity Capital Markets Syndicate group. How has the role of equity research changed since 2003? (1 mark) The main role of an Equity Capital Markets Syndicate group is to raise equity capital for companies. However since 2003, the roles have changed in that they have increased their scope of operations. In the present day, Equity Market Syndicate group operate include; distribution, overall marketing, allocation, special warrants, initial public offerings and even private placements. What is meant by a “limit order”, and what is its impact on the sales function? There are essentially two types of orders in quote driven markets, limit orders and market orders. Both types are meant to help investors give a more specific instructions to their brokers on how they want their trade fulfilled. In stop orders, an investor is simply telling his broker that he is not interested in the current market price of a given stock and that the order should only be executed once the stock price moves in a given direction. As such, the broker has to wait until the stock price hits the limit/stop price after when the order is executed. Essentially, a limit order becomes a market order once the stock price reaches the limit price. In cases where the investors have challenges in monitoring their stocks, limit orders become very advantageous. It is not always a guarantee that the order will be fulfilled at the price that the investor demands as the price ends up being lower in some cases. There are no much difference between limit orders and stop orders. In limit orders, the maximum and minimum prices for buying or selling stocks is set. (1 mark) Q5. [4 marks] Assess Freeport-McMoran’s operating and financial performance prior to, and following the merger, by reference to relevant financial ratios and performance indicators that you have calculated**. (2 marks) Profitability 2005 2006 2007 Gross Margin % 60.6 56.2 41.4 Operating Margin % 52.1 49.5 38.7 Earnings Per Share USD 2.34 3.32 3.75 Net Margin % 22.36 24.11 16.35 Asset Turnover (Average) 0.79 1.06 0.74 Return on Assets % 17.57 25.52 12.03 Return on Equity % 231.73 133.71 35.49 Return on Invested Capital % 53.12 73.14 26.23 From the profitability ratios illustrated above, it is apparent that the company’s overall profitability had generally increased from 2005 to 2006. This is evidenced by the increase in earnings per share, net margin, and Asset turn over, return on assets and return on invested capital. These ratio essentially suggest that the company was in a better position to generate revenue from the assets and resources at its disposal in 2006 compared to 2005. Nevertheless, the gross margin and operating margin had declined indicating that the company was not very effective at managing the cost of goods sold and operating expenses. There was also a sharp decline in return on equity, which was a red flag especially for the company’s shareholders. Financial Health 2005 2006 2007 Current Ratio 1.48 2.21 1.53 Quick Ratio 1.06 1.43 0.76 Financial Leverage 7.47 4.01 2.85 Debt/Equity 1.35 0.49 0.5 Its financial health was also very encouraging because 2006 saw an increase in current ratio and quick ratio which as aforementioned suggest that a company is in a better position to meet its short term financial obligations as and when they fall due. Another positive sign was the decline in financial leverage and debt to equity ratio, which implied that the proportion of debt in the company’s capital structure was also declining Efficiency 2005 2006 2007 Days Sales Outstanding 45.54 36.99 19.19 Days Inventory 114.36 92.74 66.41 Payables Period 106.43 78.68 31.56 Cash Conversion Cycle 53.47 51.06 54.04 Receivables Turnover 8.02 9.87 19.02 Inventory Turnover 3.19 3.94 5.5 Fixed Assets Turnover 1.33 1.87 1.18 Asset Turnover 0.79 1.06 0.74 Apart from exhibiting a general improvement in profitability and financial health, the company’s efficiency also improved as evidenced by the decline in day sales outstanding, day’s inventory, cash conversion cycle, inventory turnover and receivables turnover. The significance of these ratios is discussed in question one. Would you rate the acquisition of Phelps Dodge a ‘success’? Provide some support for this assessment both immediately following the acquisition (2007) and what does Management hope to benefit from the acquisition in the longer term? (2 marks) In the short run, it can be concluded that the merger was not successful because there was a general decline in profitability as evidenced by the decline in profitability ratios between 2006 and 2007. Moreover, the decrease in quick and current ratio coupled with the increase in debt to equity ratio also suggests that the financial health deteriorated. Notwithstanding, there was a general improvement in efficiency ratios, which suggests that the increase in production capacity had a positive impact on the company’s overall efficiency References Map07: , (Maps of World, 2007 ), And06: , (Sorkin & Austen, 2006), Read More