No-moat BHP (ASX: BHP) proposes to buy no-moat Anglo American (LON: AAL) in an all-share transaction via a scheme of arrangement. Under the proposal, Anglo American shareholders would receive 0.7097 BHP shares for each Anglo American share they hold.

The proposal is conditional on Anglo American first demerging and distributing its 78.6% shareholding in Anglo American Platinum, its platinum group metals, or PGMs, business, and 69.7% shareholding in Kumba Iron Ore to its shareholders. It is also subject to due diligence and other conditions. The proposal is roughly equal to our base-case fair value estimate for Anglo of GBX 2,080 per share and Anglo is reviewing the proposal.

The initial bid was knocked back by Anglo but we think BHP is proposing to pay a fair price and make no change to our Anglo American fair value estimate of GBX 2,080 per share. It is unlikely the bidding is over and we estimate an approximate 50% chance BHP is successful and make no change to our $40.50 per share fair value estimate.

We think Anglo is now in play, with its copper assets in Peru and Chile the main attraction to potential suitors also optimistic about its outlook. But the list of potential acquirers with the size and balance sheet capacity to bid is limited, and includes Rio Tinto, Vale, and perhaps Glencore. Under the United Kingdom takeover and mergers code, BHP must either announce a firm intention to make an offer or that it won’t by May 22, 2024.

Given Anglo’s share price has trailed BHP’s, Rio Tinto’s and Glencore’s recently, BHP’s proposal is opportunistic and we see some merit to the deal. The assets are mainly located in jurisdictions such as Chile, Peru, Brazil, and Australia, where BHP operates. For context, the cost to purchase Anglo excluding its PGMs business and Kumba is around 17% of BHP’s equity value. The enlarged BHP’s balance sheet is also strong, with pro forma net debt/trailing 12-month earnings before interest, taxeas, depreciaton and amortisation (“EBITDA”) of around 0.6.

What would BHP get if they manage to acquire Anglo American

As China rebalances away from infrastructure and construction-led growth, Anglo American is likely better positioned than most diversified peers. The company has greater exposure to consumption-oriented commodities like platinum and diamonds, which should enjoy better demand growth than investment-oriented commodities like iron ore and copper that prospered most in the past decade.

Anglo's platinum business should benefit as rising household incomes bolster Chinese demand for automobiles and jewelry, categories that collectively account for roughly 80% to 90% of platinum and palladium use in China. However, in the longer term, electric vehicles are likely to satisfy a greater share of demand for vehicles, weighing on demand for platinum and palladium for catalytic converters.

An 85% stake in De Beers makes Anglo the world's largest diamond miner. As with platinum and palladium, there's big upside to Chinese diamond demand, which now stands at about 10% of the global total. Realizing that upside will take more than rising Chinese incomes as diamonds lack the cultural resonance they have in the US, so maximizing Chinese diamond demand will come down to marketing. If Chinese brides come to view diamond engagement rings as a must-have like their American and Japanese counterparts did in the 20th century, diamonds have tremendous upside.

Like other large miners, Anglo’s balance sheet is strong as a result of elevated commodity prices in recent years. Net debt at the end of December 2023 was around 1.1 times adjusted EBITDA. After focusing for much of the past decade on incremental expansion of its existing operations through cost and volume improvements, Anglo is now turning to developing its greenfields growth pipeline. This includes its 60%-owned Quellaveco copper mine in Peru, which ramped up to full production in 2023, while we think Anglo will also likely develop its Woodsmith crop nutrients (polyhalite) project in the United Kingdom in coming years.

Moat rating

As a commodity producer, Anglo is a price taker and needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat. We forecast midcycle returns on invested capital in the mid-single digits, materially below its weighted average cost of capital of about 9.5%. As Anglo’s midcycle return on invested capital ("ROIC") is below its WACC, we don’t assign the company a moat.

Our forecast is based on assumed midcycle prices from 2028 for copper, iron ore, and metallurgical coal of about USD 3.65 per pound, USD 70 per metric ton (which is materially less than the average price of around USD 100 per metric ton over the past decade), and USD 155 per metric ton, respectively, based on our estimates of the marginal costs of production. We also assume platinum prices of USD 920 per ounce, palladium prices of USD 1,160 per ounce, rhodium prices of USD 5,240 per ounce, and nickel prices of about USD 8 per pound from 2025, based on spot.

In calculating ROIC, we have added back to invested capital about USD 23 billion of asset and intangibles writedowns taken over the past decade on the basis that these amounts relate to assets developed or acquired in the ordinary course of business and so should be included when calculating ROIC. Some of the more material amounts include USD 8.9 billion in relation to iron ore and USD 4.9 billion in relation to coal.

Looking at each of Anglo’s segments in turn:

Copper (no moat): Anglo’s new 60%-owned Quellaveco mine in Peru has relatively low unit costs, placing it on or around the 25th percentile of the copper cost curve, and it has a likely remaining life of more than two decades. We think Quellaveco will also improve the copper division’s average position on the industry cost curve as it ramps up. However, with Collahuasi and Los Bronces comprising most of the division’s other copper production and on average being at a middling position on the industry cost curve, nevertheless, the copper division overall is likely to remain comfortably within the second quartile of the cost curve. At our assumed midcycle copper price of USD 3.65 per pound from 2028, we think the copper division is unlikely to consistently generate returns above Anglo’s cost of capital and so we don’t deem it moatworthy.

Iron ore (no moat): Unit cash costs at its mines in Brazil and South Africa are higher than its major competitors BHP, Rio Tinto, Vale, and Fortescue, not only due to its materially lower production, but also due to the costs of upgrading its lower-grade ore at Minas Rio in Brazil in particular. Freight costs are also higher than those of the Australian iron ore majors due to the greater distance from Brazil and South Africa to customers including those in China. However, as the average grade of Anglo’s salable iron ore is above the 62% benchmark and includes a high proportion of both lump and pellets, Anglo tends to receive a pricing premium compared with the Australian iron ore majors. Driven by the cost blowout to build Minas Rio in Brazil, which cost about USD 13.8 billion to purchase and then construct, we think the iron ore division is also unlikely to consistently generate returns above Anglo’s cost of capital at our assumed midcycle iron ore price of roughly USD 70 per metric ton from 2028. As such, we don’t deem it moatworthy.

Platinum group metals (no moat): The company accounts for about one third of the world’s platinum supply and around 30% of global palladium supply. While Anglo’s mines are generally large and long life, they aren’t particularly low cost on average. The other major supplier is Russia which is low-cost thanks to high-grade operations owned by Nornickel (Norilsk). While we forecast midcycle returns in the low double digits, this isn't sufficiently above Anglo’s cost of capital and so also don’t deem this division moatworthy.

Diamonds (De Beers) (no moat): While De Beers is the second largest diamond producer in the world by volume, its rough diamonds tend to sell for higher average prices than those of competitors. Led by Jwaneng in Botswana, De Beers’ major diamond mines are large, low-cost, and long life. However, we forecast the Diamonds segment will generate returns on invested capital from midcycle materially below Anglo's cost of capital and so don't deem it moatworthy.

Nickel (no moat): Anglo’s wholly owned Barro Alto and Codemin mines in Brazil are middling on the industry cost curve and in our view are likely to remain so over the forecast period. At our forecast midcycle nickel price of USD 8 per pound from 2025, we forecast low-single-digit returns on invested capital from midcycle and we don’t deem the Nickel segment moatworthy either.

Metallurgical (or steelmaking) coal (no moat): Increased production at Moranbah and Grosvenor will likely lead to cash operating costs falling over our forecast period, but the company’s operations are likely to remain middling at best on the industry cost curve. At a midcycle metallurgical price of around USD 155 per ton from 2028, we forecast mid-single-digit returns on invested capital from midcycle. As such, we don’t deem this segment moatworthy either.

Exploration projects (no moat): These are an immaterial part of Anglo and way too early in their potential development to assign any of them a moat.

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