A Great Commodity Trade... and Long-Term Investment

BHP Billiton just blinked.

 

On August 17, the world's biggest diversified mining company offered to buy fertilizer miner Potash of Saskatchewan (POT) for nearly $42 billion, or $130 a share. This was a 27% premium to the previous day's closing price.

 

Now... you might think paying a near-30% premium for a takeover target is a reasonable offer. However, this is only a 2% premium to where POT was trading five months ago, before the broad market selloff.

 

It took about two hours for POT to issue a press release stating that the offer was "grossly inadequate." As you can see from the chart, with shares trading at $149 today – the market agrees.

 

 

I applaud BHP's patience. After all, BHP has been interested in adding POT to its empire for over 12 months. The company did a great job waiting for a selloff to show its hand.

 

But here's how I think this story will play out...

 

As you probably read in the papers, POT is the largest provider of potash in the world. It controls about 20% of the world's supply. Potash is a nutrient that helps crops retain water. In essence, it improves the quality of food while offering better yields (higher returns) for farmers.

 

What you didn't read in the papers is POT produces the nutrient at a lower cost than anyone in the world. It takes about seven years to develop a new potash mine. The costs amount to about $7 billion with no cash flow during the developmental period. That's an enormous cost for any company.

 

Also, there are few areas in the world where potash can be produced. Canada and Russia account for about 80% of potash reserves.

 

POT holds six large, low-cost producing potash mines. That gives it a huge competitive advantage. That's also why I was positive on the stock (and industry) back in March.

 

POT is a perfect fit for BHP. It will immediately become a major potash producer. POT's mines would cost north of $40 billion (at today's prices) to develop from scratch.

 

However, BHP must increase its purchase price. The $130-per-share offer values POT at about 16 times next year's earnings. Over the past 10 years, POT has traded at an average multiple of 19. That makes the stock worth about $152 a share – about where it is trading today.

 

I think BHP can get this deal done at $155 to $160. Keep in mind, according to Canadian law, only two-thirds of shareholders need to approve the transaction to gain control. At $160, it would be difficult for shareholders to say no. After all, that's almost 100% higher than where the stock was trading in July.

 

There are several ways to make money here. For example, you could purchase POT at current levels and hope for a higher bid. But I think the better move is to purchase competitors Mosaic (MOS) or Agrium (AGU).

 

Fertilizer is a never-ending growth story. The world's population is growing by tens of millions of people each year. These people need to be fed. Also, population growth – along with industrialization in areas like China and India – is reducing arable land. The only way to counter these trends is by using fertilizers to help increase production from existing fields.

 

And now that BHP has "raised the bar" on how the world values these assets, you'll not just enjoy some short-term gains... but you'll be in a very attractive area for long-term investment, as well.

 

Good investing,

 

Frank Curzio

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