Our large miners on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index have been exercising good restrain when it comes to mergers and acquisitions (M&As) despite their outperforming share prices.
This is a well-received strategy given the takeover disasters from the last boom, which showed there's no faster way for management to destroy shareholder value than to try to buy growth.
However, Citigroup thinks there could be an exception and it has its eye on iron ore major Fortescue Metals Group Limited (ASX: FMG) after the FMG share price more than doubled since the start of calendar 2019.
Why Fortescue needs to diversify
This makes Fortescue the best performing large cap miner but it may need to make a sizable acquisition to lessen its dependence on iron ore if it wants to stay ahead of the BHP Group Ltd (ASX: BHP) share price and Rio Tinto Limited (ASX: RIO) share price.
"FMG's share price is up ~110% year on year fueled [sic] by a run in the iron price. Come CY20 we expect iron ore's bull run to end," said Citigroup.
"On Citi's price deck FMG will realise US$48/t in CY21 compared to today's price of US$108/t for 58% Fe product. For longer-term strategic growth, we argue FMG should diversify its revenue stream."
Copper could be gold for Fortescue
The commodity that Fortescue should be adding to its portfolio is copper, according to Citi. While the price of iron ore has been rising strongly, the price of the red metal has been underperforming.
"The recent rally in the iron ore price has sent the copper-to-iron ore ratio to a low of 50x vs the historical average of ~100x," said the broker.
"With a healthy balance sheet and earnings set to peak, we think now is a good time for FMG to consider a part-equity funded copper acquisition to cushion earnings against a backdrop of weaker iron ore prices."
The problem is that the pool of takeover targets in the copper space is pretty shallow – particularly when it comes to pure-copper miners with sizable producing and/or development-ready projects.
Citi believes that the only option for Fortescue is OZ Minerals Limited (ASX: OZL) with its multiple medium-scale (60,000 plus tonnes a year), long-life and low-cost assets.
"With FMG's balance sheet at its disposal, OZL could evolve into a +250ktpa Cu-equivalent producer by leveraging regional exploration, developing its Brazilian assets, and lifting Carrapateena's output by expanding from a sub-level cave to a larger block cave," explained Citi.
"A cash bid for OZL at an EV of US$2.7bn (30% premium) funded by 50:50 debt-equity would favour FMG's balance sheet, peak iron ore earnings and major shareholders, in our view. Come FY22, an OZL acquisition could deliver FMG EPS and NPV accretion of 16% and 9%."
