SouthGobi Gets New 'Big Brother' in Chalco's Takeover

SouthGobi Resources may be about to lose one ‘big brother’ but stands to gain an even larger one with greater clout and residing just across the border, if a proposed deal by China’s aluminum producer Chalco to buy Ivanhoe Mining’s controlling stake in the Mongolian-focused coal producer is completed.

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Hong Kong-listed shares in SouthGobi soared almost 20 percent after Chalco said it will acquire Ivanhoe’s 57.6 percent stake for $926 million or C$8.48 a share, a 28.1 percent premium to SouthGobi's Friday closing stock price in Toronto.

“We have a big brother with Ivanhoe,” SouthGobi Resources’ CEO Alexander Molyneux told CNBC after the proposed deal’s announcement. “If the transaction closes as proposed, we would have a new big brother Chalco, closer to our region and very powerful.”

Chinalco, the state-run parent of Chalco “is already shipping coal to the coast,” Molyneux said. “That can be extended through our border crossing” enabling the company to ship more coal efficiently, “so I think there's almost no change to SouthGobi but there are some synergies that this big brother brings,” he added.

The deal makes sense from a strategic point of view but on closer inspection SouthGobi’s management seem more cautious. The board of directors has set up a special committee chaired by independent director Pierre Lebel that has appointed independent legal and financial advisors to review the offer. SouthGobi advised shareholders to “take no action” until they receive further information and advice from this committee.

Muddying the waters further, both SouthGobi and Ivanhoe says they have not received any formal documentation from Chalco relating to the offer.

‘Big Brother’ Chalco itself is looking a bit vulnerable. Arguably, Chalco needs SouthGobi and Ivanhoe more than SouthGobi and Ivanhoe need Chalco, which desperately needs to diversify its product suite to make it less reliant on aluminum, the price of which has fallen sharply due to moderating economic growth in China.

As a result, Chalco struggled to maintain profits in the fourth quarter last year and reported a bigger-than-expected net loss of 729.6 million yuan ($115.3 million), and warned that the weak performance will extend into the first quarter of 2012. The company responded by setting up an energy division in June 2011, a strategy aimed at turning it into a globally diversified miner. Against this backdrop, the overture towards SouthGobi makes perfect sense.

‘Mining Boom’

Another even larger dynamic motivating China’s interest in Mongolia-focused miners is China’s aim to secure natural resources to feed its growing economy. IHS Global Insight’s Chief Asia Economist Rajiv Biswas said Mongolia is going through a “huge mining boom” with the focus squarely on premium coking coal in the Gobi Desert.

“Mongolia is very much a key area for Chinese companies to look for improved resource access to high grade premium coal,” Biswas told CNBC. “Over the long term, Mongolia has the potential to increase its exports of coking coal, which is a very high grade, so this is extremely important for the Chinese steel industry. That’s why there is a big scramble.”

Alexander Latzer, Head of Regional Metals & Mining Research and Felix Lam, Materials Research Director at Daiwa Capital Markets are maintaining their ‘underperform’ rating on Chalco and noted a number of issues relating to the deal on Chalco’s side that needed to be addressed.

Coal mining is a “totally new business” for Chalco, the Daiwa analysts said. More importantly, how is heavily indebted Chalco planning to finance this deal? Will it be funded internally or through an equity raising?

Just last month, S&P cut Chalco’s long-term rating to 'BBB' from 'BBB+' with a negative outlook citing the company’s worse-than-expected financial performance in the fourth quarter of 2011 and expectations that aluminum prices would remain depressed this year.

Chalco's debt levels remain “high compared with peers,” said Standard & Poor's credit analyst Lawrence Lu in February. The ratio of debt to capital was about 57 percent as of Sept. 30, 2011. “We don't expect any meaningful debt reduction in the coming year because the company still has large capital expansion plans.”

Given these risks, SouthGobi investors may have gotten ahead of themselves today and have reason to pause for thought. That said, China’s government effectively controls 42 percent of Chalco through the company's parent, Aluminum Corp. of China, Chinalco. As S&P points out there is a “high” likelihood that the government would extend extraordinary support to Chalco in the event of financial distress.

Michael Langford, Proprietary Trader at agrees. He explains: "Ultimately, credit rating does not matter — China's companies are purely extensions of the Chinese government."

On closer inspection, ‘Big Brother’ Chalco may be a little wayward but he can rely on a responsible parent with deep pockets to bail him out. With that in mind, SouthGobi and Ivanhoe may very well hold out for a richer offer.