Let the metal deals flow
Does a flurry of M&A signal that commodities are overheated?
By Andy Serwer, Fortune Magazine editor-at-large

(Fortune Magazine) -- Riot police in Chile armed with water cannons and tear gas battle students seeking a greater share of windfall copper profits.

Phelps Dodge (Charts) miners in Bagdad, Ariz., wonder how the company's proposed $900 million, merger-related cost-cutting plan will affect their jobs.

Construction bosses in China fret over soaring prices for copper pipe.

And executives at a Swiss mining powerhouse contemplate upping their bid for a Canadian company.

These are all postcards from the edge of the metals and mining world, which has been turned upside down by the commodities boom. Even though these markets have pulled back some since early May, prices for base metals such as nickel, zinc, and copper have doubled or tripled this decade.

Not surprisingly, all this clamor in heavy metals has set off a mergers and acquisitions boom by suddenly cash-rich companies the likes of which this industry has rarely seen.

The latest monster deal - which has enough twists and turns to keep bankers in clover for years - entails what Wall Street has subtly dubbed a three-way, or one big company buying two others in one fell swoop.

In this case it's the $40 billion bid by copper giant Phelps Dodge, announced a few weeks back, to join forces with Canada's Inco (Charts) and Falconbridge (Charts).

Mergers aren't just for miners either. The same activity is rocking the steel biz, where Arcelor and Mittal are planning to merge in a $32 billion hookup.

Other commodities - especially oil and gas - are also the subject of nearly unfettered dealmaking. The latest? Anadarko (Charts) is conducting its own three-way, in this case snatching up Western Gas Resources and the venerable Kerr-McGee for a staggering $21 billion in cash.

(There have been plenty of transactions in other businesses too, like Johnson & Johnson's $16 billion purchase of Pfizer's consumer products division.)

Thanks in part to the flurry of commodities transactions, experts say Wall Street is on track this year to break the record for M&A set in 2000, when the total value of deals reached $3.5 trillion.

What's next for prices?

This raft of mergers is more than just a boon to i-bankers. It highlights a sharp difference of opinion over where prices for basic materials are headed - and there's some serious brainpower on each side of the debate.

Superstar mutual fund manager Bill Miller of Legg Mason, for one, says now is the wrong time to invest in commodities.

His sentiments are echoed by Jon Bergtheil of J.P. Morgan, who recently penned a research note titled "Crazy Copper and Zany Zinc, If you can't beat them, don't join them."

It reads in part: "We are living in the midst of the biggest base metals bull market in the past 50 years, both in terms of its rise (up 182%) and in terms of duration (52 months).... There is ample evidence that current prices are unsustainable...."

On the opposing team is investor and author Jim Rogers, who called the commodities bull run years ago. Rogers, who e-mailed me from Singapore, is hardly backing down now.

I asked him whether he thought that this cycle had run its course and wondered if we were in the ninth inning or fifth inning.

"The fact that [commodity companies] are buying each other up ensures the secular bull market is not over," Rogers wrote me. "None of this frenetic activity does anything for new supplies of commodities. In fact, it hurts future supply, since now the balance sheets are overextended, leaving less money for exploration, new mines, etc. There can certainly be corrections in the bull market as there have been in every bull market in history in every asset class all over the world. Stocks went down 40% in 1987, then went up 700% since it was a secular bull market. Gold corrected 50% during the two years 1974 to 1976 and shook out a lot of investors, and then went up more than 700% during its last secular bull market.... We are more likely in the fourth inning."

Phelps Dodge's ambitious bid

Clearly, another true believer is Phelps Dodge CEO Steven Whisler. His 172-year-old copper company, after all, is staking billions on its ambitious bid to create a mega-miner similar to Australia's BHP Billiton or Britain's Rio Tinto.

As you might imagine, Phelps Dodge's (Charts) stock has soared over the past four years, but naggingly still carries a valuation lower than other metal makers, such as Alcoa.

Last fall Atticus Capital, a New York City hedge fund that owns 6% of PD, began publicly agitating for Phelps to buy back stock and pay out its increasing cash hoard to shareholders. Things got testy earlier this year when Whisler blasted the hedge fund's "reckless" demand to add substantial debt to Phelps Dodge.

Then Whisler decided to go shopping in Canada. The Canadian market has been thrown into a tizzy in recent months by a flurry of M&A battles.

To wit: Back in October, Toronto nickel titan Inco made a $10.8 billion bid to buy its crosstown rival Falconbridge, a large producer of zinc, nickel, and copper.

Then, in May, another Canadian mining operator, Teck Cominco out of Vancouver, offered $15.3 billion to buy Inco.

Days later Switzerland's Xstrata, which mines coal, copper, and zinc all over the globe and already has a stake in Falconbridge, started a bidding war with Inco by offering $14.6 billion for the 80% of Falconbridge it doesn't own.

Whew, got that? "It's pretty unusual," acknowledges one investment banker in the throes of the dealmaking, "but I think it speaks to the point that you have too many players in the mining arena." Amid the frenzy Whisler spotted an opportunity.

Phelps Dodge drew up a complex plan where Inco first buys Falconbridge and then Phelps buys the combined company. Along the way, Phelps Dodge adds on $22 billion of debt (which is presumably not a "reckless" amount) and repurchases up to $5 billion in stock.

The latter point was perhaps a bone to Atticus, but the hedge fund isn't biting. Days after the announcement of the three-way, an Atticus spokesman reportedly said his firm was "not convinced on the merits of an acquisition of Inco and Falconbridge."

Others whisper that Whisler is doing the deal in part to make Phelps Dodge itself less vulnerable to a takeover.

Meanwhile Xstrata - which has seen its 20% stake in Falconbridge swell by $2 billion in less than a year - and Teck Cominco aren't out of the picture yet either.

Does the deal make sense for Phelps Dodge? One good sign is that its assumptions on copper and nickel prices aren't totally unreasonable. In its merger presentation, the company projected copper falling from $2.85 a pound to $2.25 next year and then to $1.75 in 2008, and Whisler acknowledged that there is some "froth" in pricing right now.

But as recently as three years ago, copper fetched a mere 75 cents a pound. Some analysts have predicted increasing copper surpluses next year.

For now, though, prices remain red-hot, which means the debate over their direction will stay a front-burner issue. It also may augur yet even more dealmaking.

That doesn't surprise the banker in the middle of the Phelps fracas. "It makes sense that there are deals at a top," he says. "That's what brings out the sellers."

It also brings out the buyers, of course. And what makes good sense for one party may not for the other.

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ANDY SERWER, senior editor at large of FORTUNE, can be reached at aserwer@fortunemail.com. Watch him on CNN's American Morning and In the Money.  Top of page