Description

So this is a relatively straight forward merger play with limited downside and interesting up side that will all likely play out before June 1st. 

The set up is this - 

TRQ owns the Oyu Tolgoi mine in Mongolia. They are the majority owner of it with the Mongolian government as the minority owner. TRQ is in turn majority owned by RIO - 51% with a few hedge fund investors as large minority shareholders. RIO is the entity that is operating the mine - so RIO is essentially telling TRQ how things are going and then TRQ reports it to the market. In other words, RIO knows more about the mine than TRQ (this will become important to understand later). 

Now, Tolgoi is a copper mine that had a surface operation that was losing its ore grade (e.g. they were mining ore that had less copper) and so they needed to transition to an underground operation. A few incremental billions was needed to fund that capex and some mistakes were made (by Rio) and so there were some delays and cost over runs as that subterenean mine was built out. That coupled with the commodity sell off led to the stock getting annhilated - TRQ fell from the mid $30s in 2018 to $4 a share in 2020 (it had been in the $200s during the commodity boom peak of 2010). 

Despite, the completion complications, RIO was always very excited about this underground project. They understood that once it started to get going, it gushed cash. It costs a lot to drill underneath a deposit but once you have that all built out and you get the mine going, the copper ore is just literally falling from the ceiling - you just shake the ceiling a little and let gravity do the rest. So, high initial up front capex but then low operating capex and great ore grades going forward. With this underground expansion Tolgoi is expected to be one of the most prolific copper mines in the world over the next fifty years. 

Could take more time to explain the various complications encountered but the bottom line is that today the underground mine is ready to begin producing so that key risk is out of the way. 

The other key risk to this story was Mongolia. In Mongolia, people still worship fire gods - not exactly a place you want to do business. With the underground project about to start, it was important to have a comprehensive agreement in place with the Mongolian government. Once you get the underground mine going you lose some leverage. Such an agreement was reached this past Janruary - https://www.riotinto.com/news/releases/2022/Oyu-Tolgoi-partners-reach-comprehensive-agreement-and-approve-commencement-of-underground-mining-operations. 

So today, the project is not only very de-risked (underground mine is complete and government agreement is in place) but also copper prices have ramped. So what was already going to be a cash gusher is about to become even more of a cash gusher - they look set to do almost their entire market cap in FCF a few years out. 

But just as the equity looked set to ramp during the course of this year and reflect that improved future, RIO stepped in and offered $26.68 a share (versus a share price of $20 at the time). 

So again, RIO is the operator of the mine (and also the majority owner). They know more about the project ramp and what is about to happen than anyone including TRQ management. For the first time since TRQ was created, they decided to go for all of it. 

Today, the stock sits at $28.10 as TRQ has formed a special committe to consider the bid. We will know by the end of this month what happens. 

There are three potential outcomes.

1) TRQ out right rejects the bid - 5%

This seems very unlikely. TRQ's management are former RIO guys and they are majority owned by RIO.  They will look to get a deal done with RIO. RIO has long had the ability to buy out this minority stake and now they are finally doing so which speaks volumes about how they feel about the project. If this scenario were to happen, the stock would fall to likely the $23/24 range. But almost view this as an impossbility at this point. 

2) TRQ accepts the current bid - 15% 

This could happen but also seems unlikely. The two major shareholders Pentwater and Sailingstone have sent letters highlighting the value discrepenacy and vowing to vote down the deal at the current share price. These two and a third fund Kopernick would have close to 50% of the voting power of the minority stake.  

https://pickeringenergypartners.com/an-open-letter-from-sailingstone-capital-partners-to-turquoise-hills-independent-directors/

https://www.businesswire.com/news/home/20220318005077/en/Pentwater-Delivers-Open-Letter-to-Turquoise-Hill%E2%80%99s-Independent-Directors

If a majority of shareholders vote it down then it doesn't happen. RIO wants a deal to happen and doesn't want to risk that. 

3) TRQ accepts a revised bid - 80%

We think that 3 is the most likely scenario by a long shot for a number of reasons. 

When you have a minority buy out - your average bump is in the 15% range. In this case, there is an information assyemtry as RIO is the operator and you have multiple activists agitating - seeing a bump on the 20-25% order is more realistic here. 

TRQ management is happy to do a deal (afterall they basically work for RIO) but they have to make sure these funds go along with it. They know that they won't accept $26.68 as they know that that is a non-starter so they have to find a number that is high enough that these other funds take it rather than risk a bad mark to market by voting against it and having it not go through. 

What does that number look like? 

My guess is somewhere in the $33-35 range.  That probably get

So I think near term you have a downside risk of $26.68 if they accept the deal as is - but I see that is low probability. And you have an upside of $33-35. So risk $1.5 to make $5-7.

Now, there is some probability, that Rio walks away entirely but I view that as deminimus - they want this asset badly and they'll at least force TRQ mgmt to put it to some sort of vote at a certain price. Not only is it a compelling asset from a free cash flow perspective but RIO doesnt want to deal with minority shareholders anymore potentially suing them or teaming up with the Mongolian government if things go poorly. These shareholders have caused RIO headaches in the past - Pentwater sued Rio. 

https://www.reuters.com/article/us-rio-tinto-lawsuit-turquoisehill/rio-tinto-faces-class-action-suit-over-mongolia-copper-project-idUSKBN2BH1ZE

RIO is dealing with this batshit crazy government in Mongolia. Trying to do that while some annoying hedge fund is suing you and trying to get discovery and making a big media firestorm about it is not fun. So best get rid of them now before it costs more expensive to do so later. 

In conclusion, II think the worse outcome here is that you get to sell out close to the original bid price. The much more likely scenario like 80% probability is that we see a price of $33 a share in the next few weeks - a nice 17% return over the next month. In this current market, this is probably the most compelling near term risk/reward in existence right now. 

Catalyst

- Deal final price announcement within next few weeks.