Pilbara Power

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Greg Peel

The story so far:

In 2007 the world was riding high on an economic boom driven by China’s voracious appetite for commodities. The super-cycle was clearly going to go on forever and the world’s number one and three global diversified miners – BHP Billiton ((BHP)) and Rio Tinto ((RIO)) – were going to enjoy endless barrow-loads of cash earnings. Feeling immortal, in September 2007 Rio acquired Canada’s aluminium giant Alcan, which put the company in about US$38bn of debt. BHP remained relatively debt free.

While the market pondered whether BHP might counter by bidding for Alcan’s US counterpart Alcoa, BHP instead launched an audacious bid for Rio in November 2007. Rio management rejected the deal outright as undervaluing Rio’s growth potential. Regulators across the globe set about deciding whether the deal was anti-competitive. No one expected an answer in a hurry.

As commodity prices continued to soar, and the US credit crisis was yet to turn into a global financial crisis, BHP increased its bid in February 2008. Rio again rejected the price. In July 2008 the oil price collapsed. When Lehman Bros went under in September, all commodity prices collapsed. In October, the Australian regulators approved the deal but regulators elsewhere, most particularly in Europe, were still uncommitted.

Rio’s share price collapsed from a high in May 2008 of $150 per share to $70 in October. By now it was apparent that Rio’s significant debt would prove problematic in a GFC world. But the final knife in the side came in November 2008 when BHP withdrew its bid. Rio shares crashed to $30.

At this level, issuing fresh capital to cover upcoming debt refinancings was not an attractive option. Rio’s only choice was to start jettisoning assets, and valuable ones at that. The company might stay afloat but its future earnings potential would be seriously eroded.

Enter Chinalco. In December 2008 the state-owned Chinese aluminium company offered to solve all Rio’s problems in exchange for convertible notes which would provide Chinalco with circa 18% of Rio on a share price recovery. The offer roughly valued Rio shares at $50, so they bounced straight to that level. The Chinalco deal swiftly brought two major criticisms. One was from a xenophobic public, who feared China’s ownership of Australian assets, but more importantly the other was from existing shareholders who had been shut out of any option to acquire more stock on a similar deal to Chinalco’s.

The Australian government was forced to sit down and consider whether or not it would allow the deal. In the meantime, commodity prices rallied, and the protestations of Rio shareholders became louder and louder. We want a rights issue, they screamed. Rio stuck to its guns and continued to roadshow the benefits of the Chinalco deal.

As commodity prices, and the Rio share price, continued to rally, the Chinalco deal suddenly looked less appetising. Without waiting for the yea or nay from the Treasurer, Rio cast its white knight adrift. Last week Rio announced the Chinalco deal had been abandoned. Chinalco was not happy.

We may now never know whether or not the Australian government would have blocked the deal anyway, and there will long be discussions about whether Rio’s spit in the eye of its saviour was morally questionable, but from a cold capitalist point of view, the rally in commodities prices, the reduction in credit spreads, and the rally in Rio’s share price to over $70, which all occurred post the Chinalco bid, made that bid commercially unattractive.

The shareholders won out on Friday when Rio announced a US$15.2bn rights issue at a discount on the Australian closing price of a massive 47.7%. At US$22.94 and the current exchange rate, the issue represents a share price as low as its post-BHP-withdrawal nadir in January 2009.

Resource analysts are not surprised that Rio should reject Chinalco and bow to the shareholders. Most advised this was the most sensible option. The size of the issue has surprised analysts however, given Rio had already managed to roll over some of its pending US$20bn debt commitment at a much lower credit spread than the GFC peak, and given that it will receive a US$5.8bn payment from BHP.

The payment from BHP represents another concurrent solution analysts have been crying out for. Rio and BHP will merge the operations of both their Pilbara iron ore projects – a move first considered but rejected ten years ago – to form a 50/50 joint venture. BHP was previously slightly the lesser of the balance, so its $5.8bn payment evens the score. The two miners will nevertheless market their iron ore separately, except for about 10-15% earmarked for the spot market.

(One finds it hard to believe there will be any competition on contract prices nevertheless.)

The rights issue and BHP payment will reduce Rio’s remaining debt balance to around US$17bn. Analysts calculate the theoretical ex-rights price for Rio shares to be around $53, equating to around 17% dilution. That figure is nevertheless by the by given there are unlikely to be any shareholders passing up their rights at the price. Rio will not pay an interim dividend but will base a final dividend on earnings.

Everybody, it thus seems, is happy, except for a certain Chinese aluminium company. The Pilbara JV will, on early estimation, offer $10bn of operational synergies. Assuming the rights issue goes off without a hitch, Rio will not only score enough capital to manage its debt obligations, it will have enough in the bank to reconsider growth options which had been shelved, abandoned or simply considered pie in the sky at the beginning of 2009.

From BHP’s point of view, the spectre of a competitor partly owned by its biggest iron ore customer has been alleviated. Rather, more cooperation between the two iron ore giants puts price leverage very much back in Australia’s court. And more than one analyst has pointed out this morning that the new deal does not preclude BHP launching another full bid for Rio at a later date.

There is still a regulatory hurdle to jump, although analysts agree the simple blending of BHP and Rio’s iron ore operations (but not marketing) is a far cry from two of the world’s biggest diversified miners becoming one global powerhouse, overshadowing all others. Approval should not pose too much of a problem, although it does remain  risk.

The positive response from brokers this morning has not, nevertheless, elicited any ratings changes. Several brokers are also advising on one part or other of the two deals to one or other of the parties and are thus restricted in making a recommendation. Thus ratings remain as five Buys and one Hold for Rio, and eight Holds and one Sell for BHP.

Despite the value of the deal to BHP, analysts had already concluded that BHP had rallied hard on commodity price rises of late and was no longer showing much in the way of value upside, at least for the time being. BHP’s average price target remains at $33.21.

It’s a different matter for Rio, which despite rallying over 133% from its trough is still considered to be a back-from-the-dead revival story with greater value upside potential. The average target has this morning jumped from $68.89 to $73.70.

The simple truth is Rio has also finally ended all doubt and speculation over the Chinalco affair. Chinalco has made its disappointment clear, but it’s yet to be seen just how China, in general, will respond to this snub from here on in. FNArena had previously learnt from sources close to Chinalco that the Chinese were very respectful of the Australian government’s position in considering the Chinalco deal, such that any rejection would have been taken in stride just as was the case with OZ Minerals and Minmetals. But to be rejected by Rio itself is potentially a different matter.

For Rio Shareholders, life couldn’t be sweeter.

Click to view our Glossary of Financial Terms