Rio Wields The Axe

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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

For the story so far see “The Carnival Is Over For Rio”; Australia; 08/12/08:

As soon as BHP Billiton ((BHP)) dropped its bombshell and withdrew its bid for rival Rio Tinto ((RIO)) the matter of Rio having more debt than equity became an all pervasive factor. Having scoffed at BHP’s bid – first made a year ago – on the basis of its undervaluation, suddenly Rio management desperately needed to come up with some plan to appease a frightened market. Despite Rio’s share price falling to near $30 from its once lofty heights over $150, Merrill Lynch had set an Underperform rating at least until Rio came up with an emergency strategy.

Yesterday it did. “It has taken more than two weeks since BHP withdrew its bid,” note the Merrills analysts, “for Rio Tinto to come to the market with a ‘Plan B’ – we had begun to worry that they did not have one”.

But what Rio did come up with was enough to ease Merrills’ concerns. So much so, in fact, the analysts have this morning upgraded the stock straight back to Buy and increased their target price from $50 to $60.

Rio plans to reduce its US$39bn of debt by US$10bn in 2009 through various measures. The first is to say goodbye to no less than 14,000 staff across the globe. The Sydney Morning Herald responded this morning by calling it the “End of the resources boom” – a boom which has employed so many Australians on name-your-price wages.

Then there’s the capital expenditure budget, set for the purpose of developing all sorts of new projects to exploit the aforementioned boom. This will be slashed from US$9bn to US$4bn in 2009 and more in 2010 if commodity prices don’t pick up.

Then there’s the obvious matter of the dividend. Investors do not buy diversified resource companies for yield, they buy them for cyclical growth. But such riches have Rio and BHP earned in the last couple of years that their managements have been happy to increase the payout to shareholders. Last year Rio increased its payout ratio by 20% and the intention had been to do the same this year. Analysts, on the other hand, agreed on one suggestion in the wake of the current crisis that Rio could scrap dividends all together and reduce debt rapidly. As it was, Rio decided to keep the dividend, but no longer offer the increase.

The greatest fear emanating from the market is that the once mighty Rio would be forced to issue fresh capital to ensure its survival. Well despite not cancelling the dividend, management yesterday ensured the world that there was absolutely no intention to raise more capital.

One of Merrill Lynch’s suggestions had also been that apart from straight non-core asset sales, Rio could joint venture out part of its core operations just as rival BHP has always done. And it has come to pass, for yesterday management announced it would look at “measures of generating cash from joint ventures on its existing assets”.

Analysts are generally pleased with the announcements, particularly the confirmation of no capital raising which GSJB Were suggests will now put a floor under the share price. (More than a floor – last night Rio shares traded over 20% higher in London and New York). Only Merrills made a ratings move of the brokers reporting this morning however, with the other four sticking to a Buy and three Holds.

ABN Amro (Hold) was the least convinced by the package, suggesting it provided “more questions than answers”. It’s been several months now since the wheels began to fall off the commodities market, but the analysts note that Rio is yet to be specific about which particular assets it might put up for sale, which it would keep, and which it would put on hold. It’s still very much a case of “trust me”, ABN suggests, and in the current economic environment that’s a big ask.

GSJB Were believes Rio has clear challenges ahead, not the least dealing with leverage and “a struggling aluminium business” in the middle of a credit crisis, but the analysts also note that Rio’s need to address its balance sheet means that the company will not be able to pick up on any opportunities that may present if things improve. (Unlike, of course, BHP).

Rio now has a 3/6/0 B/H/S rating in the FNArena database and its average target has snuck up to $51.16. While Rio shares have fallen a long way and a cost-cutting plan is now being implemented, there is little disagreement among analysts that with no debt problems to speak of, BHP offers the better value.

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