Should Rio Sell The Farm?

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

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

By Greg Peel

It is a common occurrence within the Australian farming community. Encouraged by strong wheat prices and a previous solid harvest a farmer decides to exploit the good times by buying a section of the neighbour’s land. The neighbour is happy to sell, believing the farmer is offering peak price, and as we all know, farming is a fickle industry and at best simply cyclical. The farmer must borrow to buy the land, but the bank is keen to lend because it, too, likes to exploit the good times.

Disaster strikes. The wheat price collapses. Suddenly the world has more wheat than it knows what to do with. The farmer realises his next crop will not allow him to meet his loan obligations. Then there’s a knock on the door. It is the neighbour offering to buy the land back – at a much reduced price. So much reduced, in fact, that it would still not cover the farmer’s immediate debt obligations. So the neighbour offers to buy more land, cutting into the farmer’s previous existing acreage. Reluctantly, the farmer accepts. His loan is paid off. But when the next season brings a return to stronger wheat prices, the farmer produces a smaller crop on his lesser acreage, and his profits are down as a result. If only he had never bought the extra acreage in the first place!

In 2007, global mining giant (arguably either number two or three in the world at the time) Rio Tinto ((RIO)) bought Canadian aluminium superpower Alcan by taking out a very big loan. At the time, the aluminium price was heading for blue sky. The market suspected the world’s biggest miner, BHP Billiton ((BHP)) might counter Rio’s triumph by bidding for American aluminium superpower Alcoa. But it didn’t, it bid for all of Rio instead.

Rio management scoffed, suggesting the BHP bid undervalued the growth potential of a company with many projects, both existing and prospective, in an era where emerging market demand would send commodity prices ever upward. BHP lifted it’s bid, but still Rio entreated its shareholders to resist. It all became academic eventually, as more than twelve months of regulatory approval process had not reached a conclusion before the bottom fell out of commodity prices. BHP subsequently pulled its bid, and Marius Kloppers has thanked God for the glacial pace of regulatory bureaucracy ever since. Had BHP acquired Rio it would have been stuck with Rio’s excessive Alcan debt. It would have been BHP in the boat Rio now finds itself in.

And that boat is a canoe without a paddle, drifting on a river rapidly flowing toward a waterfall of Niagaran proportions. But let us return to the farming analogy.

This year and next, Rio has an obligation to pay back a net US$19m of the US$38bn the company borrowed to buy Alcan at the top of the market. On current commodity production earnings, it will default. Rio is in a predicament currently being faced by so many companies across the sector, across all sectors, and across the globe. In order to meet its obligations it must sell off assets – pieces of the farm – to raise enough cash to make the repayments. But the buyers are few and fully cognisant of the predicament of the Rios of the world. They can smell a bargain. Rio needs to sell a lot of assets at giveaway prices in order to raise the cash.

Alternatively, Rio could “go to the market”. It could attempt to issue fresh capital and thus raise sufficient equity to pay back its loans. But its share price has fallen from a peak of around A$150 to as low as A$30. The stock is currently trading at around A$50, but just as asset buyers would expect bargain prices for Rio’s assets, the equity market would expect a big share price discount to cover Rio’s debt. The result would mean a large dilution of earnings per share in years to come.

Such dilution is potentially enough to dissuade Rio management from this course of action. But on the other hand, selling off assets is a long and protracted process – perhaps too protracted. Rio needs to meet its first refinancing obligation in November. That may seem a fair way off, but bear in mind there was no regulatory resolution on the BHP bid for Rio after more than twelve months. These things take time.

Perhaps there is another solution?

Imagine if a Canadian company had stuck up its hand and said “We will buy a share in a raft of your assets AND we will take a significant stake in your company AND because we’re keen we will pay you a reasonable price rather than a firesale price which will allow you, in total, to repay all of the next two year’s debt obligation”.

The champagne corks would be popping. Aussies and Canucks would be tearfully embracing in the streets. The Australian government would rubber stamp the deal faster than you could blink and then beam about an even greater bond of friendship between two longstanding allies – indeed, “great mates”. Sure – it means selling off part of the Australian farm to another sovereign state but hey – we’re all in a “global” world now, aren’t we? There are no longer borders in business! Canada might be a competitor in the commodity export stakes but all’s fair in love and war. And besides, nobody argued when we bought their aluminium producer – did they.

And but for one small difference, such a deal has been offered. It is a deal that Deutsche Bank suggests “offers up a complete suite of solutions, a veritable banquet so to speak, that significantly addresses Rio’s near-term funding impasse whilst affording the company the ‘luxury’ of or resurrecting growth options that would have otherwise been buried for years to come.”

It is the elusive silver bullet, a potential panacea. It is a glaring light at the end of the tunnel. It is manna from heaven. The only problem is, the offer has come not from Canada, or the US, or Brazil. It has come from China.

The deal has China’s state-owned aluminium giant, Chinalco, buying a stake in Rio’s aluminium assets and other assets to boot, most importantly copper and iron ore. For these assets Chinalco will pay US$12.3bn. Chinalco will also buy equity in Rio (to add to its existing stake) to the value of US$7.2bn. That’s US$19.5bn in total – enough to wipe out two years of debt repayment obligations.

The equity stake will be in hybrid form. Rather than buy ordinary shares, Chinalco will buy convertible bonds. A convertible bond is an animal which contains both debt and equity elements.

A convertible bond begins life as a form of debt similar to a corporate bond. In its simplest form, a corporate bond is issued at A$100 face value with an annual fixed coupon payment made every year for a predetermined number of years. At maturity, the A$100 is returned. A convertible bond adds an extra element, in that at any time the holder may elect to convert that bond’s face value into an equity investment – into shares – at a pre-determined ratio (dollars per share). The share price which triggers the conversion option is invariably at a premium to the existing share price. Once converted, the holder now simply owns ordinary shares in the company which are perpetual.

The conversion option is similar to any standard call option over shares. The idea of a convertible is that it is a win-win for both sides. A company looking to raise funds may eschew an equity raising if it feels the market will not pay enough to make it worthwhile. Equity holders are the last to be paid out were the company to liquidate, and a “running yield” in the form of dividends is at the company’s discretion. A company might prefer to issue equity but concede it will need to issue debt (bonds) instead.

Corporate bonds offer the holder a fixed yield (provided the company remains in business) but no ultimate valuation upside. Bond holders are, however, paid out before shareholders in the event of liquidation. If it’s income you need then bonds are a good bet. If it’s blue sky capital appreciation you crave then shares are the go. But a convertible bond provides the opportunity to receive an income during the building phase but, assuming the company is successful, switch to blue sky share investment once the share price has risen by a certain degree. And if the holder does make the switch, the issuer has just repaid its debt.

The Chinalco convertible deal sees Rio paying an effective 9.2% coupon initially but offering Chinalco the option to convert to ordinary shares any time at US$45 per share for US$3.1bn worth, and at US$60 per share for US$4.1bn worth. On today’s Aussie that’s about A$68 and A$91 with Rio currently trading at A$50. Rio has the option to “redeem” the bonds in six years time. That means if Chinalco has not exercised its option to convert within six years, Rio just gives Chinalco back the face value of the original bonds and bids farewell. Obviously Chinalco would choose not to convert only if the Rio share price never managed to return to levels above and beyond the conversion prices. This would mean Rio has not performed terribly well. But nor is Rio obliged to redeem. The convertible bonds have an ultimate maturity of 60 years.

So our farmer is desperate. The neighbour has offered to buy up some of the farmer’s land and then lend the farmer some money as well. The neighbour has the option to convert that loan into land at his discretion at a pre-determined higher price. After six years the farmer can pay back the loan and thus take away the option. Otherwise the farmer must pay back the loan after 60 years.

“Outwardly,” says BA-Merrill Lynch, “this deal would appear to solve all of Rio’s financing problems and the asset valuations look reasonable”.

“On our estimates,” say the analysts at ABN Amro, “Chinalco is paying close to NPV [net present value] in aggregate for the assets, rather than a premium, which RIO explains is related to there being no control premium”.

All around the world, potential buyers of assets have sellers of assets by the you-know-whats. There are assets being dumped at often substantial discounts. On analyst estimation, Chinalco is offering to buy Rio’s assets at about fair value. This implies no premium, but it’s a helluva lot better than a big discount. Were Chinalco to convert its bonds into equity, the company would hold a total stake of 18% of Rio. This is substantial, but not a controlling stake. Hence no control premium.

The coupon on the bonds is 9.2%, which seems like a lot for Rio to pay out when the local cash rate is 3.25%. But consider that “the world’s most successful” investor Warren Buffet last year did a similar deal with troubled US investment bank Goldman Sachs at about a 20% coupon. And the US cash rate is now zero.  The 9.2% coupon is really not that bad.

All up, it looks like a fantastic deal in the current economic climate. But the buyer is not Canada, the buyer is China. The farmer has not made a rescue deal with his neighbour, he’s made it with the bakery.

The bakery normally buys a large amount of the farmer’s wheat, plus most of the neighbour’s wheat. Each year the bakery and two farmers sit down and negotiate a price. The bakery starts low, the farmers start high, and after a lot of arguments, accusations, posturing and prevarication the two parties reach an agreement. But now the bakery has an effective 18% stake in one farmer’s business. It is both customer and producer. It will expect to negotiate a much better price, and to buy as much of the one farmer’s wheat as it can at that price. It will be difficult for the neighbour to haggle for a higher price. He will have lost his leverage as a united front.

And this is where the problem lies. Forget aluminium and copper for the time being – if the Chinalco deal goes through Rio will have signed a pact with the opposition and undermined the collective bargaining power of a united iron ore production bloc (the other party being BHP). Iron ore sales to China (and to Japan and Korea who also haggle price) form a significant part of Australia’s GDP. Rio is not just selling off the farm at the bottom of the market, it is selling to the supposed enemy.

The deal has sent shock waves through the Australian market. How can Rio sell out to China of all people? The Chinese can’t be trusted. They’re communists. They have an agenda of becoming the only world superpower. They are, indeed, the enemy. They have the power to undermine everything Australia has strived for in the last 200 years. We’re not just selling off iron ore profits, we’re selling off Australia.

Stephen Mayne, of the Mayne Report, had a different view when speaking on Sky Business last week. He believes the Chinalco deal is a wonderful solution, and an opportunity to embrace the Chinese as business partners going forward and thus form a long-lasting mutually beneficial relationship. Mayne was spiteful of the cosy Rio-BHP duopoly which in recent years squeezed China into a 300% increase in annual iron ore price. Now the boot is on the other foot. China is not taking over Rio, it is simply taking an 18% stake. It might also provide an opportunity to end what Mayne sees as the ridiculous dual listing of the company in London. Bring Rio back home, Mayne entreats.

Stock analysts are not currently offering views as to whether China should be allowed to buy into Rio or not. As noted above, the feeling is the deal offers a company-saving and fortunate opportunity at a pretty good price. On the announcement of the deal, the average target price for Rio in the FNArena database jumped up from A$49.56 to A$54.49. Deutsche Bank has set A$67.60. Analysts agree that asset sales would otherwise take too long, and that a rights issue would probably result in 20% dilution of existing shareholdings. The Chinalco convertible stake would only result in 10% dilution.

What analysts do suggest, nevertheless, is that because of the implications of the deal, the process of acquiring approval will not be a simple one. Rio has to get past authorities in Canberra (who baulk at such a level of foreign investment) and shareholders in both Australia and the UK. Rio also has to get past BHP.

BHP is a loser in the deal for the reason of losing price negotiation leverage. To prevent the deal going through BHP needs to, and has begun to, lobby both Canberra and Rio shareholders as to its evils. Already it is apparent, given views aired by significant existing Rio shareholders, that a rights issue would be preferred. Dilution could be avoided if all existing shareholders take up the new shares. If China is prepared to pay fair value for Rio then so, too, will the shareholders be prepared to accept a higher price.

But if Rio refuses to budge – and already management has begun “roadshowing” the Chinalco deal – then existing Rio shareholders will turn to BHP. They already have. They have called upon BHP to please reignite the defunct takeover offer. Whereas previously BHP was in a position to improve its pricing leverage by acquiring Rio, now it is a case of trying to save it.

It’s all well and good, but whereas BHP might have been able to buy some of Rio’s assets at firesale prices previously, now it would have to pay up. And if it buys the whole company, it would also inherit the Alcan debt problem that brought Rio to this point in the first place. And as far as regulatory approval for such a merger goes, well we’d be right back where we started. With many months of assessment ahead.

No doubt the Chinalco deal will also require many months of assessment, parliamentary debate, shareholder lobbying, wailing, and gnashing of teeth. The floor is split.

Settle in. This is going to be a long ride.

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