Analysts Begin To Assume No BHP-Rio JV

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By Greg Peel

For decades Australia's two big diversified miners, BHP Billiton ((BHP)) and Rio Tinto ((RIO)), sold their high-grade Pilbara iron ore to steelmakers in Japan, Korea and Taiwan on annual contracts with little debate and little fanfare. But the arrival of China into the iron ore market was a game-changer. No longer was the iron ore market a pedestrian one. Suddenly iron ore was hot property.

This brought into focus the longstanding differential pricing arrangements which, by virtue of differing treatment of freight charges in relation to differing seaborne distances, meant Brazil's big iron ore producer Vale had somewhat of an advantage. Moreover, the antiquated annual contract system meant producers in general were at a disadvantage in a market where iron ore prices were rising rapidly. This led BHP, some years ago, to try to regain some leverage by soliciting Rio to stand shoulder to shoulder and demand a pricing overhaul. Alone, neither had enough clout. Together was a different matter.

But Rio said no. That is, Rio said no up until there was a change at the top of management. Thereafter, Rio said yes. And since then, the two Australians have been able to broker a more realistic freight cost differential and, more recently, a move to quarterly rather than annual pricing. In the latter case, both would have been surprised when competitor Vale actually backed such a change from the outset.

Despite this new found cooperation between BHP and Rio, the fact remains the two companies do not enter into contract negotiations as a duo. There is still a possibility that one can play off against the other or that China can play each off against each other. This leaves the door open for price undercutting one way or the other. One might suggest another way to look at it is that Australia is one iron ore exporter competing with Brazil, and with India and Chinese domestic production and with anyone else selling iron ore. This is perhaps the thinking behind BHP and Rio's decision last year to propose a joint venture arrangement between the two that would see their export marketing efforts coordinated while leaving their operational efforts separate.

It was actually not a new idea – a proposal for collaboration was first made back in late 2007 – but either way the joint venture required regulatory approval across the globe. The ACCC, which does not make decisions in a hurry, suspended its decision back in July. Last week BHP and Rio asked the ACCC for a further extension.

The problem is largely the European Union's equivalent of the ACCC. While Australian steel producer BlueScope ((BSL)) has been leading the protest locally and thus holding up proceedings, it is the European steelmakers which have been most vocal in their concern of diminished competition in raw material supply. The EU regulator also moves at glacial speed, and indeed has never actually provided a timetable for its decision. The companies' request for an extension for the ACCC was made on the basis of requiring more time to prepare new submissions to the EU.

However, the longer it all takes, the less likely it appears it's ever going to happen, or more importantly be allowed to happen. And despite the request for more time to “prepare further submissions”, analysts have begun to suspect BHP in particular is already now assuming there will be no JV.

A clue here came in the form of BHP's sudden and surprising bid for the Potash Corp of Saskatchewan. At US$39bn it seems like a lot of money to throw at a diversified acquisition, particularly considering BHP already owns vast greenfield potash reserves nearby in the Canadian province. It would also be a lot of money if one took into consideration that BHP would already be up for US$5.8bn were the Rio JV to go ahead.

The US$5.8bn represents a required “equalisation fee”, agreed between the two parties, that would ensure the JV was purely 50/50.

In order to make the Potash takeover offer earnings accretive at the price, analysts needed to assume the US$5.8bn would not be spent on the JV. Otherwise it would look like a rather poor deal. What's more, it was only recently BHP CEO Marius Kloppers had declared that his policy was to “build, not buy”. A Pilbara JV might be construed as part of “building”, but a takeover of one of the world's biggest companies was clearly a “buy”. Why the change of heart?

Kloppers defended the move by noting that opportunities to buy a “tier one” asset do not come along every year. But underneath it all, analysts began to assume Kloppers had already decided the Rio JV would not be going ahead. Lord knows how long the EU regulator might be prepared to drag out the proceedings, and how much money might be wasted.

The JV agreement between BHP and Rio will terminate if conditions are not met by by the end of 2010. The way things are going, a year-end timetable seems ambitious. The analysts at UBS, in particular, believe a favourable outcome is looking less likely.

On that basis, they have decided to remove the assumption of the JV going ahead from their valuation models for both companies. The JV removal means a lower profit forecast for BHP and higher forecast for Rio, to the tune of a 4% downgrade in FY11-12 and a 10% and 6% upgrade in FY11-12 respectively. The analysts' net present value calculation is reduced by 4% for BHP and increased by 2% for Rio.

UBS has reduced its target price on BHP from $55 to $53 and increased Rio from $105 to $108. The broker actually retains a Buy rating on both companies, but with the Potash bid overhanging BHP, the greater benefit to Rio of a canning of the JV, and a potential upgrade of the aluminium price due to China's shutting down of high pollution smelters, Rio is preferred.

FNArena's Stock Analysis shows a Buy/Hold/Sell ratio on BHP of 5/2/0 out of seven (non-restricted) brokers with an average target of $48.98, while Rio scores a perfect 8/0/0 out of eight with a target of $93.65.

The targets suggest 26% upside for BHP and 24% for Rio.

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