BHp bid for Rio hangs in the balance

BHP Billiton has eight days to formalise its unsolicited offer for its rival Rio Tinto, or to walk away from the chance of forming the world's first super-major mining group
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The clock is ticking for Marius Kloppers. The chief executive of the world's largest mining group, BHP Billiton, has just eight days to either formalise his unsolicited takeover offer for the smaller rival Rio Tinto, or bin his audacious attempt to forge the world's first mining super-major. His counterpart at Rio, Tom Albanese, has branded the offer as "ballparks away" from anything that would even serve as a base from which to begin talks, and so far Mr Kloppers has refused to budge on price.

Yet as the day of reckoning approaches, most analysts expect Mr Kloppers to pull the trigger – on or before the 6 February deadline – probably with a sweetened offer. The question is just what he will have to do to get Rio to agree to a deal, and, if he can't, would he go hostile?

Greatly complicating the matter is the fall of BHP shares, the currency for the proposed all-share bid. Since 8 November, when BHP announced the three-for-one share swap deal, its stock price has lost about 15 per cent, battered by the increasingly bleak macroeconomic outlook as fears grow that the US is rapidly sliding towards recession. The thinking being that if the world's largest economy sputters, its consumer will buy less, translating to a major hit for the mining industry, which provides the raw materials for everything from new cars to new homes.

It is true that Rio's shares have fallen by about the same amount, but that doesn't make Mr Kloppers' task any easier. If the £56.28-per-share takeout price implied by the original offer was "ballparks away" when it was first suggested in November, it is much further still today.

ABN Amro analyst Tim Huff said in a research note yesterday that even if BHP comes back with a formal bid with a 3.6-to-one ratio – a level that has been mooted by several analysts – plus a £6-per-share cash sweetener, that will only be enough to get just beyond its original value. Given the worsening global economic outlook, that could be enough to bring Rio to the table, but little more. Mr Huff said: "At today's prices ... a sit-down with Rio management may only last five minutes. But it's not a bad starting point, in our view."

From the outset, Mr Kloppers has stressed that, rather than the headline price, investors should focus on the relative value of the deal. As it is an all-share offer, the trick is to strike the right balance over how much of the combined group each entity's shareholders should end up with. It is hard to find anyone to question the logic of combining the two giants, which run parallel operations at the massive Pilbara site in Western Australia from which they could extract much of the forecast synergies. More than half of Rio's investors also hold BHP stock, so a deal in which BHP isn't forced to dig too deep but gives more to Rio would presumably receive considerable support. One analyst, speaking on condition of anonymity, said he had calculated BHP could afford to do a deal at a ratio of 4.25-to-1 without it being dilutive.

It is still very early days – BHP has estimated a deal would take more than a year to complete – so Mr Kloppers will be keen to not pledge too much when there is still so much time to run. Simon Toyne of Numis Securities said: "Why would they be bullish when this is still many months from being done and there is still so much uncertainty in the market?"

The other message that Mr Kloppers has repeated, time and again, is that he will be very patient. By tabling a formal offer, BHP would set what promises to be a very long and tortuous regulatory process in motion. If in a year an offer has received the blessing of regulators in Australia and Europe, and Rio shareholders can finally vote on a deal, they may be doing so in a vastly changed world.

Much of this will depend on China, now the world's largest consumer of aluminium, iron ore and copper, and the main driver behind BHP's and Rio's record production numbers this past year. The prospects of both companies are inseparable from those of the world's most populous country.

In recent years, economists have talked a lot about how the country has "decoupled" from America. In other words, China's economy has grown to a stage, and has such momentum, that is it now self-propelling and no longer directly dependent on America. It is a theory firmly adhered to in the mining world and underpins Rio's belief that it is worth more than BHP's offer.

Rio's chief economist has claimed he is "firmly in the decoupling camp." In a recent speech, he said: "We find it hard to obtain a negative impact from a US recession on Chinese GDP in excess of 1 percentage point. This means that the economy could still grow at around 10 per cent, even with a US recession this year ... So I find it hard to understand why people panic about the effect of a US downturn on Chinese GDP."

Yet the idea of a "decoupled" China is one that remains untested by a severe market downturn. When the Hang Seng index had its largest ever one-day loss last week (with the Shanghai index also dropping 7.2 per cent) after the US Federal Reserve spooked the markets with its emergency interest rate cut, it provided plenty of fodder for the doubters. The mining companies argue that because most of the commodities that China imports are used for building up its domestic infrastructure rather than to manufacture exports, they are further insulated from the effects of a stumbling US. If the American economy tanks this year, the theory will be put to the test.

Another crucial factor is the outcome of the annual iron ore price talks that the big three—Vale, BHP and Rio – have with their Asian customers, led by China, which are expected to conclude relatively soon. Dan Smith, metals analyst at Standard Chartered, expects the companies to secure about a 50 per cent increase for the 2008 benchmark price, under which most iron ore is sold. A significant increase is already factored in to analysts' models, but if the companies manage an even bigger price hike it could be a boost to Rio, which is proportionally more dependent on the commodity than BHP.

China has an interest in seeing the deal fail. As the world's single largest commodities customer, it would surely prefer that there be more miners fighting for its business rather than less. Analysts fear the Chinese government, perhaps through Baosteel, its largest steel maker, or a government-owned fund, could take a blocking stake in Rio in an effort to preserve the status quo.

It's anyone's guess if that would happen. Most observers agree, however, that come next Wednesday Mr Kloppers will push ahead whether Rio likes it or not. It could prove to be the best option for investors in Rio, whose shares have performed better than ever since BHP first broke cover. Mr Toyne of Numis said: "There is no other bidder for Rio, so in reality there's not the price tension that Rio would prefer to have."