Rio recovers from a dog of a deal

After a disastrous M&A adventure in 2007, the mining giant has staged a remarkable recovery
  • @AlistairDawber

If they gave out awards for the worst takeover deals each year, Rio Tinto's $38.1bn (£24.5bn) buyout of the Canadian aluminium group Alcan in 2007 would have received plenty of nominations (although, of course, it wouldn't have won: that year's gong would undoubtedly have gone to Royal Bank of Scotland for its catastrophic debt-binged acquisition of the Dutch bank, ABN Amro).

The Alcan deal loaded Rio's balance sheet with more debt than it could cope with during the financial crisis, which in turn led to recession in the commodity sector as economies around the world ran down inventories. What's more, Rio's great rival, BHP Billiton, came within a whisker of getting Rio on the cheap when it recognised wounded prey and tried to buy the group in 2007. A $135bn (£87bn) bid collapsed only when the financial markets imploded, but regulators may have stepped in, worried about BHP's dominance.

Yet, just three years on from the Alcan debacle and mining sector analysts are falling over themselves to recommend Rio shares and praise the group's aggressive investment in organic growth.

Last month, the group issued its interim results showing it had, "bounced back from its annus horribilis of 2008/2009," says Charles Kernot at Evolution Securities. Net debt had been slashed from a crippling $39bn (£25bn) in June in 2009, to a more comfortable $12bn (£7.7bn), while cashflows were impressive enough for the company to declare a $9bn (£5.8bn) capital expenditure programme for next year. Indeed, in the past 48 hours, the Anglo-Australian company has announced two new expansion projects: a US$803m (£515m) development at its Argyle diamond mine in Western Australia, and the exercising of an option to buy a further 5.3 per cent stake in Ivanhoe Mines, the owner of the Oyu Tolgoi copper project in Mongolia.

"The focus in the near term appears to be resurrecting the growth projects that were curtailed during the last two years," said Olivia Ker, an analyst at UBS last month. "Our sense was that Rio would look for businesses that it understands and that would compliment [or] add value to existing businesses. Tom [Albanese, Rio Tinto's chief executive, says that] Rio would not scramble for tier one assets just to balance the portfolio."

Rio Tinto was clearly not the only company to pile the debt to its gills in the latter half of the last decade, and that then struggle as the Noughties came to end. But few can point to such as remarkable turnaround in their fortunes. Clearly, Rio Tinto's management have helped to rescue the situation, and Mr Albanese should be given much credit for that, just as he was criticised for the Alcan deal months into his tenure as the boss.

But as much as Rio Tinto has succeeded thanks to its own surgery, it has also been helped by a monumental return of the global commodities market. Prices in the Rio's two biggest earners, iron ore and copper, have surged during the last year.

With some of the best iron-ore assets in the world, Rio has been ideally placed to benefit from the spike in prices, helped by juggernaut that has been the Chinese economy. Chinese demand for the key ingredient in the steel-making process has surged thanks to Beijing's huge stimulus package, which has kept its steel mills open. And as mining groups cut back on production in the early days of the recession, so supply did not keep up with iron-ore demand, ensuring that prices jumped higher.

Iron ore fell yesterday to a six-week low, staying below the psychologically important $140-a-tonne level, but still well above the $60-a-tonne mark of last year. In last month's results, "Rio Tinto's earnings performance in the first half was dominated by iron ore which accounted for a massive 70 per cent of net earnings. This reflects both the strength of iron ore prices and increasing production," says Mr Kernot at Evolution.

Since 2000, Rio's sales to China have jumped from a mere $400m (£250m) to nearly $11bn (£7bn). China now accounts for a quarter of all Rio's revenues. Speaking in Shanghai last month, Mr Albanese said: "Rio Tinto wants to build a broad, genuine partnership with China, based on shared interests. We also seek to develop mutual respect and trust. In return, we want Rio Tinto to be a reliable and valued part of China's long-term development.

"We have acknowledged that we faced some challenges in China over the past year, and I have made it a personal objective to strengthen our relationships here," he added.

As any company will tell you, having the majority of your eggs in one basket, no matter how lucrative, can be difficult and the past three years Rio's relationship with China has at times been tested.

In the fallout of the Alcan deal, Chinalco, the Chinese-state owned aluminium miner offered to take a 18.5 per cent stake in Rio, for $19.5bn (£12.5bn), an offer Rio's shareholders spurned, preferring instead to sell off non-core assets.

A number of analysts said that this led directly to the arrest and subsequent imprisonment of four Rio executives in China, on charges of accepting bribes. The four – including the Australian Stern Hu – were convicted and jailed for between seven and 14 years in March. Rio was attacked by the likes of Trace International, which said the company had buckled under pressure from the Chinese and should have provided more assistance for them.

Indeed, within hours of the guilty verdicts, Rio Tinto moved to distance itself from the four, sacking them and saying that it was satisfied "beyond doubt" of their guilt, describing the violation of Chinese law as "deplorable behaviour". When they were first detained in July last year, Rio Tinto stressed that the allegations were "without foundation".

Regardless of the moral implications of the trial, Rio has done a remarkable job at repairing its relationship with its biggest customer. In July, Rio and Chinalco penned a joint venture deal covering the development of the potentially huge Simandou iron-ore project in Guinea, even though Rio has managed to get itself into a scrap with the Guinean government over rights to certain assets.

Similarly, along with other miners in Australia, Rio got itself into a fight with the Canberra administration earlier this year over a proposed 40 per cent profits tax. After a multi-million dollar advertising campaign, a prime ministerial resignation and an early general election that has delivered the first coalition government in Australia for decades, the industry has declared itself satisfied with a watered down levy. Rio and BHP will be hoping that the agreement will help to secure approval for a $116bn (£75bn) iron-ore joint venture project in Pilbara, Western Australia.

With the company now firing on all cylinders, investors will start to ask, what's next? Michael Rawlinson, of Liberum Capital, says: "[The] news items in the past [48] hours put the focus on Rio Tinto... We think they underline two things: a) how Rio's cash flows are burgeoning and will lead to first M&A and then buy backs in [the first half of] 2011, and; b) the underlying medium term of its key commodity iron ore is robust."

Rio Tinto's investors will treat any new M&A adventure with caution after Alcan, but that should not rule out smaller deals. And there are still rumblings that BHP, the king of the miners, may return for a tilt at its closest rival. As analysts at HSBC point out, if BHP was keen on Rio when it had debts of $40bn (£25bn), wouldn't it look even better now?