Jeremy Warner: Right way forward for Rio, or another Chinese takeaway?

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Outlook In attempting to address its short-term financing needs, Rio Tinto seems to be selling its soul. With credit about as scarce as hen's teeth, lots of companies are facing a similar dilemma – sell choice assets for bottom-of-the-market prices, or go down.

What makes it a bit different with Rio is that the debt problem is self- inflicted, which makes shareholders in no mood to be forgiving of their board, and there may be other choices. Rio might have been able to overcome its financing problems equally well by having a rights issue, axing the dividend, and slashing capital spending. This might not have delivered quite the same certainty as Chinalco of being able to repay the debt that falls due in the next two years, but it would have come close, and with a bit of tweaking, Rio could have got there.

In any case, Rio's chairman, Paul Skinner, faces an uphill struggle convincing his investors that the new Chinese partnership is the way to go. Some say they need no convincing – they have already made up their minds to vote against.

The Chinalco proposal suffers from a number of flaws. First, it rides roughshod over pre-emption rights. Second, it involves selling stakes of between 15 and 50 per cent to the Chinese in some of Rio's choicest assets at the trough of the market. And third, it involves jumping into bed with the company's biggest customer, with all the implications that might have for pricing power.

China won't need satellites and telephone bugs any longer, it was being said yesterday. With two representatives on the Rio board plus a say in the management of nine of Rio's biggest mines, it will be right inside the company's underpants. If Boeing were to stick the head of procurement for the US airforce on its board, there could scarcely be a more blatant conflict of interest. For obvious reasons, customers and suppliers are not normally privy to a company's innermost secrets.

Was there any adequate exploration of the alternatives? There appears not to have been. Once the Rio board had decided to hitch its wagon to the Chinese juggernaut, that was it. There was no attempt to engage other parties to see if an auction might engender a higher price. On the face of it, then, this seems a rotten deal that deserves to fail.

The case for the defence runs thus. First of all, the prices wrung from the Chinese are not bad to really quite good. For the assets, Rio achieves something close to net present value, which in these markets and as a distressed seller is pretty good. It is unlikely anyone else would have paid much more, though alternative disposals might have come free of the strings attached to the Chinalco deal.

Second, the terms of the convertible look relatively favourable. At 9 per cent, the coupon is no higher than the company already pays for its debt, and it is guaranteed 60-year money to boot. Many would kill for such bounty. What's more, the convertible is priced at a massive 100 per cent premium to the ruling stock market price, which is not quite the heady peaks to which the stock rose during the commodities bubble, but isn't so far off the "normalised" price that ruled in pre-recession 2007.

Take the two together, and Rio reckons Chinalco is paying about 18 per cent of enterprise value for just an 8 per cent share of earnings before interest, tax, depreciation and amortisation (Ebitda). None of this quite chimes with what Chinalco says. The Chinese aluminium company is equally determined that it is getting an absolute bargain. They can't both be right, but then each has different audiences to answer to.

Whichever way you cut it, you can't argue with the following proposition. The Chinese have cleverly taken advantage of Rio's distress to buy into assets that have taken more than 100 years to accumulate. This is China's largest ever single overseas investment, and it is hard to believe they are going to be entirely passive in the way it is treated. Chinalco's move, financed by China Development Bank, is not just about setting up one of China's company's to be one of the leading lights in international mining finance. It is also about securing scarce reserves to feed China's growing industrial appetite.

Which brings us on to the third main justification for the deal. Rio reckons forming a strategic partnership with China, far from being the negative some shareholders fear, will be a positive boon, making the company uniquely well placed to take advantage of the opportunities offered by the world's largest emerging market. Yet it's a leap in the dark, made all the more contentious by the fact that the company's chairman in waiting, Jim Leng, has just resigned in disgust over what he thought a thoroughly bad deal.

If Rio had come to shareholders with clean hands, untainted by the strategic error of buying Alcan at the top of the market and the more arguable misjudgement of refusing a merger with BHP Billiton, then shareholders would in all likelihood have given their board the benefit of the doubt.

The Alcan howler makes it much more difficult. In the City, the parallel is already being drawn with Royal Bank of Scotland, which also bought expensively at the top of the market and had to be bailed out by the state. The difference is that Rio is looking to Beijing, not London, for its handouts. But does Tom Albanese, the chief executive, really need to give away value to the East to secure the company's future?

In Australia, where some of the assets are located, the deal seems to have gone down like a lead balloon. It is possible Australian regulators will veto the whole thing before the inevitable showdown with shareholders. Yet if investors vote it down, they must be prepared to dig deep to see Rio through its debt crisis, and find a new board to boot. Not an easy choice.

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