Jeremy Warner's Outlook: Branson exploits Rock embarrassment

Rio puts up shutters against BHP
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Are Sir Richard Branson and other members of the Virgin consortium getting a steal in the proposals announced yesterday for Northern Rock? It's complicated, but I suspect they probably are.

Take for starters the £250m valuation the deal puts on Virgin Money, Sir Richard's existing banking operation. In the scale of things, this seems a relatively trivial part, and anyway it does admittedly bring potentially valuable Virgin branding with it.

Even so, in today's banking environment, no money operation sells for the 35-times earnings envisaged for Virgin Money. Royal Bank of Scotland, a rather larger and, despite all the rumours, a possibly more bankable proposition, sells at just 6 times. Northern Rock will also have to pay Sir Richard a personal royalty for use of the Virgin brand.

The uptick in the share price yesterday may be justified by the possibility that Sir Richard's proposals provide a benchmark which others might better, but it seems doubtful it is by the terms of the offer itself. The bottom line here is that the consortium values Northern Rock at about 33p a share, once the injection of £1.3bn of fresh equity and Virgin Money is taken into account.

Half the cash – or £650m – is to be raised via an underwritten rights issue to existing shareholders. Most of Northern Rock's 180,000 small shareholders, collectively accounting for about a fifth of the company's equity, are quite unlikely to come up with the average of £750 a head needed to subscribe. The Branson consortium and its underwriting partners are therefore likely to end up with a lot more than the 55 per cent it says in the press release.

If Sir Richard and other members of the Virgin consortium are at least taking something of a risk in attempting to acquire Northern Rock, the same cannot be said of the City advisers or the bankers that promise to refinance £11bn of the Government's exposure. The advisers to Virgin get a minimum £5m even if the deal falls through. Goodness knows what Blackstone's John Studzinski and others directly advising Northern Rock are in for.

Yet these fees are just the tip of the iceberg. As I understand it, the refinancing fees for the £11bn of public money which is to be repaid immediately under the terms of the deal will be a minimum of £400m, further eating into net assets already damaged by writedowns. There's a lot of mouths already feeding on the Northern Rock carcass before Sir Richard gets his bite. No wonder he's offering the shareholders so little. Once everyone has had their pound of flesh, there will be nothing left.

There are a number of reasons why the company has been bounced by the Government into naming Virgin as the preferred bidder. One is that despite the Treasury guarantee, there has in recent weeks been a renewed surge in withdrawals of retail deposits. This unsecured borrowing by Northern Rock is being replaced with collateralised lending by the Government through the Bank of England's lender of last resort facility. Unfortunately, the collateral is running out. That's one cause for urgency.

The other is the Government's need for political reasons to find a solution which looks acceptable to the public. Northern Rock has turned into a profound embarrassment for the Treasury, which may yet end up costing the public purse a very considerable sum of money. Sir Richard seems to provide an immediate way off the hook, even if eventually it proves to be only temporary.

Most of the alternatives – nationalisation, administration and JC Flowers – involve run-off, the loss of thousands of jobs in the North-east, and a very uncertain prospect of the Government ever getting all its money back.

The hope for shareholders is that others will now come forward with proposals which better serve their interests. Luqman Arnold, the former Abbey National boss, was seeing the tri-partite committee last night and though he has left it very late in the day, he remains a credible alternative bidder. Nor should JC Flowers, having already put so much work into it, be thought of as entirely out of the game. For the time being, the Government's need for a quick deal favours Sir Richard. The Virgin solution seems to save jobs and looks good on paper even if it still leaves the Treasury with a massive exposure. Yet by opting so wholeheartedly for Sir Richard's plausible banter, the Government has acknowledged a couple of important points which others might be able to exploit to the better advantage of shareholders.

One is that the Rock doesn't have to be nationalised and might continue to be run as a going concern. In order to get round the problem with Europe of the provision of possibly illegal state aid, the Government has also said that the balance of any public sector debt after repayment of the first £11bn will be on comparable terms to the commercial debt. That appears to remove the "penalty rate of interest" currently charged by the Bank of England for these monies and potentially makes them cheaper.

A very real possibility therefore emerges that Virgin is not the best deal either for the shareholders or the Government. What's more, to make it happen, the Government must first convince shareholders that they'll get nothing at all unless they back Virgin. At this stage, few seem prepared to take the threat seriously.

Rio puts up shutters against BHP

It was possibly something of an exaggeration for Thomas Albanese, the chief executive of Rio Tinto, to describe BHP Billiton's offer as not even within two ballparks of the company's true value. Yesterday's annual investor seminar nonetheless did more than enough to justify the 13 per cent premium that Rio shares trade at to the value of the mooted bid.

There was much which was old hat in the group's strategy and growth plans – to well informed industry analysts at least – but some points which were also genuinely new. The dividend is to be increased by 30 per cent this year and then 20 per cent in each of the next two years, anticipated annual synergies from the Alcan acquisition are increased from $600m to $940m and the divestment target is increased from $10bn to $15bn.

The growth plans are also reasonably convincing, though it ought to be noted that some of the estimates of reserves are non-compliant with industry reporting requirements and instead are just company guesstimates.

Even so, very substantial growth is anticipated for iron ore production, and the company seems to be making a reasonable point in saying it doesn't actually need any of BHP's infrastructure to get this increased output to market. To the contrary, on this front BHP may need Rio rather more than Rio needs BHP.

The big picture is that China and India will continue to feed growing demand for minerals into the indefinite future. In these circumstances, both companies ought to be able to thrive independently. There are often substantial diseconomies of scale involved in big mergers, while the promised annual $3.5bn of eventual cost cuts and revenue benefits may be vulnerable to any concessions BHP has to make to get the deal through regulators.

Still, the BHP chief executive Marius Kloppers can at least draw comfort from the fact that the Chinese seem to have ruled themselves out of making a spoiling bid for all or part of Rio.

The country's new sovereign wealth fund, China Investment Corporation, yesterday formally denied reports that it was planning a counter-bid in conjunction with some of the country's largest steel makers. Paul Skinner, the Rio Tinto chairman, also pretty much ruled out using the so-called " Pac-man defence", whereby he would turn round and bid for BHP. He couldn't see the point of it, he told me, from a shareholder value perspective.

All the same, BHP is going to have to up its indicative bid quite a bit to get Rio to the negotiating table. The problem BHP's Mr Kloppers has got is that the more value he gives away to Rio shareholders, the less there is for his own.