Perils of a Rio break-up

Reports out of London that Rio Tinto has been hinting to brokers that it will consider breaking itself up if BHP Billiton’s bid clears the European competition regulatory obstacles raise the prospect of a policy nightmare for the Rudd government. It could find itself in a full-on confrontation with China if Rio feels obliged to put up a 'sum of the parts' alternative to BHP’s share-swap offer. After briefings this week by Rio’s chief financial officer, Guy Elliott, London brokers have been saying that he indicated that the group had received a host of enquiries and proposals from other resource groups, customers and financial players in reaction to BHP’s offer. While Rio apparently made it clear it hadn’t started to actively pursue any of the approaches, it did, apparently, make it clear that it would do so if BHP’s offer was cleared by the European Commission and Rio directors continued to believe the offer (currently a swap of 3.4 BHP shares for every 1 Rio share) undervalued their company. There are, broadly, only three scenarios under which a 'sum of the parts' valuation could produce a return to Rio shareholders that was clearly superior to a merger with BHP. The first, obviously, is if it were considered that the terms of BHP’s bid clearly under-valued Rio. That's what Rio currently believes, although its shares are trading at a material discount to the offer terms (perhaps because of the regulatory uncertainty) and BHP has provided some broad hints that it has a sweetener up its sleeve if it gets past the EC. BHP has estimated, probably very conservatively, that there would be more than $US3.7 billion a year of synergies from a merger with Rio. If the merger occurred Rio shareholders would own something in the mid-40 per cent range in terms of their proportion of the combined group. It would be difficult to make the case that an option that would involve the significant value leakage of a break-up could be more attractive than one that contained a substantial premium and therefore a disproportionate share of the merged entities, the synergies and the exposure to the upside of the world’s largest resource group. It may, of course, be that the EC imposes significant conditions on BHP in return for an anti-trust clearance. It may have to agree to sell some strategic assets and perhaps give some behavioural undertakings. The cost of any such concessions would, obviously, have to be subtracted from the combination of the value of the synergies and the extent to which the premium offered by BHP was greater than the sum of the premia offered by buyers of individual Rio assets. BHP ought to value all of Rio more highly than any collection of trade buyers – Rio is uniquely complementary to BHP. The other scenario under which the sum of the parts valuation might produce something better than BHP would be prepared to offer is if the buyer of the key Rio assets – its Pilbara iron ore operations and/or its aluminium businesses – has a motivation other than a conventional return on the investment. If one assumes that if the EC imposes too great a cost on BHP as the price of approval it would behave rationally and walk away (although Rio and BHP could conceivably have different views about the cost of any conditions), the only way the sum-of-the-parts option would be exercised would be if BHP looked likely to win control of Rio. The only way that option could compete with whatever BHP’s final bid might be would be if a collection of buyers paid more for Rio’s assets than they were worth to BHP after taking into account the synergies. Why would anyone do that? How could they justify out-bidding the buyer with the most synergies? One doesn’t have far to look to see a group with the incentive to pay what would otherwise be an irrational price. China, which appears paranoid about the prospect of the merger and its impact on commodities markets – and most particularly on the iron ore market – would inevitably seek a major involvement. The state-owned Chinalco already has a 12 per cent interest in Rio Tinto Plc. Any attempt by the Chinese to acquire strategic Australian assets from Rio would set the scene for a major confrontation between China and the Rudd government – which has already demonstrated acute sensitivity to the prospect of Chinese state-owned enterprises acquiring much less strategic Australian resource assets than most of those in Rio’s portfolio. Given that engagement with China over the coming decades is vital to the long-term national interest, the dilemma the Federal government would face would be excruciating. If BHP can get past the EC with sufficient net synergies to put real pressure on the Rio board (after taking into account any concessions), both bidder and target are likely to be quietly but heavily 'encouraged' by the government to agree a deal that averts the prospect of Rio initiating an auction for its parts. If they failed, BHP would be under extreme pressure to call off the bid, allowing Rio to retain its independence, rather than risk the potentially inflammatory consequences that might flow from a break-up of Rio. Source: Business Spectator