Why it's compelling for Rio to merge with BHP

RIO Tinto has made a compelling case for a merger with BHP Billiton. Arguably, it should now get on with it. And not exactly incidentally, grab the extra $20 a share while it is still "on offer''. From both BHP (bhp.ASX:Quote,News) and the wider world. I will explain. Now, it was not exactly the case Rio (rio.ASX:Quote,News) set out to make, with its sparkling interim results yesterday. The one intended was first, that BHP was not offering enough -- Rio Tinto's "absolute value'' argument. And second, "Look, we can do very nicely thank you on our own''. In short, we don't have to be taken over. And certainly not at BHP's current 3.4-for-1 offer price. True enough. But in the broad the Rio numbers showed two things. If you put the two companies together, there is no way Rio shareholders are entitled to more than 40 per cent of the merged equity. And even that is a stretch. Comparing the two June halves, Rio would bring 37 per cent of bottom line earnings to the marriage. Albeit right on 40 per cent of gross earnings (EBITDA). The difference is hugely significant -- and not in Rio's favour. BHP is offering Rio shareholders 44 per cent of the merged equity. That's already on the edge of repeating the Billiton "generosity''. Except that Rio is no Billiton. But it is my contention that were Rio to embrace a merger with BHP, it could sensibly expect -- and BHP could sensibly pay -- about $20 extra cash per share. Indeed, with so much cash flowing through the two groups -- temporarily or sustainably -- it would be one of the most sensible ways to spend the money. Why the disparity between the EBITDA and bottom line shares? There is a one word answer and it goes to the heart of the difference between the two groups. It also goes precisely to why the merged group would be so much better than the two companies separately. The word is aluminium. Rio is now an aluminium company with a big iron ore business and "the rest''. Arguably, it made a huge mistake buying Alcan. At best, it bought itself a business that subtracts from its fabulous iron ore metrics. In the latest half a thumping 42 per cent of group revenue came from aluminium. But only 22 per cent of group EBITDA. Rio has a better, less risky and higher-margin iron ore growth path in the Pilbara than BHP. The Olympic Dam copper-uranium mine is probably the biggest resources play in the world today. But it is both high risk and high return. A few things though are indisputable. Rio's future is entirely a bet on aluminium, With an iron ore chaser. They make nearly 70 per cent of group revenue. BHP has a much bigger direct energy exposure. Top down, what the merger would achieve is to balance out these plays on both sides. Aluminium would come down to just 20 per cent of group revenue -- equal with base metals, mainly copper, and iron ore. The merged group would be "short'' energy compared with BHP on its own. And arguably too long aluminium. But it would have a much better balance of commodity hedges against both futures. The most likely future: China keeps on trucking. The alternative future: this proves to be just another commodity cycle. Especially one that is ended by a dramatic increase in supply of key commodities. Source: dailytelegraph