Alcan could deliver Rio to BHP

PESKY European regulators permitting, it is Rio Tinto's audacious $45 billion acquisition of Alcan last year that could deliver it to BHP Billiton. It is vital to understand that in direct contrast to Rio Tinto's dismissive attitude to energy in the form of BHP's oil and gas, Alcan was actually much more an energy play than an aluminium one. The critical, perhaps fatal, problem for Rio is that the expected upside from Alcan's energy will kick in too late to fight off BHP. This will be when the takeover battle finally goes live early next year in the shadow of the companies' respective profit reports for the December period -- those pesky regulators permitting. We got a preview in the sparkling Rio half-year report last week. Aluminium, both old Rio and new Alcan, contributed a thumping 42 per cent of group revenue and it probably would have been more than 50 per cent if Rio had included the downstream processing and merchandising bits of Alcan it is holding off-balance-sheet -- and out of the profit -- because it intends to sell them. Yet aluminium contributed just 22 per cent of gross profit -- earnings before interest, tax and depreciation. Because it is even more heavily capital intensive than the rest of Rio, and has a big-D depreciation, the bottom line contribution was even less, at 18 per cent. So, 42 per cent of group revenue, but just 18 per cent of group profit. In very simple terms aluminium's metrics are a drag on the group's numbers, and so on the takeover defence. The mix is likely to get worse in the December half, relative to BHP. This was implicitly conceded by Rio's number two man, the classically City of London urbane group chief financial officer, Guy Elliott, in discussion during the week. I stress "implicitly conceded" because he stressed that the aluminium upside was long term -- which means long after this takeover is resolved one way or the other. Brutally, the aluminium numbers are not going to get dramatically better in the short to medium term. Arguably in contrast, BHP's will as it certainly reaps higher prices for its coal sales, which are much larger than Rio's, and it probably nets a higher average oil price. In the excitement over the "plunge" in the oil price to the mid-$US110s, it has not been well recognised that is still about $US20 a barrel higher than the $US96 BHP averaged on its 2007-08 sales. So if the price just stays there, BHPB will reap all that as pretty well pure profit -- on somewhat higher actual volumes, as its petroleum growth in the short run is weighted to liquids. Of course, if the oil price really plunged, that would go negative, but if the oil price really plunged, all tradable commodity prices would be heading in the same direction. Only the contracted bulks would still deliver super prices and only through the contract year. For that to happen, China would have to go into some sort of meltdown. In those circumstances all bets would very definitely be off. Now we've obviously got a similar mix of possible pluses and minuses with Rio. There's not much point in trying to assess -- guess -- the numbers into the immediate future, when we are all going to have the December period figures to work on. Everything before we see those figures is purely analytical and entirely hypothetical. Not so the longer term, on which much of the critical discussion, and the evaluation of the offer, will take place, and here Rio board and management have made their bet, sorry bed, on aluminium, and shareholders are going to have to lie on it. Rio would like the takeover to be assessed purely in the Pilbara -- ideally, just comparing iron ore with iron ore, or at the very least with the respective iron ore divisions as the major component of evaluation for each company's value. Either way, Rio would win hands down in both the takeover and long-term operational horizons. Well, if the board and management wanted that, they shouldn't have gone out and spent $45 billion to buy Alcan. In doing so they made aluminium the major division in the group, although Elliott revealed that internally Rio valued the iron ore business as worth more than aluminium. That's not exactly a surprise. After all, iron ore made $US2.9 billion in the half, aluminium just a tick under $US1 billion. Nevertheless, it has to be included in the valuation assessment. There is a positive: the Alcan buy leveraged its balance debt, and leverage usually boosts return metrics. Usually -- some notable exceptions aside, which surfaced yesterday. Rio also got the money at just 3.9 per cent interest, precisely because of all those global exceptions. Its Alcan finance is at just 35 points over Libor, currently in the mid-threes because of the sub-prime meltdown. Now, as Elliott explained, Alcan was such a great buy because of its long-term hydro power in Canada, which would remain cheap as coal-fired power increased in price in a carbon-constrained world. That would deliver two benefits: the direct one of cheap power set against continued rising commodity prices in a world driven by Chinese demand. So, in time, Rio's aluminium would start to look like Rio's iron ore. Secondly, as China became more market rational, you would see old, inefficient domestic coal-fired aluminium production shutting down. This would multiply the global price benefit. A small immediate problem is the fact that this hasn't happened yet. Chinese aluminium production is still going up. It might happen some time in the future, but not in the relevant takeover future. There's also a much bigger problem: a direct contradiction between the aluminium power play and the value in the rest of Rio (and BHB), and especially the jewel, iron ore. Rio is planning to triple iron ore production to 600 million tonnes on the expectation that the China boom just keeps on keeping on. If that is true, you can kiss goodbye to any serious move by China to limit its carbon emissions. As I wrote last week, believe that and you should go short fur coats. The value in Alcan totally turns on hydro power in effect driving out coal power. More directly, it is based on China not keeping on keeping on. In short, Alcan booms -- some time in the future, but the rest of Rio slides backward. Or the rest of Rio keeps sparkling, as we saw last week, and Alcan keeps "promising". In a very holistic sense, you might see Alcan as a hedge against all this, but even if that were so, it's not going to work in the takeover time frame. Rio mocked, and mocks, energy in the form of oil, but oil is a much better hedge against a general commodity slide. Further, if aluminium -- Canadian hydro power -- works, it would clearly work better inside a combined BHP-Rio. There it would be one of four roughly equal businesses. In Rio it's too big at 42 per cent -- and underperforming. Rio might not realise it, but it has actually made a very strong case for the merger. Source: www.theaustralian.news.com.au