William MacNamara BHP stalks Rio Tinto: That old chestnut

The Rio Tinto rumour mill is buzzing with the idea that BHP Billiton could yet again be interested in buying part or all of Rio Tinto, following a Sunday Telegraph report and a Friday  note from respected mining analyst Michael Rawlinson.

Revived speculation about a BHP-Rio megamerger follows from a wider controversy about Rio’s agreed deal with Aluminum Corp of China (Chinalco), which would see Rio selling stakes in top-tier mines and smelters to Chinalco, plus an exclusive chunk of convertible bonds, in return for almost $20bn that Rio would use to pay off crippling debts. Some powerful UK and Australian investors remain opposed to the deal, and Australian regulators are making signs that they might be more opposed to China’s creeping influence in the Australian resources sector than first thought.

There is wider talk about compromise or alternatives of some sort. Cue world’s biggest miner BHP Billiton, which dropped its hostile bid for Rio just four months ago, in deference to crashing commodity markets. The reasoning goes thus: With commodities showing tentative recovery, Rio is no longer in the desperate position it was when it agreed the Chinalco deal – and could break it for a (mere?) $195m. And with BHP maintaining one of the best balance sheets in the business, it is the only miner that could make an attractive offer to rival Chinalco’s.

Will BHP revive its bid for Rio? Almost certainly not. Will it revive its attempt to buy some of Rio’s best assets? Perhaps, but not for a few months. In general the BHP-Rio redux is more sensational than realistic.

BHP’s chief exec Marius Kloppers, engineer of the failed takeover, has made no secret of his ongoing interest in Rio Tinto’s mines, within the context of being interested in any top-quality mining asset for sale around the world. An acquisition fund is the purpose of the roughly $6bn raised in the bond markets last week.

But the best chance for BHP to bid for Rio assets is if the Chinalco deal falls apart. And that has never been as likely as some irate UK investors would wish it to be. When Australian regulators turned down the terms of Chinese miner Minmetals’ proposed takeover of Oz Minerals last week, Minmetals was compromising, indicating that Chinalco might also want success with the spirit of the Rio deal rather than the letter of it. As long as its hold on the Rio assets was secure (this is a once in a lifetime opportunity for Chinalco), it might not walk away if Rio came back to the table with some amendments to please UK investors, such as an extension of the convertible rights issue to other investors.

Rio is not allowed to solicit or discuss rival bids before completion, although the board can entertain rival offers if they are determined to be in the interests of the company. This, as Michael Rawlinson notes, makes it imperative that BHP makes a full, unsolicited offer either for the company or the assets.

A full hostile offer is impossible before Rio shareholders vote on Chinalco. BHP cannot revive a bid until November 25 2009. We must assume that an agreed full offer is nearly impossible, both because of the collective exhaustion and ill-will of the companies who so recently fought for over a year on the subject, and because of the difficulty of financing such a mega-deal in depressed markets – with no certainty on the medium-term outlook for commodity prices.

BHP could put smaller sums to better use by looking at other big miners, like Teck Cominco, that carry neither the freight nor the valuation of Rio.

The idea of BHP stepping in and bidding for Rio assets, if Chinalco falls through in June or July, remains the most convincing possibility. Even here, however, there are question marks. The strongest rationale for the BHP-Rio merger was the consolidation of the two rivals’ iron ore operations in the Pilbara region of northwestern Australia (Rio’s assets there are called Hamersley Iron Ore, and the 15 per cent stake it proposes to sell to the Chinese is the most valuable part of the deal’s asset-stake component). But would a BHP-led consolidation of the Pilbara pass the competition authorities? This, as much as a tie-up between Rio and Chinalco, could be argued to have a bad influence on fair pricing for iron ore.

If Chinalco falls apart, however, BHP’s interests would be aided by the debt-repayment problems that would immediately face Rio. Here is one plausible scenario that would pair BHP with Rio: The Australian treasury vetoes the Chinalco-Rio deal in late June. As Rio assesses whether Chinalco should be salvaged, BHP steps in immediately with an offer to buy some assets, perhaps as simple as an offer to buy out Rio’s interest in the Escondida copper mine for a large premium. Rio’s board faces the need to repay almost $9bn in debt in October, four months later. BHP offers the most expeditious solution. They break with Chinalco, accept BHP’s offer taking $8bn-$10bn for some assets, and launch a rights issue in the UK to replace the failed convertible bond. This time fully respecting UK investors rights to preemption. Everyone is happy. Voila.

Unfortunately for some this remains improbable. There is no strong indication yet, despite rumour and the frequently quoted opinions of UK institutional investors who have a vested interest in an alternative, that Chinalco will not work.