Rio deal will ‘have to evolve’

By William MacNamara
Published: April 27 2009 22:40 Last updated: April 27 2009 22:40

The $20bn question circulating in the mining industry is how willing is Rio Tinto to change or drop its proposed fundraising deal with Chinalco? And if it does make changes, how receptive would Chinalco be?
As the Anglo-Australian miner and the Chinese metals group endure a third month of trying to seal their proposal – in which Chinalco will make a $19.5bn capital investment in Rio – it appears that no-one has an answer to these questions.
The uncertainty is summed up in Rio’s divided investors, many of whom are prepared to vote “no” on the proposal because they believe the cash-for-mines-and-shares deal tramples on their rights as shareholders.
It is difficult to predict how much of the deal architecture will remain this summer, when a vote is likely. All sides appear to be adopting a “wait and see” attitude that, while keeping options open, also prevents Rio from knowing how it will resolve its debt problems.
But the questions have been raised as the world changes from the one in which the deal was hatched.
In early February Rio announced it would raise $19.5bn by selling chunks of mines, smelters and power plants to Chinalco, the Chinese state-owned mining group that is its largest shareholder, as well as offering Chinalco an exclusive bond that would eventually double its stake in Rio to 18 per cent. At the time of the announcement debt markets were frozen and commodity prices were depressed. Rio faced $19bn in debt repayments over the coming two years, which stemmed from its $38bn purchase of Alcan in 2007, a defining moment of the commodities boom.
In early 2009 the board was divided on how to repair Rio’s balance sheet. It drew up plans for a rights issue that would raise close to $10bn, as well as for the $20bn Chinalco option. The larger looked the best idea, as the market was pessimistic about demand for iron ore, copper and the raw materials that are the basis of Rio’s revenues.
Since then a fragile recovery has gained momentum. On Friday Cazenove upgraded the entire European mining sector and said commodity prices had probably seen the worst. Copper prices have gained more than 38 per cent this year, carrying Rio’s shares higher.
In the past six weeks, blue-chip miners BHP Billiton, Anglo American and Rio have raised billions of dollars in the bond markets. Demand for Anglo’s $1.7bn convertible bond pushed the coupon rate down to 4 per cent, compared with 9 per cent on the convertible bond Rio is offering Chinalco.
That has strengthened the argument for “optionality” in Rio’s fundraising efforts. Does Rio really need $19.5bn all at once? One alternative would be to go ahead with the sale of $13.2bn in asset stakes to Chinalco but scrap the convertible bond – which has enraged shareholders by ensuring that they will be diluted – and instead launch a modest-sized rights issue.
“The deal will have to evolve,” said a fund manager at one of Rio’s largest institutional investors. He claims Rio’s management is still describing the Chinalco package as “an option”. He is one of several people involved in the deal who say Rio is more receptive to alternatives – including an arrangement with once-hostile bidder BHP Billiton – than its public commitment to Chinalco implies. Asked two weeks ago whether there was room for compromise on the deal, Paul Skinner, the soon-to-be-retired chairman said: “Let’s see where we get down the track.”
But for the moment Rio is trapped by its own rhetoric of commitment to Chinalco and is not able to prepare investors for a “Plan B”. Nor can it yet gauge the necessity for a “Plan B”.
The company’s fortunes are tied to fickle things such as the copper price which, although it has risen almost 40 per cent this year, dropped 8 per cent in the past week. What will demand for copper or iron ore be in June? If prices continue to oscillate at low levels, investors might well come round to the idea that $19.5bn from Chinalco is a prudent solution.
But Rio’s rising share price is making the deal look imperfect to many shareholders. The shares closed on Monday at £26.86 in London, close to the conversion price of £30 for the first tranche of convertible bonds offered Chinalco. It is possible that the share price will have risen past both conversion thresholds – the second at £41 a share, at today’s exchange rates – by the time the deal comes to a vote.
Events in the next two months might embolden Rio to walk away from the Chinalco deal – for a $195m break fee. Complicating that decision, however, are the politics involved. China is Rio’s largest customer – a fact that Tom Albanese, chief executive, likes to cite as a rationale for the deal. The Chinese government sees the deal winning international prestige for state-owned companies and reviews it on a weekly basis at the highest level of the politburo, according to sources. There would be consequences for Rio if the Chinese government “lost face”.
Amid all the possibilities there is one rarely considered: that the deal passes without a hitch in its current form and in several years, with demand for commodities nowhere near 2008 levels, it is considered a masterstroke.