Aug 25

Written by: Peter Mathers
25/08/2008

The following is an initial analysis of the company briefing, and may be subject to modification.
Company Development
The Treasurer, Wayne Swan, has approved the proposal by the Aluminium Corporation of China Limited (Chinalco) to acquire up to 14.99% of the shares in RIO Plc. A 14.99% stake equates to an interest of around 11% RIO Plc and Ltd combined. The Treasurer found no objections under Australia's foreign investment policy to Chinalco acquiring a shareholding interest of up to 14.99 per cent of RIO Plc on the basis of Chinalco making two undertakings:
"First, Chinalco has undertaken to me that it would not raise its share holding above this level without notifying and receiving fresh approval from the Government under Australia's foreign investment review arrangements.
"Second, Chinalco has also undertaken that it will not seek to appoint a director to RIO Plc or Ltd for as long as it holds a shareholding of below 15 per cent. Any future proposal to increase its level of ownership above 14.99% would require re-assessment at that time against Australia's national interests under the Foreign Acquisition and Takeovers Act 1975."
Analysis and Recommendation       
In March we outlined in detail how we thought BHP's bid for RIO could fail due to a number insurmountable hurdles. These hurdles included a potential blocking stake by Chinalco, regulatory rulings, valuation differences, cultural differences and non-acceptance by RIO's shareholders.
The Treasure's decision gives Chinalco the ability to block a full takeover of RIO by BHP although BHP's current pre-conditional bid is based on a minimum acceptance of 50% for both RIO's Plc and Ltd company structures. It also gives Chinalco the ability to participate in any assets sell-down as required by the EC when it makes its ruling on the 11 November. Either way, the Treasurer's decision has made it less likely that BHP can gain full control of RIO and, therefore, will be hard pressed to achieve all the merger benefits that would come with full control - mainly market price control.
Since March RIO's share price has slipped from above the equivalent of 3.4 x BHP's share price to a recent low of 3.0 x BHP's share price. It had slowly dawned on the market that BHP's proposed takeover of RIO did face significant hurdles. This resulted in a 14% outperformance by BHP over RIO since March. We did  upgrade our RIO recommendation from a Hold to an Accumulate in July as RIO had become attractively priced in absolute terms due to a general market correction despite our preference for BHP.
The market now expects Chinalco to increase its stake in RIO above 9% by buying on-market. This means the deterioration in RIO's share price relative to BHP's may have come to a halt and RIO may even outperform BHP in the short term.
However, we still have a preference for BHP (Buy) over RIO (Accumulate) based on the potential for significant capital management initiatives, stronger earnings growth, greater diversity and a higher quality balance sheet. We do note that, based on our modelling, BHP and RIO's PE profiles do align two years out.
We still believe RIO's share price would correct significantly if BHP's proposed bid were to be fully blocked by regulators or, alternatively, require significant asset divestments unpalatable to BHP whereby BHP walks from the deal. There remains some risk that BHP proceeds with the RIO takeover regardless of divestments required by regulators and Chinalco's potential 11% stake. However, at this stage it is too early to make that call as a decision by the EC is not due until 11 November.

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