Buying into Rio's Chinese courtship
by, 19th-March-2009 at 09:07 AM (13873 Views)
The Chinese courtship
Rio Tinto is aiming to form a strategic partnership with Chinalco by selling to them about 10-15% ownerships in a number of assets.
The deal is currently waiting approval by FIRB, and some of the key issue are definitely political. Many politicians have spoken out against a deal. Every argument from protection of national interests, undue Chinese influences on price and poor human right records of Beijing has been thrown around. Furthermore, the FIRB decision to extend the time of deliberation by another 90 days (from 13 Mar 09) leave the company in further limbo.
Today RIO slumped ~8%, and has fallen from recent high of $53 to ~$47.5, against a strong overall market. In contrast, BHP has only fallen by 3%.
Bless this courtship
My view is that the partnership will be given the go ahead. By and large, the asset sales are for minority interests only, and RIO maintains the ultimate control. Many commentators are concerned about the level of influence the Chinese can have on production, marketing and price negotiation, which in turn will affect the entire mining industry. These, while valid, should be viewed as levers for bargaining. There are lots of safeguards that can be put in place to manage this conflict of interest, and FIRB can add further conditions rather than banning the deal outright.
But I believe the most important consideration for FIRB should be that, the national interest served (mostly political) by approving this deal is substantially more than any national interest protected (mostly economical focusing on a specific sector of the economy) from banning the partnership. Saying NO to the Chinese today presents a huge risk further down the track when we need them on other fronts - trade talks, military arrangements, buying Australian government bonds, accessing investment opportunities in China, hosting the FIFA world cup... After all, for Chinese it is all about relationship, reciprocity and face. With Rudd having a strong understanding of the Chinese way of thinking, I doubt this will be overlooked.
Downside scenario not that bad
Furthermore, even if the deal doesn't go ahead, it is not necessarily all bad for RIO:
- The Chinese has put a price tag on these assets that is substantially higher than their current market value. There is no better independent valuation.
- There are plenty of alternatives - rights issue, equity raising etc. Many existing shareholders have expressed support for such moves.
- RIO can actually handle their debt in 2009. So they have the time to come up with other resolutions.
- The market will always assume BHP is lurking in the shadow, and price RIO accordingly
RIO has ~$10B debt maturing in each of 2009 and 2010. The 2009 portion is pretty much taken care of by reducing cap ex, cost cutting and its own FCF. Now, assume they undertake a rights issue to raise a massive $4B to cover the debt in 2010, and they do it at a steep discount of $38 (~20% to current price). This means ~100m new shares which can be covered with a 2-for-9 rights issue. Total shares on issue increased from 457m to 560m. The share price would be diluted (all things being equal) to ~$45-46. And this ignores any interest savings. Ultimately, this is only a drop in price of <5%. A similar calc assuming a $8B issue will take the price down to may be $43 - bad but not catastrophic.
The trade approach
As I intend to trade on this particular event, the most sensible trade is a pairs trade by shorting BHP. This take any movement in the underlying commodity prices out of the equation.
The current price ratio is $47.5/$31.1, or 1.53. The average ratio has been since announcement of the partnership (12 Feb 09) has been 1.62. So the divergence is starting to become tradable, although I will probably wait for a more favourable entry, given that this has at least 90 days to play out yet.
For target, I will exit if the ratio reaches 1.7, or when the events are played out.
For stop loss, I will set the ratio at 1.42. This is based on the fully diluted RIO SP post-rights issue over current BHP price. Position size to be 1.5% of capital based on this stop loss.
P.S. Thank you to Robert Gottliebsen from the Business Spectator for some great information and analysis.
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