BHP saw too much cargo to continue with Rio Tinto bidFont Size: Decrease Increase Print Page: Print Bryan Frith | November 27, 2008 Article from: The Australian CHILDREN'S author Pamela Allen wrote an award-winning book, Who sank the boat? in which a cow, a pig, a donkey, a sheep and a mouse decided to go for a row in a boat.
As each animal climbed into the boat it settled a little lower until finally, when the tiny mouse clambered aboard, it sank. But the question remained, who sank the boat?
The mouse was the tipping point but the boat wouldn't have sunk unless the other animals were also aboard.
The same question can be asked of BHP Billiton's aborted takeover offer for Rio Tinto -- what sank the boat? There were a number of factors that ultimately led the BHP board to pull the pin but it's difficult to say whether there was one decisive factor or it was simply the cumulative weight of the various issues.
Until recently BHP was sanguine about the downturn in commodity prices and the equities markets because it had all along maintained that the bid was based on relative values.
Moreover, it was clearly winning that argument. Rio's defence was based on the claim that Rio was undervalued because it had a superior project pipeline and would grow faster than BHP.
That was undermined when Rio ran into problems with the main assets identified as contributors to Rio's growth -- the Simandou copper project in Guinea and the Oyu Tolgoi copper project in Mongolia.
In February, when BHP boosted its bid ratio from three BHP shares for each Rio to 3.4 to one there was considerable speculation it would have to lift the offer to at least 3.6:1 to have any chance of success.
That changed as the outlook for Rio darkened. It is worth recalling that for the past eight months Rio shares have sold at a discount to the value of the BHP offer.
Prior to BHP pulling the plug the margin had blown out to 25 per cent, which meant Rio was on its knees and was there for the taking.
In the past two months the world has gone into a tailspin, with the forced rescue, and quasi-nationalisation, of many of the world's major banks and the threat of a global recession.
During three main developments all would have contributed to sinking the BHP bid. For a start commodity prices, which had already fallen sharply, fell off a cliff in the past four weeks.
Measured by reference to the LME copper cash price, commodity prices fell 43 per cent in the year to October, but in the following month to November 21 they fell another 23 per cent.
Then Rio last month flagged that it wouldn't be able to achieve its promise of selling $10 billion of non-core assets in Alcan -- mainly the packaging and engineering businesses -- to reduce its $43 billion debt in the wake of last year's Alcan takeover.
That meant not only would BHP have been saddled with an additional $US42 billion of debt, rather than $US32 billion, but it would have had to assume the management of those marginal Alcan operations. Those Alcan businesses employ 75,000 people -- more than double BHP's entire workforce of 36,000.
Moreover, those businesses have a massive exposure to the US industrial economy and in a worsening economic climate that would have posed a real probability of having to close down some operations. It would have presented a major management task, and one that BHP would have been reluctant to take on.
Moreover, the deteriorating US economic outlook would have made the task of selling those assets even harder, raising the likelihood that BHP would be stuck with them for some time.
The consequence would be that BHP would have gone from a group with minimal debt of $US6 billion to one owing almost $US50 billion, while at the same the plunging commodity prices would have reduced cash flow and thus reduced the interest cover.
The third development was the European Commission's requirement that BHP would have to divest some iron ore and coking coal assets to have a chance of antitrust clearance.
The Rio camp contend that the EU requirements were so draconian they would have been a deal-breaker on their own, which may well be an attempt to justify the arrogant refusal to engage even when the tide turned clearly in favour of BHP.
That's not how BHP sees it. It says "in the normal range of economic conditions" it would have been prepared to offer remedies it believed would have been both acceptable to the EU and manageable.
These weren't normal conditions, however. In this climate BHP would have found it extremely difficult to find buyers for the divestment assets, and if any could be found it would probably be at fire sale prices, which would involve a loss. So BHP was not prepared to offer any divestments to the EU, which it expected would lead to clearance being withheld.
That the EU's stance wasn't the decisive factor is demonstrated by BHP's statement that if the EU nevertheless gave clearance BHP would recommend that its shareholders vote against approval of the takeover bid. In other words, the other changed factors were of themselves enough for BHP to pull the plug.
It's clear BHP has formed the view that there has been a shift in the relative values -- that the value of Rio for BHP has deteriorated, and as a result the bid was no longer justified. BHP remains in a good position with a strong balance sheet and is well placed to take advantage of opportunities to acquire other resource assets that will no doubt arise in the current market environment.
For Rio it's a debacle. The group is now constrained by its debt -- gearing is already above 50 per cent, which is causing it to cut back its ambitious capital expenditure program, including in the Pilbara, and it will also be constrained in considering acquisition opportunities.
That could provide the opportunity for BHP to close the gap in the main area where Rio has a stronger position -- iron ore. In that regard, it's worth noting that BHP on Tuesday also announced a $US4.8 billion proposal to expand its WA iron ore capacity by 50 million tonnes to 205 million tonnes annually.
It's now clear that Rio dramatically overpaid for Alcan and it must be considered likely that it will be forced to make heavy writedowns, which would further increase its gearing and increase the likelihood it will be forced into a large equity raising to pay down the debt, with a $US9 billion refinancing required by October next year.
Rio chairman Paul Skinner yesterday demonstrated that he is in denial, dismissing concerns that an equity raising would be required and expressing confidence that asset sales would be made over the next few months.
The market doesn't believe any of that. BHP's share yesterday rose $1.03, or 3.9 per cent, to $27.25, after at one stage being up more than 15 per cent at $28.56. Rio's share price plunged more than one-third, by $21.89, or 34.26 per cent to $42.01, after sales as low as $40.80.
At those prices Rio's market capitalisation is about $US2 billion, which is lower than its $US40 billion debt. BHP, by contrast, has market capitalisation of $US96 billion and debt of only $US6 billion.
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