Mistakes haunt Rio Tinto plans for lithium buy
If the speculation that Rio Tinto is considering a $US4.5 billion to $US5 billion investment in the world’s largest lithium producer is borne out, it could be a defining moment in Jean-Sébastien Jacques’ tenure as chief executive.
The key question, and one that would be raised by any significant acquisition Rio makes during his term, is whether it is an Alcan or Riversdale “moment” -- the two massive blots on what was otherwise a pretty impressive Rio track record of acquisitions.
There have been reports emanating from Chile that Rio has made, or is about to make, an offer for Potash Corp’s 32 per cent stake in Chile’s Sociedad Quimica y Minera de Chile, or SQM.
SQM is the world’s largest and lowest-cost producer of lithium, as well as a major low-cost producer of iodine and potassium. Listed on the New York Stock Exchange, it has a market capitalisation of about $US14.5 billion.
The Potash Corp stake in SQM is up for grabs because of conditions imposed by Chinese and Indian authorities as the price of approval for its $US36 billion friendly merger with fellow-Canadian potash producer, Agrium. A number of Chinese companies are also said to be interested in acquiring the stake.
The appeal of SQM isn’t hard to understand. It is the biggest and lowest-cost producer of the world’s hottest commodity. Lithium prices have soared about 65 per cent this year, primarily because of the rapid increase in demand for electric vehicles.
China, the world’s largest consumer of lithium and whose authorities are very focused on reducing pollution levels, increased its demand for electric vehicles by more than 50 per cent last year.
With the cost of batteries falling and demand for electric vehicles rising there is a scramble going on among producers and aspiring producers to fill what otherwise could be a yawning gap between demand and supply for one of the key ingredients in the batteries.
Earlier this year UBS analysts said global lithium production would need to increase nearly 3000 per cent to meet demand. They also said producers’ gross profit margins could be over $US5000 a tonne through to the mid-2020s.
SQM, which has a foothold in this market through a 50-50 joint venture with Kidman Resources under which it will invest $US110 million to build a mine and concentrator for the Mt Holland lithium project in Western Australia, represents the obvious entry point to the sector for one of the really big miners like Rio.
Rio does have an existing interest in lithium. Its Jadar project in Serbia, which Rio has said is a significant and world-class lithium-borate resource — one of the world’s largest and, if developed, capable of supplying about 10 per cent of the current demand — is at a pre-feasibility stage.
While the basic description of SQM is attractive — the biggest producer and the lowest-cost producer of a strategic commodity in short supply — the risk for Rio and J-S, as he’s known, would be in overpaying. SQM’s share price has already risen about 95 per cent this year.
That’s the risk that Rio miscalculated, with near-fatal results, when it paid $US38 billion for Alcan in 2007, just ahead of the financial crisis. It massively overpaid, which compounded the impact of Rio’s misreading of the sector’s fundamentals. It subsequently wrote off more than $US30 billion.
Four years and billions of dollars of equity raising and asset sales later, Tom Albanese (who, as a new CEO, narrowly survived the Alcan debacle) had regained a licence from the market to make acquisitions.
He spent nearly $US4 billion in 2011 acquiring Riversdale Mining and its undeveloped metallurgical coal project in Mozambique. Rio’s interest in the project was sold three years later for $US50 million. Albanese didn’t survive the fallout from that purchase.
Despite some commentary flowing from those two disastrous deals suggesting Rio isn’t good at acquisitions, over its history Rio (or, more correctly, CRA before it was subsumed into its parent) has actually been a very strategic and disciplined — and aggressive — acquirer. Alcan and Riversdale are the aberrations.
In the 1980s and 1990s Rio made a strong of big acquisitions — Kennecott Utah Copper, BP’s Australian coal assets, 70 per cent of Coal and Allied, North Broken Hill and Ashton Mining — of which the most significant was probably North BH. With that $3 billion deal Rio gained access to a second rail line and the Cape Lambert port in the Pilbara, which helped underpin the dramatic expansion of the iron ore division that is by far its most valuable business.
When Sam Walsh, a Rio veteran, replaced Tom Albanese as CEO he reinstated a lot of “old’’ CRA practices and systems that had been lost as the group’s culture evolved and its centre of gravity shifted from Australia to London after CRA was merged into Rio.
He and his chief financial officer, Chris Lynch — both with long experience in Australian resources — cleaned up Rio, sold billions of dollars of assets, slashed its debt levels to a mere $US7.6 billion of net debt and dramatically improved its cash flows.
They also started cautiously investing in relatively low-risk expansion, including the brownfields expansion of the Silvergrass iron ore project, the Amrun bauxite project in Queensland and the underground phase of the copper-gold Oyu Tolgoi project in Mongolia.
J-S began his term as CEO in the middle of last year quite conservatively and introspectively. Like BHP Billiton, he has focused on productivity. He abandoned the giant Simandou iron ore project in Guinea and has overseen a staged (and lucrative) exit from Rio’s thermal coal interests.
While he has said Rio will limit itself to $US5.5 billion, at most, in sustaining and growth capital expenditures for the foreseeable future, Rio does have the balance sheet and cash flows to make acquisitions while still satisfying shareholder expectations.
In the first half of this year Rio had operating cash flows of $US6.3 billion and free cash flows of $US4 billion. Subsequently it sold its Coal and Allied assets to Yancoal for $US2.7 billion.
Given the current price matrix for commodities, it would be awash with cash. It has and inevitably will continue to use its dividends and share buybacks to divert a large proportion of those cash flows to shareholders, but it would have the capacity to invest more aggressively in its existing asset base or acquire new assets as well.
J-S has said he isn’t averse to acquisitions, providing they are at the right price — which has been difficult in an environment where, during the period when commodity prices slumped, quality resource asset values held up surprisingly well. There were no bargains.
That’s what makes SQM an interesting proposition, and potentially a reputation-changing one.
If the longer term demand for lithium does match the very bullish projections a big strategic shareholding in SQM, even at current prices, might, with hindsight, look like a prescient and value-adding transaction.
SQM won’t be a Riversdale, which ultimately had no value. It is a profitable company with a long operational history. It could, however, be an Alcan — an overpriced acquisition made on optimistic assumptions that proved to be wrong.
If Rio is to regain and hold onto its licence to make reasonably large acquisitions, it can’t post a third strikeout within a decade.
Its next acquisition, whether that’s a stake in SQM or something else, needs to be demonstrably successful.
J-S and his board would be acutely aware of that
KDR Price at posting:
$1.31 Sentiment: Buy Disclosure: Held
