Buy Baby Buy!

Last Tuesday, the 18-month saga of BHP’s battle for Rio Tinto ended. BHP withdrew its bid for the rival mining company, explaining that the recent fall in commodity prices and a worsening world economy had made the $68 billion deal too risky to complete. The proposed exchange of 3.4 shares of BHP for each share of Rio Tinto was once valued at more than $170 billion.

 

The stakes for China in this battle were high. The global iron ore industry is dominated by three players: Brazil’s Companhia Vale do Rio Doce (CVRD), Rio Tinto and BHP If the merger had gone through, 79 percent of the world’s iron ore supply would have found itself in the tight grip of a powerful duopoly, both companies roughly equal in size.

 

With 500 million tons or more of steelmaking capacity, China accounts for over one-third of global capacity and is, by far, the largest steelmaking country in the world. Unlike ArcelorMittal and U.S Steel, two of the largest companies in the global steel industry, however, China’s steelmakers are not vertically integrated. Therefore, China’s steel industry is vulnerable despite its size because it is caught in the middle—between the powerful iron ore suppliers on the one hand, and a diverse group of customers for steel products on the other. The combination of BHP and Rio Tinto would have created the iron ore equivalent of OPEC. While iron ore may not be as sexy as oil, it’s no less strategically important to China, the largest consumer of this product in the world.

 

For these reasons, MTD has been following the story closely. In High Noon for China and Rio Tinto, we first called attention to BHP’s proposal and its implications for China in November of last year, and suggested that the Chinese government use its vast foreign currency reserves to counter BHP’s efforts. In China’s Fragmented Steel Industry, posted in January, we took exception to the argument that China’s fragmented steel industry was about to consolidate, and that this consolidation would somehow help Chinese steelmakers deal with a combined BHP/Rio Tinto. In February, we expressed relief that Aluminum Corp of China (Chinalco) had teamed up with ALCOA of the United States to take a stake in Rio Tinto Also in February, we highlighted the formal offer by BHP and reviewed the adverse implications for China if the deal were to go through With inflation the hot economic topic in China in the spring, we discussed the implications of Baosteel, China’s largest steelmaker, agreeing to a 65 percent price increase for iron ore.

 

While this chapter of the BHP/Rio Tinto saga is finished, many believe that the final one has yet to be written. David Lee Smith at The Motley Fool questions whether BHP has cut bait for good:

 

So for now, it appears that a saga has ended — at least temporarily. Blame it on a plummeting global economy if you wish. But for my money, this is something like watching 24: It may take a while, but the action is likely to begin again. Fools would be well advised to stay tuned.

 

Chinalco may very well make the next move. After BHP made its announcement, Lu Youqing, a vice president and spokesman for the company said that Chinalco plans to lift its stake in Rio Tinto to at least 14.99 percent. Lu went on to say that Chinalco might consider seeking as much as 49.99 percent of Rio, but added that that this was an idea that had been suggested by investment bankers and was not the company’s policy. (Although Chinalco issued a clarification later, Lu admitted that “Some company leaders are considering 49.99 percent,” as well). On the possibility of merging Chinalco and Rio, Lu said: “This may be difficult because of legal issues. The Chinese government would not want us to be controlled, and the Australian government would not want Rio to be controlled.” However, Lu did not rule out a possibility of such a merger in the future, given changing market conditions. Asked if Chinalco wanted to become a majority shareholder in Rio, he said: “We would certainly want to.”

It seems quite clear that Chinalco intends to buy as much of Rio Tinto as it can—and it should. Despite the falloff in demand and prices, iron ore and other natural resources mined by Rio Tinto are no less important strategically now than when prices and demand were at their peak. Because China’s steel industry is not vertically integrated, it will always depend on importing key raw materials.

Also, there is no better time to buy than now. Rio Tinto’s equity value has dropped sharply from its peak of $170 billion to $32 billion. Although Chinalco has lost some $10 billion on paper on the stake it took in January, current price levels give the company the opportunity to average down on the cost of its investment.

Finally, Rio Tinto is vulnerable and will be receptive to any help Chinalco can provide. Rio Tinto took on debt to finance its $38.1 billion purchase of Alcan in late 2007 and committed to sell $15 billion in assets, including $10 billion this year. Rio Tinto has fallen behind on its divestiture plans, and the economic crisis will now make it that much more difficult to fulfill these commitments. Rio Tinto has $9 billion of debt coming due in October 2009.

In times like this, cash is king, and individuals, companies and countries with liquidity have their pick of investments. China should take this opportunity to fix a glaring weakness in its supply chain that was exposed in the last commodity cycle. Although we are now in a down cycle, and it’s always difficult to predict when cycles turn, the continued industrialization of China, India and other emerging economies will only put upward pressure on all raw material prices over the long term.

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