"China BHP Billiton/Rio Tinto

"The one-stop raw materials shop
On the weekend I was reading the latest edition of US financial magazine Fortune. Personally I think Fortune is an excellent magazine, generally full of thought provoking articles. It is, however, extremely US centric in its approach, but I use it as a gauge of broader US investor sentiment.

This week's edition was titled "what were they smoking" and had photos of leaders (most now fired) of various leading US financial institutions who have suffered heavy sub-prime trading losses. I always think when you get corpse kicking from the financial press you are at the bottom of a given market event and this headline confirmed in my contrarian mind that the worst of sub-prime trading fallout is now priced in. Most leading US financials are now down 50% and now we have analysts who never predicted any problems telling us there is worse to come. Nothing like being cautious after the bus smash!

As I read further through the magazine I almost dropped my coffee when I turned to an article on the Australian Iron Ore industry. Here was the leading US financial magazine "discovering" the Australian Iron Ore industry. The article was written as if the strength of the Australian iron ore industry was new news. This again confirmed to me the same feedback I got from my own recent trip to the US, that being that American investors are only just realising there is real growth outside of their own economy. The "Chindia" growth story is not widely acknowledged by US investors, or the US financial press, but there is no doubt that the BHP/RIO merger proposal has put the topic right in the forefront of investor's minds.

Here is the biggest proposed merger in "materials" sector history and its occurring right as the US economy experiences a slowdown in growth. The deal is finally making US investors consider what is truly driving commodity prices and resource company earnings. It is making them consider the reality of a new world economic order and the new drivers of global growth.

The charts below from BHP Billiton paint a very clear picture of the true drivers of global materials demand. The charts show growth in global crude steel production from 1996 to 2006. They show you that of the 494 million tonnes of global steel production growth between 1996 and 2006 that China accounted for 65% of that growth and the US just 1%. That is an amazing statistic and even Europe grew at 6x the rate of the US while "other" grew at 20x.

I don't think I've seen any other chart that illustrates the new world economic order more clearly. Growth in global steel production is all driven by the new world. Analysts worry that a slowdown in America will affect demand for steel making raw materials. However, the vast bulk of this steel production growth is consumed internally in these growing new world economies. This is not about cheap cost of production in the new economy and exports. This is about internal consumption driven by rising GDP per capita. The chart below shows the correlation between GDP per capita and intensity of steel consumption. You can see that "Chindia" is in its infancy compared to its North Asian peers.

The stated goal of the Chinese Central Government is to grow GDP per capita to US$10,000 by 2015. If Chinese steel demand per capita tracks the Japanese example, which we think it will, then in just 8 years time steel consumption per capita will grow in China to 400kg/steel per capita from the current 250kg. The ramifications for steel making raw materials and the way they are priced are enormous under that scenario.

This can only be the top of the commodity cycle if you believe this is the peak of Chinese GDP per capita. We certainly don't think that is the case and we think China could meet its goal of US$10,000 GDP per capita earlier than 2015. There is huge internal momentum in the Chinese economy and it will not be disrupted by a weaker period of US economic growth. I suspect the vast bulk of the Chinese population don't even know what sub-prime is. They just want to move to the city and make more money.

The equity markets are pricing global cyclical stocks cheaply because they have never known a period of US economic weakness that hasn't had a direct effect on commodity demand and pricing. This is classic rear-view mirror analysis and it is not the way to approach the new world economic order.

Over the last 5 years any US inspired dips in commodity stock pricing have been a buying opportunity. Even the August trading correction has proved an excellent buying opportunity in leading resource stocks as the world again mistook resources with risk. Then along came BHP.

The BHP proposal to merge with RIO confirms the new world order in terms of commodity demand. On the same night Chairman Bernanke was addressing the Senate on US economic woes news broke of BHP's approach to the RIO Board. I was not alone in seeing the significance of these two events.

My personal view of the BHP move on RIO is that it is superbly timed. We are right at a cross roads in terms of resource stock sentiment (hedge funds locking in gains to ensure yearly performance fees) and BHP have put a proposal to the RIO Board that will ensure that both RIO and BHP shareholders prosper more from the cycle ahead than they would have individually. RIO shareholders who roll into the merged entity will have diluted exposure to the controversial and clearly defensive Alcan acquisition, yet all shareholders in the merged group will have greater economic leverage to the underlying cycle as post the proposed $30bil buyback the entity will be more optimally geared. It's without doubt a 1 1 =3 deal.

Think global; act local

Throughout this entire cycle we have always recommended that investors "think global and act local". We have always argued that the best risk adjusted leverage to the "super cycle" was via buying 1st world listed resource stock, with particular emphasis on the extreme political and legal stability of Australian resource companies.

The merged BHP/RIO would have the lowest sovereign risk of any major resource company. As the chart below reinforces, 49% of core assets would be in Australia, 28% in North America, and 11% in Europe. The remaining 12% would be in South America, Southern Africa, and "other". You could argue BHP are "thinking global and acting local" which greatly reduces sovereign risk and should lead to a corresponding P/E premium for the merged entity.

This means when the merged entity moves into new higher risk territories seeking new production growth the overall impact on asset portfolio stability is low. The merged entity will also be more diversified by product and on last year's numbers have combined EBIT of over US$40bil.

These numbers look backwards and assume no synergies (quantified at US$3.7bil but most likely to be larger) and no production growth. The merged entity becomes the world's only true one stop raw materials shop. The ramifications for product pricing and interaction with customers are also underestimated by the analysts. BHP has already started to challenge the way products are traded and you can expect the merged entity to extract maximum economic rent from every commodity it produces. That is the part of the merged entity equation nobody can forecast. The merged entity will be able to guarantee volumes to customers to an unprecedented degree, but pricing will be set by the market as it should be.

The combination of BHP and RIO is such a powerful combination as both a corporate entity and an investment proposition. Many people are misinterpreting this merger. They want a takeover premium for what is essentially a merger. They are completely missing the point and the opportunity.

RIO shareholders should be counting their lucky stars. RIO was starting to dramatically underperform BHP Billiton. That underperformance was driven by BHP's exposure to Oil and a market perception that BHP has stronger management, a stronger balance sheet, and much stronger profile of organic growth options. RIO's share price was also underperforming due to valid concerns about the Alcan acquisition, its timing, its motivation, its pricing and its funding. The BHP full year result and the RIO half year result were like chalk and cheese as were the respective capital management programs and outlook statements. BHP was clearly getting new investor dollars over RIO and we think that was, and remains, completely justified.

BHP is attempting to create the no.1 global exposure to the new world economic order and they are allowing RIO shareholders to participate in ALL the upside. Interestingly most RIO shareholders are also BHP shareholders. The overlap is even greater now that arbitrage funds are buying RIO and shorting BHP. I suspect the "real" overlap is closer to 80% now and the arbitrage funds are doing a good job for BHP. BHP owns no shares in RIO but the arb funds are long RIO and short BHP. The only outcome they want is BHP to own RIO using scrip. After a while the arb funds and institutional investors will get frustrated and they will force the RIO Board to the table. If the RIO Board doesn't go to the table BHP has the option of a hostile offer which will be well received by arb funds and RIO shareholders who also own BHP shares. Yet remember, a hostile deal will see lower synergies and a lower return to all shareholders.

One way or another, this deal is going to happen. It is economically logical and shareholder logical. The pressure will start building on the RIO Board to justify their position. By justify their position I don't mean the "A standard" takeover response of "why there is hidden value in us". I suspect the "A standard" takeover response is coming at the RIO "investor briefing day" (Monday 26th of November). This briefing day could well prove the turning point in direct pressure on the RIO Board. They have inadvertently built up expectations and the chances are that investors are left disappointed. If they talk about joint ventures with BHP then they are basically arguing in favour of the merger in my view.

Shareholders who own BHP and RIO should be putting pressure on the RIO Board to come to the negotiating table right now. Time is of the essence. The merged group upside is larger the quicker this deal is cemented. Not only will you get an excellent short-term result for your RIO holding but you get tax free rollover into a much stronger entity with much stronger medium-term prospects. An agreed deal will see BHP shares rally sharply and improve the implied price for RIO shareholders.

The consensus broker price target for BHP shares is currently $46.67. That is a pre-synergies, pre-merger price target. On a 3:1 ratio that equates to a $140.00 for RIO. However, in my opinion I believe BHP shares would rally to $50.00 on confirmation of an agreed deal which would value RIO at $150.00. Clearly that price is well "in the ballpark" and it will be achieved as the index funds will wait for confirmation of an agreed deal before buying the significant index uplift in BHP.

BHP's index weight rises aggressively all around the listed world. It's not just in the FTSE 100 and the ASX200 (16%). "New BHP" would move into the Dow Jones Global Titans index and the Dow STOXX 50. It would be upweighted in the S&P Global 100, the S&P Europe 350, the FTSE 100 EuroFirst, and the MSCI Pan European. The global index effect would be enormous and it is completely underestimated by most commentators.

It continues to surprise me and many RIO shareholders who I speak to that the RIO Board refuses to engage BHP. The large RIO shareholders I speak to are nervous that the RIO Board may overplay their hand here. They are nervous that they could experience the "triple loss" event if the RIO Board doesn't come to the table. The "triple loss" is loss of synergies, loss of BHP upside, and loss of RIO upside. That outcome could decimate the portfolio performance of large cross holders of BHP and RIO. That is why it will be the shareholders who force the RIO Board to the table. It's not only about the upside you should also consider the downside if the deal isn't consummated. RIO shares would be 30% lower without BHP's proposal

If this is simply an argument on price as it seems to be (note RIO have not said anything about the logic of the deal) then the way to sort that out is negotiation, not an investment banker slanging match in the financial press.

It appears the RIO Board have been caught offguard by this approach. They thought the defensive Alcan move had seen off Argus and Kloppers in the medium-term. It appears they knew BHP was circling but they didn't think they would pull the trigger after the Alcan move. They were wrong and perhaps all they are doing now is buying a little time. However, time is of the essence here as stalling will risk having political and vested interest groups creating headwinds for the deal and therefore risk shareholder value.

This is the deal of the new century. BHP and RIO shareholders should be pushing for it to occur. The medium-term upside for both sets of shareholders is tremendous, but it appears it's going to have to be shareholders who drive the outcome. A bit of shareholder activism never hurt anybody. We continue to recommend buying BHP shares at current prices.