Rio must play demerger game

If BHP Billiton proceeds with its demerger plan, then Rio Tinto must follow.

Pressure on Rio Tinto to replicate BHP Billiton’s plan to spin off assets regarded as non-core can already be measured in the stockmarket.

Since news of the demerger broke late last month, BHP Billiton’s shares have risen by 3.8%. Over the same time, Rio Tinto has risen by 1.5%.

Both of the big resource companies have outperformed the wider market with the All Ordinaries Index up by 0.1% over the same time, and the ASX 200 up by 0.3%.

Improving shareholder returns

Small as all of the share price and index movements are, there is a financial signal being sent by investors: and it is one that is backed up by the biggest holder of BHP Billiton shares and second-biggest holder of Rio Tinto shares, the world’s biggest fund manager, BlackRock. Chinese minerals conglomerate Chinalco is Rio's largest shareholder.

In a telling interview three days ago, Evy Hambro, managing director of BlackRock’s natural resources division, welcomed the BHP Billiton demerger proposal as a way of improving shareholder returns.

Much of what London-based Hambro said could easily have been applied to Rio Tinto.

“I think we are at a stage in the resources cycle where companies in general are looking to address the imbalances from the past with regards to capital spending versus returns of capital to shareholders,” he said.

Hambro launched his campaign against mining company waste two years ago and has urged the big miners to do whatever is necessary to boost their financial performance, starting with cutbacks in capital spending, followed by outright asset sales.

“I think we’re now in a mini-phase of this process, where if assets are unable to be sold then I think companies are looking at other options, and that may include demergers of assets. It’s something we have seen in previous cycles.”

While he did not name Rio Tinto as a company that must follow the mining industry’s leader, Hambro’s message is clear – and it is significant that he referred to companies in the plural when answering questions about BHP Billiton’s demerger plan.

As Rio Tinto’s second-biggest shareholder, Hambro expects management to sharpen its focus by shifting underperforming assets off its books in the same way BHP Billiton is planning to offload its weakest assets, including nickel, aluminium, manganese and some thermal coal mines.

How its planned demerger will affect the financial performance and investment appeal of BHP Billiton is being analysed now by the team at StocksinValue, with the results scheduled to be published next week.

Rio’s assets garage sale

In the meantime, it is worth considering which Rio Tinto assets might be allocated into a “bad” company portfolio similar to the business BHP Billiton is busy creating.

Top of the Rio Tinto spin-off list, and in keeping with Hambro’s comments about demerging what can’t be sold, are the company’s diamond operations. They were offered for sale last year but failed to draw an attractive bid, and are now sitting in a sort of no-man’s land, obviously unwanted by management (or why offer them for sale) and unlikely to attract fresh capital in the future.

Shifting diamond assets in Australia, Canada and Zimbabwe into a separate stock exchange listed vehicle would serve the purpose of removing a business which has more to do with retailing and the mood of consumers than mining.

It is even possible that the first steps in a Rio Tinto spin-off have been taken with one of the company’s divisions already looking a lot like the bad-company division created last year by BHP Billiton.

Just as BHP Billiton has a hodgepodge of assets in a business called “aluminium, manganese and nickel”, Rio Tinto has a division called “diamonds and minerals”.

Interestingly, none of the assets in either the BHP Billiton or Rio Tinto divisions have much in common, other than sharing a poor recent financial performance. Both companies appear to have established the equivalent of a corporate sick bay.

BHP Billiton’s walking wounded are obviously for sale and form the basis of most estimates as to what will go into its spin-off (unless sold before the demerger), along with some of its thermal coal assets in South Africa and Colombia, the Cannington zinc mine in Australia, and possibly some Australian thermal coal.

Rio Tinto’s diamonds and minerals division obviously includes the diamond assets that could not be sold last year, along with titanium dioxide (mineral sands) assets in South Africa and an industrial salt-making business in Western Australia.

Other possible inclusions in a Rio Tinto bad company could be some of its poorly performing and already heavily written-down aluminium smelting operations, and business units listed as “development projects” including a lithium-borate deposit in Serbia.

This week Rio announced it had backed out of one of the world's largest copper deposits by gifting its minority stake in Northern Dynasty, the developer of the massive Alaskan Pebble copper and gold project, to two Alaskan charities.

A new Rio

Stripped of its non-core assets, which is the plan being pursued by BHP Billiton, and Rio Tinto could emerge as a company with stronger investor appeal thanks to its highly profitable iron ore operations leading the way, followed by a reasonably strong copper division, an improving aluminium division, and a coal business with potential to benefit from further cost cutting.

For investors, and this is what StocksinValue will analyse next week, the key consideration is that BHP Billiton’s decision to streamline itself into a business with a smaller number of world-class assets in first-world countries sets a precedent that should earn it a higher rating among institutional investors.

Rio Tinto, and other big mining companies, will face a choice. Either mimic what the leader (BHP) is doing or risk a lower investment rating because of messy structures loaded with surplus assets that have evolved over the past 10 years of boom and bust in commodity pricing.

In effect, the big miners are cleaning house and should emerge as more appealing businesses once the clean-up is over, with investors handed the decision of either hanging on to their entitlement in the spin-off company or selling

That is the ultimate appeal of the demerger process. It takes part of the capital allocation decision away from management and hands it to shareholders.