Rio will slump to $115 without BHP bid

"Deal or no deal"
The BHP Billiton/RIO Tinto merger proposal is clearly entering a new phase with RIO applying to the UK Takeovers Panel to invoke the "put up or shut up" rule. Under U.K. law, a company subject to a proposed offer may request that the panel impose a time limit for the potential acquirer to clarify its takeover intentions, under the so-called "put up or shut up" rules. The panel then sets a timetable, usually one to two months, whereby the acquirer is required to either announce the intention to make a firm takeover offer, or withdraw the offer. If BHP withdraws, management would need to wait at least six months before it would be allowed to return with a firm bid or another proposed offering.

Game on

Clearly the verbal jousting has concluded and the real game is beginning. There is little doubt that BHP has put forward in our view a compelling proposal which generates significant synergies and value creation for both sets of shareholders. That compelling argument was again put forward in London last night and here is a selection of charts put forward by BHP. These charts justify BHP's premium rating to RIO. Total shareholder returns have been stronger driven by stronger investment in production growth.

Spread has contracted since RIO presentation

Importantly, RIO has seemingly not disagreed with the merits of the merger, but management has rejected the proposal on value criteria. However, we believe the recent RIO investor presentation failed to reveal any new information different to consensus forecasts.

In support of our view, since the RIO presentation, BHP's share price has actually outperformed RIO, and the spread (RIO divided by BHP) has contracted from a high point of a 3.48x to 3.28x currently. This price action is hardly supportive of a significantly higher offer. However, it also reflects the clear increasing absolute risks for RIO shareholders, many of which we pointed out last week.

In the meantime, the RIO defence has centred on the key theme that the proposal fails to reflect the inherent value in RIOs growth profile. As a result RIO believes the offer is "two ballparks away." Consequently, RIO management who are effectively speaking on behalf of the shareholders, feel no need to engage with BHP. Subsequently, the CEO Tom Albanese revealed, "the deal is dead in the water." Considering the firm rejection and the dismissal of the proposal, the obvious conclusion is that RIO management would pursue its own organic growth options.

Therefore the application to the UK Takeover's Panel appears to represent a very abrupt change in attitude. If RIO actually believes the deal is "dead in the water" then why apply to the UK regulatory body? The only conclusion we can draw is that RIO believes that by invoking the "put up or shut rule", this will force BHP to sweeten the proposal.

Our view remains that this scenario is extremely unlikely to happen unless BHP receives a recommended deal from the RIO board. As we have previously mentioned, BHP could simply walk. We think by invoking "the put up or shut rule" and trying to force BHP's hand, this has become a very real possibility. We strongly believe BHP will not be sucked into bidding against themselves simply to start negotiations. This would be very bad news for the RIO share price. In the meantime, while we believe it is game on, the game might not end to the short term satisfaction of RIO shareholders.

Rio; under pressure

Despite the public denial, our conversations with Australian shareholders suggest the RIO board is coming under increasing pressure from shareholders to engage BHP, remembering over 70% of RIO Ltd shareholders also own BHP ltd. As we have stated before, we believe this is not the time for games. This is an auction with only one qualified bidder.

The risk of not engaging BHP was dramatically highlighted by the recent collapse of two acquisitions worth a total $11.3b. The rising cost of debt funding has forced SP Ausnet (SPN) to scrap a $8.3b plan to acquire the former Alinta gas and electricity transmission assets from Singapore Power. Apparently, a 70-80bpt rise in funding costs rendered the deal uneconomic. In addition, it appears that the collapse of ChinaChems joint $3b bid with Blackstone for Nufarm (NUF) has also been derailed due the tight credit markets and the sharp rise in debt funding costs.

Clearly with credit markets tight and the cost of debt rising it is becoming increasingly difficult to debt fund takeovers. As a result, deals are falling over left, right and centre.

Our credit market sources reveal that a large consortium of international banks was needed before BHP finally raised the US$70b in debt funding for the merger proposal. Considering the rising cost, and the difficulty to obtain debt funding, we rate a competing RIO bid as a very low probability.

Risks

There have been similar instances where takeover bids failed to materialise when management perceived the offer was inadequate. The Orica Board decided not to show shareholders a $32.00 cash offer considering the Board's view that the bid undervalued the company's growth prospects. Sound familiar? Subsequently private equity walked away and the ORI share price fell approx 20% to a low around $27.00, much to the dismay of some very disgruntled shareholders.

We believe RIO Board is taking a considerable risk considering there is a very real possibility of a similar situation developing. We think there is increasing market pressure on RIO management to engage BHP in discussions. What is the downside in RIO talking to BHP? We don't think there is any. It's hardly like BHP are a "dummy bidder".

In rejection of BHP's merger proposal, we think it is just too simplistic for RIO management to say that the proposal fails to reflect value and is not "within two ballparks." Clearly the market has not previously shared a similar view as the charts above confirm.

Firstly, it is worth noting that the RIO share price has nearly doubled since the initial takeover rumours. Additionally, it is worth remembering that the RIO/BHP ratio has averaged only 2.4 times over the last 6 months. In fact over the last 12 months the RIO share price has only reflected the 3 for 1 spread for two brief periods before the merger was proposed, and subsequent to the proposal being made public. Lastly, as we previously mentioned, the RIO/BHP spread has actually contracted since the RIO defence presentation. It has contracted aggressively since the "put up or shut up" initiative as hedge funds correctly worry that BHP may well "shut up"

Despite RIO management's insistence that the merger proposal significantly undervalues RIOs growth prospects, clearly past share prices have not reflected this view. On current earnings forecast it is a massive stretch to believe that RIO is worth $150 per share as a standalone proposition.

However in the meantime management's response has been that BHP's proposal is "two ballparks away.'' We think the risks for RIO shareholders have increased significantly considering BHP could simply walk away from the proposal.

Limited defence options

We believe a lack of traditional takeover defence strategies is another risk for RIO management and shareholders by not engaging BHP. In addition we believe this is a major reason for RIOs approach to the UK Takeovers Panel.

The BHP/RIO merger is unique considering the size of the synergies, and the value uplift available to both sets of shareholders. The huge synergistic benefits allow BHP the ability to overbid potential acquirers which discourages competing offers. CVRD (Vale) has already stated their intention to pursue organic growth opportunities and the rest of the global major's lack the financial firepower and the synergies.

In addition, there appears little opportunity for the emergence of a white knight. Despite the plethora of rumours of a blocking stake from the Chinese steel industry backed by China's massive FX reserves, the Baosteel Chairman has finally and publicly denied any interest. A Chinese sovereign fund utilising FX reserves to take a blocking stake in a foreign company for political reasons is fraught with dangers. It won't happen. The Chinese will not block this deal.

Finally, considering RIO has leveraged its previously strong balance sheet with the Alcan takeover, RIO is financially unable to offer a capital management incentive encouraging shareholders to reject the offer. As we have written for six months it appears to the naked eye that the Alcan move was RIO's "defensive" response to BHP's initial approach. In our view they have already used the balance sheet defence.

Our view is that RIO has no traditional defence options left. As a result, we believe the only real option for RIO is to encourage BHP into raising their offer. This is probably the real reason for RIOs approach to the UK Regulator. However this is a risky strategy as we simply can't see the situation where BHP bids against itself. Why would they? It makes no sense. Our view is that the only way that BHP would ever marginally sweeten the offer is in the situation of a recommended bid. In the meantime the pressure remains on RIO to convince shareholders the bid significantly undervalues RIOs growth prospects.

Walk equals $115

At the time we viewed, "the dead in the water" comment from CEO Albanese as absolutely bewildering. Clearly we believe there will be no competing offer and it is our view that RIO has no defence other than encouraging BHP to bid against itself. As a result, surely the key issue for RIO management was to create an environment of price tension in order to encourage BHP to sweeten the offer.

The comment confirmed our opinion that RIO was making a tactical error by not engaging BHP. There is no way in our view that BHP will bid against themselves when there is no prospect of competing offers and RIOs only defence is price. The approach to the UK Takeover Panel is a final attempt to encourage BHP to raise their offer. However the real risk is that BHP walks away and RIO shareholders are faced with the same prospect as ORI where the share price fell 20% . We believe if BHP walks, then as we previously mentioned, the RIO share price will fall to around $115 to reflect current earnings prospects and the removal of corporate price tension.

This saga will go on for a few weeks and BHP would be well advised to say nothing until they are obliged to "put up or shut up". The longer this goes on the more hedge funds will get nervous and the more the RIO/BHP spread will contract towards the BHP proposal of 3x. As time goes on the market will realise there is only one bidder for RIO and it is BHP Billiton. We again reiterate our stated concerns that the RIO Board may overplay their hand here and the downside in RIO shares is considerable if BHP walks from this proposal.

We don't want you to mistake us as "anti-RIO". We are not "anti-RIO"; they are one of the world's great companies with wonderful long duration assets. The fact is "we are pro this deal". This deal makes so much logical sense for both sets of shareholders that it must occur. However, it must not occur at a ratio that is to the detriment of BHP shareholders. It continues to concern us that some people want to get a cash takeover premium for what is essentially a merger where both sets of shareholders share in the upside of the combined group. Nobody seems to argue that the combination of the two releases huge value that can only be released by this combination.

BHP again reiterated their stance on the offer last night in London and my interpretation is that they are showing no signs of bidding against themselves. They are also showing no signs of going hostile. We just don't see Argus and Kloppers as blokes who get pushed around. They want to engage RIO in a friendly and respectful manner, but they want to engage RIO without having to bid against themselves first. This is completely understandable and it is the right corporate strategy particularly when you have the option of walking completely and watching the target share price most likely fall 20% .

Some people disagree that RIO shares would fall -20% if BHP choose to walk. There seems to be some belief that the hedge fund ownership of RIO shares is actually quite low. We don't think that is the case and we think RIO shares will fall as hard as any other stock where an expected bid is withdrawn.

So what do we do?

As in our note last week about the growing risks in RIO shares we continue to urge RIO shareholders to hedge their bets and lock some of the outperformance off the October BHP/RIO ratio low of 2.4x. We continue to believe that the greater absolute upside lies in BHP shares from this point. We think BHP shares rally if they walk and rally if they secure a deal.

The BHP side is arguing the deal well using unemotional logic and facts. That same unemotional logic could easily see them walk if RIO won't engage. RIO shareholders need to be aware of this clear and present risk. BHP, in my view, even hinted at this scenario in last night's presentation with comments about their own superior "standalone" growth options and discussions with shareholders about "whether there is a basis for taking the proposal forward".

We continue to believe it is a major mistake to underestimate BHP's financial discipline and patience. BHP management didn't blink in last night's presentation. In our view, the simple fact remains that RIO shareholders need BHP a whole lot more than BHP shareholders need RIO. RIO shareholders need BHP and they need them now. At current prices RIO shares can't justify a standalone option. History suggests that RIO assets will perform better with BHP management; the upside of the combined group is compelling.

We genuinely hope commonsense and economic logic prevail here, but we remain the only people genuinely concerned that what should be a world changing combination of two tremendous companies is going end up in divorce before they have reached the altar. We hope for both RIO and BHP shareholders that isn't the case. In the mean time the ratio of RIO to BHP shares remains too wide relative to the growing risks of the marriage not being consummated. We continue to recommend buying BHP.