Rio's aluminium burden

At face value, the substantial earnings downgrade announced by Alumina isn't good news for Rio Tinto in its quest to fend off the overtures from BHP Billiton. It is, after all, still in the early stages of digesting Alcan, acquired for $US38 billion last year.

The same influences that have hurt Alumina and its partner Alcoa, ripping $85 million from Alumina's earnings base, would also be impacting Alcan. Lower aluminium prices, higher $A/$US exchange rates, increased freight and energy costs, higher borrowing costs and higher input costs generally are hitting the producers even as economic activity in the US and Europe is slowing.

Rio paid what by any standard was a high price for Alcan – 65 per cent higher than its previous record high and a third, or $10 billion, more than Alcoa had bid. The question raised by Alumina's downgrade is whether it paid too much – whether it paid top of the cycle prices even as the cycle was turning.

The answer, of course, isn't straightforward. Rio acquired Alcan in a fiercely-contested auction and is thought to have only narrowly outbid Brazil's Vale (formerly CVRD). It paid what was necessary to win the contest

It was prepared to pay a massive premium for two broad reasons. One was that Alcan was an almost unique opportunity to reshape the aluminium industry and uniquely complementary to Rio's own interests in the sector. The other was that Rio was taking a long-run view of the prospects for aluminium, where it believes the metal has lagged the rest of the commodity cycle but will inevitably experience the same China-driven surge in demand and tightness in the supply/demand equation that has driven the rest of the resources sector.

That suggests that judgments on the success or otherwise of the Alcan acquisition can only be made in the medium to longer term. Rio would also, no doubt, point to the higher-than-expected synergies, with the original forecast of $US600 million a year almost instantly upgraded to $US940 million a year. They will offset some of the sector's negatives in the near term.

The contrary view would be that, whether the Alcan deals proves sensible or not in the longer term, Rio got its timing and funding wrong and therefore paid more than it should have and will have to wear the consequences of introducing a disappointing element to its results at the point where it is vulnerable to BHP. Making a fully debt-funded bid just as the sub-prime crisis was starting to bite has left the traditionally conservative Rio more leveraged than it would be comfortable with.

Rio is fortunate that it doesn't have to produce its 2007 results, and the commentary around them, until 13 February – a week after the UK Takeover Panel's deadline for BHP to "put up or shut up” – to make a bid or go away for at least six months. (It may not be luck, as BHP lobbied the panel for a date beyond the results announcement and Rio for an earlier deadline).

The fortuitous timing may not mean much if BHP bids rather than walks away. A disappointing Rio result would swing sentiment towards the bidder.

Even if BHP were to "shut up”, that would be purely tactical, with BHP giving the market six months to strip the substantial takeover premium from the Rio share price. Marius Kloppers wasn't appointed chief executive of BHP to make one half-hearted thrust at Rio and then retreat at the first setback.

It is more likely that BHP will bid, probably on the same terms as the 3:1 share swap Rio has already rejected, or perhaps even at some lesser value to inject a bit of fear (BHP would say sense) into the market's expectations of value.

BHP could argue that the current terms reflected a premium for obtaining the Rio board's endorsement and a straightforward and relatively efficient transaction and therefore, if forced to go hostile, the offer should be lower. That would unsettle the market and perhaps create some external pressure on Rio to negotiate with its suitor. Particularly if the offer was made against a backdrop of disappointment with the early post-Alcan Rio results.