Why APEC visitors came bearing chequebooks

It was certainly an eventful week in Sydney last week as the APEC circus rolled into town. The security was the tightest we have ever experienced, and fair enough considering the roll call of world leaders who turned up.

Even the Australian Air Force’s F/A 18 Hornets got a workout (luckily both were operational at the time), being scrambled to intercept a single-engine Cessna flown by a Hunters Hill solicitor who had strayed into the no-fly zone. The Chaser can get a fake motorcade within 10 metres of the red zone, but don’t fly that Cessna over Penrith!

The long-term significance of the APEC conference on the Australian economy cannot be underestimated. Long after the barriers have been taken away and the Hornets return to base, the APEC conference will be viewed as the recognition by the major world powers of the significance of Australia as a strategic commodity and energy supplier to the global economy.

These global conferences are usually characterised by well-rehearsed rhetoric and the inevitable back-slapping by fellow leaders followed by the usual empty promises. In many ways APEC was no different. The US was represented by the President George W Bush and an entourage of 250 staff including five chefs. Sure, Bush thought he was at an OPEC conference in “Austria”, but let’s just put that down to jetlag.

Despite the usual platitudes that dominate similar conferences, it would be very unwise to dismiss the presence of Bush and the leaders of China and Russia as unimportant. The usual political protocol demands that the major countries usually send anonymous trade delegates, vice-presidents or deputy prime ministers. However the attendance of President Hu and President Putin is very significant.

We all know Hu

The Chinese leader arrived a week and a half earlier to attend meetings with the senior management of major resource companies. In addition, a visit to rural Australia to visit sheep and cattle stations is similarly significant.

China views Australia as a strategic long-term trading partner and crucial supplier of hard and soft commodities. In fact, we believe agricultural exports will be as important as mineral exports in future decades. The Chinese urbanisation process is not solely driving a massive increase in base metal and energy demand. The inevitable rise in per capita incomes and changing lifestyle will drive a massive change in Chinese dietary habits to more Western-style food. It is not surprising that President Hu was looking at sheep instead of cuddling koalas.

President Vladimir Putin’s visit should be viewed in a similar context. The past diplomatic relationship between Russia and Australia could be described as lukewarm at best. In fact media reports suggested that in the past the Russian leader, while recognising our existence, never gave Australia a second thought. This is hardly a positive endorsement. Despite these issues, Putin became the first Russian leader in power to ever visit Australia, and that is a significant development.

There is little doubt that Putin has learned the harsh lessons of history after the fall of the Iron Curtain. As a result, considering the actions of Gazprom, the massive state energy utility, Russia is now following a path of economic superiority instead of military dominance. Clearly, Russia views Australia as a strategic commodity producer and trade partner in the same light as the Chinese Government.

Putin and Hu’s presence at APEC is a very strong endorsement for the Australian resource industry. Clearly two of the largest BRIC economies have announced their interest in securing reliable and long-term commodity supplies and Australia is the target.

China has accumulated $US1.3 trillion in foreign reserves and Russia has nearly $US400 billion. Both countries have publicly stated their intention is to use their foreign reserves in resource projects. It is no coincidence that Oleg Deripaska, majority owner of Russian aluminium giant Rusal (trying to IPO in London; personal wealth $US20 billion) and Alexander Medvedev, deputy chairman Gazprom (Market cap $US245 billion), accompanied Putin to Australia.

In addition, it comes as no surprise that China’s delegation also included Fu Chengyu, the chairman and chief executive of CNOOC (China National Offshore Oil Corporation), China’s second-largest oil and gas player (market cap $US52 billion); Wang Lili, senior executive vice-president of the Industrial and Commercial Bank of China (market cap $US255 billion); and Zhu Min, executive vice-president of the Bank of China (market cap $US235 billion).

I have long maintained that overseas corporates would exploit the undervaluation and positive fundamentals of Australian resource companies. However, the APEC conference confirmed that Chinese and Russian resource companies supported by the massive Government foreign reserves are targeting Australia.

I think this has very serious implications for domestic resource stocks. The first signs are already here with the Norilsk takeover of Lionore (LIM), the Magnitogorsk 5.3% stake in Fortescue Metals Group (FMG) and Russian oligarch Alisher Usmanov taking 19.9% of Mount Gibson (MGX). In addition, the Chinese steel company Ansteel has accumulated a major stake in Gindalbie (GBG). We can no longer say that the Chinese and Russians are coming for Australian resource companies. They are already here.

BHP/CVRD/RIO: tell them they’re dreaming

The trading market continues to get excited about the prospect of BHP Billiton and CVRD joining forces to take over Rio Tinto. The Rio rumour just won’t go away. It keeps resurfacing in a different form every few weeks, and in my opinion the rumour is being instigated from London.

I believe there is absolutely no chance of BHP joining with CVRD to bid for Rio Tinto. I believe what is occurring is that the Rio shareholders have been calling back into borrowed stock with the intention to vote of the RIO/Alcan merger. This has caused a short-squeeze which has been helped along with tailwind of the takeover rumour for Rio. This combination of short-term issues has seen Rio shares recover from a recent low under $80 to trade above $100 last week.

Call me a cynic, but it is important for Rio shares to be strong ahead of the shareholder vote on the Alcan deal. The way Rio shares were wallowing around the mid$80’s, despite repeated management presentations to shareholders, was not helpful to the deal. It seems something more than a coincidence that this well-timed takeover rumour arrived just when Rio shares needed support. I smell the work of investment bankers and hedge funds all over this.

There is no doubt in my mind that the Rio move on Alcan was a defensive move. It seems blatantly obvious that someone approached Rio (perhaps private equity) and then Rio decided its ungeared balance sheet needed to be put to work. That defensive move, including taking on $40 billion of debt, has worked in the short term to ward off any predators, particularly given the huge $US1 billion break fee any other party would have to pay if they had a hostile shot at Rio right now. Time will tell whether this was the right decision for Rio shareholders, but I believe diluting the wonderful iron ore earnings stream to become a geared aluminium exposure, where the Chinese are self-sufficient, is less than an ideal strategy.

The trading market seems to want to believe the rumour about BHP and CVRD bidding for Rio because BHP made a one-line comment in its results presentation about the style of asset it would consider acquiring if the opportunity presented itself. Rio clearly has a first-tier asset base with upstream, long-life, low-cost, expandable assets in politically stable operating environments. There is no doubt Rio’s assets are world class and would exceed BHP’s hurdle rates if acquired at an opportunistic price. However, that time is certainly not now, as Rio shares are certainly not “opportunistically priced”; they are commanding a P/E premium to BHP that we believe is completely unjustified.

BHP: it’s about organic growth

While the trading market has locked on to one line about acquisition policy in the BHP results presentation, it’s really worth remembering that the other 99% of the BHP outlook commentary was focused on the huge organic growth profile the company possesses. The whole thing focused on organic growth and the optionality in its project pipeline. The “jellybean jar” below is the chart that reinforces that optionality.

I find it extremely unlikely that BHP would, just two weeks after focusing all investor attention on its organic production growth profile, suddenly embark on the biggest takeover in global corporate history. I also find it extremely unlikely that BHP would need to team up with CVRD to do anything.

Although I certainly believe BHP under Marius Kloppers and the next generation will be a far more front foot company, it’s worth remembering that Marius Kloppers doesn’t actually take the controls until October 1. I find it extremely difficult to believe that the BHP board will sign off on a company transforming acquisition before the new chief executive has taken over, or even in the first six months of his tenure.

BHP: UK buyback trying to send you a message

Our strong belief remains that the best investment BHP can make at this point of time is in its own shares, particularly the discounted UK scrip. By its own actions, it seems BHP agrees. Since the full-year result, BHP has aggressively stepped up the rate of the UK on-market buyback. Last week, for example, BHP bought back, on market, 7,496,226 BHP plc shares, participating at levels significantly above most broker NPVs. The volume is roughly three times the average volume they have previously being buying back.

In the midst of a widely believed Rio takeover rumour, BHP bought more shares back in the UK last week than in any other week in the past 12 months at close to record high share prices. I believe that is BHP attempting to send the market a clear message. That message is that our strategy is what we clearly enunciated at the full-year results. That strategy is an organic growth strategy combined with strong capital management.

Remember, it was only two months ago that the world believed BHP was on the cusp of a tilt at Alcoa. We wrote in these notes, in fact an entire note (July 19: “BHP/ Alcoa, it’s just a hedge fund dream), that BHP would not bid for Alcoa as BHP would only be potentially interested in one Alcoa upstream asset. Since we wrote that note Alcoa shares have fallen from $US48.80 to $US35. Rio shareholders need to be aware that Alcoa shares fell 28% as the BHP takeover rumour proved to be completely inaccurate.

During all these takeover rumours involving BHP, the only thing BHP has actually done is buy back its own shares at an aggressive pace. The trading world seems to want to believe BHP will buy everything, but all it is doing is buying back its own shares while the stock continues to be rated as nothing more than a cyclical price taker, particularly in the UK market.

I believe BHP is a true global structural growth stock with massive barriers to entry and pure pricing power. It is increasingly a price maker, extracting pure economic rent, yet its shares remain priced as a basic cyclical price taker.

For example, industry sources tell me BHP recently sold three cargoes of iron ore into the spot market for $US104 a tonne FOB, 48% above the current Australian export iron ore contract price. This is important because it shows you BHP will trade iron ore where it gets the best price. It won’t simply be locked into the contract market as a price taker. This development of selling into the spot market is in sync with the strategy the company presented at the results.

BHP is starting to exercise its pricing power, and clearly becoming a price maker. We expect this trend to develop further under the new management team. Extracting maximum economic rent out of its own asset bases is the core of the strategy. That rent extraction funds greenfields and brownfields production growth, which in turn funds higher returns to shareholders.

Acquiring their own scrip

You must not mistake a more aggressive BHP for a more acquisitive BHP. The biggest “acquisition” it will make in the next 12 months will be BHP shares. I would expect the rate of on-market buying in the UK to continue at the current accelerated rate, while I would also expect some form of off-market buyback initiative in Australia in the next few months. BHP remains a strong buy and the world’s cheapest risk adjusted global growth stock.

While there is no doubt that misplaced US economic sentiment will continue to affect the short-term pricing of resource stocks (albeit to a lesser degree), there clearly is a medium-term message coming from the APEC conference. While President Bush brought the security, the Chinese and Russians brought the cash. Australia’s future is a BRIC one. Do not bet against it.

Charlie Aitken is a director of Southern Cross equities. He may have interests in any of the stocks mentioned.