Why BHP can't lose

I wanted to wait a day or two to respond to BHP's interim profit, hostile bid for Rio Tinto, and its subsequent rejection. Sometimes you just need a little time to digest all the events and work out how to respond to them. More often than not the kneejerk reaction is the wrong one.

First, I think Wednesday's 8% fall in BHP shares was clearly not a direct investor response to the first-half profit numbers. I think the profit had nothing to do with the heavy share price response. The fall in the stock was clearly a response from hedge funds, arbitrageurs, and traders to the firm and hostile all-scrip bid for Rio Tinto. The move on Rio was the sole driver and sole topic in BHP trading this week with the strong profit numbers completely overshadowed

In hindsight, I suspect that was always going to be the case, one way or another. Even sitting at the results presentation you could just tell the whole room was waiting for chief executive Marius Kloppers to get on to the topic of the Rio bid. Just about all the questions of management were about the bid strategy and for the time being the market is most likely to ignore BHP's strong fundamentals.

Unfortunately, in the short-term BHP shareholders are going to be held hostage to the trading whims of those playing the arbitrage between BHP and Rio shares, yet that is a double-edged sword as the more hedge funds and arbitrageurs get involved in the deal the more likely BHP is to succeed in its approach to Rio shareholders. It is short-term share price pain for potentially very large long-term gain. The weakness in BHP shares is what I would call a "necessary evil" and BHP does require hedge funds to do some of the work for them building a "stake" in Rio as I have written before.

While all the headlines and all the trading was focused on the bid for Rio it would be remiss of me not to focus on the strong interim earnings and the outlook for commodities. If you own BHP shares or buy BHP shares you are buying BHP's earnings right now. You are not buying Rio's earnings or anything else despite that premise dominating the liquidity in BHP trading right now. BHP's view on the cycle is important to your view on ALL other Australian resource stocks and I'll always choose to listen to their "insider" opinion.

It is amazing that making $US6 billion in a half is completely overlooked by the market. EBIT of $US9.6 billion was also ignored by the market as was net operating cash flow of $US7.9 billion.

Some commentators described BHP's profit as "disappointing" but I still find it surprising that making $US6 billion is disappointing to anyone, particularly when the NPAT was dragged down a fraction by the effective tax rate rising from 28% to 32%. Considering the high tax rate, the quality of the result is excellent. EBIT grew 6% driven by iron ore, base metals and petroleum as the divisional EBIT split shows. That petroleum division for BHP is a big money spinner and something Rio does not have.

Net operating cash flows rose by 10.6% to $US7.9 billion, which is probably a number bigger than the entire US banking sector right now! That cash flow gives BHP all the strategic options and clearly higher total returns to shareholders are part of that strategy. The interim dividend was increased 45% to US29¢, with BHP saying "demonstrating confidence in our cash generating ability and strategy". BHP has net gearing of just 28%.

Of course operational costs, the Achilles heel of the resource industry right now, were extremely well controlled and reaffirm my long-held view that BHP from the top down is a very tight ship. To have cost growth of just 1.9% was an outstanding managerial effort considering the macro cost environment. You will not see any other resource company contain costs as well as BHP.

This was a strong set of numbers and it's worth remembering the stock is cum a US29¢ dividend. The outlook was balanced but again reinforced the point that "one unit of GDP growth in China is five times as metal-intense as one unit of US GDP growth".

Despite the kneejerk trading reaction to the Rio bid, BHP remains Australia's strongest company. There is no doubt about this. Return on capital is 30% and EBIT margins are 44%, while interest cover is 40 times. Yes, interest cover is 40 times and that confirms this is a low-risk company in a volatile environment. At the moment the hedge funds have control of the stock from the short side, but the company has never been in stronger financial or strategic shape. All this for 11 times 2008-09 earnings. That is genuine risk-adjusted value in my way of thinking.

The offer for Rio Tinto

My stated view was that BHP would never bid "against themselves" or "overpay" for Rio Tinto. I could not see any outcome where Rio shareholders ended up with a controlling stake in the merged entity in return for contributing 40% of merged group earnings. I always predicted BHP would lob a firm bid for Rio on the "put up or shut up" deadline, but I was wrong in forecasting that bid to be the three for one offer.

I believed there was absolutely no reason for BHP to improve their "proposed 3:1" offer for Rio considering global economic and market volatility and the fact no other bidder had emerged for Rio despite the long courtship. I suspect Chinalco's superbly executed and timed raid changed all that and from that point BHP had competition of some form. I still doubt Chinalco's true intentions are honourable but only time will tell on that front. I maintain the view that BHP is the only truly qualified bidder for the whole Rio house and the only one that can extract the synergies and allow Rio shareholders to participate in the upside with the clear advantage of rollover relief. The carrot at the end of a completed deal is a proposed $US30 billion buyback (nice order to get, I'll be waiting by the phone!)

As I had speculated, BHP first approached Rio about a merger of equals in early 2007. That was confirmed by BHP yesterday. That approach was rejected (the Alcan bid followed) as was the next approach of 3:1 late last year. Wednesday’s bid, while accurately described as the first firm bid, was in reality the third proposal BHP had put to the Rio board but the first it had put directly to Rio shareholders. BHP had no luck in initiating talks with the Rio board and has chosen the only other alternative, which is to go directly to Rio shareholders, remembering many of them are BHP shareholders as well. The bid, at 3.4 for one, is pitched at a level that some Rio investors have told BHP they would consider. The Rio board again rejected the new offer this week, claiming the offer undervalued the company. That's three approaches and three rejections. I have spoken to domestic investors who are increasingly worried that Rio may overplay its hand here.

The bid is pitched at nearly a 50% premium to the pre-bid speculation BHP/Rio spread relationship level, which is a record for a resource company merger of this scale. In addition, the all-scrip proposal pitched at a nearly 50% premium compares extremely favourably with the other friendly global share mergers in the resources industry. In the oil sector, the Exxon-Mobil merger premium was 27%, BP–Amoco was 23% and Chevron–Texaco was 18%. In the industrial sector Procter Gamble–Gillette and AT&T–Bell South were both 18%.

It genuinely surprises me that the Rio board wouldn't at least sit down and talk to BHP about this offer. I suspect their shareholders would expect them to also. Surely 3.4:1 gets you in the door, particularly given that many investors believe the bid is now pitched at the right level.

Clearly, BHP didn't want to antagonise Rio shareholders by simply formalising a bid that their board had already rejected. I think it was a conciliatory move to 3.4:1 to win over Rio shareholders and show them that BHP respects them.

My view is that on a standalone basis Rio shares would be trading significantly below today's prices and BHP significantly higher (huge shorts). I suspect the ratio, all things being equal, would be closer to 2.5 times.

Why didn't BHP walk, watch Rio shares fall 30% and then come back in six months? This is a question I have heard from a lot of BHP and Rio shareholders. The answer in my view is that in these big prize games you don't play games with the target shareholders. That "walk" strategy would have only antagonised Rio shareholders and would have been akin to a form of market bullying.

It's fair to say I have been so vocal on this BHP/Rio transaction because I want it to happen. This is an industry changing transaction that releases upside only available if the two sets of assets are put together. It's a win-win for both sets of shareholders and creates the genuine "super major" that would be a core portfolio holding of all global investors.

I am not anti-Rio. Rio is a fine company with fine assets that have underperformed BHP's assets. But I don't agree that the Chinalco raid sets a new valuation for the company, and I don't believe Chinalco will ever bid for the entire company. As the Financial Times’ Lex column accurately writes, "strategic investors, by their nature, overpay". That raid doesn't set any benchmark price in my opinion, particularly if our views about its real motivation prove correct.

And keep in mind the speculation that Chinalco is an agent for the Chinese Government and has access to $US120 billion in funds from the Chinese Investment Corporation. If the speculation is correct, then the Australian Government through the Foreign Investment Review Board (FIRB) would find it impossible to allow a Rio takeover by a Chinese sovereign wealth fund.

The whole issue is probably irrelevant considering I think there is little chance of the Australian Government allowing a Chinese takeover of Rio, thereby gaining partial control of a strategic stake in the Pilbara.

Obviously I didn't expect BHP to increase the offer to a firm bid of 3.4:1; however I am not surprised management felt under no obligation to match the 4:1 implied Chinese consortium offer. Despite the naive expectations of conflicted parties promoting Rio's cause, there is no way BHP could possibly justify bidding 4:1 and ceding 48% to Rio shareholders considering a 40% profit contribution to the merged entity. Quite rightly management has refused to dilute BHP shareholders.

I believe BHP has made the correct decision to improve the offer to a generous 3.4:1 level without diluting shareholders. In addition, considering Rio management refuses to engage, BHP's only option is to allow Rio shareholders the opportunity to vote on the proposed merger.

The ball is now firmly in the Rio board’s hands. I think BHP have done all they can. The question has to be asked after last night's rejection of the 3.4:1 if the Rio board want to be taken over at all? Their response to the first BHP approach was to pay a record price for Alcan using cash. Their response to the second approach was "no" as it was to the third approach. Some conspiracy theorists in the market now believe that the arrival of the Chinese on the register may well have been encouraged by Rio. I don't believe that but if you didn't want to be taken over by BHP the perfect white knight spoiler is the Chinese. It's the perfect defence: see off BHP and win favour with the Chinese.

Due to regulatory approvals, etc, this will be a very slow process. This deal, under all scenarios, will not complete in less than 12 months and for hedge funds the time value of holding the trade will become an issue. There are clear completion risks to the deal and this will drag on.

BHP has been a highly volatile trading stock of late (40% trading range) due to the unprecedented hedge fund involvement that deals bring, but on all fundamental analysis BHP remains a strong medium-term buy. We are facing a period of the share price being controlled by hedge funds, arbitrageurs, and traders, which may lead to a period of fundamentals being ignored; it doesn't mean the shares will fall, it means they will be volatile inside a trading range of $35 to $40. BHP is a heads you win, tails you win investment proposition. If it gets Rio the stock will be re-rated; if it misses Rio, it will embark on huge buyback programs that will see the stock re-rated.

The last point I will make is actually about global investment banking. It concerns me that some have now reportedly withdrawn funding from two marquee transactions in Vale's rumoured bid for Xstrata and BHP's offer for Rio Tinto. You would only pull out of funding these marquee transactions, in my opinion, if you had genuine liquidity issues yourself.

The question has to be asked: Is there something seriously wrong out there again? I don't know the answer to that but my gut suggests something is not quite right. Why wouldn't you finance a company with 40 times interest cover? Why wouldn't you want to be involved in the two biggest resource takeovers in history? Investment banks love league tables, particularly US investment banks. Until some clarity is brought to the issue of why global investment banks are dropping out of funding syndicates I would be holding fire on buying global investment bank stocks. There may be another leg down in that sector and global markets if our concerns prove valid. That's another reason the Rio board should engage BHP.

Charlie Aitken, a director of Southern Cross Equities, may have interests in any of the stocks mentioned.