Rio Tinto & Implications

I had expected China to join in the battle for Rio Tinto following BHP Billiton's bid a couple of weeks back. Now that Rio Tinto has rejected a merger proposal from its largest rival, BHP Billiton, which valued Rio at about US$142 billion (HK$1.10 trillion), this creates an opening for China. BHP Billiton, Rio Tinto and Brazil's Cia Vale do Rio Doce are the three biggest mining companies in the world. Together they account for 70% of the globe's total iron ore output.

The potential merger of BHP and Rio Tinto aroused concerns among China's steelmakers and the central government as China is the world's top steel consumer. China Development Bank has secretly bought about 1% in Rio Tinto during the week that BHP Billiton offered the hostile bid. Despite no confirmation, the move was seen as a move by China to ensure there will be no combined entity dictating iron ore pricing.

China's newly set up sovereign wealth fund, China Investment Co, will join the bidding for the world's second-largest mining group, Rio Tinto, together with Boasteel, Shougang and Angang. China's collective bid could be around US$200bn. Well, thanks to BHP Billiton, they have now stirred a hornet's nest. US$200bn will see China bidding 40% higher than BHP's offer. Plus, BHP's offer was an all share offer, that should be easily topped by China.

Why the fervour to snap up Rio Tinto? Well, China already takes half of all iron ore from BHP. As mentioned before, the top 3 producers control 70% of the global iron ore production. A tie up between BHP & Rio would strengthen the producers pricing power and put China at their mercy.

BHP would probably back off as investors have been hammering BHP's share price following the audacious bid. Following the bid for Rio Tinto, BHP Billiton's share has seen some US$32bn being erased from its market cap.

BHP's bid is not so much to control prices but for the company to post strong earnings growth. The relatively new CEO of BHP, Marius Kloppers probably sees the bid as the easiest way to grow considering the size of BHP. Return on assets at BHP has averaged 35% during the past five years, compared with 32% for Rio Tinto. BHP's five-year growth in earnings before interest, tax, depreciation and amortization also outstrips Rio's, 29% to 26%. What is likely to happen is BHP backing down, and the Chinese steel companies gradually accumulating strategic stakes in Rio Tinto and Brazil's Cia Vale in order to preempt something like this happening in the future. The Chinese don't really want to take over Rio Tinto at this point in time, its too sensitive and aggressive. Nothing to stop them from accumulating small strategic stakes though.

Posco, JFE and Chinese steelmakers attacked the BHP's bid proposal, saying it would be harmful to the iron-ore market. The Brussels-based International Iron & Steel Institute, which represents ArcelorMittal and 18 others among the world's 20 largest steelmakers, urged regulators to block the bid.

Steelmakers in China are already facing an increase of as much as 50% in prices for iron ore over the last 6 months. Prices have tripled to US$72.11 a metric ton for Brazilian iron ore the past five years. About 1.6 tons of iron ore are needed to make a ton of steel. Hence it is pretty important to China that they "control" iron ore prices to some extent.