Rio Tinto Deal Blows Up

Rio Tinto can say goodbye to its $19 billion equity and convertible bond deal with China Aluminium (Chinalco) at least in its present form. Opposition to it was already gathering nationalist momentum in Australia and shareholder momentum in London.

Now China's rejection of Coca-Cola's bid for leading fruit juice maker, Hong Kong-listed Huiyuan will immeasurably strengthen the hand of those who claim that China expects investment access rights which it refuses to others.

Even before the rejection, Australian critics were making much of the fact that although China is open to foreign investment in most fields, foreign entry into mining is tightly restricted.

China has rejected the Cocoa-Cola bid on monopoly grounds. Huiyuan currently has some 20 percent of the fruit drinks market and 40 percent of the pure fruit juice market. The combined share of the two companies would be 40 percent or so of the overall fast growing mainland juice and fruit drinks market.This would not normally be regarded in China as a monopoly level particularly in an industry where competition is fierce and the entry costs for local regional newcomers not very high. Nor is fruit juice by an definition a key national industry to be kept in Chinese hands.

Instead the government has clearly responded to a wave of nationalist sentiment against foreign takeover of a brand which is both very well known – it currently has double Coca-Cola's share of the juice market – and is regarded as a high quality and reliable brand. The goodwill attached to Huiyuan's brand name is especially valuable give then scandals which have hit many Chinese food products companies, most notably the milk industry found to have regularly adulterated its products with melamine.

At another time, this episode would probably have been regarded as just one of those obstacles that foreign investment faces from time to time in almost all countries. China like some other countries is much more open to greenfield investment than to acquisitions of existing, locally owned enterprises. But it came hard on the heels of Australia announcing postponement to June of the decision by its Foreign Investment Review Board (FIRB) on the Chinalco/Rio deal. Under this Chinalco would acquire direct stakes both in some of Rio's mines, including iron ore and copper, amd bonds which on conversion would take its stake in the holding company to18 percent.

It is arguable whether or not the price being offered by Chinalco is adequate or not. It is certainly above current market values for Rio and many other mining stocks. Rio has the added problem of having to raise $9 billion in cash by October to meet debt repayments. On the other hand, on a net present value basis it may be viewed as cheap.

However what is really sticking in the throat of many Australian analysts is not the price but the side agreements which are part of the deal. Not only would Chinalco get two seats on Rio's main board but a set of agreements covering a range of key issues, including production and marketing.

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In other words, China's state company would have a major say in the management of a major supplier to China not only of alumina and bauxite but of iron ore and copper. For China the cost and direct equity percentage acquired are probably far less important than a key role in its investment and marketing policies. Its goal is to minimize the long term price and maximize security of supply of these minerals. It is particularly keen to gain some leverage over iron ore, an industry dominated by a handful of Australian and Brazilian exporters. Rio's aim should be to maximize long term returns, which means keeping control of investment and production policy.

The other beneficiaries from the deal would be the incompetent, London-based board and American chief executive Tom Albanese whose arrogance and greed got Rio into its current mess. He needs the deal to save his own job. Albanese's stewardship has been the mining industry's equivalent to AIG – and the various culprits have been collecting big bonuses! That Albanese is still there, after buying Alcan with debt at the top of the market then refusing an offer from BHP should by rights have consigned him to the dustbin of corporate history, is amazing. But thanks to a board of fellow incompetents he is still in place trying to sell this deal, and save his own skin, to investors and the Australian government.

The closer Rio gets to that debt deadline the harder it may be to resist Chinalco. But if the FIRB does reject it, or the board has second thoughts, Rio still has the option of a rights issue. That would be unpopular with many shareholders who would prefer to see the Chinese money rather than their own bail out Rio. But it is feasible – though would doubtless be the end of Albanese.

Alternatively in the prospect that BHP, which is also Anglo-Australian but based in Melbourne, either renewing its bid for the whole company, or doing a deal to buy some key assets and keep them in semi-Australian hands and out of the clutches of a customer. Although Rio is a rival to BHP in some respects, they have a common interest in keeping keeping control of production and marketing in the hands of themselves the producers.

Australia is unlikely to start knocking back Chinese investment on a regular basis. It need the capital and it needs to ensure that China looks to Australia as a preferred supplier which offers security both in supply and investment terms. However, as there are already two other significant China deals up for FIRB review, one for a Hunan Valin Iron stake in newcomer iron ore miner Fortescue and one from state-owned metals trader and investor Minmetals to rescue zinc miner Oz Minerals, there is now a strong possibility that it will display openness by allowing through the smaller deals but reject the Rio one on national interest grounds.

The Chinese could not complain too much. Not only because of their own policies but because it is only years since Australia rejected a bid by Anglo-Dutch group Shell for Woodside, owner of gas deposits on the Northwest Shelf. Although a very large deposit, it was arguably less significant for Australia than allowing a Chinese state entity to be major influence in the management of Australia's second largest mining company.