Chinalco ups ante for Rio Tinto

Aluminium Corporation of China (Chinalco) has agreed to invest a further $19.5 billion in Australian natural resources firm Rio Tinto in what will rank as China's largest outbound investment to date. The unlisted Chinese metals and mining firm will invest $12.3 billion in aluminium, copper and iron ore joint ventures and another $7.2 billion in two tranches of convertible bonds.

The bonds will increase Chinalco's shareholding in the Rio Tinto Group to 18% upon conversion. The bonds have a maturity of 60 years and are convertible at any time from 41 days after closing. The Australian bonds pay an annual coupon of 9% while the UK bonds pay 9.5%. $3.1 billion of the bonds will convert into Rio Tinto shares at a price of $45 per share and the balance $4.1 billion will convert at a price of $60 per share.

Chinalco's stake in the joint ventures will range from a 15% stake in the Hammersley iron ore project to a 50% ownership in the Yarwun aluminium project. In total, Chinalco will take a stake in nine projects. Rio Tinto and Chinalco will also set up an equally owned development fund of $500 million. Rio Tinto highligted that it has extensive experience of operating JVs with customers - as critics of the deal have commented that Chinalco's equity ownership in projects from which it sources product will give the Chinese firm control over pricing and supply - and the Chinalco JVs would be no different.

Chinalco will be entitled to nominate two non-executive directors to the Rio Tinto board as long as it owns 14.9% of Rio Tinto (assuming the bonds are converted) and one board seat if its ownership falls below 14.9% but remains above 9.9%.

It is a deal which it was impossible to keep under wraps. Earlier this month, Rio Tinto was forced to confirm that it was in discussion with Chinalco, even though it was clear that a deal announcement was some way off. On Wednesday this week, the Australian company once again noted "continued media speculation in connection with a possible transaction with Chinalco".

But it is not a deal which is universally supported. Rio Tinto's chairman elect Jim Leng resigned from the board of the firm on February 9 in a move widely perceived as a lack of support by him for the sale to Chinalco.

Meanwhile, BHP Billiton is understood to be lobbying against the Chinalco deal in Canberra on the grounds of national interest and could also table competing bids for some of the assets in which Chinalco has expressed an interest. The disquiet created by the attempt by a Chinese state-owned enterprise to up the ante for an Australian firm was evident from the fact that Australia's treasurer, Wayne Swan, announced new guidelines for evaluating foreign takeovers yesterday. The revision brought the issuance of convertible bonds under the ambit of the Foreign Acquisitions and Takeovers Act by treating them as equity and was obviously formulated on an urgent basis once terms of the Chinalco deal became known to the government.

Rio Tinto repeatedly stressed that this deal was the most value accretive of a number of strategic options under consideration since late last year. Rio Tinto maintains a dual listing with 23% floating on the Australian Securities Exchange and the balance 77% held through a London listing.

Rio Tinto will use the proceeds in part to prepay an $8.9 billion tranche of its Alcan credit facilities due in October 2009 and $10 billion due in October 2010.

Of Rio Tinto's long register of advisers on the defence of a hostile bid from BHP Billiton, Credit Suisse and Morgan Stanley managed to secure a role as financial advisers on this deal with Linklaters providing legal advice. The Lehman Brothers team, now at Nomura, which advised Chinalco on its initial acquisition, continued to work with the Chinese firm on the deal. Blackstone, China International Capital Corp and J.P. Morgan also secured roles advising Chinalco on the current deal, while Clifford Chance provided legal advice.

Rio Tinto also declared results yesterday, reporting a 38% rise in operating profit to $10.3 billion for calendar year 2008, but a drop in net profit to $3.7 billion, due largely to write-downs related to the group's aluminium business that could only be partially offset by asset sales.

The deal has been greeted with scepticism by some analysts. Goldman Sachs JBWere said on Tuesday: "The potential of high quality asset sales to reduce debt has the potential to be value destroying" and commented that the sale of assets for shares when the share price is well below net present value (NPV) is NPV-dilutive for existing shareholders.

In a research update issued after the deal was announced, Goldman Sachs JB Were estimated that Rio Tinto has sold the stakes in the joint ventures at a firm value to Ebitda multiple of 9.1 times. But on an adjustment for mid-cycle commodity prices, the multiple falls to 3.7 times. The brokerage firm goes on to comment that it believes implications of the deal are mixed for Rio Tinto as the company has had to agree a hefty interest cost on the convertible bonds -- a weighted coupon of 9.28% -- and "shareholders' interests in future growth from some of Rio's best assets is diluted".

On a media briefing call yesterday, Rio Tinto's CEO, Tom Albanese, stressed that "the valuation being paid by Chinalco would have looked good before the financial crisis and today [the valuations] look outstanding". Albanese suggested that Chinalco had paid 18% of Rio Tinto's current firm value for an 8% share of Ebitda. He also said that given market conditions the quantum of money being invested by Chinalco would have been difficult to raise via a rights issue and the premium being paid would have been difficult to achieve. Albanese also highlighted that the deal improves Rio Tinto's financial flexibility.

But the Australian media was not easily convinced. It repeatedly questioned whether Chinalco or China would have undue influence on Rio Tinto.

"I guess the world has changed since 2007 and any asset bought that year has come down in value," replied Albanese in response to a question about whether Rio Tinto had overpaid for its acquisition of Canadian aluminium producer Alcan in 2007.

The Chinalco deal is subject to approval by Australia's Foreign Investment Review Board and Albanese did not answer a question about whether the asset sales might proceed even if Chinalco does not receive approval to own more than 14.9% in Rio Tinto.

At least five times during the media call Albanese was forced to clarify that the earlier BHP Billiton offer was conditional and never reached fruition, but media seemed unconvinced that the Chinalco deal is preferable to a merger with BHP.