Spotlight on Chinalco's investment in Rio Tinto

The Australian government defers its decision on Chinalco's investment in Rio Tinto for 90 days, while a large investor in Rio questions the deal struck with China.

Yesterday was a difficult day for mining company Rio Tinto. Australia's investment watchdog, the Foreign Investment Review Board (FIRB), announced it will defer a decision on a proposed investment by Chinese state-owned enterprise Aluminum Corporation of China (Chinalco) in Rio Tinto for a period of 90 days. And a Rio Tinto shareholder, Australian Foundation Investment (AFI), went public with its disquiet over how much control Chinalco could potentially exert over Rio Tinto should the deal progress.

Rio Tinto issued a statement to the Australian Securities Exchange enclosing the gazetted notice and saying the deferral by FIRB was "as expected".

Under the terms of the deal, which was announced on February 12, diversified metals and mining company Chinalco will invest $19.5 billion in Rio Tinto. The amount is split between $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 the SOE's shareholding in the Rio Tinto Group to 18% upon conversion, from 9.3% currently. Chinalco's stake in the joint ventures will range from 15% to 50%.

The FIRB extension suggests Rio Tinto may not be able to close the deal by the second quarter of 2009 -- the Australian company told its shareholders in February that the deal was slated for closure by "Q2/Q3 2009". It is not immediately clear how the delay will impact the repayment schedule for Rio Tinto's $39 billion debt burden, but retiring part of this debt was a key driver for the deal with Chinalco.

It is debatable whether Rio Tinto did expect the FIRB extension, but it is unlikely the mining company expected a shareholder to publicly voice its opposition to the deal on the very same day as the FIRB announcement. In a shareholder presentation posted on the ASX yesterday, AFI tabled a list of reservations about Chinalco's investment.

AFI is Australia's largest listed investment company with most of its portfolio invested in Australian equities. Its long-term investment portfolio as of February 28 amounted to A$3.2 billion ($2.1 billion), invested in approximately 100 securities. AFI's holding in Rio was valued at A$111.9 million on February 28, making the investment the eighth largest among its holdings in ordinary securities.

In a presentation with the quirky title "We cannot control the tide, all we can do is make sure the boat doesn't leak", AFI briefed investors of its financial situation. AFI said it was assessing the Chinalco investment from the perspective of being a long-term investor in Rio Tinto. It noted that existing shareholders had not been allowed to participate in a recapitalisation of Rio Tinto and instead preference was given to one shareholder, Chinalco. AFI also said significant influence has been given to Chinalco with no premium paid by the Chinese SOE.

Rio Tinto's CEO Tom Albanese has earlier 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.

"We are deeply concerned about Chinalco becoming involved with the running of the business," AFI went on to say in the presentation. Specific concerns cited by AFI include the fact that Chinalco is a "sovereign government, customer [and] competitor"; is being given two seats on the parent [Rio Tinto] board; and will be integrated into the decision making process and information flows. It also highlighted the potential for conflicts of interest over investment decisions. AFI has shared its concerns with Rio Tinto, the investment manager added.

Rio Tinto is advised by Credit Suisse and Morgan Stanley, with Allens Arthur Robinson and Linklaters providing legal advice. Nomura is advising Chinalco along with Blackstone, China International Capital Corporation and J.P. Morgan, while Clifford Chance is providing legal advice.

Rio's share price fell 2.5% on the ASX yesterday to close at A$50.75. It is still trading in the same ballpark range as it was when Chinalco negotiated the convertible bonds -- the share price was at A$42.15 on January 30 before the market got whiff of the deal and traded up to A$49.40 on February 10, the last trading day before details of the deal were announced. Chinalco is buying bonds which are convertible at $45 per share and $60 per share, respectively, and is likely to be keenly watching the market price -- especially in light of the dismal performance of a number of investments by Chinese companies in listed global firms.

Chinalco bought its initial 9% stake in Rio Tinto at £60 ($84.9) per share, a hefty 21% premium to the prevailing share price in January 2008 when it launched the dawn raid. With its second investment, Chinalco will be seeking to average out its acquisition cost and seek some management control.

Citi initiated coverage on Chinalco's Hong Kong-listed subsidiary Chalco earlier this month with a sell recommendation. Citi estimates that all of Chalco's businesses -- bauxite, alumina and aluminium mines -- are losing money currently and that Chalco's losses this year will destroy 9% of equity value. Citi is also concerned about increasing competitions in alumina, aluminium as well as fabrication.

In case approvals for the Rio deal take too long, Chinalco could decide to conserve resources for its subsidiary Chalco or for other opportunities. Under different circumstances, a consortium of private equity firm Bain and Company and China's Huawei Technologies decided to withdraw their offer for US networking firm 3Com in March last year when US regulators kept delaying approvals for the deal.

Meanwhile, other Chinese and Australian firms trying to forge alliances are likely to be watching developments on the Chinalco-Rio Tinto deal keenly from the sidelines.

Last week, Hunan Valin Iron and Steel Group Company (Valin) agreed to increase its stake in Australia's Fortescue Metals Group to 17.4% by paying another A$87 million for new shares. Last month Valin agreed to acquire a 16.5% stake in Fortescue for a total outlay of A$1.24 billion.

Also in February, Melbourne-headquartered Oz Minerals turned to another SOE, China Minmetals Corporation, for a bailout. Minmetals has agreed to buy 100% of Oz Minerals for an equity value of A$2.6 billion. Oz Minerals has A$1.2 billion of debt due to be refinanced shortly.

Neither the Valin nor Minmetals deals have been approved by FIRB at this point. And their fates could well be linked to what happens to Chinalco.

¬ Haymarket Media Limited. All rights reserved.
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