Mining in sequence

Rio/Chinalco: Rio Tinto is right to scrap plan A and pursue plan B. Following a sharp rise in the Anglo-Australian miner’s share price, the terms of the $19.5 billion cash injection from Chinalco agreed back in February gave too much too cheaply to the Chinese state-owned aluminium company, Rio’s biggest shareholder and effectively its largest customer.

A Chinese solution may have made sense when Rio had few options to repay the whopping $19 billion of debt maturing in the next 16 months. In the original deal, Rio was set to get $12.3 billion from selling Chinalco interests in some of its best assets plus $7.2 billion from a bond convertible into shares at a price below the current market price.

With the market price up 40 per cent since the original Chinalco deal was announced, Rio’s position is much stronger. Shareholders were never happy to have a strategic solution to a financial problem. In any case, Rio and Chinalco appear not to have been able to agree on new terms.

A mega-rights issue now looks doable. Capital markets have improved substantially, as demonstrated by HSBC’s $20 billion fundraising. Bankers say Rio could get at least $12 billion underwritten, even if Chinalco which owns a 9 per cent stake didn’t take up its share. That would allow Rio to respect shareholder pre-emption rights and avoid sacrificing too much control to the Chinese.

A $12 billion issue wouldn’t close the financing gap, but it would give Rio time to plan for the next step. It should mine its own shareholders for as much funding as possible before seeking additional cash from asset sales. But if sales are necessary, a less weak balance sheet would put Rio in a better position to extract higher prices.

The most likely non-Chinese asset buyer is Rio’s cash-rich rival BHP Billiton. BHP has stepped back from its proposed merger of the two companies, but it is keen to take as much advantage as possible of its strong balance sheet. In the face of such a buyer, Rio’s shareholders will be grateful for a careful two-step approach to selling.