What is Rio Tinto Really Worth, BHP Billiton Would Like to Know

Winston Churchill is sitting at a dinner party, goes an old story. He asks the woman sitting next to him if she will sleep with him for one million pounds. The woman pauses to reflect but eventually says yes. Churchill then asks her if she’ll sleep with him for just one pound. The woman is offended. “What do you think I am, a prostitute?” she asks. “Madam,” Churchill says coolly, “We’ve already established what you are, now we’re just haggling over the price.”

We’ve now established that Rio Tinto (ASX: RIO) is for sale. We are now haggling over what its worth.

Today’s issue is heavy on charts and an analysis of the Rio Tinto / BHP Billiton drama. But there was news in the market. Yesterday was horrible. BHP Billiton (ASX: BHP) fell the most in twenty years as its own shareholders got cold feet. The overnight from the U.S. lead was inconclusive, as we expect it to be most of this year.

So who wants Rio Tinto more? BHP Billiton or China?

The reality is that what the ore of the Pilbara is worth depends on who you ask. And it depends on if you want to sell it a profit, or it plays a role in your grand national strategy of global economic ascendancy and resource security.

In rejecting BHP Billiton’s 3.4 for 1 share offer, Rio’s Paul Skinner told investors that the offer, “while improved, still fail to recognise the underlying value of Rio Tinto’s quality assets and prospectsOur plans are unchanged, and will remain so unless a proposal is made that fully reflects the value of Rio.”

BHP Billiton’s second bid is a 14% increase over the first one. It values Rio Tinto at about A$165 billion. That’s about 12 times Rio Tinto’s 2006 earnings before interest, taxes, depreciation, and amortisation (EBITDA). Goldman Sachs and Citigroup were convinced it was a fair enough valuation (or happy enough to have the business) that they agreed to a US$55 billion loan to help BHP Billiton finance a post-deal share buy back.

In the middle of an epic credit crunch, it’s the largest loan ever for what would be the second-largest takeover (behind Vodafone and Mannesman in 1999). The takeover would create the world’s largest miner and undisputed colossus of coal and iron ore. It would also be the third largest-company in the world by market-cap, just behind Exxon Mobil and GE. And it’s all happening just twenty minutes from our desk here in Melbourne.

Despite all the gaudy numbers, the reality is that Rio Tinto may still be worth a lot more than BHP Billiton has offered.

Back in November, private equity firm Blackstone said that Rio Tinto’s Pilbara iron operations alone-based on existing proven reserves-could be worth US$110 billion. One of Blackstone’s shareholders, you may recall, is the China State Investment Company, which anted up US$3 billion last May for a 10% stake.

Is Blackstone’s valuation bogus? BHP Billiton made its first offer for Rio Tinto on November 8th of last year. Just a week later, Blackstone came out with its valuation of Rio Tinto’s ore assets, which essentially suggested that Rio Tinto’s ore business alone was worth nearly as much as BHP Billiton’s bid for the entire portfolio of Rio Tinto’s assets (including uranium, copper, gold, talc, and zinc).

Everyone knows that Rio Tinto can expand its Pilbara production quickly (it plans to do so, in fact.) That’s what makes it so attractive to BHP Billiton. Rio Tinto’s pipeline of new projects is closer to production than BHP Billiton’s. More importantly, Rio Tinto has the superior asset portfolio. The figure below, taken from BHP Billiton’s January briefing to investors on the Pilbara, shows how rich the area is in ore, though it probably understates the quality of Rio’s unexplored and undeveloped tenements.

The Pilbara-the heart of Australia’s “red gold” rush
Rio Tinto and BHP Billiton Reserves

Ultimately, you can’t take out more profit from a business than it generates in earnings growth. BHP Billiton is eager for Rio Tinto’s assets in large part because the profit margins on high-grade hematite ore from the Pilbara are so high (see figure below).

FY 07 WA Iron Ore EBITDA Margin

In its own presentation to investors, Rio Tinto showed that it thinks there is a lot more growth in its business than BHP Billiton has accounted for. The main reason for that? China, of course.

China Commodity Demand

But make no mistake. The key commodity here is iron ore. According to the figures below, Rio Tinto reckons it’s in a far stronger position to benefit from Chinese demand than BHP Billiton, with better tenements and better mineralization.

Iron Ore the Pilbara//www.marketsandmoney.com.au/images/20080207DRD.png

Pilbara Iron Ore Reserves

The only reason it would make sense to pay more for a business than its future earnings is if you weren’t concerned about making a profit. You would have to have some other concern, like access to a key ingredient in your historical development and industrialization.

Let’s see if we hear from China this week.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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3 Comments on "What is Rio Tinto Really Worth, BHP Billiton Would Like to Know"

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Coffee Addict

Yeah. Rios assets are probably underperforming due to infrastructure constraints that affect the earning side of the P/E equation. So what!

It is ridiculous to assign credence to a limited number of financial indicators that are a narrowly focussed, short term and arbitrary. But I hear ongoing drivel about P/E ratios night after night, day after day at nauseam within the financial media.

Rios long term value obviously extends way beyond existing notified reserves (impacting Price) and the current capacity to dig it out (earnings).


The Daily Reckoning is truly excellent, as is this article Dan. I wonder if John Howard’s nephew is still holding his esteemed position within Rio?…

Jason Foong

What is the fair exchange ratio ?
Offer of 3.4 to 1 gives RIO owners 44% of the merged group.
The question is what porportion of value of RIO & BHPB in the merge group ?

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