05/12/2006 - 22:00

The barbarians are gathering

05/12/2006 - 22:00

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If cash really is king in the investment world, and the investment world is being shaken by private equity funds seeking cash to fund their debt loads, then surely the game to be played by investors keen to play ‘pick the takeover target’ involves stocks loaded with cash.

Accept that logic, and disregard the debate over private equity (good or bad?) and you inevitably head for the Australian resources sector, where companies in production are spinning off cash by the truckload.

Take Rio Tinto for example. In the June half-year it posted earnings before interest, tax, depreciation and amortisation of $US6.2 billion, which meant that interest payments were covered 95 times. On some recent estimates, interest cover has blown out even further, to 110 times.

For anyone familiar with the way business works, these are astonishing numbers, which leads to two questions: (a) why has Rio Tinto got any debt at all; and (b) imagine the gearing potential available to a private equity raider who could dump a mountain of debt onto the company while reaping monstrous fees for himself and his fat cat clients.

Rio Tinto is not alone in the resource cash-flow stakes. BHP Billiton is estimated to have an interest cover of around 250 times, Alumina 50 times and Oxiana 50 times.

Until now, the sensible answer to suggestions that companies like this are takeover targets for their cash has been “resources are too cyclical”. In other words, no-one actually believed that the cash would flow strongly forever, and that the commodity price cycle would go into reverse, which would inhibit future dividend and debt-servicing ability.

Two things have changed that view, to produce a situation that Briefcase suggests is perfectly suited to that dreadful expression from the dot.com boom of 10-years ago – ‘a paradigm shift’.

First, there is the hardy band of true believers who argue vehemently that this commodity price cycle really (truly-rooly, cross my heart) is different. It is a super-cycle that will be stronger for longer.

Second, there is the rise of the ‘private equiteers’, who (as Briefcase explained last week) have re-invented asset stripping and the delights of excess debt, in a dead-set re-run of the way Alan Bond, Christopher Skase, and others behaved in an earlier generation.

These debt tragics, and their eager followers, will do well for a while. The problem is guessing when the music will stop, leaving the last man left holding a worthless fistful of paper while the banks take possession of the asset.

If the super-cycle forecasters are right, the grim day of re-possession could be some time off and great speculative profits will be made.

If the super-cycle does not last forever (and nothing ever does), then today’s dance with debt has a built in use-by date, which is Briefcase code for enter at your own peril.

•••

Having issued its standard ‘wealth warning’ about pursuing any investment strategy suggested by Briefcase, it’s important to go back and look at one of the company’s named for its high cash-generating capacity, Rio Tinto.

Popular wisdom says that this particular Anglo/Australian miner is too big for a private equity raid, and too complex because of its split personality created by dual listings on the Australian and London stock exchanges.

Don’t you believe it.

At a market value of around $A75 billion, based on the London value assigned to Rio Tinto PLC (say $US55 billion), the company is actually being valued at about the same level as the funds managed by just one US-based private equity fund, the Carlyle Group.

Of equal interest, it is the Carlyle Group that opened an office in Sydney a couple of months ago to aid its search for Australian assets. And, it was the boss of the Carlyle Group, David Rubenstein, who said in an interview three weeks ago that Australian resource stocks were on his shopping list, and he was more confident of predicting future commodity prices.

If you tick off that checklist you find that price for private equiteers is not an issue. Why? Because they really don’t care. The managers are not spending their own money, and the fee flow is fantastic, as is the break-up potential of Rio Tinto a business loaded with near-priceless world-class assets.

A ‘sum of the parts’ exercise must be fascinating the privateers as the following snapshot shows.

• Rio Tinto Iron Ore posted earnings before tax and other charges in the six months to June 30 of $US1.66 billion. So, lets assume full-year EBITDA of $US3.3 billion.

• Rio Tinto Copper posted pre-tax earnings of $US2.79 billion. So, let’s assume full year EBITDA of $US5.6 billion.

At the old 12-times rule for valuing assets (pre-tax earnings times 12) the iron ore division of Rio Tinto is worth $US39 billion, and Rio Tinto Copper is worth $67 billion – combined, they’re worth $US106 billion – or more than double the value of the entire Rio Tinto group.

Of added interest, Briefcase has not run the numbers on Rio Tinto Energy, aluminium, diamonds, industrial minerals and other bits and pieces of the group, which combined to produce the half-year EBITDA of $US6.2 billion (say $US12 billion for the year) which, at 12 times, values Rio Tinto at $US144 billion.

This exercise, obviously, has more leaks in it than Alan Carpenter’s cabinet. But, it is the type of exercise that the privateers will be running.

Why? Because they have the cash, because they must spend it, because they are prepared to break-up a business and sell the parts, and above all else, because they can.

Barbarians are indeed at the gates of Australia’s biggest businesses.

•••

“Moral indignation is jealousy with a halo.” H.G. Wells

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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