Monday, June 23, 2008

BHP/Rio Tinto

In November, the huge Australian mining company BHP Billiton announced a bid to acquire a rival company, the Rio Tinto Group, with a 3-to-1 share swap. In other words, it wanted Rio stockholders to turn in each of their shares for three shares of the new, larger, combined company.

The offer was sweetened a bit in February (3.4 to 1) and in that form is still on the table. Oddly, the prices of the two companies haven't really been trading as if the market finds this offer credible.

If there were a significant amount of arb activity, and a general expectation that the deal would go through, one would expect that the price of a share of Rio stock on the market would be, roughly, 3.4 times the value of a share of BHP stock. So if (just choosing my numbers to make the math easy here) BHP is trading for Aus$40 on a given day, you'd expect to see Rio shares trading for Aus$136.

Why? Because there's a good deal of speculative activity out there that is specifically in the merger arb business. (Sometimes, much less fittingly, called "risk arb," a usage I'll ignore). If the two company's market valuation got out of line, you'd expect the people and institutions in the merger arb business to act on it. Suppose, in may example, BHP is at $40 and Rio is a good deal lower than the valuation implicit in the 3.4 to 1 ratio. Suppose Rio went to $80, which implies a 2:1 ratio. What would happen?

The merger arbs would move in and buy Rio shares like mad. They'd do so in the expectation of being able to trade in each one for their 3.4 shares of BHP -- getting a return of $136 for each investment of $80, an easy $56 if ever there was one. The very fact of their moving in to do this would constitute an increase of demand for the stock of course, increasing its price -- forcing its price up to the level dictated by that 3.4 offer.

To repeat, that's what would happen IF two conditions obtained: there was a general expectation the deal would close, and there was a lot of arb activity.

Apparently one or both of those conditions is missing. Rio is trading at a discount of more than 8% to where it "should" be on such reasoning. Why? I'm guessing the market believes regulators in one or another of the many affected jusridictions will intervene and stop or complicate the deal.

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