Market bets that BHP will walk

Fat Prophets are well established commodity bulls and currently one of the resource sector's biggest bargains in our view is Rio Tinto (RTP). Not only has this mining giant been knocked significantly over recent weeks by stock market turmoil, markets are now betting that BHP will choose to defer any potential corporate play for Rio for at least six months. With a February 6 deadline looming for BHP to either 'put up or shut up', most of the takeover premium that was in Rio's share price appears to have leaked away.

"We by no means believe that BHP has given up on Rio. We firmly believe that they'll be back."

The charts below illustrate this point. Despite volatility over the past three months, we believe the longer term outlook remains positive for Rio. Following the initial takeover offer from BHP in November, the share price spiked to an intraday high of $484.21. However, since this high, prices have corrected as much as 35% touching a low of $310.44 on Tuesday.

Although there remains a high probability of further volatility in the weeks ahead, we believe that the stock is currently oversold. Accordingly, while prices remain above support in the $330 to $310 region, we anticipate a near-term rebound.

As evident on the weekly chart, a strong upward trend has been in place for close to a decade. While the falls of the past month have clouded the near-term outlook, we believe that the longer-term upward trend remains intact with potential remaining for further gains in the years ahead.

The events on world stock markets over recent weeks have unearthed some real bargains, with Rio Tinto being one of them. Speculators hoping for a quick profit by way of an imminent takeover offer by BHP Billiton will be bitterly disappointed in our view, but for other investors this presents a buying opportunity.

Rio's shares have been hit by a double-whammy recently. Not only have they been subject to market volatility, but also the substantial share price premium associated with potential BHP takeover activity appears to have well and truly ebbed away. This is not surprising in our view.

It was our view from the outset that BHP's original 3-for-1 scrip offer was unlikely to attract market support as it undervalued Rio. In our most recent coverage of Rio late last year, the company's CEO Tom Albanese described BHP's bid as being 'dead in the water'.

He also made it perfectly clear that BHP would have to stump up with a significantly enhanced offer for Rio to have any interest.

Rio has been extremely canny with respect to its defense, going firmly on the front foot and applying to the UK Takeover Panel to effectively get BHP to put up or shut up with respect to its corporate ambitions.

In our view it is obvious that BHP's CEO Marius Kloppers would not want to be seen to be dancing to Rio's tune, effectively dictating terms to its pursuer. To mount a bid within the February 6 deadline would be a rushed strategy in our view, particularly given the current turmoil on international equity markets.

In a sense the current fallout is a blessing in disguise for BHP. It gives it another justification to walk away from a bid in the short-term, without looking as though it's being bullied by Rio.

Furthermore, given BHP's offer needed sweetening (most likely with a cash component), it is unlikely in the current market that funding would have been easily forthcoming. After all, most US investment banks are busy raising cash themselves to stave off potential insolvency, let alone finding tens of billions of dollars to fund BHP's takeover ambitions.

Despite rumors in some quarters that BHP is hurriedly preparing an offer, our view is that the February 6 deadline will pass without a bid being lodged and that the status quo will be maintained for the next six months.

As we've previously stated, we believe it's unlikely that BHP will walk away indefinitely, as that would be seen virtually as an admission of defeat. However, it is also clear that BHP's offer will not succeed in its current form. We reiterate our view that Rio Tinto remains in a position of strength as far as the whole saga is concerned.

From an operational perspective, things are going extremely well for Rio, as its December quarter production report attests. Rio's key commodities are iron ore, aluminum and copper, which all recorded solid performances. Record annual output levels were achieved for iron-ore, aluminum and refined copper as well as bauxite, alumina and refined gold.

Furthermore, Mr Albanese pointed to an acceleration of sales growth during 2008. Like us, he is of the belief that Chinese commodity demand will stand up strongly in the face of US economic uncertainty.

Rio Tinto's iron ore production set a new annual record at 179 million tonnes during 2007. On an attributable basis, 2007 iron ore production was 145 million tonnes, 9% up on 2006. Fourth quarter attributable iron ore production was also a record, 11 per cent ahead of the fourth quarter of 2006 and seven per cent up on the previous quarter of 2007.

The Pilbara operations in Western Australia continued their rapid expansion, with the Hamersley mines raising production by 17% compared with the fourth quarter of 2006. At the end of December 2007, the Pilbara ports were operating at a rate of 190 million tonnes per annum (164 million tonnes on an attributable basis).

Rio Tinto's newest iron ore mine, Hope Downs, commenced production in November 2007, three months ahead of schedule. With the first expansion already approved, it is expected to reach 30 million tonnes annual capacity in 2009 - a rapid and sizeable increment to production in the Pilbara.

Fourth quarter bauxite, alumina and aluminum production were at record levels, increasing by 74%, 133% and 287% respectively compared with the same quarter in 2006. This is hardly surprising following the Alcan acquisition and the subsequent integration with effect from 24 October 2007. On a pro-forma basis, excluding the Alcan acquisition, quarterly and annual production records were set for bauxite and aluminum.

Given the solid operational performance to date and the outlook for future expansion within the robust resource sector, Rio Tinto will remain firmly held within the Fat Prophets portfolio. For Members without exposure we recommend the stock as a long term buy around $354.

Disclosure: Interests associated with Fat Prophets declare an interest in Rio Tinto