A Takeover Game Worth Staking a Claim

03/07/2012 9:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

The world of mining is in great transition across the globe, and below is a unique play on a very interesting stock, writes Roger Conrad in Global Investment Strategist.

We’ve held Xstrata (London: XTA) in our Metals and Mining Portfolio for roughly a year now. Thus far, the position has outperformed many mining stocks, surging 62% after hitting a low in early October. The position, however, is still underwater by about 11.7% in US dollar terms.

The question is whether we should continue holding the stock now that the company is the target of a takeover by 34% owner Glencore International (London: GLEN). Our considered answer is yes.

In fact, Xstrata remains a buy up to 1500 pence on the London Stock Exchange, or alternatively up to $5 through its unsponsored American Depositary Receipt (ADR), which is traded under the symbol XSRAY. Five Xstrata ADRs are worth one ordinary share traded in London.

Glencore also has an unsponsored ADR (GLNCY), which ensures adequate liquidity will prevail on both sides of the pond if this deal gets done. Its ADRs are worth two ordinary shares traded in London.

The two companies have been rumored merger partners for several years, under the rationale that Glencore’s expertise in metals marketing and trading would be the perfect complement to Xstrata’s immense mineral wealth. Things got serious in early February, when Glencore offered 2.8 shares for each Xstrata share it didn’t already own. That’s a value of roughly 1216 British pence per share, or $3.78 per ADR based on Glencore’s current price.

Several major Xstrata investors have claimed that price isn’t high enough, and they have a point. Xstrata ADRs sold in the low teens in mid-2008, and strong resource prices alone have arguably increased the company’s value since then.

Moreover, the premium in this deal is only about 8% above where the stock was trading before the offer, making it the second-lowest premium for any mining deal worth more than $5 billion, according to data compiled by Bloomberg.

There’s no guarantee the price will go higher. But the math does appear to work in Xstrata shareholders’ favor: Only 16.48% of the voting shares can block the deal, as Glencore won’t be allowed to vote its stake.

That number doesn’t appear difficult to make, given statements from several major shareholders. For example, Fidelity Worldwide Investment’s official statement is that the terms of the deal “need to be revisited,” though the owner of 1.6% of Xstrata shares is “supporting the deal in principle.” That follows similar comments by Standard Life and Schroders, who together own 3.5% of shares, and have hinted they’ll approve the deal on a higher offer.

My view is we’ll likely see at least a marginally higher offer, though perhaps not as high as an offer of 3.2 Glencore shares that some appear to be seeking. But the real value of this deal for shareholders will be based upon how well the two halves of this company work together. And that does appear to be quite favorable.

The combined company will have $209 billion in sales, giving it scale to match giants BHP Billiton (BHP) and Rio Tinto (RIO). It will also have marketing channels that pair can’t match, as well as projects in 33 countries with 101 mines, a fleet of more than 200 vessels to ship product, and some 130,000 employees.

Glencore’s business is inherently volatile, demonstrated by management’s recent estimate that last year’s earnings dropped 18% due to losses at its agriculture division. Xstrata’s earnings are also somewhat volatile, because they depend on natural resource prices as much as successful execution of project management and expansion. Xstrata’s earnings before exceptional items rose 12% last year, but were nonetheless impacted by costs and erratic selling prices.

The precedent for “knowledge”-based companies combining with asset-based counterparts generally shows that profits are more volatile than the asset company’s on a standalone basis.

But they’re also far less volatile for the trading half, which now has real output to use as a peg. And the ability to market effectively can also be a valuable hedge against volatile commodity prices, just as super oils’ downstream operations leaven earnings volatility over time.

In this case, Glencore would have major holdings of copper, coal, and zinc to sell into its network for energy, metals, and farming products. And it would provide a major push in financial power for Xstrata’s own effort to expand mining efforts.

Synergies resulting from the deal could mean annual gains of $500 million to $600 million in the near term alone. And it would boast mining, processing, storage, freight, logistics, marketing, and sales expertise.

Xstrata CEO Mick Davis has been making the rounds pitching the deal’s merits, even as the company works through European Union approvals. The latter appears highly likely, since this deal does not restrict competition in any way or eliminate a competitor. And Davis has a history of making deals work, having helped orchestrate one of the most successful in mining industry history: BHP Billiton in 2001.

That makes the odds of a deal here good, which would include a higher offer for Xstrata. And it will create a larger, stronger company able to meet the ever-increasing need for scale in this industry.

That’s an outcome that makes it worth sticking around. Hold Xstrata if you already own it, and buy shares up to $5 (or 1,500p in London) if you don’t. Note that we’re not advising tendering your shares unless the large shareholders accept a higher offer.

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