'Glenstrata' - Bigger Is Better

by: Ramon Vredeling

Glencore (GLCNF.PK) and Xstrata (XSRAY.PK), set to create a $90 billion mining powerhouse, are going on the offensive. I'm not referring to Glencore's $5.5 billion approach for Canada's biggest grain handler Viterra (OTC:VTRAF) announced Friday afternoon, although certainly another great move on Glencore's part. I'm talking an actual 'charm' offensive. Ivan Glasenberg, the multi-billionaire CEO of commodities group Glencore, is planning a global investor road show with Xstrata boss Mick Davis in an effort to win over investors reluctant to back their "merger of equals".

The planned charm offensive came alongside Glencore announcing its first set of full-year results as a public company, in which it gave no indication that it would sweeten its offer for the miner Xstrata. Glencore already owns 34% of Xstrata and is offering 2.8 Glencore shares for every Xstrata share it doesn't yet own. Glasenberg said:

In April Mike and myself will go on a road show to convince investors ... A lot of Xstrata shareholders are not shareholders of Glencore. A lot think Glencore has not got 'tier one' assets. We have got to educate them that Glencore has got tier one assets.

The commodity trader reported a 106% increase in basic earnings per share to $0.72 for the year ended December 31, 2011 from 35 cents a year ago. A final dividend of $0.10 per share has been proposed, bringing the total dividend for the year to 15 cents. Revenue was 28% higher at $186.1 billion, while adjusted earnings before interest, tax, depreciation and amortization [EBITDA] was up 4% at $6.46 billion.

The latest efforts by Glasenberg to sell the Xstrata merger - a deal which was widely understood to be the reason the company floated last year - come at a time were the two companies are putting iron ore at the top of their post-merger to-do list, building up the one key commodity where they are all but absent. Iron ore has become a major contributor to diversified miners' profits, making up between 40 and 70% of earnings at Anglo American (AAUKF.PK), Rio Tinto (RIO) and BHP Billiton (NYSE:BHP).

Traders and banks are piling in, due to large physical trading volumes alongside increasing trade volatility, and China's and India's appetite for steel as they expand cities, power lines and rail links. In a sign of its intentions, Glencore in January decided to put iron ore into a separate business arm. It seems Glencore's traders have been given a clear indication of the aim: build coal, part II.

"When I was in the coal business, people told me it was too late to develop the coal business because it was already owned by the majors and there wasn't a way in," Glencore CEO Glasenberg recently commented.

There is always a way in, there will be opportunities, you just have to find them. Today with the amount of iron ore opportunity in Africa, and development in Africa, it is definitely not too late.

Coal has been a success story for both Glencore and Xstrata, with both Glasenberg and Davis having built their careers in the commodity. The two will control virtually a third of the world's seaborne thermal coal trade and will become the top exporter. Few would bet against Glasenberg, but with Glencore's share of the seaborne iron ore market less than 1%, some say it may be tough to crack a market dominated by Vale (VALE), Rio and BHP, currently holding approximately 60% of the market.

'Glenstrata' will have aspirations of a 15-20% (trading) market share like it tries to aim for in other commodities. The challenge of course is what you can buy, and becoming a $90 billion powerhouse has its advantages in that respect. Iron ore valuations are high, with tough competition for assets that include infrastructure and are either producing or close to first production. Precisely the sort of project Glencore and Xstrata would like to immediately boost to volumes and profit. Xstrata last year exercised an option to buy a majority stake in the Zanaga project in the Republic of Congo and bought junior miner Sphere Minerals [SPH:ASX] in Mauritania.

Glencore and Xstrata have already considered a string of projects and companies, with iron ore prices hovering around three or four times the cost of mining, but no major deal has yet made the grade. There's some speculation in the market that 'Glenstrata' could seriously consider acquiring Anglo American in the future, but given Anglo American's current market cap of $53.5 billion that deal is a bit too rich to shoot for right away.

Few expect Glencore to just wait for Xstrata's early stage iron ore projects to produce as the ultimate prize for Glencore is not production but trading potential. And it will be impossible for Glencore to become an iron ore heavyweight without it boosting volumes. Glencore has traded iron ore since 2008, when the trading of iron ore swaps began, but in 2011 it traded just 10.3 million tons. Only a fraction of what is a 1.1 billion ton market.

Glenstrata could possibly get as much as 15 million tons a year from smaller producers, but really needs to leap above the 50 million tons. The bulk of what the big three miners produce is sold through long-term contracts, making it imperative for Glencore to secure its own contract with them or its own source of production. 'Glenstrata' will want to buy a big enough iron ore produce if they are serious about getting a foothold in the iron ore market, and many in the market seem to agree that Fortescue Metals Group (FSUMY.PK) is a prime candidate.

Buying Fortescue Metal Group Ltd, Australia's third-largest iron ore producer, would secure some 55 million tons of annual output in a stroke and the potential to triple that, but there are more buyers sniffing around. If Glencore is interested in these assets, it will face competition. A mystery buyer last month snapped up 2.9% of Fortescue, which has a market value of approximately $18 billion.

The situation to their entry into coal is different from a few years ago. You have to pay top dollar for iron ore mines now, whereas in the past mines were cheap. The solution for Glencore may be to follow the same path with iron ore as they did previously with copper. That will mean swooping in to rescue smaller, cash-strapped, iron ore miners in West Africa, repeating the 'offtake' and financing deals that gave Glencore a toe-hold in African mining assets and eventually, via debt-for-equity swaps, its current portfolio of high-grade Congolese copper assets.

We will have to wait and see what the future holds for Glencore. The new company, Glencore Xstrata International, will certainly be one of the most diverse major resource groups around, which should provide ongoing value for its shareholders. The industrial business continues to benefit from stronger average prices for the key commodities it produces as well as the planned increase in production at many operations including Prodeco, Katanga, Kazzinc and Mutanda.

During announcement of the full-results for 2011 Glasenberg mentioned that thus far in 2012, market conditions have improved and the year has started well across all segments of Glencore's business.

Emerging market urbanization will continue to increase commodity intensity per capita as the demand for goods and products that industrialized societies take for granted increases. This demand dynamic alongside the strength of our organic growth prospects will continue to be a fundamental driver of our business in 2012.

There will certainly be much more discussion on the merits of the tie-up and the relative value for investors in each firm before major investors in Xstrata decide whether to ultimately reject or back the deal. European steelmakers group Eurofer, which includes members like the world's largest steelmaker, ArcelorMittal (MT) and Germany's largest steel producer ThyssenKrupp, has indicated its concern that a combined Glencore Xstrata may harm competition in the zinc, nickel and coal markets, and that Eurofer may therefore decide to file an antitrust complaint with the European Commission.

Regardless of these possible complications, Glencore's results speak for themselves and if we look at the company's market valuation at this time, with increased revenue, EPS, dividend, a P/B of 1.52, and a P/E of 8.95, it seems this company provides an attractive value proposition at present and is certainly making all the right moves to increase shareholder returns well into the future.

I will end with this excerpt from my first SA article on Glencore International written a little over six months ago:

What you get with Glencore is a bit of a one-of-a-kind investment, a specialized company in an unusual sector and a business that investors do not typically have a chance to get exposure to. Marc Rich & Co and subsequently Glencore has been a privately run company of 37 years and made a truckload of money along the way, which clearly shows they know what they're doing and with a bit more market intelligence than most. It's obviously extremely well run and its IPO has given Glencore just that bit more firepower for further acquisitions and will allow them to do larger deals.

It's safe to say this still holds true today.

Disclosure: I am long OTCPK:GLCNF, BBL, MT, and GLEN.L (LSE).