$90 Billion Glencore-Xstrata Powerhouse To Go Ahead After Increased Offer

Sep.10.12 | About: Glencore Plc (GLCNF)

Before its May 2011 IPO on the London Stock Exchange, and a secondary float on the Hong Kong Stock Exchange, Glencore International Plc's (OTCPK:GLCNF) business dealings were typically described as secretive. This is understandable, as the company was famously known for its lack of disclosure. The world's largest commodities trading company, with a 60% global market share in the internationally tradeable zinc market, 50% in the tradeable copper market, 9% in the tradeable grain market and 3% in the tradeable oil market, was often referred to as the Goldman Sachs of the commodities world. Elusive, but highly successful.

This closely held partnership, best-known in North America for its high-profile March 2012 takeover of Canada's biggest grain handler Viterra (OTC:VTRAF), was launched in 1974 by founder Marc Rich under his own name. Not that Glencore likes to mention Rich, as he is considered rather notorious and as such is not even mentioned in the official history on Glencore's website. Rich escaped Nazi Europe as a seven-year-old, and grew up in the United States. Rich grew to become something of a sensation and some even credit him with the invention of the spot market for crude oil. By 1983, however, U.S. authorities had charged him with evading taxes and selling oil to Iran during the 1979-1981 hostage crisis. Marc Rich fled to Switzerland, where he lived as a fugitive for 17 years.

Rich has always insisted he did nothing illegal and he was officially pardoned by President Bill Clinton on his last day in the White House in January 2001. Among those who lobbied on his behalf were names like Ehud Barak and Shimon Peres, according to a book by journalist Daniel Ammann. But by 2001 Marc Rich & Co. had already long changed its name to Glencore International after management had bought out Rich in 1994. Since 1974 the company had slowly become a leader in sourcing, marketing and trading commodities, now employing thousands of people.

Glencore's enigmatic status finally changed when the company went public last year four times oversubscribed, with proceeds subsequently directed at further expansion, capex for three years, and an increased stake in zinc producer JSC Kazzinc from 50.7% to 90.3%. The listing was LSE's largest ever international IPO, with a market capitalization of $59.3 billion (£36.5 billion GBP) at the IPO-price of 530 pence, which made Glencore the first company in 25 years to enter the FTSE 100 Index on admission.

At the time it was already widely anticipated that longer term Glencore would attempt to take full control of mining group Xstrata Plc (OTC:XSRAF) (OTC:XSRAY), in which it already holds a 34% stake. Pre-IPO Glencore's CEO Glasenberg said: "We've always said there would be good value in putting the two companies together but this is not a decision for today."

Glencore's 2011 profits came in at $4 billion, slipping from $4.3bn in 2010, hit by cotton trading losses in the second half of last year, even as generally stronger commodity prices and increased production pushed revenue up 28% to $186.2 billion.

Under the original offer of 2.8 shares Glencore for every Xstrata share, Xstrata's Mick Davis, a mining veteran, would have taken the job of chief executive of the combined group. Davis, who has held the top job at Xstrata for a decade, has build Xstrata up from a $500 million collection of zinc and ferrochrome assets into the world's fourth-largest diversified miner.

In 2011, Xstrata's revenue increased by 11% to nearly $34 billion. Record operational cash flows substantially funded the accelerating organic growth program. Profit increased by 12% to $5.8 billion and EPS came in at $1.97.

Under the raised $36 billion all-share bid, a last-minute concession to recalcitrant Xstrata shareholders after last-ditch talks with Qatar Holding, Glencore is now offering 3.05 new shares for every Xstrata share held. That represents a 27% premium to the ratio at which the two companies were trading last week. Xstrata's independent directors will respond by 06:00 GMT on September 24 after consulting with major shareholders. Glencore has said it will not improve the terms again.

The new offer retains a merger structure, board balance and a retention scheme for the miner's top managers, but under the revised terms Glasenberg will take over as chief executive of Glencore-Xstrata after an interim period of six months under Davis. Glencore has also asked the independent Xstrata board to consider what, if any, changes they would propose to the retention and incentive arrangement packages to ensure that they are acceptable to independent Xstrata shareholders,

The Glencore-Xstrata merger comes 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," 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.

The combined group 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 a combined Glencore-Xstrata 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.

Glencore-Xstrata 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. The group will want to buy a big enough iron ore produce if they are serious about getting a foothold in the iron ore market.

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 "off take" 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.

Glencore-Xstrata 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. On March 5, 2012, during announcement of the full-results for 2011, Glasenberg mentioned improved market conditions, 2012 starting well across all segments of Glencore's business.

According to Glasenberg "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.."

There will certainly be much more discussion on the merits of the Glencore-Xstrata tie-up and the relative value for investors in each firm. European steelmakers group Eurofer, which includes members like the world's largest steelmaker, ArcelorMittal (MT) and Germany's largest steel producer ThyssenKrupp (OTCPK:TYEKF), has indicated its concern that a combined Glencore-Xstrata could 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 possible complications, Glencore's and Xstrata's results speak for themselves. At the time of writing, GLEN:LSE is trading at 373.35 pence on the London market. That gives Glencore a current P/B of 1.2, a P/S of 0.2, and a P/E of 7.3. Dividend yield stands at 2.56%. XTA:LSE is trading at 1,037.13 on the London market, which translates into a P/B of 1.0, a P/S of 1.5, and a P/E of 9.4. Current dividend yield is 2.28%.

Glencore had been a privately run company of 37 years before its May 2011 IPO. The company 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. A combined Glencore-Xstrata will create a business with over $210 billion in sales, bringing together Glencore's global trading network for energy, metals and farming products with Xstrata's coal, copper and zinc mines.

Synergies from the merger are expected to deliver annual gains of $500 - $600 million, which will mainly come from putting Xstrata production into Glencore's marketing and trading system. Investing in a post-merger Glencore means investing in a company unlike any other in this space. Glencore-Xstrata will be a combined group with a huge amount of flexibility and capabilities to get value from exploration to delivery.

Disclosure: I am long OTCPK:GLCNF, OTC:XSRAY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.